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Economics, Arab World Edition

R. Glenn Hubbard, Anthony Patrick O’Brien, Ashraf Eid, Amany El Anshasy,

Chapter 19Output and Expenditure in the Short Run

pp: 617-625

The Fluctuating Demand in the Arab World: The Effects of the Recent Global Financial Crisis

19.1 Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

19.2 Discuss the determinants of the four components of aggregate expenditure and define the marginal propensity to consume and the marginal propensity to save.

19.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium.

19.4 Define the multiplier effect and use it to calculate changes in equilibrium GDP.

19.5 Understand the relationship between the aggregate demand curve and aggregate expenditure.

APPENDIX Apply the algebra of macroeconomic equilibrium.

Learning Objectives

The greater openness and links to the global economy increased Arab countries’ exposure to global downturns.

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Output and Expenditure in the Short Run

Aggregate expenditure (AE) The total amount of spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

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The Aggregate Expenditure Model

Aggregate expenditure model A macroeconomic model that focuses on the relationship between total spending and real GDP, assuming that the price level is constant.

Aggregate Expenditure

Learning Objective 19.1

• Consumption (C)

• Planned Investment (I)

• Government Purchases (G)

• Net Exports (NX)

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The Aggregate Expenditure Model

Aggregate expenditure = Consumption + Planned investment + Government purchases + Net exports

Aggregate Expenditure

Learning Objective 19.1

or:

AE = C + I + G + NX

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The Aggregate Expenditure Model

Inventories Goods that have been produced but not yet sold.

The Difference between Planned Investment and Actual Investment

Learning Objective 19.1

Aggregate expenditure = GDP

Macroeconomic Equilibrium: Occurs where total spending, or AE equals total production, or GDP

In the short run, we assume that the economy is not growing then the equilibrium GDP will not change unless AE changes.

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The Aggregate Expenditure ModelAdjustments to Macroeconomic Equilibrium

Learning Objective 19.1

IF … THEN … AND …Aggregate expenditure isequal to GDP

inventories areunchanged

the economy is inmacroeconomic equilibrium.

Aggregate expenditure isless than GDP inventories rise

GDP and employmentdecrease.

Aggregate Expenditure isgreater than GDP inventories fall

GDP and employmentincrease.

Table 19-1The Relationship between Aggregate Expenditure and GDP

So an increase or decreases in AE cause changes in GDP, thus to be able to understand macroeconomic equilibrium, it is important to understand what are the factors that determining AE?

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Determining the Level of Aggregate Expenditure in the Economy

Learning Objective 19.2

TABLE 19-2Components of Real AggregateExpenditure, 2007

Source: WDI 2010, World Bank.

AE = C + I + G + NX

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Determining the Level of Aggregate Expenditure in the Economy

Learning Objective 19.2

Consumption

FIGURE 19-1Kuwait’s Real Consumption,1970–2008

Consumption follows an upward trend, interruptedonly infrequently by recessions.

Source: Country National Accounts, United Nations, 2009.

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Determining the Level of Aggregate Expenditure in the Economy

Learning Objective 19.2

• Current disposable income

• Household wealth

• Expected future income

• The price level

• The interest rate

1. Consumption

The following are the five most important variables that determine the level of consumption:

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Determining the Level of Aggregate Expenditure in the Economy

Learning Objective 19.2

The most important determinant of consumption is the current disposable income of households.

disposable income: the income remaining to households after they have paid income tax and received government transfer payments.

Consumption:Current Disposable Income

Household Wealth

Consumption also depends on the wealth of households.

A household’s wealth is the value of its assets( home, stock, bond& bank accounts) minus the value of its liabilities (loans that it owes).

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Determining the Level of Aggregate Expenditure in the Economy

Learning Objective 19.2

Consumption also depends on expected future income. Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly.

Consumption:

Expected Future Income

The Price Level

The price level measures the average prices of goods and services in the economy. Consumption is affected by changes in the price level.

The Interest Rate

When the interest rate is high, the reward to saving is increased, and households are likely to save more and spend less.

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Learning Objective 19.2

Consumption function : The relationship between consumption spending and disposable income.

Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

Change in consumptionChange in disposable income

CMPCYD

Determining the Level of Aggregate Expenditure in the Economy

C= f (YD)

The Consumption Function

Consumption

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Learning Objective 19.2

Change in consumptionChange in disposable income

MPC

or

Change in consumption = Change in disposable income × MPC

Determining the Level of Aggregate Expenditure in the Economy

The Consumption Function

Example: between 2013 and 2014, consumption increased by \$30 billion, while YD increased by \$33 billion. Find MPC?

