The Core of Macroeconomic Theory

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The Core of Macroeconomic Theory
Chapters 19-20
The Market forGoods and Services Planned aggregate expenditure Consumption (C) Investment (I) Government spending (G) Net exports (EX IM) Aggregate output (income) (Y) Equilibrium output (income) (Y) Chapter 23 Chapter 24 Chapter 25
The Market forGoods and Services Planned aggregate expenditure Consumption (C) Investment (I) Government spending (G) Net exports (EX IM) Aggregate output (income) (Y) Equilibrium output (income) (Y) Connections between the goods market and the money market r Y Aggregate Demand and Aggregate Supply Aggregate demand curve The Labor Market The supply of labor The demand for labor Employment and unemployment
Chapters 21-22 Aggregate supply curve
The Money Market The supply of money The demand for money Equilibrium interest rate (r)
Equilibrium price level (P)

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Aggregate Output andAggregate Income (Y)

• Aggregate output is the total quantity of goods
  and services produced (or supplied) in an economy
  in a given period.
• Aggregate income is the total income received by
  all factors of production in a given period.

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Aggregate Output andAggregate Income (Y)

• Aggregate output (income) (Y) is a combined term
  used to remind you of the exact equality between
  aggregate output and aggregate income.
• When we talk about output (Y), we mean real
  output, not nominal output. Output refers to the
  quantities of goods and services produced, not
  the dollars in circulation.

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Income, Consumption,and Saving (Y, C, and S)

• A household can do two, and only two, things with
  its income It can buy goods and servicesthat
  is, it can consumeor it can save.
• Saving is the part of its income that a household
  does not consume in a given period.
  Distinguished from savings, which is the current
  stock of accumulated saving.

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Saving / Aggregate Income - Consumption

• All income is either spent on consumption or
  saved in an economy in which there are no taxes.

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Explaining Spending Behavior

• Some determinants of aggregate consumption
  include
• Household income
• Household wealth
• Interest rates
• Households expectations about the future
• In The General Theory, Keynes argued that
  household consumption is directly related to its
  income.

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A Consumption Functionfor a Household

• The relationship between consumption and income
  is called the consumption function.

• The consumption function for an individual
  household shows the level of consumption at each
  level of household income.

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An Aggregate Consumption Function

• For simplicity, we assume that points of
  aggregate consumption, when plotted against
  aggregate income, lie along a straight line.

• The slope of the consumption function (b) is
  called the marginal propensity to consume (MPC),
  or the fraction of a change in income that is
  consumed, or spent.

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An Aggregate Consumption FunctionDerived from
the Equation C 100 .75Y

• At a national income of zero, consumption is 100
  billion (a).
• For every 100 billion increase in income (DY),
  consumption rises by 75 billion (DC).

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An Aggregate Consumption FunctionDerived from
the Equation C 100 .75Y
AGGREGATEINCOME, Y(BILLIONS OF DOLLARS) AGGREGATEINCOME, Y(BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C(BILLIONS OF DOLLARS) AGGREGATE CONSUMPTION, C(BILLIONS OF DOLLARS)
0 100
80 160
100 175
200 250
400 400
400 550
800 700
1,000 850
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Consumption and Saving

• Since there are only two places income can go
  consumption or saving, the fraction of additional
  income that is not consumed is the fraction
  saved. The fraction of a change in income that
  is saved is called the marginal propensity to
  save (MPS).

• Once we know how much consumption will result
  from a given level of income, we know how much
  saving there will be. Therefore,

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Deriving a Saving Functionfrom a Consumption
Function
AGGREGATEINCOME, Y AGGREGATEINCOME, Y AGGREGATE CONSUMPTION, C AGGREGATE CONSUMPTION, C AGGREGATE SAVING, S AGGREGATE SAVING, S
(ALL IN BILLIONS OF DOLLARS) (ALL IN BILLIONS OF DOLLARS) (ALL IN BILLIONS OF DOLLARS) (ALL IN BILLIONS OF DOLLARS) (ALL IN BILLIONS OF DOLLARS)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
400 550 50
800 700 100
1,000 850 150
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Planned Investment (I)

• Investment refers to purchases by firms of new
  buildings and equipment and additions to
  inventories, all of which add to firms capital
  stocks.
• One component of investmentinventory changeis
  partly determined by how much households decide
  to buy, which is not under the complete control
  of firms.

change in inventory production sales
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Planned Investment (I)

• Desired or planned investment refers to the
  additions to capital stock and inventory that are
  planned by firms.
• Actual investment is the actual amount of
  investment that takes place it includes items
  such as unplanned changes in inventories.

