Transcript Chapter_21

Chapter 21:
The Simplest
Short-Run Macro Model
Copyright © 2014 Pearson Canada Inc.
Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
21.1 Desired Aggregate
Expenditure
1.
explain the difference between desired and actual
expenditure.
2.
identify the determinants of desired consumption
and desired investment.
21.2 Equilibrium National
Income
3.
understand the meaning of equilibrium national
income.
21.3 Changes in
Equilibrium National
Income
4.
explain how a change in desired expenditure affects
equilibrium income through the "simple multiplier."
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 2
21.1 Desired Aggregate Expenditure
The national accounts divide actual GDP into its components:
- Ca, Ia , Ga, and NXa.
Total desired expenditure is divided into the same categories:
• desired consumption, C
• desired investment, I
• desired government purchases, G
• desired net exports, NX
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Chapter 21, Slide 3
The sum is called desired aggregate expenditure:
AE = C + I + G + NX
Two types of expenditures:
• autonomous expenditures do not depend on
the level of national income
• induced expenditures do depend on
the level of national income
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 4
Assumptions of the simplest short-run macro model:
• there is no trade with other countries
• there is no government
• the price level is constant
By simplifying the model we are better able to understand its
structure and therefore how more complex versions of the model
work.
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 5
What Does "Desired" Really Mean?
"Desired" expenditure is not just a list of what consumers and
firms would buy if they had no constraints on their spending—it
is much more realistic than that.
Desired expenditure is what consumers and firms would like
to purchase, given their real-world constraints of income and
market prices.
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Chapter 21, Slide 6
Desired Consumption Expenditure
Two possible uses of disposable income:
• consumption (C) or saving (S)
In the simplest theory, consumption is determined primarily by
current disposable income (YD).
In more advanced theories, individuals are forward looking,
and so consumption depends more on "lifetime" income.
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Chapter 21, Slide 7
Fig. 21-1
Consumption and Disposable Income in Canada
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Chapter 21, Slide 8
The simple consumption function is written as:
C
45º line
C
a
Slope = b
Note: the slope of this
simple consumption
function (b) is
less than one.
YD
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Chapter 21, Slide 9
The marginal propensity to consume (MPC) relates the change
in desired consumption to the change in disposable income that
brings it about.
MPC =  C/ YD
The MPC is the slope of the consumption function.
In the previous diagram, the MPC is the same at any level of income.
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 10
The average propensity to consume (APC) is equal to total
consumption divided by total disposable income.
APC = C/YD
In the previous diagram, the APC falls as the level of income rises.
EXTENSIONS IN THEORY 21-1
The Theory of the Consumption Function
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 11
Fig. 21-2
The Consumption and Saving Functions
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Chapter 21, Slide 12
Since all of disposable income is either consumed or saved, we have
• APC + APS = 1
• MPC + MPS = 1
MyEconLab
www.myeconlab.com
Copyright © 2014 Pearson Canada Inc.
Is our simple theory of the consumption function supported by
empirical evidence? For some Canadian data on aggregate
consumption and disposable income, look for The Consumption
Function in Canada in the Additional Topics section of this book’s
MyEconLab.
Chapter 21, Slide 13
Fig. 21-3 Shifts in the
Consumption Function
If consumption function
shifts upward, the
saving function must
shift downward.
What causes a shift?
• 
wealth
• 
interest rate
• 
expectations
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 14
Desired Investment Expenditure
Investment expenditure is the most volatile component of GDP:
 changes in investment expenditure are strongly
associated with short-run fluctuations
Three important determinants of aggregate investment expenditure
are:
• the real interest rate
• changes in the level of sales
• business confidence
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 15
Fig. 21-4
The Volatility of Investment, 1981–2011
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Chapter 21, Slide 16
The Real Interest Rate
The real interest rate is the opportunity cost for:
• investment in new plants and equipment
• investment in inventories
• investment in residential construction
Thus, all three components of desired investment expenditure are
negatively related to the real interest rate, other things being equal.
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 17
Changes in Sales
The higher the level of production and sales, the larger the desired
stock of inventories:
 changes in the rate of sales cause temporary bouts of investment
in inventories
Business Confidence
When business confidence improves, firms want to invest now
so as to reap future profits.
Business confidence and consumer confidence may feed off
of one another.
