Scribd Logo
Upload

Welcome to Scribd!

  • 17 views

    Scan00121 PDF

    Uploaded by

    udit raj singh

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content

    You might also like

    Scan00121 PDF

    Uploaded by

    udit raj singh
    17 views23 pages

    Original Title

    scan00121.pdf

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    17 views23 pages

    Scan00121 PDF

    Uploaded by

    udit raj singh

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    of 23
    IMME e ecard Agsregate Expenditure and Equilibrium Output the macroeconomy works. We know how to calculate gross domestic product (GDP), but what factors determine it? We know how to define and measure inflation ane unemployment, but what circum stances cause inflation and unem ployment? What, if anything, can government do to reduce unem ployment and inflation? ‘Analyzing the various compo- nents of the macroeconomy is a complex undertaking, The level of GDP, the overall price level, and the level of employment—three chief concerns of macroecono- smists—are influenced by events in three broadly defined “markets” = Goods-and-services markets = Financial (money) markets = Labor markets We will explore each market, as well as the links between them, in our discussion of ‘macroeconomic theory. Figure 21.1 presents the plan of the next seven chapters, which form the core of macroeconomic theory. In Chapters 21 and 22, we describe the market for goods arket.In Chapter show how the equilibrium level of national income is government and no imports or exports. In Chapter 22, we provide a more complete picture of the economy by adding government purchases, taxes, and net exports to the analysis. In Chapters 23 and 24, we focus on the money market. Chapter 23 introduces the money market and the banking system and discusses the way the US. central bank (the Federal Reserve controls the money supply. Chapter 24 analyzes the demand for money and the way interes rates are determined, Chapter 25 then examines the relationship between the goods market and the money market. Chapter 26 explores the aggregate demand and supply curves first men. tioned in Chapter 18, Chapter 26 also analyzes how the overall price level is determined, as well asthe relationship between output and the price level. Finally, Chapter 27 discusses the supply of and demand for labor and the functioning of the labor markerin the macroeconomy. This mate rials essential to an understanding of employment and unemployment. Before we begin our discussion of aggregate output and aggregate income, we need te stress that production, consumption, and other activities that we will be discussing in the ‘we explain several basic concepts and and services, often called the goods ‘mined in a simple economy with no Chapter Outline Aggrogate Output and Aggregate Income (Y) Equilibrium Aggregate ‘Output (Income) The Saving/in 0 Equi Adjustment to Equiitia | |r Mulipier Equator The Size ofthe Mutipi The Mutipier in Action Depres Looking Ahead ‘Appondix: Deriving the “Multiplier Algebraicaly 455 fiaicoe Sissons cuseren 26 —— aaa Consumption (0) sTiaeaws Sant Permedimestren () agente donand oe Goverment (6) = Nvspos (X— = caurronz7 + Aggregate output (income) (Y) Connections between —__¥ re ee ae the gods maaan pggrgate supp cue «The supply of bor 7 > Site Semana abr : Ss D coe dairies 20 ae Senelomen ‘The Money Market + Eaulibiuminorest rate (r') He a1 of money + Equlorum ouput ‘+The demand for money (income) (¥*) Titoes to eam pce level (P*) ‘We build up the macroecanomy slowly. In Chapters 22. and 22 we examine the market for goods and services, and in Chapters 23 and 24 we examine the money market. Then in Chapter 25 we bring the two markets together, In so doing explaining the links between aggregate ‘output (7) and the interest rate (7). In Chapter 26 we explain how the aggregate demand curve can be derived from Chapters 22 through 25, and we introduce the aggregate supply curve. This sets the stage for an explanation ofthe price level (P). We then explain in Chapter 2 how the labor market fits into the macroeconomic picture. following chapters are ongoing activities. Nonetheless, itis helpful to think about these activ- they took place ina series of production periods. A period might be a month long or pethaps 3 months long. During each period, some output is produced, income is generated, and spending takes place. At the end of each period we can examine the results. Was every- thing that was produced in the economy sold? What percentage of income was spent? What percentage was saved? Is output (income) likely to rise r fallin the next period? AGGREGATE OUTPUT AND AGGREGATE INCOME (Y) Each period, firms produce some aggregate quantity of goods and services, which we refer to as aggregate output (¥). In Chapter 19, we introduced real gross domestic product as a mea sure of the quantity of output produced in the economy, ¥. Output includes the production of services, consumer goods, and investment goods. Its important to think of these as com- ponents of “real” output. We have already seen that GDP (1) can be calculated in terms of either income or expendi- tures. Because every dollar of expenditure is received by someone as income, we can compute total GDP (¥) either by adding up the total spent on all final goods during period orby adding ‘roduced (oF supplied) in an upaall the income—wages, rents, interest, and profits—received by all the factors of production. | ‘canon in agen period. We will use the variable Y to refer to both aggregate output and aggregate income adgregate income te because they are the same seen from two different points of view. When output increases, {otal icome recived ty a additional income is generated. More workers may be hired and paid; workers may put in, factors of production n'a gwen and be paid for, more hours; and owners may earn more profits. When output is cut, income pet. falls, workers may be laid off or work fewer hours (and be paid less), and profits may fall. aggregate output (income) (¥) A sombines In any given period, there is an exact equality between aggregate output (production) term used to remind you of the and aggregate income. You should be reminded of this fact whenever you encounter exact equality between agzregate the combined term, % aces} ‘output and aggregate income. bon ined err neato utp (K . 