Ch21
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Chapter 21 The Simplest ShortRun Macro Model
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Learning Objectives 1. Differentiate between desired expenditure and actual expenditure. 2. Explain the determinants of desired consumption and desired investment expenditures. 3. Define equilibrium national income. 4. Explain how a change in desired expenditure affects equilibrium income, and how this change is reflected by the multiplier.
Copyright © 2005 Pearson Education Canada Inc.
3 of 30
21.1 Actual Vs. Desired Agg. Expend. The National Income and Expenditure Accounts (NIEA) divide actual GDP, calculated from the expenditure side, into its components: Ca, Ia , Ga, and NXa. RECALL: GDP = Ca + Ia + Ga + NXa. Is an accounting identity. Every year (week, month) if we added up Ca, Ia , Ga, and NXa we will get actual output GDP. The small ‘a’ indicates we are measuring what each groups actually spent during the time period.
Copyright © 2005 Pearson Education Canada Inc.
4 of 30
21.1 Desired Aggregate Expenditure Total desired (planned, intended) expenditure on domestically produced goods and services can be divided into similar categories: • desired consumption (C), • desired investment (I), • desired government purchases (G), and • desired net exports (NX).
5 of 30
The sum of these components is called desired aggregate expenditure, or more simply Aggregate Expenditure (AE). AE = C+I+G+(X-IM) Components of aggregate expenditure that do not depend on national income are called autonomous expenditures. Components of aggregate expenditure that do change in response to changes in national income are called induced expenditures. 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. Their ‘intended’ or ‘planned’ expenditures. Copyright © 2005 Pearson Education Canada Inc.
6 of 30
Desired Consumption Expenditure There are only two possible uses of disposable income: consumption (C) or saving (S). The factors that influence consumption or saving are given in the consumption function and the saving function. In the simplest theory, consumption is determined primarily by current disposable income (YD). In more advanced theories of consumption, individuals are explicitly forward looking, and current income is less important than some measure of “permanent” or “lifetime” income. Copyright © 2005 Pearson Education Canada Inc.
7 of 30
The simple consumption function is written as: C = a + bYD where a represents autonomous consumption expenditure and bYD represents induced consumption expenditure. C
a
45º line
Slope = b
Notice that the slope of the 45º line is one. The slope of the simple consumption function is less than one.
YD Copyright © 2005 Pearson Education Canada Inc.
8 of 30
Consider C = a + bYd where a = 4000 and b =0.5
Yd $ 0 $ 5000 $ 8000 $10000 $15000 $20000
a + bYd = $4000 $ 0 $4000 $ 2500 $4000 $ 4000 $4000 $ 5000 $4000 $ 7500 $4000 $10000
C $ 4000 $ 6500 $ 8000 $ 9000 $11500 $14000
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Picture of the Consumption Function C= a + bYd
C $14000 Break even
$8000 $6000 $4000 Intercept
$0
$5000 $8000
$20000
Yd
10 of 30
Exercise: do the chart and graph Repeat the above exercise using the following a $5000 $3000 $4000 $4000
b 0.5 0.5 0.7 0.3
you should find intercept shifts up intercept shifts down slope rotates upwards slope rotates downwards
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The marginal propensity to consume (MPC) relates the change in desired consumption to the change in disposable income that brings it about — it is the slope of the consumption function. MPC = ∆ C/∆ YD (equals b ) In the previous diagram, the MPC is the same at any level of income. The average propensity to consume (APC) is equal to total consumption divided by total disposable income. The APC falls as the level of income rises. APC = C/YD
Copyright © 2005 Pearson Education Canada Inc.
