A Basic Model of the

Determination of GDP in the

Short Term
Chapter 16

Learning Outcomes

The macroeconomic theory that we now study

explains the deviation of actual from potential
GDP, that is the GDP gap.

The determination of GDP in the short run

depends on the behaviour of key categories of
aggregate spending: consumption, investment,
government spending, and net exports.

Learning Outcomes

Consumption spending depends on disposable income

and wealth.

Investment spending depends on real interest rates

and business confidence.

A necessary condition for GDP to be in equilibrium is

that desired domestic spending equals actual
output.

A BASIC MODEL OF THE DETERMINATION OF GDP

What Determines Aggregate Expenditure

Desired aggregate expenditure includes desired
consumption, desired investment, and desired
government expenditures, plus desired net
exports.

It is the amount that economic agents want to

spend on purchasing the national product.

In this chapter we consider only consumption and

investment.

A BASIC MODEL OF THE DETERMINATION OF GDP

What Determines Aggregate Expenditure

A change in personal disposable income leads to
a change in private consumption and saving.
The responsiveness of these changes is measured
by the marginal propensity to consume [MPC] and
the marginal propensity to save [MPS], which are
both positive and sum to one.
This indicates that, by definition, all disposable
income is either spent on consumption or saved.

A BASIC MODEL OF THE DETERMINATION OF GDP

A change in wealth tends to cause a change in

the allocation of disposable income between
consumption and saving. The change in
consumption is positively related to the change
in wealth, while the change in saving is
negatively related to this change.
Consumption is negatively related to change in
interest rates.

A BASIC MODEL OF THE DETERMINATION OF GDP

Investment consists of inventory accumulation,

residential housing construction and business fixed
capital formation.
Investment depends, among other things, on real
interest rates and business confidence.
Higher the interest rates lower the level of
desired inventory of goods and material, lower the
spending for residential construction and lower
the investment in fixed capital.
Current profits which largely finance capital
formation are an important determinant of
investment
In our simple theory investment is treated as
autonomous, or exogenous, as is the constant term
in the consumption function, called autonomous
consumption.
The part of consumption that responds to changes
in income is called induced spending.

A BASIC MODEL OF THE DETERMINATION OF GDP

Equilibrium GDP
At the equilibrium level of GDP, purchasers
wish to buy exactly the amount of national
output that is being produced.
At GDP above equilibrium, desired expenditure
falls short of national output, and output will
sooner or later be curtailed.

A BASIC MODEL OF THE DETERMINATION OF GDP

Equilibrium GDP
At GDP below equilibrium, desired expenditure
exceeds national output, and output will
sooner or later be increased.
In a closed economy with no government, desired
saving
equals
desired
investment
at
equilibrium GDP.

A BASIC MODEL OF THE DETERMINATION OF GDP

Equilibrium
GDP
is
represented
graphically by the point at which the
aggregate expenditure curve cuts the
450 line, that is, where total desired
expenditure equals total output.
This is the same level of GDP at which
the saving function intersects the
investment function.

A BASIC MODEL OF THE DETERMINATION OF GDP

Changes in GDP
With a constant price level, equilibrium
GDP is increased by a rise in the desired
consumption or investment expenditure
that is associated with each level of
national income.
Equilibrium GDP is decreased by a fall in
desired spending.

A BASIC MODEL OF THE DETERMINATION OF GDP

Changes in GDP
The magnitude of the effect on GDP of
shifts in autonomous expenditure is
given by the multiplier.
It is defined as K = Y/A, where A is the
change in autonomous spending and Y
the resulting increase in GDP.

A BASIC MODEL OF THE DETERMINATION OF GDP

The simple multiplier is the multiplier

when the price level is constant.
It is equal to 1/[1 - z], where z is the
marginal propensity to spend out of
national income.
Thus the larger z is, the larger is the
multiplier. It is a basic prediction of
macroeconomics
that
the
simple
multiplier, relating 1 worth of
increased spending on domestic output
to the resulting increase in GDP, is
greater than unity.

Terminology of Business Cycles

A trough is characterized by high

unemployment and a level of demand that
is low in relation to the economys
capacity to produce.
Recovery is characterised by run down
equipment being replaced, employment,
income and consumer spending all beginning
to rise and expectations becoming more
favorable.
A peak is the top of a cycle. At the peak
existing capacity is utilized to a high
degree.
Recession is defined as a fall in real GDP
for two quarters in succession. It is a
phase of downturn in economic activity.

