Macroeconomic (4)

8/10/2019 Macroeconomic (4)

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TheCoreofMacroeco

nomicTheory

2012 Pearson Education, Inc. Publishing as Prentice Hall

Prepared by: Fernando Quijano & Shelly Tefft

P R I N C I P L E S O F

ECONOMICST E N T H E D I T I O N

CASE FAIR OSTER


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PART

The Core of

Macroeconomic

Theory

V


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TheCoreofMacroeconomicTheory


The level of GDP, the overall price level, and the level ofemploymentthree chief concerns of macroeconomistsareinfluenced by events in three broadly defined markets:

Goods-and-services market

Financial (money) market

Labor market


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FIGURE V.1 The Core of Macroeconomic TheoryWe build up the macroeconomy slowly.

In Chapters 23 and 24, we examine the market for goods and services.

In Chapters 25 and 26, we examine the money market.

Then in Chapter 27, we bring the two markets together, in so doing explaining the linksbetween aggregate output (Y) and the interest rate (r), and derive the aggregate demandcurve.

In Chapter 28, we introduce the aggregate supply curve and determine the price level (P).We then explain in Chapter 29 how the labor market fits into the macroeconomic picture.


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CHAPTER OUTLINE

23AggregateExpenditure andEquilibrium Output

The Keynesian Theory of Consumption

Other Determinants of Consumption

Planned Investment (I)

The Determination of Equilibrium Output (Income)

The Saving/Investment Approach to Equilibrium

Adjustment to Equilibrium

The Multiplier

The Multiplier Equation

The Size of the Multiplier in the Real World

Looking Ahead

Appendix: Deriving the Multiplier Algebraically


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aggregate output The total quantity of goods and services produced(or supplied) in an economy in a given period.

aggregate income The total income received by all factors ofproduction in a given period.

In any given period, there is an exact equality between aggregate output(production) and aggregate income. You should be reminded of this factwhenever you encounter the combined term aggregate output (income) (Y).

aggregate output (income) (Y)A combined term used to remind youof the exact equality between aggregate output and aggregate income.


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consumption function The relationship between consumption and income.

FIGURE 23.1 A Consumption

Function for a Household

A consumption function for anindividual household shows thelevel of consumption at each

level of household income.



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With a straight line consumption curve, we can use the following equation to

describe the curve:

FIGURE 23.2 An Aggregate

Consumption Function

The aggregate consumption function

shows the level of aggregateconsumption at each level ofaggregate income.The upward slope indicates thathigher levels of income lead to higherlevels of consumption spending.


C=a+ bY


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marginal propensity to consume (MPC) That fraction of a change in incomethat is consumed, or spent.

marginal propensity to consume slope of consumption functionC

Y

aggregate saving (S) The part of aggregate income that is not consumed.

S YC



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identity Something that is always true.

marginal propensity to save (MPS) That fraction of a change in income thatis saved.

MPC+ MPS 1

Because the MPC and the MPSare important concepts, it may help to reviewtheir definitions.

The marginal propensity to consume (MPC) is the fraction of an increase inincome that is consumed (or the fraction of a decrease in income that comes

out of consumption).

The marginal propensity to save (MPS) is the fraction of an increase in incomethat is saved (or the fraction of a decrease in income that comes out of saving).



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FIGURE 23.3 The Aggregate

Consumption Function Derived from the

Equation C= 100 + .75Y

In this simple consumption function,consumption is 100 at an income ofzero.

As income rises, so doesconsumption.For every 100 increase in income,consumption rises by 75.The slope of the line is .75.

Aggregate

Income, Y

Aggregate

Consumption, C

0 100

80 160

100 175

200 250

400 400

600 550

800 700

1,000 850



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The assumption that consumption depends only on income is obviouslya simplification.

In practice, the decisions of households on how much to consume in agiven period are also affected by their wealth, by the interest rate, and

by their expectations of the future.

Households with higher wealth are likely to spend more, other thingsbeing equal, than households with less wealth.


Other Determinants of Consumption


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Economists have generallyassumed that people make theirsaving decisions rationally, just asthey make other decisions aboutchoices in consumption and thelabor market.

Saving decisions involve thinkingabout trade-offs between presentand future consumption.

Recent work in behavioraleconomics has highlighted the role of psychological biases in saving behavior

and has demonstrated that seemingly small changes in the way savingprograms are designed can result in big behavioral changes.

E C O N O M I C S I N P R A C T I C E

Behavioral Biases in Saving Behavior


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FIGURE 23.5 The Planned

Investment Function

For the time being, we will assumethat planned investment is fixed.It does not change when incomechanges, so its graph is ahorizontal line.

Planned Investment (I)

planned investment (I) Those additions to capital stock andinventory that are planned by firms.

actual investment The actual amount of investment that takesplace; it includes items such as unplanned changes in inventories.


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equilibrium Occurs when there is no tendency for change. In

the macroeconomic goods market, equilibrium occurs whenplanned aggregate expenditure is equal to aggregate output.

planned aggregate expenditure (AE) The total amount theeconomy plans to spend in a given period. Equal toconsumption plus planned investment: AEC+ I.