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Yd
$
C
0
$ 5000 $ 8000 $10000 $15000 $20000
$ 4000 $ 6500 $ 8000 $ 9000 $11500 $14000
APC C / Yd
∆ YD ∆ C
MPC ∆C/∆YD
… $5000 $2500
0.5
$3000 $1500
0.5
$2000 $1000
0.5
$5000 $2500
0.5
$5000 $2500
0.5
1.30 1.00 0.90 0.77 0.70
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What about savings?? If C = a + bYd and Yd = C + S then S= -a +(1-b)Yd
Yd $ 0 $ 5000 $ 8000 $10000 $15000 $20000
C $ 4000 $ 6500 $ 8000 $ 9000 $11500 $14000
Calculate APS = S/YD
Savings = Yd - C -$4000 -$1500 $ 0 $1000 $3500 $6000 MPS = ∆ S/∆ YD
Desired Xonsumption
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45º line
600
C
450 300 150
•
Both consumption and saving rise as disposable income rises.
Desired Saving
150 300 450 600 Real Disposable Income 150 0 -30
-150
S 150
300
450
600
Real Disposable Income Copyright © 2005 Pearson Education Canada Inc.
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The average propensity to save (APS) is equal to total desired saving divided by total disposable income: APS = S/YD The marginal propensity to save (MPS) relates the change in desired saving to the change in disposable income that brought it about: MPS = ∆ S/∆ YD
Since all of YD is either consumed or saved, we have: • APC + APS = 1 • MPC + MPS = 1
Copyright © 2005 Pearson Education Canada Inc.
Suppose there is an unexpected increase in wealth. The consumption function will shift upward, and the saving function downward. Other reasons the consumption function might shift include changes in interest rates or expectations.
45º line C1
600 450
C0
•
300 150
•
30 150 300 450 600 Real Disposable Income Desired Saving
Shifts in Consumption Functions
Desired Consumption
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S0
150 0 -30
-150
S1 150
450
600
300 Real Disposable Income Copyright © 2005 Pearson Education Canada Inc.
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Desired Investment Expenditure Investment expenditure is the most volatile component of GDP. Changes in investment expenditure are strongly associated with economic fluctuations. Three important determinants of aggregate investment expenditure are: • the real interest rate, • changes in the level of sales, and • business confidence.
Copyright © 2005 Pearson Education Canada Inc.
18 of 30
The Real Interest Rate 1. The real interest rate is the opportunity cost of using money (either borrowed or retained earnings) for investment in new plants and equipment. 2. It is also the opportunity cost of holding an inventory of a given size. 3. Also, higher real interest rates mean a higher cost associated with mortgage financing for residential construction. Thus, all three components of desired investment expenditure are negatively related to the real interest rate.
Copyright © 2005 Pearson Education Canada Inc.
19 of 30
Changes in Sales The higher the level of production and sales, the larger the desired stock of inventories. This means that changes in the rates of production and sales cause temporary bouts of investment (or disinvestment) in inventories. Business Confidence When business confidence is high, firms will want to invest now so as to reap future profits (investment takes time to “come on line”). Business confidence and consumer confidence may feed off of one another.
Copyright © 2005 Pearson Education Canada Inc.
20 of 30
Investment Function Desired investment is treated as autonomous – completely unrelated to the current level of Y We can write
I=I
Were I is determined by - real interest rates - expectations (confidence) - changes in sales
21 of 30
Investment Function (what does it look like?) Desires Investment
I 200
150 100 0
interest rate falls expectations improve sales increase
I’ I I’’
interest rate rises expectations worsen sales decrease
Y Actual National Income
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The Aggregate Expenditure Function The aggregate expenditure function relates the level of desired aggregate expenditure to the level of actual national income. (Note the distinction between desired aggregate expenditure and actual national income.) In the absence of government and international trade, desired aggregate expenditure is just equal to C + I. AE = C + I
Copyright © 2005 Pearson Education Canada Inc.
23 of 30
Consider the following example. The consumption function is: C = a + bYd Suppose
C = 30 + (0.8)Y
The investment function is: I = I I = 75 The AE function is then given by: AE = C + I = 30 + (0.8)Y + 75 and so AE = 105 + (0.8)Y Copyright © 2005 Pearson Education Canada Inc.