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Planned Investment (I)

• For now, we will assume that planned investment
  is fixed. It does not change when income
  changes.
• When a variable, such as planned investment, is
  assumed not to depend on the state of the
  economy, it is said to be an autonomous variable.

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Planned Aggregate Expenditure (AE)

• To determine planned aggregate expenditure (AE),
  we add consumption spending (C) to planned
  investment spending (I) at every level of income.

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Equilibrium Aggregate Output (Income)

• In macroeconomics, equilibrium in the goods
  market is the point at which planned aggregate
  expenditure is equal to aggregate output.

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Equilibrium Aggregate Output (Income)

• aggregate output / Yplanned aggregate
  expenditure / AE / C Iequilibrium Y AE, or
  Y C I

Disequilibria
Y gt C I aggregate output gt planned aggregate
expenditureInventory investment is greater than
planned.Actual investment is greater than
planned investment.
C I gt Yplanned aggregate expenditure gt
aggregate outputInventory investment is smaller
than planned.There is unplanned inventory
disinvestment.
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Inventory Adjustment
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Deriving the Planned Aggregate Expenditure
Schedule.
Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C 100 .75Y. Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C 100 .75Y. Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C 100 .75Y. Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C 100 .75Y. Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C 100 .75Y. Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C 100 .75Y.
(1) (2) (3) (4) (5) (6)
AGGREGATEOUTPUT(INCOME) (Y) AGGREGATECONSUMPTION (C) PLANNEDINVESTMENT PLANNEDAGGREGATEEXPENDITURE (AE)C I UNPLANNEDINVENTORYCHANGEY - (C I) EQUILIBRIUM?(Y AE?)
100 175 25 200 - 100 No
200 250 25 275 - 75 No
400 400 25 425 - 25 No
500 475 25 500 0 Yes
600 550 25 575 25 No
800 700 25 725 75 No
1,000 850 25 875 125 No
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Finding EquilibriumOutput Algebraically
There is only one value of Y for which this
statement is true. We can find it by rearranging
terms
By substituting (2) and (3) into (1) we get
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The Saving/InvestmentApproach to Equilibrium

• Saving is a leakage out of the spending stream.
  If planned investment is exactly equal to saving,
  then planned aggregate expenditure is exactly
  equal to aggregate output, and there is
  equilibrium.

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The S I Approach to Equilibrium

• Aggregate output will be equal to planned
  aggregate expenditure only when saving equals
  planned investment (S I).

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The Multiplier

• The multiplier is the ratio of the change in the
  equilibrium level of output to a change in some
  autonomous variable.
• An autonomous variable is a variable that is
  assumed not to depend on the state of the
  economythat is, it does not change when the
  economy changes.
• In this chapter, for example, we consider planned
  investment to be autonomous.

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The Multiplier

• An increase in planned investment causes output
  to go up. People earn more income, consume some
  of it, and save the rest.
• The multiplier of autonomous investment describes
  the impact of an initial increase in planned
  investment on production, income, consumption
  spending, and equilibrium income.

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The Multiplier

• The size of the multiplier depends on the slope
  of the planned aggregate expenditure line.

• The marginal propensity to save may be expressed
  as

• Because DS must be equal to DI for equilibrium to
  be restored, we can substitute DI for DS and
  solve

therefore,
, or
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The Multiplier

• After an increase in planned investment,
  equilibrium output is four times the amount of
  the increase in planned investment.

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The Multiplier

• In reality, the size of the multiplier is about
  1.4. That is, a sustained increase in autonomous
  spending of 10 billion into the U.S. economy can
  be expected to raise real GDP over time by 14
  billion.

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The Paradox of Thrift

• When households are concerned about the future
  and plan to save more, the corresponding decrease
  in consumption leads to a drop in spending and
  income.

• In their attempt to save more, households have
  caused a contraction in output, and thus in
  income. They end up consuming less, but they
  have not saved any more.