Y > C+ I

aggregate output > planned aggregate expenditure

C+ I > Y

planned aggregate expenditure > aggregate output



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TABLE 23.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium.The Figures in Column 2 Are Based on the Equation C= 100 + .75Y.

(1) (2) (3) (4) (5) (6)

Aggregate

Output

(Income) (Y)

Aggregate

Consumption (C)

Planned

Investment (I)

Planned

Aggregate

Expenditure (AE)

C+ I

Unplanned

Inventory

Change

Y (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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FIGURE 23.6 EquilibriumAggregate Output

Equilibrium occurs whenplanned aggregate expenditureand aggregate output are equal.Planned aggregate expenditureis the sum of consumptionspending and planned

investment spending.



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Because aggregate income must be saved or spent, by definition, YC+ S, which is an identity. The equilibrium condition is Y= C+ I, butthis is not an identity because it does not hold when we are out ofequilibrium. By substituting C+ Sfor Y in the equilibrium condition,we can write:

C+ S= C+ I

Because we can subtract Cfrom both sides of this equation, we areleft with:

S= I

Thus, only when planned investment equals saving will there beequilibrium.




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FIGURE 23.7 The S= I

Approach to Equilibrium

Aggregate output is equal toplanned aggregate expenditureonly when saving equalsplanned investment (S= I).Saving and planned investmentare equal at Y= 500.




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The adjustment process will continue as long as output (income) isbelow planned aggregate expenditure.

If firms react to unplanned inventory reductions by increasing output,an economy with planned spending greater than output will adjust to

equilibrium, with Yhigher than before.

If planned spending is less than output, there will be unplannedincreases in inventories. In this case, firms will respond by reducingoutput. As output falls, income falls, consumption falls, and so on, untilequilibrium is restored, with Ylower than before.


Adjustment to Equilibrium


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multiplier The ratio of the change in the equilibrium level of output to a changein some exogenous variable.

exogenous variableA variable that is assumed not to depend on the state of

the economythat is, it does not change when the economy changes.

The Multiplier


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FIGURE 23.8 The Multiplier as

Seen in the Planned Aggregate

Expenditure Diagram

At pointA, the economy is inequilibrium at Y= 500.When I increases by 25,planned aggregate expenditureis initially greater thanaggregate output.

As output rises in response,additional consumption isgenerated, pushing equilibriumoutput up by a multiple of theinitial increase in I.The new equilibrium is found atpoint B, where Y= 600.Equilibrium output has

increased by 100 (600 - 500), orfour timesthe amount of theincrease in planned investment.

The Multiplier


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MPSS

Y

MPSI

Y

Because Smust be equal to Ifor equilibrium to be restored, we cansubstitute Ifor Sand solve:

Therefore, Y IMPS

1

, or

Recall that the marginal propensity to save (MPS) is the fraction of achange in income that is saved. It is defined as the change in S(S)over the change in income (Y):

The Multiplier

The Multiplier Equation

MPS

1multiplier

MPC1

1multiplier

It follows that


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The Paradox of Thrift

An increase in planned saving from S0to S1causes equilibrium output todecrease from 500 to 300.

The decreased consumption thataccompanies increased saving leadsto a contraction of the economy and toa reduction of income.

But at the new equilibrium, saving isthe same as it was at the initial

equilibrium.

Increased efforts to save have causeda drop in income but no overallchange in saving.

E C O N O M I C S I N P R A C T I C E

The Paradox of Thrift

An interesting paradox can arise when households attempt to increase their saving.


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In considering the size of the multiplier, it is important to realize thatthe multiplier we derived in this chapter is based on a verysimplifiedpicture of the economy.

In reality, the size of the multiplier is about 2. That is, a sustained

increase in exogenous spending of $10 billion into the U.S. economycan be expected to raise real GDP over time by about $20 billion.

The Multiplier

The Size of the Multiplier in the Real World


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In this chapter, we took the first step toward understanding how the economyworks.

We assumed that consumption depends on income, that planned investment isfixed, and that there is equilibrium.

We discussed how the economy might adjust back to equilibrium when it is outof equilibrium.

We also discussed the effects on equilibrium output from a change in plannedinvestment and derived the multiplier.

In the next chapter, we retain these assumptions and add the government tothe economy.

Looking Ahead


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actual investment

aggregate income

aggregate output

aggregate output (income) (Y)

aggregate saving (S)

consumption functionequilibrium

exogenous variable

identity

marginal propensity to consume

(MPC)

marginal propensity to save (MPS)

multiplier

planned aggregate expenditure (AE)

planned investment (I)

1. S Y C2.

3. MPC+ MPS 14. AE C+ I5. Equilibrium condition: Y=AEor

Y= C+ I6. Saving/investment approach to

equilibrium: S= I

7.

slope of consumption functionC

MPC

Y

- MPCMPS 1

1

1Multiplier

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