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C 54 126 150 270 390 450 510 750
I 75 75 75 75 75 75 75 75
AE 129 201 225 345 465 525 585 825
900 Desired Aggregate Expenditure
Y 30 120 150 300 450 525 600 900
AE
600 300 105
300 600 900 Actual National Income
The slope of the AE function is the marginal propensity to spend. In the simplest model with no taxes and no international trade, this is just the MPC.
Copyright © 2005 Pearson Education Canada Inc.
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Summary The AE function combines the spending plans of households and firms. It shows, for any level of actual national income, the level of desired aggregate spending.
Copyright © 2005 Pearson Education Canada Inc.
26 of 30
21.2 Equilibrium National Income Desired Expenditure and Actual Output If desired aggregate expenditure exceeds actual output, there will be pressure for output to rise. If desired aggregate expenditure is less than actual output, there will be pressure for output to fall. Why? Think about what happens to inventories when AE > Y, and why this leads to more production.
Copyright © 2005 Pearson Education Canada Inc.
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National Income (Y) OUTPUT 30 120 150 300 450 525 600 900
Desired Aggregate Expenditure (AE = C + I) 129 201 225 345 465 525 585 825
Effect Pressure On output to rise ↓ ↓ Equilibrium income ↑ Pressure on output to fall
Equilibrium occurs where aggregate desired expenditure equals actual national income (output). Copyright © 2005 Pearson Education Canada Inc.
28 of 30
How the Economy Gets to Equilibrium – Inventory Adjustment Mechanism What happens if output (GDP) is greater than desired AE? AE < Y - Firms cannot sell all that they are producing - Inventories build up (unintended I) - Signals that a decrease in output is necessary - Firms decrease output until AE=Y
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How the Economy Gets to Equilibrium – Inventory Adjustment Mechanism What happens if output (GDP) is less than desired AE? AE > Y - Firms are selling more then they are producing - Inventories are being run down (unintended I) - Signals that an increase in output is necessary - Firms increase output until AE=Y
30 of 30
Desired Saving and Desired Investment We can view the equilibrium differently by considering desired saving and desired investment. The difference between desired investment and desired saving is exactly equal to the difference between desired aggregate expenditure and actual national income. To see this, suppose the difference between desired saving and desired investment is equal to some number, W. Thus, S-I=W
Copyright © 2005 Pearson Education Canada Inc.
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Now, recall that S = Y - C. We can therefore write: Y-C-I=W Since AE = C + I, we can rewrite the equation again as: Y - (C + I) = W
⇒ Y - AE = W Thus defining the equilibrium as the level of output where AE = Y is exactly the same as defining the equilibrium as the level of output where S = I.
Copyright © 2005 Pearson Education Canada Inc.
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45º line
Equilibrium Illustrated
AE
Or, equivalently, it is the level of national income where desired saving equals desired investment.
Saving, Investment
Equilibrium national income is that level of national income where desired aggregate expenditure equals actual national income.
Desired Aggregate Expenditure
900 600
•
300 105 300 600 900 Actual National Income S 75 0 -30
I
• 300
600
900
Actual National Income Copyright © 2005 Pearson Education Canada Inc.
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21.3 Changes in Equilibrium National Income Shifts in the AE Function AE
AE e1
AE1
AE
∆e´´ ∆e´
∆e
e0
AE0
∆Y Y0
Y1
Y
Y0
Y1
Y
A movement along the AE function occurs in response to a change in Y; a shift of the AE function indicates a change in desired expenditure for any given level of Y. Copyright © 2005 Pearson Education Canada Inc.
34 of 30
AE =Y
AE
E1
e1
•
AE1 AE0
E1
e2
e´1 e0
AE =Y
AE
•E 0 Y0
e0 Y1
Y
•
AE1 AE0
•E0 Y0
Y1
Y
Two types of shifts can occur with the AE function: • First, the AE function can shift parallel to itself. • Second, the slope of the AE function can change.
35 of 30
The Multiplier What is the Multiplier? The multiplier is a measure of the size of the change in equilibrium national income that results from a change in autonomous expenditure. In the simplest of macro models, the multiplier is greater than one. For example, a $1 billion increase in desired investment expenditure will increase the equilibrium level of national income by more than $1 billion.
