Transcript 11. The Income-Expenditure Model

Economics
NINTH EDITION
Chapter 11
The
Income-Expenditure
Model
Prepared by Brock Williams
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Learning Objectives
11.1 Discuss the income-expenditure model.
11.2 Identify the two key components of the consumption
function.
11.3 Calculate equilibrium income in a simple model.
11.4 Explain how government spending and taxes affect
equilibrium income.
11.5 Discuss the role of exports and imports in determining
equilibrium income.
11.6 Explain how the aggregate demand curve is related to
the income-expenditure model.
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11.1 A SIMPLE INCOME-EXPENDITURE
MODEL (1 of 3)
Equilibrium Output
At any point on the 45° line, the distance
to the horizontal axis is the same as the
distance to the vertical axis.
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11.1 A SIMPLE INCOME-EXPENDITURE
MODEL (2 of 3)
Equilibrium Output
At equilibrium output y*, total demand y*
equals output y*.
• Planned expenditures
Another term for total demand for
goods and services.
• Equilibrium output
The level of GDP at which planned
expenditure equals the amount that is
produced.
equilibrium output = y* = C + I =
planned expenditures
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11.1 A SIMPLE INCOME-EXPENDITURE
MODEL (3 of 3)
Adjusting to Equilibrium Output
Equilibrium output (y*) is determined at a, where
demand intersects the 45° line.
If output were higher (y1), it would exceed demand and
production would fall.
If output were lower (y2), it would fall short of demand
and production would rise.
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11.2 THE CONSUMPTION FUNCTION (1 of 3)
Consumer Spending and Income
• Consumption function
The relationship between consumption spending and the level of income.
• Autonomous consumption
The part of consumption that does not depend on income.
• Marginal propensity to consume (MPC)
The fraction of additional income that is spent.
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11.2 THE CONSUMPTION FUNCTION (2 of 3)
Consumer Spending
and Income
The consumption function relates
desired consumer spending to the
level of income.
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▼FIGURE 11.5
Moments of the Consumption Function
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11.2 THE CONSUMPTION FUNCTION (3 of 3)
Changes in the Consumption Function
Two factors that can cause autonomous consumption to change:
• Increases in consumer wealth will cause an increase in autonomous consumption.
• Increases in consumer confidence will increase autonomous consumption.
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APPLICATION 1
FALLING HOME PRICES, THE WEALTH EFFECT, AND DECREASED
CONSUMER SPENDING
APPLYING THE CONCEPTS #1: How do changes in the value of homes affect
consumer spending?
Home equity is the difference between the home value and what is owed on the mortgage.
• The largest component of net wealth for most families.
• Changes in home equity like other forms of wealth affect consumer spending.
From 1997 to mid-2006 housing prices rose by about 90 percent and consumer wealth
grew by $6.5 trillion.
This ended in 2006 as housing prices began to fall.
According to a review of studies by the Congressional Budget Office, each $1 decline in
consumer wealth would lower consumption spending between $.02 and $.07, or $21 to $72
billion of spending.
This would reduce economic growth 0.1 to 0.5 percent during 2007.
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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (1 of 4)
Equilibrium output is determined where the
C + I line intersects the 45° line.
•
At that level of output, y*, desired spending
equals output.
•
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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (2 of 4)
Saving and Investment
• Savings function
The relationship between the level of saving and the level of income.
S=y−C
y=C+I
y−C=I
S=I
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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (3 of 4)
Saving and Investment
Equilibrium output is determined at the
level of output, y*, where savings equals
investment.
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11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (4 of 4)
Understanding the Multiplier
When investment increases from I0 to I1,
equilibrium output increases from y0 to y1.
The change in output (Δy) is greater than the
change in investment (ΔI).
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APPLICATION 2
MULTIPLIERS IN GOOD TIMES AND BAD
APPLYING THE CONCEPTS #2: Are multipliers for government spending higher
during recessions?
•
•
•
A common belief is that fiscal multipliers are larger during recessions, when there is more
slack in the economy. But, it is quite difficult to estimate government multipliers
accurately.
Valerie Ramey and Sarah Zubiary find no evidence of greater multipliers during slack
times in the U.S.
Daniel Riera-/Crichton, Carlos Veigh, and Guillermo Vuletin found different results. By
carefully looking at periods when both government spending increased and the economy
had slower or negative growth, they found the multiplier to be 2.3. This is larger than
conventionally calculated multipliers.
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11.4 GOVERNMENT SPENDING
AND TAXATION (1 of 5)
•
Fiscal Multipliers
Planned expenditures including
government = C + I + G
•
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11.4 GOVERNMENT SPENDING
AND TAXATION (2 of 5)
•
Fiscal Multipliers
The consumption function with taxes is
The formula for the tax multiplier is
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11.4 GOVERNMENT SPENDING
AND TAXATION (3 of 5)
Using Fiscal Multipliers
Although it is very simple, our income-expenditure model illustrates some important
lessons:
• An increase in government spending will increase total planned expenditures for goods and
services.
• Cutting taxes will increase the after-tax income of consumers and will also lead to an increase in
planned expenditures for goods and services.