456 Aggregate output can also be considered the aggregate quantity supplied, because itis the amount that firms are supplying (producing) during the period. Inthe discussions that follow, ‘we use the phrase aggregate output (income), instead of aggregate quantity supplied, ut keep in ‘mind that the two are equivalent. Also remember that “aggregate output” means “real GDP” Think in Real Terms From the outset you must think in “real terms” For example, when we talk about output (¥), we mean real output, not nominal output. Although we discussed in ‘Chapter 19 thatthe calculation of real GDP is complicated, you can ignore these complications in the following analysis. To help make things easier to read, we will frequently use doar values for ¥, but do not confuse ¥ with nominal output. The main point is to think of Y as being in real terms—the quantities of goods and services produced, not the dollars circulating in the economy. INCOME, CONSUMPTION, AND SAVING (Y, C, AND S) Each period (a month or 3 months) households receive some aggregate amount of income (1). We begin our analysis in a simple world with no government and a “closed” economy, that is, no imports and no exports In such a world, a household can do two, and only two, things with its income: Itcan buy goods and services—that is it can consume—or it can save. This is shown in Figure 21.2. The part ofits income that a household does not consume in a given period is called saving. Total household saving in the economy (S) is by definition equal to income minus consumption (C): saving = income ~ consumption Se¥-c ‘The triple equal sign means this is an Identity, or something that is always true. You will encounter several identities inthis chapter, which you should commit to memory. Remember that saving does not refer to the total savings accumulated over time. Saving (without the finals) r=fers to the portion of a single period’s income that is not spent in that period. Saving (S) is the amount added to accumulated savingsin any given period. Saving is a flow variable; savings is stock variable, (Review Chapter 3 if you are unsure of the differ- ence between stock and flow variables.) EXPLAINING SPENDING BEHAVIOR So far, we have said nothing about behavior. We have not described the consumption and saving behavior of households, and we have not speculated about how much aggregate out pt firms will decide to produce in a given period. Instead, we have only a framework and a set of definitions to work with. “Macroeconomics, you will recall isthe study of behavior. To understand the functioning of the macroeconomy, we must understand the behavior of households and firms. In our Consumption (C) ‘saving (S) Ser Households ‘Aggregate meame (Y) All income is either spent on consumption or saved in an economy in which there are no taxes. Thus, S2¥-C. ei cnaprer 21. 457 ‘Agrees penta and Eaulbrim Outpt ‘saving (S) The part of ts income that a household does ‘ot consume in a given period Distinguished trom savings. \ihich i the curent stock of ‘ccumulated saving. Identity Something that is always te. 458 parry simple economy in which there is no government, there are two types of spending behavior: ‘The Goods and Money Markets. 3 - . e a a ui a spending by households, or consumption, and spending by firms, or investment. Household Consumption and Saving How do households decide how much to consume? In any given period, the amount of aggregate consumption in the economy depends on a number of factors Some determinants of aggregate consumption include: 1. Household income 2. Household wealth 23. Interest rates 4. Households’ expectations about the future ‘These four factors work together to determine the spending and saving behavior of house holds, both for individual ones and for the aggregate. This is no surprise. Households with higher income and higher wealth are likely to spend more than households with less income and less wealth. Lower interest rates reduce the cost of borrowing, so lower interest rates are likely to stimulate spending. (Higher interes rates increase the cost of borrowing and are likely to decrease spending.) Finally, positive expectations about the future are likely to increase cur- rent spending, whereas uncertainty about the future is likely to decrease current spending. All these factors are important, but we will concentrate for now on the relationship between income and consumption.! In The General Theory, Keynes argued that the amount of consumption undertaken by a household is directly related to its income: ‘The higher your income is, the higher your consumption is likely to be. People with ‘more income tend to consume more than people with less income. The relationship between consumption and income is called a consumption function. tener between Figure 21.3 shows a hypothetical consumption function for an individual household. The Household consumption () - Household income () ‘A consumption funetion for an individual household shows the level of consumption at each level of household income, ‘The assumption tha consumption i dependent soley on income of cous, ony splits: Nonethles, many important ‘insights bout how the economy works an be obtained though this smpliferion Ln Cher 29, we els his stmpton ot onsider the behavior of households and fms in the macrocconomy in mote deta re ee curve is labeled cy), which is read “casa function of y” or “consumption as a function of income.” There are several things you should notice about the curve. First, it has a positive slope. In other words, as y increases, so does c. Second, the curve intersects the c-axis above zero, This means that even at an income of zero, consumption is positive. Even if a house- hold found itself with a zero income, it still must consume to survive. It would borrow or live off its savings, but its consumption could not be zero. Keep in mind that Figure 21.3 shows the relationship between consumption and income for an individual household, but also remember that macroeconomics is concerned with aggregate consumption. Specifically, macroeconomists want to know how aggregate con- sumption (the total consumption of all households) is likely to respond to changes in aggregate income. If all individual households increase their consumption as income increases, and we assume that they do, itis reasonable to assume that a positive relationship exists between aggregate consumption (C) and aggregate income (¥) For simplicity, assume that points of aggregate consumption, when plotted against aggregate income, lie along a straight lin, as in Figure 21.4. Because the aggregate consump. tion function is a straight line, we can write the following equation to describe it C=a+bY Yiis aggregate output (income), C is aggregate consumption, and a is the point at which the consumption function intersects the C-axis—a constant. The letter b is the slope of, the line, in this case AC /AY [because consumption (C) is measured on the vertical axis, and income (¥) is measured on the horizontal axis.’ Every time income increases (say by AY), consumption increases by b times AY. Thus, AC = b x AY and AC/AY = b. Suppose, for example, that the slope of the line in Figure 21.4 is .75 (that is, b= .75). An increase in income (AY) of $100 would then increase consumption by BAY = .75 x $100, or $75. ‘The marginal propensity to consume (MPC) is the fraction of a change in income that is consumed. In the consumption function here, bis the MPC. An MPC of .75 means consumption changes by .75 of the change in income. The slope of the consumption function is the MPC. consumption (C) Ageregate income (¥) ‘The consumption function shows the level of consumption at every evel of income. The upward slope Indicates that higher levels of income lead to higher levels of consumption spending, he Gree eter (dela) means "change in” For ample AY (read “deka Y") meas the" changin income income (1) in 2004 $100 and income ln 208110 then AY for this period 10 $100» $10, ora eview ofthe concept af slope, se ‘Appendix Chae cuapter 21 459. ‘Areas Expenditure sd Elion Out marginal propensity to consume (MPC) That fraction of a change in income ‘that's consumed, or spent. marginal propensity to ‘save (MPS) That traction of 2 change in income that's saved ‘There are only two places income can go: consumption or saving. If $0.75 of a $1.00 increase in income goes to consumption, $0.25 must go to saving. If income decreases by $1.00, consumption will decrease by $0.75 and saving will decrease by $0.25. The marginal propensity to save (MPS) is the fraction of a change in income that is saved: ASIAY, where Sis the change in saving. Because everything not consumed is saved, the MPCand the MPS must add up to 1 ‘MPC+ MPS=1 Because the MPC and the MPS are important concepts, it may help to review their definitions. ‘The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consump- 61 eee eee fractioii of fn increase in income "tht is Saved (or the fraction of a decteasein income that comes out of saving). Because C is aggregate consumption and Y's aggregate income, it follows that the MPC is, society's marginal propensity to consume out of national income and that the MPS is society's ‘marginal propensity to save out of national income, Numerical Example The numerical examples used in the rest of this chapter are based on the following consumption function: 00+ 25x tb ‘This equation is simply an extension of the generic C= a + bY consumption function we have been discussing. At a national income of zero, consumption is $100 billion (a). As income rises, so does consumption. We will assume that for every $100 billion increase in, income (AY), consumption rises by $75 billion (AC). This means that the slope of the consumption function (b) is equal to ACIAY, or $75 billion/$100 billion = .75. The mar- ginal propensity to consume out of national income is therefore .75; the marginal propensity to save is .25. Some numbers derived from this consumption function are listed and graphed in Figure 21.5. Now consider saving, We already know Y= C+ S, income equals consumption plus sa ing. Once we know how much consumption will result from a given level of income, we know how much saving there will be. Recall that saving is everything that is not consumed. eG From the numbers in Figure 21.5, we can easily derive the saving schedule that is shown. Atan income of $200 billion, consumption is $250 billion; saving is thus a negative $50 billion (Ss ¥- C= $200 billion - $250 billion = -$50 billion). At an aggregate income of $400 billion, consumption is exactly $400 billion, and saving is zero. At $800 billion in income, saving isa positive $100 billion. ‘The consumption and saving functions we have been discussing are shown in Figure 21.6. To analyze their relationship, we will use the device of the 45° line as a way of comparing C and Y. The 45° line—the solid black line in the top graph—shows all the points at which the value on the horizontal axis equals the value on the vertical axis. ‘Thus, the 45° line in Figure 21.6 represents all the points at which aggregate income equals aggregate consumption.) Where the consumption function is above the 45° line, con sumption exceeds income, and saving is negative. Where the consumption function cnarrer 21 461 ‘Aegegte Expendre 00 | daub Outpt 00 } ony 1o0+.75¥ eee om ano son to sto eo 70000 oD 100 Aggregate income, ¥(billons of dollars) AGGREGATE INCOME, Y AGGREGATE CONSUMPTION, ¢ LIONS OF DOLLARS) (BILLIONS OF DOLLARS) 100 160 15 250 400 150 700 850 In this simple consumption function, consumption is $100 biion at an income of zero, As income rises, so does consumption. For every $100 billn increase in income, consumption rises by $75 bit lian, The slope ofthe line is .75. crosses the 45° line, consumption is equal to income, and saving is zero. Where the con- sumption function is below the 45° line, consumption is less than income, and saving is positive. Note that the slope of the saving function is AS/AY, which is equal to the mar: ginal propensity to save (MPS). ‘The consumption function and the saving function are mirror images of one another No information appears in one that does not also appear in the other. These functions tell us how households in the aggregate will divide income between consumption spending and saving at every possible income level. In other words, they embody aggregate houschold behavior. PLANNED INVESTMENT (1) Consumption, as we have seen, is the spending by households on goods and services, but what kind of spending do firms engage in? The answer is investment. What Is Investment? Let us begin with a brief review of terms and concepts. In everyday language, we use investment to refer to what we do with our savings: “I invested in a mutual fund and some AOL stock.” In the language of economics, however, investment 462 party ‘The Goode and Money Marat Aggregate income, ¥(hilions of dors) . c : s Acgrecare ‘AGGREGATE ‘CONSUMPTION ‘SAVING LIONS OF DOLLARS) (BILLIONS OF DOLLAR: | 100 =100| 160 80 ‘Because S = Y~ G tis easy to derive a saving function from a consumption function. A 45° line drawn {fom the origin can be used as a corwenient too to compare consumption and income graphically At Y= 200, consumption is 250. The 