Copyright © 2005 Pearson Education Canada Inc.
36 of 30
Suppose there is an increase in autonomous desired expenditure equal to ∆A.
AE E1
e1
We can derive the precise e´1 value of the simple multiplier: Simple multiplier = ∆Y 1 = ∆A 1-z
AE =Y
e0
•
•
AE1 AE0
∆A
•E
0
∆Y
Y0
Y1
Y
where z is the marginal propensity to spend out of national income. Copyright © 2005 Pearson Education Canada Inc.
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AE AE =Y E1
•
∆A 0
E1
Y1
•
Y
AE1 AE0
∆A
•E
0
∆Y
Y0
AE
AE1 AE0
•E
AE =Y
Y0
∆Y Y1
The larger the marginal propensity to spend out of national income (z), the steeper the AE curve and the larger the multiplier.
Y
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Economic Fluctuations as Self-Fulfilling Prophecies Households and firms base their desired investment and consumption partly on their expectations for the future. As a result, changes in expectations about the future can lead to real changes in the current state of the economy. To see this, imagine that many firms feel optimistic about future economic prospects. This increased optimism will increase their desired investment, shifting up the AE curve. As we have seen, this shift will increase national income, justifying the firms’ initial optimism. Copyright © 2005 Pearson Education Canada Inc.
39 of 30
Now imagine the opposite scenario. It should be clear that if firms and households are pessimistic about the future in large numbers, the ensuing change in their behaviour will lead to a self-fulfilling prophecy of reduced national income.
Could the Prime Minister ever announce to the country that the government made a ‘big’ mistake! For example: suppose that government analyst report to the Prime Minister that having signed the Kyoto Accord might result in a recession. Copyright © 2005 Pearson Education Canada Inc.
40 of 30
Chapter 21 The Simplest ShortRun Macro Model
2 of 30
Learning Objectives 1. Differentiate between desired expenditure and actual expenditure. 2. Explain the determinants of desired consumption and desired investment expenditures. 3. Define equilibrium national income. 4. Explain how a change in desired expenditure affects equilibrium income, and how this change is reflected by the multiplier.
Copyright © 2005 Pearson Education Canada Inc.
3 of 30
21.1 Actual Vs. Desired Agg. Expend. The National Income and Expenditure Accounts (NIEA) divide actual GDP, calculated from the expenditure side, into its components: Ca, Ia , Ga, and NXa. RECALL: GDP = Ca + Ia + Ga + NXa. Is an accounting identity. Every year (week, month) if we added up Ca, Ia , Ga, and NXa we will get actual output GDP. The small ‘a’ indicates we are measuring what each groups actually spent during the time period.
Copyright © 2005 Pearson Education Canada Inc.
4 of 30
21.1 Desired Aggregate Expenditure Total desired (planned, intended) expenditure on domestically produced goods and services can be divided into similar categories: • desired consumption (C), • desired investment (I), • desired government purchases (G), and • desired net exports (NX).
5 of 30
The sum of these components is called desired aggregate expenditure, or more simply Aggregate Expenditure (AE). AE = C+I+G+(X-IM) Components of aggregate expenditure that do not depend on national income are called autonomous expenditures. Components of aggregate expenditure that do change in response to changes in national income are called induced expenditures. 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. Their ‘intended’ or ‘planned’ expenditures. Copyright © 2005 Pearson Education Canada Inc.
6 of 30
Desired Consumption Expenditure There are only two possible uses of disposable income: consumption (C) or saving (S). The factors that influence consumption or saving are given in the consumption function and the saving function. In the simplest theory, consumption is determined primarily by current disposable income (YD). In more advanced theories of consumption, individuals are explicitly forward looking, and current income is less important than some measure of “permanent” or “lifetime” income. Copyright © 2005 Pearson Education Canada Inc.