Calculation of average and

marginal propensity to consume

The Consumption and Saving Functions

450

2000

500

C
1500

250
0
-100

1000

500

-500
500
450

1000

1500

2000

Real Disposable Income

500

1000

1500

2000

(ii). Saving Function [ million]

Real Disposable Income

(i). Consumption Function [ million]

Note: Initially, at zero income consumers are drawing down on existing

savings / assets .

Consumption and savings schedules

(millions)

The consumption and saving

functions

Both consumption and saving rise as disposable

income rises.
Line C relates desired consumption to disposable
income.
Its slope is the marginal propensity to consume
(MPC).
Saving is all disposable income that is not spent on
consumption.
The relationship between disposable income and
desired saving is shown by line S.

The consumption and saving

functions

Its slope is the marginal propensity to save

(MPS).
Any given amount of disposable income must be
accounted for by consumption plus saving.
Consumption and saving schedules (Table) show
the numerical values of desired consumption and
saving at each level of income, and correspond
to the C and S lines in the figure.

The aggregate spending function in a

closed economy with no government
(million)

An Aggregate Expenditure Function

5000

AE

4000

3000

2000

1000
350
1000

2000

3000

4000

5000

Real National Income Function [GDP] [m]

An aggregate expenditure function

The aggregate expenditure function relates
total desired expenditure to national income.
Here desired expenditure is the sum of desired
consumption and desired investment.
It is assumed that desired investment is 250
million while consumption is 100 million plus
0.8 times income.
So when income is zero there is autonomous
expenditure of 350 million.
The marginal propensity to spend is 0.8.

The determination of
equilibrium GDP (million)

Equilibrium GDP
[ii]. Saving Function[S = I]

[i]. An Aggregate Expenditure Function[AE = Y]

500
3000

450
[AE = Y]

250
E0
Desired saving (m)

2000

1000

350
0

450
1000

Y0

2000

3000

Real National Income [GDP] [m]

0
-100

-500
1000

Y0

2000

3000

Real National Income [GDP] [m]

Equilibrium GDP

GDP is in equilibrium where aggregate desired

expenditure (AE) equals national output.
In the figure equilibrium GDP occurs at E0 where
AE intersects the 450 line.
If GDP is below Y0 desired AE will exceed
national output and production will rise.

Equilibrium GDP

If GDP is above Y0 desired AE will be less than

national output and production will fall.
When saving is the only withdrawal and
investment is the only injection, the equilibrium
level of GDP is also that where saving equals
investment.

The Simple Multiplier

AE = Y

450
0

Real National Income [GDP]

The Simple Multiplier

AE = Y

AE0

e0

E0

450
0

Y0

Real National Income [GDP]

The Simple Multiplier

AE = Y
E1

AE1

e1
a

e1

AE0

A
e0

E0

Y
450
0

Y0

Y1

Real National Income [GDP]

The simple multiplier

An increase in the autonomous component of

desired aggregate expenditure increases
equilibrium GDP by a multiple of the initial
increase.
The initial equilibrium is at E0, where AE0
intersects the 450 line. Here desired
expenditure equals national output.

The simple multiplier

An increase in autonomous expenditure of
A then shifts the AE function up to AE1.
Because desired spending is now greater
that output, production and GDP will rise.
Equilibrium occurs when GDP rises to Y1.
Here desired expenditure e1 equals output
Y1.

The multiplier A numerical

example

The multiplier A numerical

example

A numerical example of the multiplier

Assuming that the marginal propensity to

spend out of national income is 0.8 and there
is an autonomous expenditure increase of
100m.
National income and output initially rises
by 100m.

A numerical example of the multiplier

Those receiving 100m in income then spend

80m.
This 80m of income leads to further
spending of 64m.
This 64m of income lead to a further
increase in spending of 51.2m.
If we carry on this process it will converge
to an extra income and output totalling
500m.
The multiplier in this case is 5.

A BASIC MODEL OF THE DETERMINATION

OF GDP
The macroeconomic problem: inflation and
unemployment
Models of the short-term determination of GDP
explain why actual GDP deviates from potential
GDP.
Actual GDP above potential can be associated with
inflation, while actual GDP below potential is
associated with unemployment and lost output.

A BASIC MODEL OF THE DETERMINATION

OF GDP
Key Assumptions
For simplicity we aggregate all industrial sectors
into one, so the economy produces only one type of
output good.
We explain GDP determination through the major
expenditure categories: private consumption,
investment, government consumption, and net
exports.