45" ine shows us that consumption Is lager than income by 60. Thus 'S=¥—C=-50. At Y= 800, consumption isles than income by 100. Thus, S always refers to the creation of capital stock. To an economist, an investment is something produced that is used to create value in the future. ‘You must not confuse the two uses of the term. When a firm builds a new plant or adds new machinery to its current stock, itis investing. A restaurant owner who buys tables, chairs, cooking equipment, and silverware is investing. When a college builds a new sports nt Pscas centr its investing, rom now on, ve use Investment only to refer to purchases by firms of sre scyaget® 2m ew buildings and equipment and inventories, all of which add to frm capital stocks oowacmen Recall hat inventories are par of the capital stock. When ims add to their inventories, tis cata soc they are investing—they are buying something that creates value in the future. Most ofthe Investment Purchases by capital stock of a clothing store consist of its inventories of unsold clothes in its warehouses and on its racks and display shelves. The service provided by a supermarket or department store is the convenience of having a large variety of commodities in inventory available for purchase ata single location, ‘Manufacturing firms generally have two kinds of inventories: mputs and final products General Motors (GM) has stocks of tires, rolled steel, engine blocks, valve covers, and thou- sands of other things in inventory, all waiting to be used in producing new cars. In addition, GM has an inventory of finished automobiles awaiting shipment. Investment isa flow variable—it represents additions to capital stock in a specific period A firm's decision on how much to invest each period is determined by many factors. For now. ‘we will focus simply on the effects that given investment levels have on the st of the economy. Actual versus Planned Investment One of the most important insights of macro economics is deceptively simple: A firm may not always end up investing the exact amount that it planned to. The reason is that a firm does not have complete control over its investment decision; some parts of that decision are made by other actors in the economy. (This is not true of consumption, however. Because we assume households have complete control over their consumption, planned consumption is always equal to actual consumption.) Generally, firms can choose how much new plant and equipment they wish to purchase in any given period. If GM wants to buy anew robot to stamp fenders or McDonald’ decides to buy an extra french fry machine, it can usually do so without difficulty. There is, however, another component of investment over which firms have less control—inventory investment. Suppose GM expects to sell 1 million cars this quarter and has inventories ata level it considers proper. Ifthe company produces and sells 1 million cars, it wll keep its inventories just where they are now (at the desired level). Now suppose GM produces I million cars, but due to a sudden shift of consumer interest it sells only 900,000 cars. By definition, GM’s inventories of cars must go up by 100,000 cars. The firm's change in inventory is equal to production minus sales. The point here is: ‘One component of investment—inventory change—is partly determined by how much households decide to buy, which is not under the complete control of firms. If households do not buy as much as firms expect them to, inventories willbe higher than expected, and firms will have made an inventory investment that they did not plan to make. Because involuntary inventory adjustments are neither desired nor planned, we need to distinguish between actual investment and desired, or planned, investment. We will use Ito refer to desired or planned investment only. In other words, Iwill refer to planned purchases of plant and equipment and planned inventory changes. Actual investment, in contrast, is the actual amount of investment that takes place. If actual inventory investment turns out to be higher than firms planned, then actual investment is greater than J, planned investment. For the purposes of this chapter, we will ake the amount of investment that firms together plan to make each period (/) as fixed at some given level, We assuume this level does not vary with income. In the example that follows, we will assume that I= $25 billion, regardless of income. As Figure 21.7 shows, this means the planned investment function isa horizontal line. PLANNED AGGREGATE EXPENDITURE (AE) We define total planned aggregate expenditure (AE) in the economy to be consumption (©) plus planned investment (I. planned aggregate expenditure = consumption + planned investment AE=C+I “tn practic, plnned aggre esenie ao ncads government spending (@) and net exports (EXIM: AB C+ 1+ G “F(X IND nhs caper af sing that Gand (EX I ate eo, This sung ean inthe ex chapter cnapren2s 463 ‘asso and eal Output change in inventory Production mieus sales. te-captal stock and inventory ‘that ae planned by tes. actual Investment Te takes place: it includes tems ‘ch 8 unplanned changes in planned aggregate expenditure (AE) The toa! ‘amount the economy plans to spend in a given period. Equal to consumation plus planned Investment: AE = C+ 464 party The Gonds and Money Marts equilibrium Occurs when there is no tendency for change Inthe macroeconomic goods ‘market equim occurs when planned aggregate expenditure is leaual to aggregate outout Aggregite income, ¥ (billions of las) For the time boing, we will assume that planned investment is fixed. It does not change when income changes, s0 its graph Is a horizontal line Bis the total amount that the economy plans to spend in a given period. We will now use the concept of planned aggregate expenditure to discuss the economy's equilibrium level of output. EQUILIBRIUM AGGREGATE OUTPUT (INCOME) Thus far, we have described the behavior of firms and households. We now discuss the nature of equilibrium and explain how the economy achieves equilibrium. ‘A number of definitions of equilibrium are used in economics. They all refer to the idea that at equilibrium, there is no tendency for change. In microeconomics, equilibrium is said to exist in a particular market (for example, the market for bananas) at the price for which the quantity demanded is equal to the quantity supplied. At this point, both suppliers and demanders are satisfied. The equilibrium price of a good is the price at which suppliers want to furnish the amount that demanders want to