• Policymakers need to take into account the multipliers for government spending and taxes as
they develop policies.
In the long run, of course, we are better off if government spends the money wisely, such
as on needed infrastructure such as roads and bridges. This is an example of the principle
of opportunity cost.
PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.
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APPLICATION 3
THE BROKEN WINDOW FALLACY AND KENSESIAN ECONOMICS
APPLYING THE CONCEPTS #3: How does Keynesian Economics change our normal
ideas of economic scarcity?
• Austrian economist, Henry Hazlitt, popularized the “Broken Windows” fallacy in economics. Imagine
that a hoodlum threw a brick through a store window. While at first this seems to be a tragedy, the
store owner has to hire a firm to fix the window. That generates business for the window repair firm
and, through a multiplier, additional business throughout the community. Was the broken window
good for society?
• The fallacy here is that the money that the store owner paid to have the window repaired would have
been spent elsewhere in the economy, say on clothing.
• Hazlitt applies a similar argument to public spending financed by taxes. A government spending
program may appear to increase business, but the taxes needed to finance the spending—either paid
now or in the future—will mean less business for other firms. Government spending and the taxes
necessary to finance it will just crowd out other production of goods and services in the economy.
• But in the Keynesian world, where resources are underemployed, the story is quite different. Here the
increase in spending—even financed by taxes—will bring resources that are not being utilized into the
economy. As long as there is excess capacity in the economy, the extra spending will increase output
and not crowd out other goods and services.
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11.4 GOVERNMENT SPENDING
AND TAXATION (4 of 5)
Understanding
Automatic Stabilizers
After World War II, fluctuations
in GDP growth became
considerably smaller.
SOURCE: Angus Maddison, Dynamic Forces in Capitalist Development (New York:
Oxford University Press, 1991); U.S. Department of Commerce.
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11.4 GOVERNMENT SPENDING
AND TAXATION (5 of 5)
Understanding Automatic
Stabilizers
C = Ca + b(1 − t)y
adjusted MPC = b(1 − t)
An increase in tax rates decreases the
slope of the C + I + G line.
This lowers output and reduces the
multiplier.
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11.5 EXPORTS AND IMPORTS (1 of 2)
To modify our model to include the effects of world spending on exports and U.S.
spending on imports, we need to take two steps:
1. Add exports, X, as another source of demand for U.S. goods and services.
2. Subtract imports, M, from total spending by U.S. residents. We will assume that
imports, like consumption, increase with the level of income.
M = my
• Marginal propensity to import
The fraction of additional income that is spent on imports.
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11.5 EXPORTS AND IMPORTS (2 of 2)
Output is determined when the
demand for domestic goods equals
output.
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▼FIGURE 11.13
How Increases in Exports and Imports Affect U.S. GDP
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APPLICATION 4
THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A
COUNTRY’S OUTPUT
APPLYING THE CONCEPTS #4: How do countries benefit from growth in their trading
partners?
From the early 1990s until quite recently, the United States was what economists term the
“locomotive” for global growth.
• Our demand for foreign products increased.
• U.S. imports increased along with output during this period.
• The increased demand fueled exports in foreign countries and promoted their growth.
Studies have shown that the increase in demand for foreign goods was actually more
pronounced for developing countries than for developed countries.
Conclusion: The United States was truly a locomotive, pulling the developing countries
along.
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11.6 THE INCOME-EXPENDITURE MODEL
AND THE AGGREGATE DEMAND CURVE (1of 2)
As the price level falls from P0 to P1,
planned expenditures increase, which
increases the level of output from y0 to y1.
The aggregate demand curve shows the
combination of prices and equilibrium
output.
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11.6 THE INCOME-EXPENDITURE MODEL
AND THE AGGREGATE DEMAND CURVE (2of 2)
As government spending increases
from G0 to G1, planned expenditures
increase, which raises output from y0
to y1.
At the price level P0, this shifts the
aggregate demand curve to the right,
from AD0 to AD1.
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KEY TERMS
Autonomous consumption
Consumption function
Equilibrium output
Marginal propensity to consume (MPC)
Marginal propensity to import
Planned expenditures
Savings function
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (1 of 9)
Formula for Equilibrium Output
1
2
3
4
5
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (2 of 9)
The Multiplier for Investment
For the original level of investment at I0, we have
For a new level of investment at I1, we have
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (3 of 9)
The Multiplier for Investment
Substituting for the levels of output, we have
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (4 of 9)
The Multiplier for Investment
Finally, because (I1 − I0) is the change in investment, ΔI, we can write
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (5 of 9)
Another Way to Derive the Formula for the Multiplier
The term in parentheses is an infinite series whose value is equal to
Substituting this value for the infinite series, we have the expression for the
multiplier:
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (6 of 9)
Government Spending and Taxes
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (7 of 9)
Government Spending and Taxes
Using this formula and the method just outlined, we can find the multiplier for
changes in government spending and the multiplier for changes in taxes:
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (8 of 9)
Balanced-Budget Multiplier
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APPENDIX A FORMULAS FOR EQUILIBRIUM
INCOME AND THE MULTIPLIER (9 of 9)
Equilibrium Output with Government Spending, Taxes, and the Foreign
Sector
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