MPC = ΔC/ ΔYD = 30/33 = 0.90

We can also use the MPC to determine how much consumption will change as income changes:

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Learning Objective 19.2

We can rearrange the equation like this:

National income = GDP = Disposable income + Net taxes

Disposable income = National income − Net taxes

Determining the Level of Aggregate Expenditure in the Economy

The Relationship between Consumption and National Income

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Learning Objective 19.2

FIGURE 19-2The Relationship between Consumption and National Income

Determining the Level of Aggregate Expenditure in the Economy

The Relationship between Consumption and National Income

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Learning Objective 19.2

National income = Consumption + Saving + Taxes

Change in national income = Change in consumption + Change in saving + Change in taxes

Y = C + S + T

Determining the Level of Aggregate Expenditure in the Economy

Income, Consumption, and Saving

TSCY

and

To simplify, we can assume that taxes are always a constant amount, in which case ΔT = 0, so the following is also true:

ΔY = ΔC + ΔS

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Learning Objective 19.2

Marginal propensity to save (MPS) The change in saving divided by the change in disposable income.

Determining the Level of Aggregate Expenditure in the Economy

Income, Consumption, and Saving

Y C SY Y Y

or,

1 = MPC + MPS

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Solved Problem 19-2Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save

Learning Objective 19.2

YCMPC

YSMPS

NATIONAL INCOME AND REAL GDP (Y)

CONSUMPTION(C)

SAVING(S)

MARGINAL PROPENSITY TO CONSUME (MPC)

MARGINAL PROPENSITY TO SAVE (MPS)

\$9,000 \$8,000 \$1,000 — —

10,000 8,600 1,400 0.6 0.4

11,000 9,200 1,800 0.6 0.4

12,000 9,800 2,200 0.6 0.4

13,000 10,400 2,600 0.6 0.4

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Learning Objective 19.2

Determining the Level of Aggregate Expenditure in the Economy

2. Planned Investment

FIGURE 19-3Real Investment Spending In Egypt, 1970–2008

Investment is subject to more changes than is consumption. Investment declined significantly in the 1980s but started recovering during the 1990s.

Source: Country National Accounts, United Nations, 2009.

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Learning Objective 19.2

• Expectations of future profitability

• The interest rate

• Taxes

• Cash flow

Determining the Level of Aggregate Expenditure in the Economy

Planned Investment

The four most important variables that determine the level of investment are:

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Learning Objective 19.2

Expectations of Future Profitability

The optimism or pessimism of firms is an important determinant of investment spending.

The Interest Rate

A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending.

Determining the Level of Aggregate Expenditure in the Economy

Planned Investment

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Determining the Level of Aggregate Expenditure in the Economy

Learning Objective 19.2

Planned Investment

Taxes

Firms focus on the profits that remain after they have paid taxes.

Cash Flow

Cash flow The difference between the cash revenues received by a firm and the cash spending by the firm.

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Learning Objective 19.2

The Construction Boom in the Gulf (2005-2008) Induces Steel Production Capacity Growth

Makingthe

Connection

The construction boom in the GCC between 2004 and 2008 led to a hugeexpansion in steel production capacity in these countries.

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Learning Objective 19.2

Determining the Level of Aggregate Expenditure in the Economy

3. Government Purchases

FIGURE 19-4Saudi Arabia Real GovernmentPurchases, 1970–2008

Government spending increased sharply after the first oil price shock in 1974, and kept growing but at a slower pace in the 1980s. At the beginning of the 1990s, concerns about the budget deficit caused real government purchases to fall for the following four years, beginning in 1991, before it started steadily rising in 1996. Source: Country National Accounts, United Nations, 2009.

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Learning Objective 19.2

Determining the Level of Aggregate Expenditure in the Economy

4. Net Exports

FIGURE 19-5Jordan’s Real Net Exports, 1970–2008

Net exports were negative in all years between1970 and 2008.

Source: Country National Accounts, United Nations, 2009

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Learning Objective 19.2

1. A country’s domestic price level relative to the price levels in other countries.

2.The growth rate of GDP in the domestic economy relative to the growth rates of GDP in other countries.

3.The exchange rate between a country’s currency and other currencies.