buy. In macroeconomics, we define equilibrium in the goods market as that point at which planned aggregate expenditure is equal to aggregate output. aggregate output = ¥ ‘planned aggregate expenditure = AE = equilibrium: ¥ = AE, or ¥ =C+1 40 Note that the equilibrium condition is not an identity. This definition of equilibrium can hold if, and only if, planned investment and actual investment are equal. (Remember, we are assuming there is no unplanned consumption.) To understand why, consider Y not equal to AE. First, suppose aggregate output is greater than planned aggregate expenditure: y>c4l aggregate output > planned aggregate expenditure ‘When output is greater than planned spending, there is unplanned inventory investment Firms planned to sell more oftheir goods than they sold, and the difference shows up as an unplanned increase in inventories. ‘Next, suppose planned aggregate expenditure is greater than aggregate output: CHI>Y planned aggregate expenditure > aggregate output @ @ ulate np hen agnesare sactoare vest our agoneoare exrtnTURE AE ‘Seaver (NcOME}on —__CONSUMPHION ( wor een 10 5 200 | » | 20 | 2 oo | io | 2 = os | | +00 | ° = | 0 | | es | a = | ito | ms te 1.000 850 | ! 815 1125 ‘When planned spending exceeds output, firms have sold more than they planned to, Inventory investment is smaller than planned. Planned and actual investment are not equal Only when output is exactly matched by planned spending will there be no unplanned inven: tory investment. If there is unplanned inventory investment, this will be a state of disequilib- rium, The mechanism by which the economy returns to equilibrium will be discussed later. Equilibrium in the goods market is achieved only when aggregate output (¥) and planned aggregate expenditure (C+ 1) are equal, or when actual and planned investment are equal. ‘Table 21.1 derives a planned aggregate expenditure schedule and shows the point of equi librium for our numerical example. (Remember, all our calculations are based on C= 100 + 75Y.) To determine planned aggregate expenditure, we add consumption spending (C) to planned investment spending (1) at every level of income. Glancing down columns I and 4, ‘we see one, and only one, level at which aggregate output and planned aggregate expenditure are equal: Y= 500. igure 21.8 illustrates the same equilibrium graphically. Figure 21.8(a) adds planned. investment, constant at $25 billion, to consumption at every level of income. Because planned investment is a constant, the planned aggregate expenditure function is simply the consumption function displaced vertically by that constant amount. Figure 21,8(b) plots the planned aggregate expenditure function with the 45° line. The 45° line represents all points ‘on the graph where the variables on the horizontal and vertical axes are equal. Any point on the 45° line is a potential equilibrium point. The planned aggregate expenditure function crosses the 45° line at a single point, where Y = $500 billion. (The point at which the two lines cross is sometimes called the Keynesian cross.) At that point, Y= C+ I. "Now let us look at some other levels of aggregate output (income). First, consider Y = $800 billion. Is this an equilibrium output? Clearly itis not. At Y= $800 billion, planned aggregate expenditure is $725 billion. (See Table 21.1.) This amount i less than aggregate output, which is ‘$809 billion. Because output is greater than planned spending, the difference ends up in inventory as unplanned inventory investment. In this case, unplanned inventory investment is $75 billion. Next, consider Y= $200 billion. Is this an equilibrium output? No. At ¥= $200 billion, planned aggregate expenditure is $275 billion. Planned spending (AE) is greater than output (1), and there is unplanned inventory disinvestment of $75 billion. At Y= $200 billion and Y= $800 billion, planned investment and actual investment are unequal. There is unplanned investment, and the system is out of balance. Only at ¥ = $500 billion, where planned aggregate expenditure and aggregate output are equal, will planned investment equal actual investment. Finally, let us find the equilibrium level of output (income) algebraically. Recall that we know the following: wy (2)C=100+.75Y (consumption function) c+ (equilbrium) @)1=25 (planned investment) EQUILIBRH (= Ae?) uM? Planned ageregate expenditure: z planned ik inventor 5 cotpat ae b é a : é Aggregate output, ¥ (billions of dollars) Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned ‘aggregate expenditure is the sum of consumption spending and planned investment spending. By substituting (2) and (3) into (1), we get: y 00 +.75Y, +25, Cat ‘There is only one value of ¥ for which this statement is true, and we can find it by rearrang- ing terms: ¥ ~75Y = 100+ 25 Y= 75 = 125 23¥ = 125 125. so 25 ‘The equilibrium level of output is 500, as seen in Table 21.1 and Figure 21.8 a @ pane a — meh con cy - ve 1 = = | = | | wo | 0 | | 1,000 I 850, 1 1 When planned spending exceeds output, firms have sold more than they planned to. Inventory investment is smaller than planned. Planned and actual investment are not equal ‘Only when output is exactly matched by planned spending will there be no unplanned inven tory investment. If there is unplanned inventory investment, this will be a state of disequilib- rium, The mechanism by which the economy returns to equilibrium will be discussed later. Equilibrium in the goods market is achieved only when aggregate output (¥) and planned aggregate expenditure (C+ 1) are equal, or when actual and planned investment are equal. Table 21.1 derives planned aggregate expenditure schedule and shows the point of equi librium for our numerical example. (Remember, all our calculations are based on C= 100 + 75Y.) To determine planned aggregate expenditure, we add consumption spending (C) to planned investment spending (J) at every level of income. Glancing down columns 1 and 4, ‘we see one, and only one, level at which aggregate output and planned aggregate expenditure are equal: ¥ = 500. Figure 21.8 illustrates the same equilibrium graphically. Figure 21.8(a) adds planned. investment, constant at $25 billion, to consumption at every level of income. Because planned investment is a constant, the planned aggregate expenditure function is simply the consumption function displaced vertically by that constant amount. Figure 21.8(b) plots the planned aggregate expenditure function with the 45° lin. The 45° line represents all points on the graph where the variables on the horizontal and