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 18
The Aggregate Expenditure Function
The AE function:
• relates desired aggregate expenditure to actual national
income
In the absence of government and international trade, desired
aggregate expenditure is:
AE = C + I
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Chapter 21, Slide 19
Consider the following example.
The consumption function is:
C = 30 + (0.8)Y
The investment function is:
I = 75
The AE function is then given by:
AE = C + I = 30 + (0.8)Y + 75
 AE = 105 + (0.8)Y
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Chapter 21, Slide 20
Fig. 21-6
The Aggregate Expenditure Function
The slope of the AE function is the marginal propensity to spend:
• in this simple model, it is just MPC
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Chapter 21, Slide 21
21.2 Equilibrium National Income
If desired aggregate expenditure exceeds actual output:
• what is happening to inventories?
• there is pressure for output to rise
If desired aggregate expenditure is less than actual output:
• what is happening to inventories?
• there is pressure for output to fall
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Chapter 21, Slide 22
Table 21-1
Equilibrium National Income
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Chapter 21, Slide 23
Fig. 21-7
Equilibrium National Income
In this model,
output is said to be
demand determined.
The equilibrium
condition is:
Y = AE(Y)
In words: Equilibrium national income is that level of national income
where desired aggregate expenditure equals actual national income.
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 24
MyEconLab
www.myeconlab.com
Copyright © 2014 Pearson Canada Inc.
A different, but equivalent, way of thinking about the equilibrium
level of national income involves comparing desired saving with
desired investment. For more details, look for Investment,
Saving, and Equilibrium GDP in the Additional Topics section
of this book's MyEconLab.
Chapter 21, Slide 25
21.3 Changes in Equilibrium National Income
Shifts in the AE Function
(i) A parallel shift in AE
(ii) A change in the slope of AE
Two types of shifts can occur with the AE function:
1. The AE function can shift parallel to itself
2. The slope of the AE function can change
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 26
The Multiplier
The multiplier is a measure of the size of the change in equilibrium Y
that results from a change in autonomous expenditure.
In our simplest of macro models, the multiplier exceeds one.
APPLYING ECONOMIC CONCEPTS 21-1
A Simple Multiplier: A Numerical Example
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Chapter 21, Slide 27
Fig. 21-9
The Simple Multiplier
Simple multiplier =
 Y

=
1
1-z
A
where z is the marginal
propensity to spend out
of national income and  A
is the change in autonomous
expenditure.
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 28
Fig. 21-10 The Size of the Simple Multiplier
(i) Flat AE, multiplier = 1
(ii) Intermediate case
(iii) Steep AE, multiplier large
The larger is z, the steeper is the AE curve and the larger is the
simple multiplier.
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Chapter 21, Slide 29
EXTENSIONS IN THEORY 21-12
The Algebra of the Simple Multiplier
Economic Fluctuations as Self-Fulfilling Prophecies
Households and firms base their desired investment and consumption
partly on their expectations of the future:
 changes in expectations can lead to real changes in the current
state of the economy
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 30
Example:
• imagine that firms feel optimistic about the future
• this increases their desired investment, shifting up the AE curve
• this increases Y, justifying the initial optimism
Copyright © 2014 Pearson Canada Inc.
Chapter 21, Slide 31
Review
Consider the following aggregate expenditure function: AE = $300
billion + (0.87)Y. Assuming that we have no government, no
international trade and desired investment is autonomous and is
equal to $56 billion, then which of the following is the correct
statement of the consumption function?
A) C = $244 billion + (0.87)Y
B) C = $356 billion + (0.87)Y
C) C = $244 billion + (0.13)Y
D) C = $300 billion + (0.13)Y
E) C = $356 billion + (0.13)Y
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Review
Refer to diagram. A shift in the aggregate
expenditure function from AE0 to AE1
could be caused by
A) a decrease in desired investment
expenditures.
B) an increase in desired investment
expenditures.
C) a fall in the marginal propensity to
consume.
D) a rise in the marginal propensity to
consume.
E) a rise in the multiplier.
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Review
Consider the following information
The simple multiplier in this
describing a closed economy with
economy is
no government. Aggregate output is
demand determined and the price
A) 2.0.
level is constant.
B) 2.5.
C) 3.0.
D) 4.0.
1. Y = C + I
E) 5.0.
2. C = 100 + 0.6Y
3. I = 200
© 2014 Pearson Education Canada Inc.
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