7 of 30
The simple consumption function is written as: C = a + bYD where a represents autonomous consumption expenditure and bYD represents induced consumption expenditure. C
a
45º line
Slope = b
Notice that the slope of the 45º line is one. The slope of the simple consumption function is less than one.
YD Copyright © 2005 Pearson Education Canada Inc.
8 of 30
Consider C = a + bYd where a = 4000 and b =0.5
Yd $ 0 $ 5000 $ 8000 $10000 $15000 $20000
a + bYd = $4000 $ 0 $4000 $ 2500 $4000 $ 4000 $4000 $ 5000 $4000 $ 7500 $4000 $10000
C $ 4000 $ 6500 $ 8000 $ 9000 $11500 $14000
9 of 30
Picture of the Consumption Function C= a + bYd
C $14000 Break even
$8000 $6000 $4000 Intercept
$0
$5000 $8000
$20000
Yd
10 of 30
Exercise: do the chart and graph Repeat the above exercise using the following a $5000 $3000 $4000 $4000
b 0.5 0.5 0.7 0.3
you should find intercept shifts up intercept shifts down slope rotates upwards slope rotates downwards
11 of 30
The marginal propensity to consume (MPC) relates the change in desired consumption to the change in disposable income that brings it about — it is the slope of the consumption function. MPC = ∆ C/∆ YD (equals b ) In the previous diagram, the MPC is the same at any level of income. The average propensity to consume (APC) is equal to total consumption divided by total disposable income. The APC falls as the level of income rises. APC = C/YD
Copyright © 2005 Pearson Education Canada Inc.
12 of 30
Yd
$
C
0
$ 5000 $ 8000 $10000 $15000 $20000
$ 4000 $ 6500 $ 8000 $ 9000 $11500 $14000
APC C / Yd
∆ YD ∆ C
MPC ∆C/∆YD
… $5000 $2500
0.5
$3000 $1500
0.5
$2000 $1000
0.5
$5000 $2500
0.5
$5000 $2500
0.5
1.30 1.00 0.90 0.77 0.70
13 of 30
What about savings?? If C = a + bYd and Yd = C + S then S= -a +(1-b)Yd
Yd $ 0 $ 5000 $ 8000 $10000 $15000 $20000
C $ 4000 $ 6500 $ 8000 $ 9000 $11500 $14000
Calculate APS = S/YD
Savings = Yd - C -$4000 -$1500 $ 0 $1000 $3500 $6000 MPS = ∆ S/∆ YD
Desired Xonsumption
14 of 30
45º line
600
C
450 300 150
•
Both consumption and saving rise as disposable income rises.
Desired Saving
150 300 450 600 Real Disposable Income 150 0 -30
-150
S 150
300
450
600
Real Disposable Income Copyright © 2005 Pearson Education Canada Inc.
15 of 30
The average propensity to save (APS) is equal to total desired saving divided by total disposable income: APS = S/YD The marginal propensity to save (MPS) relates the change in desired saving to the change in disposable income that brought it about: MPS = ∆ S/∆ YD
Since all of YD is either consumed or saved, we have: • APC + APS = 1 • MPC + MPS = 1
Copyright © 2005 Pearson Education Canada Inc.
Suppose there is an unexpected increase in wealth. The consumption function will shift upward, and the saving function downward. Other reasons the consumption function might shift include changes in interest rates or expectations.
45º line C1
600 450
C0
•
300 150
•
30 150 300 450 600 Real Disposable Income Desired Saving
Shifts in Consumption Functions
Desired Consumption
16 of 30
S0
150 0 -30
-150
S1 150
450
600
300 Real Disposable Income Copyright © 2005 Pearson Education Canada Inc.
17 of 30
Desired Investment Expenditure Investment expenditure is the most volatile component of GDP. Changes in investment expenditure are strongly associated with economic fluctuations. Three important determinants of aggregate investment expenditure are: • the real interest rate, • changes in the level of sales, and • business confidence.
Copyright © 2005 Pearson Education Canada Inc.