Determining the Level of Aggregate Expenditure in the Economy

Net Exports

The following are the three most important variables that determine the level of net exports:

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Determining the Level of Aggregate Expenditure in the Economy

Learning Objective 19.2

1. A country’s domestic price level relative to the price levels in other countries.

If inflation in the A is lower than inflation in other countries, prices of the A products increase more slowly than the prices of products of other countries and thus A export increases & its imports decrease,

2.The growth rate of GDP in the domestic economy relative to the growth rates of GDP in other countries.

When incomes in the country A rise faster than incomes in other countries, imports for A will increases and exports will decrease.

3.The exchange rate between a country’s currency and other currencies.

An increase in the value of the country’s currency will reduce its exports and reduce imports, so net exports will rise.

Net Exports

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Graphing Macroeconomic Equilibrium

Learning Objective 19.3

FIGURE 19-645°-Line Diagram, Keynesian cross

Equilibrium→

AE = GDP

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Learning Objective 19.3

FIGURE 19-7The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram

Graphing Macroeconomic Equilibrium

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Graphing Macroeconomic Equilibrium

Learning Objective 19.3

FIGURE 19-8Macroeconomic Equilibrium on the 45°-Line Diagram

To draw AE graph remember :

AE = C + I + G + NX

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Learning Objective 19.3

Graphing Macroeconomic Equilibrium

Graphically:

Equilibrium occurs at the point at which the aggregate expenditure curve crosses the 45° line in part (a).

Equilibrium occurs when there are no unplanned changes in business inventories in part (b).

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Graphing Macroeconomic EquilibriumLearning Objective 19.3

If AE real GDP (the AE curve is above the 45° line), there is an unplanned decrease in inventories,

To restore inventories, firms hire workers and increase production.

Real GDP increases.

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Learning Objective 19.3

Graphing Macroeconomic Equilibrium

If AE < real GDP (the AE curve is below the 45° line), …

there is an unplanned increase in inventories.

To reduce inventories, firms fire workers and decrease production.

Real GDP decreases.

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Graphing Macroeconomic EquilibriumShowing a Recession on the 45°-Line Diagram

Learning Objective 19.3

FIGURE 19-10

Showing a Recession on the 45°-Line Diagram

Recession: it is an economic situation where the economy will operate below normal capacity, unemployment rate well be above natural rate of unemployment

When AE intersects the the 45°-Line at a level of GDP below the potential RGDP, the economy is in Recession.

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Graphing Macroeconomic Equilibrium

Learning Objective 19.3

Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories.

The Important Role of Inventories

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Learning Objective 19.2

Business Attempts to Control Inventories, Then . . . and Now

Makingthe

Connection

Dell Computer uses supply chain management to keep its inventory low.

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Learning Objective 19.3

Graphing Macroeconomic EquilibriumA Numerical Example of Macroeconomic Equilibrium

Real GDP (Y)

Consumption(C)

Planned Investment

(I)

Government Purchases

(G)

Net Exports

(NX)

Planned Aggregate

Expenditure(AE)

Unplanned Change in Inventories

Real GDP Will …

\$8,000 \$6,200 \$1,500 \$1,500 – \$500 \$8,700 –\$700 increase

9,000 6,850 1,500 1,500 –500 9,350 –350 increase

10,000 7,500 1,500 1,500 –500 10,000 0be in

equilibrium

11,000 8,150 1,500 1,500 –500 10,650 +350 decrease

12,000 8,800 1,500 1,500 –500 11,300 +700 decrease

Table 19-3Macroeconomic Equilibrium

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Solved Problem 19-3Determining Macroeconomic Equilibrium

Learning Objective 19.3

Real GDP (Y)

Consumption(C)

Planned Investment

(I)

Government Purchases

(G)

Net Exports

(NX)

Planned Aggregate

Expenditure(AE)

Unplanned Change in Inventories

\$8,000 \$6,200 \$1,675 \$1,675 \$–500 \$9,050 \$–1,050

9,000 6,850 1,675 1,675 –500 9,700 –700

10,000 7,500 1,675 1,675 –500 10,350 –350

11,000 8,150 1,675 1,675 –500 11,000 0

12,000 8,800 1,675 1,675 –500 11,650 350

Planned aggregate expenditure (AE) = Consumption (C) + Planned investment (I) + Government (G) + Net exports (NX)

Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (AE)

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Learning Objective 19.4

The Multiplier Effect

FIGURE 19-11The Multiplier Effect

The economy begins at point A, at which equilibrium RGDP is \$ 9.6 billion, If there is an increases in investment by 100 million, AE1 shaft to AE2 and the new equilibrium is at B. So 100 million increase in investment results in \$400 million increase in equilibrium RGDP, this is the Multiplier effects.