vertical axes are equal. Any point on the 45° line is a potential equilibrium point. The planned aggregate expenditure function crosses the 45° line at a single point, where Y= $500 billion. (The point at which the two lines cross is sometimes called the Keynesian cross.) At that point, Y= C+ I. ‘Now let us look at some other levels of aggregate output (income). First, consider Y= $800 billion. Is this an equilibrium output? Clearly itis not. At ¥ = $800 billion, planned aggregate expenditure is $725 billion. (See Table 21.1.) This amount is ess than aggregate output, which is {$800 billion. Because output is greater than planned spending, the difference ends up in inventory as unplanned inventory investment. In this case, unplanned inventory investment is $75 billion. Next, consider Y= $200 billion. Is this an equilibrium output? No. At ¥= $200 billion, planned aggregate expenditure is $275 billion. Planned spending (AE) is greater than output (¥), and there is unplanned inventory disinvestment of $75 billion. ‘At Y= $200 billion and Y= $800 billion, planned investment and actual investment are unequal. There is unplanned investment, and the system is out of balance. Only at ¥ = $500 billion, where planned aggregate expenditure and aggregate output are equal, will planned investment equal actual investment. Finally, let us find the equilibrium level of output (income) algebraically. Recall that we know the following wy=ce+r (cquilbrium) (2) =100+.75Y (consumption function) @)1=25 (planned investment) EQUILIBRIUM? (y= Ae?) No No wo} cu Planned aguezate ‘capediar i, Unplanned e = g: 22 ns Aggregate output, ¥ (Glions of dali) Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned aggregate expenditure isthe sum of consumption spending and planned investment spending. ‘By substituting (2) and (3) into (1), we get: y (00 +.75Y +25, E47 ‘There is only one value of ¥for which this statement is true, and we can find it by rearrang: ing terms: Y ~.75Y = 100-425 Y ~.75Y = 125 25Y = 125 125 25 500 The equilibrium level of output is 500, as sen in Table 21.1 and Figure 21.8 THE SAVING/INVESTMENT APPROACH TO EQUILIBRIUM Because aggregate income must cither be saved or spent, by definition, Y= C+ S, which isan identity. The equilibrium condition is Y= C+ 1, but this is not an identity because it does not hold when we are out of equilibrium.* By substituting C+ § for Yin the equilibrium condi tion, we can write C+S=C+1 Because we can subtract C from both sides of this equation, we are left with S=1 Thus, only when planned investment equals saving will there be equilibrium, ‘This saving/investment approach to equilibrium stands to reason intuitively if we recall ‘two things: (1) Output and income are equal, and (2) saving is income that is not spent. Because it is not spent, saving is like a leakage out of the spending stream. Only if that leakage is coun- terbalanced by some other component of planned spending can the resulting planned aggre gate expenditure equal aggregate output. This other component is planned investment (0) This counterbalancing effect can be seen in Figure 21.9. Aggregate income flovis into households, and consumption and saving flow out. The diagram shows saving flowing from households into the financial market. Firms use this saving to finance investment projects. If the planned investment of firms equals the saving of households, then planned aggregate expenditure (AE = C + 1) equals aggregate output (income) (¥), and there is equilibrium: The leakage out of the spending stream—saving—is matched by an equal injection of planned investment spending into the spending stream. For this reason, the saving/invest- ‘ment approach to equilibrium is also called the leakages/injecrions approach to equilibrium, Planned aggregate ‘expenditure ence) Saving (5) Aggregate neome Y) ‘Saving isa leakage out ofthe spending stream. If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilirium. ‘ti would bean deny Fincad unplanned invetory acumuaions—in eer won f ere actaalimvestment instead of nme este cuarter 21 467 ‘Aageaats Expenditure an Elo Output inventories, investment, aggregate expenditure Ea © Further Exploration © News Analysis SS Inventory Changes Signal Slower Growth The Effect of a Natural Disaster on Government Spending and Taxation, | IN JUNE 2005, THE GOVERNMENT announced that imentres hed at ce USS wlesaler increase by 1.1 pe cert, woh was more han analyte and fms had expected, Since inven Real Goods as a Store | tary inaases are par of ivestment of Value During Inflation | spending, the nee was counted 2 ar of GDP Bix what abot “lanes lvestment spending which measures the toa spending on goods and se wees that ms “plan make in en prog? | an unerecod increase in iment | ies means tat actual sales ae less Money Demand than what was expected Ths they and interest Rates to lead to fms outing back on pro ducton inthe fate Pemaps the unantipated sein invemores in 2005 was 0 signal of with Detiation things to come? Bloonoers.com ‘mor than a year, @ goverment reper _iwentariesat_ wholesales of sowed. durable goods, which include cat, - The June increase in vetoes, machinery and appliances, ose 14 U.S. Wholesalers’ whlch brought the value of goods at percent June after rsing 1.9 per Sisbutors,warsnouses an termi- ent the previous month, Sales ose Inventories Rose 1.1% fais $309.5 nilon,foloned a 05 pera ater nochange te i {ain of 14 percent the moth bea, vious month. A 1 pereet crop in in June (Update 1) te commerce Deparment sai In Sls of electal equpment ater a Washington, Sales were unchanged 39 erent increase 8 month arer ee Se ‘ug. 9 (Bloomberg)Imentores stan increase of 0.3 percent in May. sales. US. wholesalers ose 1.1 percent in Consumer spending cooled bythe June, eater than forecast, as sales most in almost thee year ving the = fale 0 Inerease for he fst time in month “Sauer oonoea ie Figure 21.10 reproduces the saving schedule derived in Figure 21.6 and the horizontal investment function from Figure 21.7. Notice that $= at one, and only one, level of aggregate output, Y= 500. At Y = 475 and I = 25. In other words, Y= C+ I, and therefore equilibrium exists. ADJUSTMENT TO EQUILIBRIUM We have defined equilibrium and learned how to find it, but we have said nothing about how firms might react to disequilibrium. Let us consider the actions firms might take when planned aggregate expenditure exceeds aggregate output (income). ‘We already know the only way firms can sell more than they produce is by selling some inventory. This means that when