18 of 30
The Real Interest Rate 1. The real interest rate is the opportunity cost of using money (either borrowed or retained earnings) for investment in new plants and equipment. 2. It is also the opportunity cost of holding an inventory of a given size. 3. Also, higher real interest rates mean a higher cost associated with mortgage financing for residential construction. Thus, all three components of desired investment expenditure are negatively related to the real interest rate.
Copyright © 2005 Pearson Education Canada Inc.
19 of 30
Changes in Sales The higher the level of production and sales, the larger the desired stock of inventories. This means that changes in the rates of production and sales cause temporary bouts of investment (or disinvestment) in inventories. Business Confidence When business confidence is high, firms will want to invest now so as to reap future profits (investment takes time to “come on line”). Business confidence and consumer confidence may feed off of one another.
Copyright © 2005 Pearson Education Canada Inc.
20 of 30
Investment Function Desired investment is treated as autonomous – completely unrelated to the current level of Y We can write
I=I
Were I is determined by - real interest rates - expectations (confidence) - changes in sales
21 of 30
Investment Function (what does it look like?) Desires Investment
I 200
150 100 0
interest rate falls expectations improve sales increase
I’ I I’’
interest rate rises expectations worsen sales decrease
Y Actual National Income
22 of 30
The Aggregate Expenditure Function The aggregate expenditure function relates the level of desired aggregate expenditure to the level of actual national income. (Note the distinction between desired aggregate expenditure and actual national income.) In the absence of government and international trade, desired aggregate expenditure is just equal to C + I. AE = C + I
Copyright © 2005 Pearson Education Canada Inc.
23 of 30
Consider the following example. The consumption function is: C = a + bYd Suppose
C = 30 + (0.8)Y
The investment function is: I = I I = 75 The AE function is then given by: AE = C + I = 30 + (0.8)Y + 75 and so AE = 105 + (0.8)Y Copyright © 2005 Pearson Education Canada Inc.
24 of 30
C 54 126 150 270 390 450 510 750
I 75 75 75 75 75 75 75 75
AE 129 201 225 345 465 525 585 825
900 Desired Aggregate Expenditure
Y 30 120 150 300 450 525 600 900
AE
600 300 105
300 600 900 Actual National Income
The slope of the AE function is the marginal propensity to spend. In the simplest model with no taxes and no international trade, this is just the MPC.
Copyright © 2005 Pearson Education Canada Inc.
25 of 30
Summary The AE function combines the spending plans of households and firms. It shows, for any level of actual national income, the level of desired aggregate spending.
Copyright © 2005 Pearson Education Canada Inc.
26 of 30
21.2 Equilibrium National Income Desired Expenditure and Actual Output If desired aggregate expenditure exceeds actual output, there will be pressure for output to rise. If desired aggregate expenditure is less than actual output, there will be pressure for output to fall. Why? Think about what happens to inventories when AE > Y, and why this leads to more production.
Copyright © 2005 Pearson Education Canada Inc.
27 of 30
National Income (Y) OUTPUT 30 120 150 300 450 525 600 900
Desired Aggregate Expenditure (AE = C + I) 129 201 225 345 465 525 585 825
Effect Pressure On output to rise ↓ ↓ Equilibrium income ↑ Pressure on output to fall
Equilibrium occurs where aggregate desired expenditure equals actual national income (output). Copyright © 2005 Pearson Education Canada Inc.
28 of 30
How the Economy Gets to Equilibrium – Inventory Adjustment Mechanism What happens if output (GDP) is greater than desired AE? AE < Y - Firms cannot sell all that they are producing - Inventories build up (unintended I) - Signals that a decrease in output is necessary - Firms decrease output until AE=Y
29 of 30
How the Economy Gets to Equilibrium – Inventory Adjustment Mechanism What happens if output (GDP) is less than desired AE? AE > Y - Firms are selling more then they are producing - Inventories are being run down (unintended I) - Signals that an increase in output is necessary - Firms increase output until AE=Y
30 of 30
Desired Saving and Desired Investment We can view the equilibrium differently by considering desired saving and desired investment. The difference between desired investment and desired saving is exactly equal to the difference between desired aggregate expenditure and actual national income. To see this, suppose the difference between desired saving and desired investment is equal to some number, W. Thus, S-I=W
Copyright © 2005 Pearson Education Canada Inc.