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Learning Objective 19.4The Multiplier Effect

Autonomous expenditure An expenditure that does not depend on the level of GDP.

Multiplier The increase in equilibrium real GDP divided by the increase in autonomous expenditure.

Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

Factors that will have Multiplied effect:

MPC

11

eexpenditur autonomousin ChangeGDP real mequilibriuin Change Multiplier

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Learning Objective 19.4

The Multiplier EffectTable 19-4The Multiplier Effect in Action

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Learning Objective 19.4

The Multiplier in Reverse: The Great Depression of the 1930s

Makingthe

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Learning Objective 19.4

The Multiplier EffectA Formula for the Multiplier

MPC11

MPC

11

eexpenditur autonomousin ChangeGDP real mequilibriuin Change Multiplier

4100400 Multiplier

With a multiplier of 4, each increase in autonomous expenditure of \$ 1 will result in an increase in equilibrium GDP by \$ 4.

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Learning Objective 19.4

The Multiplier EffectSummarizing the Multiplier Effect

1 The multiplier effect occurs both when autonomous expenditure increases and when it decreases.

2 The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be.

3 The larger the MPC, the larger the value of the multiplier.

4 The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that an increasing GDP can have on imports, inflation, and interest rates.

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Solved Problem 19-4Using the Multiplier Formula

Learning Objective 19.4

REAL GDP (Y)

CONSUMPTION(C)

PLANNED INVESTMENT

(I)

GOVERNMENT PURCHASES

(G)NET EXPORTS

(NX)

\$8,000 \$6,900 \$1,000 \$1,000 –\$500

9,000 7,700 1,000 1,000 –500

10,000 8,500 1,000 1,000 –500

11,000 9,300 1,000 1,000 –500

12,000 10,100 1,000 1,000 –500

a. What is the equilibrium level of RGDP?

b. What is the MPC?

c. Suppose G increase by \$200billion. What will be the new equilibrium level of RGDP?

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Solved Problem 19-4Using the Multiplier Formula (continued)

Learning Objective 19.4

REALGDP (Y)

CONSUMPTION(C)

PLANNED INVESTMENT

(I)

GOVERNMENT PURCHASES

(G)

NET EXPORTS

(NX)

PLANNED AGGREGATE EXPENDITURE

(AE)

\$8,000 \$6,900 \$1,000 \$1,000 –\$500 \$8,400

9,000 7,700 1,000 1,000 –500 9,200

10,000 8,500 1,000 1,000 –500 10,000

11,000 9,300 1,000 1,000 –500 10,800

12,000 10,100 1,000 1,000 –500 11,600

a. the equilibrium level of RGDP = \$10.000

b. the MPC = Δ C/ Δ Y = 800/1000 = 0.8

c. M = 1/1-MPC = 1/ 1- 0.8 = 5

So Δ Y = M * Δexp = 5 * 200 = 1000 billion, thus the new level of equilibrium GDP = 10000+ 1000 = 11000 billion

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Learning Objective 19.5

The Aggregate Demand CurveFIGURE 19-12The Effect of a Change in the Price Level on Real GDP

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Learning Objective 19.5

The Aggregate Demand CurveFIGURE 19-13The Aggregate Demand Curve

A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

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An Inside LOOK Jordan Expected Thousands of Workers Home from the Gulf: Is it Good News for the Jordanian Economy?

Can Jordan Dodge the Downturn Bullet?

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Aggregate demand curveAggregate expenditure (AE)Aggregate expenditure modelAutonomous expenditureCash flowConsumption functionInventories

K e y T e r m s

Marginal propensity to consume (MPC)

Marginal propensity to save (MPS)

MultiplierMultiplier effect

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The Algebra of Macroeconomic Equilibrium

Appendix

)(YMPCCC

1I

GG

XNNX

NXGICY

1 Consumption function

2 Planned investment function

3 Government spending function

4 Net export function

5 Equilibrium condition

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The Algebra of Macroeconomic Equilibrium

Appendix

( )

1

1

Y C MPC(Y) I G NX

Y - MPC(Y) C I G NX

Y MPC C I G NX

C I G NXYMPC

Or,

Or,

Or,

The letters with bars over them represent fixed, or autonomous, values. So, represents autonomous consumption, which had a value of 1,000 in our original example. Now, solving for equilibrium, we get:

C

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The Algebra of Macroeconomic Equilibrium

Appendix

Remember that is the multiplier. Therefore an alternative

expression for equilibrium GDP is:

11 MPC

Equilibrium GDP = Autonomous expenditure x Multiplier

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