planned aggregate expenditure exceeds aggregate output, cnapter 21 469 xponature 2d Eglo Outpt Aggregate output, Y(ilions of dolls) ‘Aggregate outout will be equal to planned aggregate expenciture only when saving equals planned investment (S =. Saving and planned investment are equal at ¥ = 500. ‘unplanned inventory reductions have occurred. It seems reasonable to assume firms will respond to unplanned inventory reductions by increasing output. If firms increase output, income must also increase (output and income are two ways of measuring the same thing). [As GM builds more cars it hires more workers (or pays its existing workforce for working ‘more hours), buys more steel uses more electricity, and so on. These purchases by GM rep- resent income for the producers of labor, stel, electricity, and so on. If GM (and all other firms) try to keep their inventories intact by increasing production, they will generate more income in the economy as a whole. This will lead to more consumption. Remember, when income rises, consumption also rises The adjustment process will continue as long as output (income) is below planned aggregate expenditure. If firms react to unplanned inventory reductions by increasing ‘output, an economy with planned spending greater than output will adjust to equilib- rium, with ¥ higher than before. If planned spending is less than output, there will be unplanned increases in inventories. In this case, firms will respond by reducing output. ‘As output falls, income falls, consumption falls, and so forth, until equilibrium is restored, with Ylower than before. AAs Figure 21.8 shows, at any level of output above Y= 500, such as Y= 800, output will fall until it reaches equilibrium at Y = 500, and at any level of output below Y= 500, such as. Y= 200, output will rise until it reaches equilibrium at Y= 5005 THE MULTIPLIER "Now that we know how the equilibrium value of income is determined, we ask: How does the equilibrium level of output change when planned investment changes? If thre isa sud: dden change in planned investment, how will output respond, if it responds at all? As we will see, the change in equilibrium output is greater than the initial change in planned invest- ‘ment. Output changes by a multiple of the change in planned investment. So, this multiple is, called the multiplier. “tn dicusing simple supply and demand equim in Chapters 3 and 4 we that when quanti spi ced uanty ead the pic fale nd the quantity pie declines Sar when quantity demande exces quant sapped the pice "sand the qunaty spied nce th ana ere we ae orig poten in pies oi the pice vane ‘easing on chang inthe el of lott income Later ae we hve intodued mote athe pric lee the anass, pre wl beer pore A his sg, however only peste output (nce) (1) ads when area xpd xed reat: tpt ith ovestor ling or when geal cxrde appeal expend (wh venoy lg). ‘multiptior The ratio of the change inthe equilibrium eve of output toa change in some ‘autonomous variable, autonomous variabi Avarable tat is assumed not to depend onthe state of the ‘economy—that sit does not change when the economy changes. ‘The muttiplier is defined as the ratio of the change in the equilibrium level of output to a ‘change in some autonomous variable, An autonomous variable isa variable that is assumed not to depend on the state of the econom)—that is, a variable is autonomous if it does not change in response to changes in the economy: In this chapter, we consider planned investment to be autonomous. This simplifies our analysis and provides a foundation for later discussions. With planned investment autonomous, we can ask how much the equilibrium level of ‘output changes when planned investment changes. Remember that we are not trying here to explain why planned investment changes: we are simply asking how much the equilibrium level of output changes when (for whatever reason) planned investment changes. (Beginning in Chapter 25, we will no longer take planned investment as given and will explain how planned investment is determined.) Consider a sustained increase in planned investment of $25 billion—that is, suppose 1 increases from $25 billion to $50 billion and stays at $50 billion. If equilibrium existed at [= $25 billion, an increase in planned investment of $25 billion will cause a disequilibrium, with planned aggregate expenditure greater than aggregate output by $25 billion. Firms immediately see unplanned reductions in their inventories, and, as a result they begin to increase output. Let us say the increase in planned investment comes from an anticipated increase in travel that leads airlines to purchase more airplanes, car rental companies to increase pur- chases of automobiles, and bus companies to purchase more buses (all capital goods). The firms experiencing unplanned inventory declines will be automobile manufacturers, bus producers, and aircraft producers—GM, Ford, Boeing, and so forth. In response to declining inventories of planes, buses, and cars these firms will increase output. Now suppose these firms raise output by the full $25 billion increase in planned invest- ment. Does this restore equilibrium? No, it does not, because when output goes up, people earn more income and a part of that income will be spent. This increases planned aggregate expenditure even further. In other words, an increase in Talso leads indirectly to an increase in C.To produce more airplanes, Boeing has to hire more workers or ask its existing employ- ces to work more hours. It also must buy more engines from General Electric, more tires from Goodyear, and so forth. Owners of these firms will earn more profits, produce more, hire more workers, and pay out more in wages and salaries. ‘This added income does not vanish into thin ait. It is paid to households that spend some oft and save the rest. The added production leads to added income, which leads to added consumption spending. If planned investment (1) goes up by $25 billion initially and is sustained at this higher levelan increase of output of $25 billion will not restore equilibrium, because it generates even ‘more consumption spending (C). People buy more consumer goods. There are unplanned reductions of inventories of basic consumption items—washing machines, food, clothing, and so forth—and this prompts other firms to increase output. The cycle stars all over again. Output and income can rise by significantly more than the initial increase in planned invest ‘ment, buthow much and how large isthe multiplier? This is answered graphically in Figure 21.11 ‘Assume the economy isin equilibrium at point A, where equilibrium output is 300. The increase in fof 25 shifts the AE= C+ Icurve up by 25, because Iis higher by 25 at every level of income. The new equilibrium occurs at point B, where the equilibrium level of output is 600. Like ‘eng th ciclo nay agg out it gi with Y= > 1 Tha cer per rege opt pr ‘iced yrs and every period, lane agate expen ss sue take hse gods ad series of he marke Now ote what happens we planed neste spending incense nd insted a higher eel ems experience ‘npland declines in irene od they ince opt ore el utp produced in aubeequnt prods, However, the ded opt means more income; hus we se added noms ving to hocks Ths meats more spending Howseelds spend some portion other ed incon (equal othe aed income times the MPC) on consumer sod. ‘hat wth ighereonsumption planed aggrept expenditure wil be preter Firms ain se an npn dectine invents tie and they respond by nceting the opt of consume rods Ths set of et anther round of income and expendi increase Output ise and income ss esl, thi increnng consampion Higher consumption eds oye another d- ‘alluvial and outta ser pin cnapren s1 471. agree pence and Eulbam Ovtpt aye 00 Aggregate output, Y(ilions of dallas) {At point A the economy is in equilrium at Y= 500. When | increases by 25, planned aggregate expen ‘ture is intially greater than aggregate output. As output rises in response, additional consumption is generated, pushing equlvium output up by a multiple ofthe intial increase in|. The new equilibrium Is found at point 8, where Y = 600. Equilbrium output has increased by 100 (600 - 500) o four times ‘the amount of the increase in planned investment. point A, point Bis on the 45° line and is an equilibrium value. Output (¥) has increased by 100 (600 — 500), or four times the inital increase in planned investment of 25, between point A and point B The multiplier in this example is 4. At point B, aggregate spending is also higher by 100. If 25 of this additional 100 is investment (J, as we know itis the remaining 75 is added con- sumption (C), From point Ato point B then, AY= 100, Al= 25, and AC=75. Why doesn't the multiplier process go on forever? The answer is that only a fraction of the inerease in income is consumed in each round, Successive increases in income become smaller and smaller in each round of the multiplier process, due to leakage as saving, until equilibrium is restored. The size of the multiplier depends on the slope of the planned aggregate expenditure line. The steeper the slope of this line is, the greater the change in output for a given change in investment. When planned investment is fied, asin our example, the slope of the AE= C + Tine is just the marginal propensity to consume (ACIAY). The greater the MPC is, the {greater the multiplier. This should not be surprising. A large MPC means that consumption increases a lot when income increases. The more consumption changes, the more output has to change to achieve equilibrium. THE MULTIPLIER EQUATION Is there a way to determine the size ofthe multiplier without using graphhic analysis? Yes, theres. ‘Assume that the market is in equilibrium at an income level of ¥ = 500. Now suppose planned investment (/)—thus planned aggregate expenditure (AE)—increases and remains higher by $25 billion, Planned aggregate expenditure is greater than output, there is an unplanned inventory reduction, and firms respond by increasing output (income) (¥). This, leads to a second round of increases, and so on. What will restore equilibrium? Look at Figure 21.10 and recall: Planned aggregate expen- diture (AE® C+ 1)is not equal to aggregate output (¥) unless $= fthe leakage of saving must exactly match the injection of planned investment spending for the economy to be in equi- librium. Recall also we assumed that planned investment jumps to a new, higher level and stays there; i isa sustained increase of $25 billion in planned investment spending. As income rises, consumption rises and so does saving. Our $= I approach to equilibrium leads us to conclude: Equilibrium will be restored only when saving has increased by exactly the amount of ‘the initial increase in J Otherwise, will continue to be greater than $, and C+ Iwill continue to be greater than ¥. (The $= approach to equilibrium leads to an interesting paradox in the macroeconomy. ‘See the Further Exploration box, “The Paradox of Thrift”) Itis possible to figure how much ¥ must increase in response to the additional planned investment before equilibrium will be restored. ¥ will rie, pulling $ up with it until the change in saving is exactly equal to the change in planned investment—that is, until Sis again equal to [at its new higher level. Because added saving isa fraction of added income (the MPS), the increase in income required to restore equilibrium must be a multiple of the increase in planned investment. Recall that the marginal propensity to save (MPS) isthe fraction of a change in income that is saved. Iti defined as the change in S (AS) over the change in income (AY). as ps = 9S ay Because AS must be equal to Al for equilibrium to be restored, we can substitute AJ for AS and solve: AL ay ‘Therefore, ay =arx MPS As you can see, the change in equilibrium income (A¥) is equal to the initial change in planned investment (Al) times 1/MPS. The multiplier is 1/ MPS: 1 ‘multiplier = 1 la ‘MPS Because MPS + MPC 1, MPS= 1 - MPC. It follows that the multiplier is equal to 1 ultplier = multiplier In our example, the MPCis.75, so the MPS must equal 1 ~.75, or 25. Thus, the multi- plier is 1 divided by .25, or 4. The change in the equilibrium level of Yis 4 x $25 billion, 6 $100 billion.” Also note that the same analysis holds when planned investment falls. If The muir an aloe drive algebraic s the append to this chapter demonstrates An interesting paradox can arise wiien house holds attempt to increase their saving. What happens i households become concerned about the future and want to save more today to be prepared for hard times tomorrow? It households increase ther planned saving, the saving schedule in Figure 1 shits upward from $05; The plan to save more isa planto con sme less, and the resulting drop In spending leads to a drop in income. Income drops by 3 ‘multiple ofthe inital shit the saving sched le. Before the increase in saving, equilibrium exists at point A, whete S, = and Y= $500 bi lion Increased saving shits the equim to intB, the point at which, = New equi rium output is $300 bilion—a $200 billion

    You might also like