31 of 30
Now, recall that S = Y - C. We can therefore write: Y-C-I=W Since AE = C + I, we can rewrite the equation again as: Y - (C + I) = W
⇒ Y - AE = W Thus defining the equilibrium as the level of output where AE = Y is exactly the same as defining the equilibrium as the level of output where S = I.
Copyright © 2005 Pearson Education Canada Inc.
32 of 30
45º line
Equilibrium Illustrated
AE
Or, equivalently, it is the level of national income where desired saving equals desired investment.
Saving, Investment
Equilibrium national income is that level of national income where desired aggregate expenditure equals actual national income.
Desired Aggregate Expenditure
900 600
•
300 105 300 600 900 Actual National Income S 75 0 -30
I
• 300
600
900
Actual National Income Copyright © 2005 Pearson Education Canada Inc.
33 of 30
21.3 Changes in Equilibrium National Income Shifts in the AE Function AE
AE e1
AE1
AE
∆e´´ ∆e´
∆e
e0
AE0
∆Y Y0
Y1
Y
Y0
Y1
Y
A movement along the AE function occurs in response to a change in Y; a shift of the AE function indicates a change in desired expenditure for any given level of Y. Copyright © 2005 Pearson Education Canada Inc.
34 of 30
AE =Y
AE
E1
e1
•
AE1 AE0
E1
e2
e´1 e0
AE =Y
AE
•E 0 Y0
e0 Y1
Y
•
AE1 AE0
•E0 Y0
Y1
Y
Two types of shifts can occur with the AE function: • First, the AE function can shift parallel to itself. • Second, the slope of the AE function can change.
35 of 30
The Multiplier What is the Multiplier? The multiplier is a measure of the size of the change in equilibrium national income that results from a change in autonomous expenditure. In the simplest of macro models, the multiplier is greater than one. For example, a $1 billion increase in desired investment expenditure will increase the equilibrium level of national income by more than $1 billion.
Copyright © 2005 Pearson Education Canada Inc.
36 of 30
Suppose there is an increase in autonomous desired expenditure equal to ∆A.
AE E1
e1
We can derive the precise e´1 value of the simple multiplier: Simple multiplier = ∆Y 1 = ∆A 1-z
AE =Y
e0
•
•
AE1 AE0
∆A
•E
0
∆Y
Y0
Y1
Y
where z is the marginal propensity to spend out of national income. Copyright © 2005 Pearson Education Canada Inc.
37 of 30
AE AE =Y E1
•
∆A 0
E1
Y1
•
Y
AE1 AE0
∆A
•E
0
∆Y
Y0
AE
AE1 AE0
•E
AE =Y
Y0
∆Y Y1
The larger the marginal propensity to spend out of national income (z), the steeper the AE curve and the larger the multiplier.
Y
38 of 30
Economic Fluctuations as Self-Fulfilling Prophecies Households and firms base their desired investment and consumption partly on their expectations for the future. As a result, changes in expectations about the future can lead to real changes in the current state of the economy. To see this, imagine that many firms feel optimistic about future economic prospects. This increased optimism will increase their desired investment, shifting up the AE curve. As we have seen, this shift will increase national income, justifying the firms’ initial optimism. Copyright © 2005 Pearson Education Canada Inc.
39 of 30
Now imagine the opposite scenario. It should be clear that if firms and households are pessimistic about the future in large numbers, the ensuing change in their behaviour will lead to a self-fulfilling prophecy of reduced national income.
Could the Prime Minister ever announce to the country that the government made a ‘big’ mistake! For example: suppose that government analyst report to the Prime Minister that having signed the Kyoto Accord might result in a recession. Copyright © 2005 Pearson Education Canada Inc.
40 of 30
