Chapter 11 Notes

Chapter 11 Notes - Chapter 31 flatput and Expenditure in...

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Unformatted text preview: Chapter 31 flatput and Expenditure in the Short Run “the Aggregate Expenditnre Model a. aggregate Expenditnre - The business cycle involves the interaction of many economic variables. 0 The relationships among these variables can be understood by developing a simple aggregate expenditure model. 0 The aggregate expenditure model is a macroeconomic model that focuses on the relationship between total spending and real GDP, assuming the price level is constant. 0 The key idea of this model is that in any particular year, the level of gross domestic product (GDP) is determined mainly by the level ofaggregale expenditure. _ o In 1936, the English economist John Maynard Keynes published a book, The General Theory of Employment, Interest, and Money, in which he analyzed the relationship between fluctuations in aggregate expenditure and fluctuations in GDP. 0 Keynes identified four categories of aggregate expenditure that together equal GDP: 0 Consumption (C): Spending by households on goods and services, such as automobiles and haircuts. 0 Planned Investment (1): Planned Spending by firms on capital goods, such as factories, office buildings, and machine tools, and by households on new homes. 0 Government Purchases (G): Spending by local, state, and federal governments on goods and services, such as aircraft carriers, bridges, and the salaries of FBI agents. 0 Net Exports (MX): Spending by foreign firms and households on goods and services produced in the United States minus spending by US. firms and households on goods and services produced in other countries. Be The Difference between Planned investment and aeteai investment p t o Inventories refer to goods that have been produced but not yet sold. 1/ *7? 5% o Businesses always spend the amount they planned on machinegy and office gnddings, but the amount businesses plan to spend on inventories may be different from the amount they actually Spend ">3 me D Actual investment will equal planned investment only when there is no unplanned change in inventories. “:13 <\ m. A: J a C, Maeroeeenemic Eqniiinrium - Macroeconomic equilibrium occurs where total spending, or aggregate expenditure, equals total production, or GDP. _ Aggregate expenditure = GDP (L4 91» G, + w- a era a ea: is Ul'“--*P%fl«i"~uwen A \h \fl-\!~€,¥L‘lc}t’ tee l P.- I}. Adinstments to Macroeconemin Equilibrium - When aggregate expenditure 'is greater than GDP, inventories will decline and GDP and total employment will increase. I _ I I g I 6cm“. Sewers-oer More... aim/m pro defies. an: antes-Ctonseg xi! :9 Pfaefitbfi? were age r: 0 When aggregate expenditure is less than GDP, inventories will increase and GDP and total employment will decrease. C0 in $0 watt-1:3 \3g 5;; «33.1,me v’ 5 V} v. 3.5 gitsfirgj if": 0 When economists forecast that aggregate expenditure is likely to decline, the federal government may implement macroeconomic policies in an attempt to head of)c the fall in expenditure and keep the economy from falling into recession. tiff”, sift? E Hm - Suppose that Ace Computers, Inc. produced $500 million of new computers in 2006. Ace sells computers to households, private firms, and local and state government agencies. Some of Ace’s sales are to households, firms, and government agencies in Canada. The following represents three different scenarios for Ace Computers” sales. Sales to: Scenario I Scenario II Scenario III Households $200 million $250 million $300 million Private firms $ 50 million $ 50 miliion $ 50 miliion Government $100 million $100 million $100 million Exports $100 million $00 million $100 million Total sales $450 million $500 million $550 million a. What is the contribution of Ace Computers to GDP for 2006 under each of the three scenarios? @600 t‘f‘i 13. Based on the sales figures, predict how Ace Computers would change its rate of output in 2007 in each of the three scenarios. 1:) L550 r ; . 3:1?) 5:50 a eoo :2:- {V’WZ «ix: output: '2‘;in {ll “0“ c. Use the Ace Computers example to describe how macroeconomic equilibrium is achieved in the aggregate expenditure model. 3”) Wei->4? \iv Betetmine the Level onggregate Expenditure in the Economy A‘ fiensomption 0 There are four components of aggregate expenditure. 0 Consumption is the largest component of aggregate expenditure. 0 There are five most important variables that determine the level of consumption: 0 a) current disposable income, Q‘H‘Qfif ctgx WkCL‘: we, 0 b) household wealth, c) expected future income, _. \ d)thepricelevel, 3?"? 1') C “34" W -‘ (xi e) the interest rate. meme reteftfl « , 3 r i 3m,» we.- in “to?! v ‘s r 4, 17,,- OOO M-r- Y \1/ :3 nice, j‘xitfiféil $37 ’3‘“ i“: o The consumption function refers to the relationship between consumption spending and disposable income. C 1: {1 \g a}; wing) ‘NU7C, 5 Wflfflé} Effiggggqg in} “; Ci i§*?Oézfl--»i‘:éei. Erwio'e'an/ o The marginal propensity to consume (MPC) is the slope of the consumption function and refers to the amount by which consumption spending increases when disposable income changes. We can write the expression for the MPC as: MP0 _ Change in consumption _ AC Change in disposable income AH) I B. 'i‘ise Relationship between {Ionsnmptien and Netienai income 0 Because national income differs from disposable income only by net taxes, we can graph the consumption function using national income rather than disposable income. YD 1535 in}; is} W :5 {2. income, {innsumptiem and Saving 0 The marginal propensity to save (MPS) refers to the change in saving divided by the change in disposable income. 0 In calculating the MP5, as in calculating the MPC, we can safely ignore the difference between nationai income and disposable income. > mpg 2.; » \ e Wig—3‘ W at D B. Pianned investment The four most important variables that determine the level of investment are: a. Expectations of future profitability: The optimism or pessimism of firms is an important determinant of investment spending. - b. The interest rate: A higher reai interest rate results in Iess investment spending, and a lower real interest rate results in more investment Spending. c. Taxes: The federal government imposes a corporate income tax on the profits corporations earn, including profits from the new buildings, equipment, and other investment goods they purchase. A reduction in the corporate income tax increases the after-tax profitability of investment spending. Investment tax incentives increase investment spending. “Pci Ac if 53"; 3 flay/ii «A 5,33) , , r- «1— I g “ E \ ’5 f3” mg.“ I J‘ ;‘ ‘ I ‘ my _ * mach Leer; 1m :guwwgkmh \Wgeaggj :3 5C 11 kg mom} d. Cash flow: Cash flow is the difference between the cash revenues received by the firm and the cash spending by the firm. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment. ~ .' ‘ . ‘- 5, .‘Z '-> tirsvitdmg oi? .J E. Government Purchases - Government purchases grew steadily for most of the 1979—2006 period, with the exception of the mid-19903, when concern about the federal budget deficit caused real government purchases to fall for three years, beginning in 1992. F. fiat Exports 0 Net exports refers to the value of spending by foreign'firms and households on goods and services produced in the United States, subtracting the value of spending by US. firms and households on goods and services produced in other countries. 0 The three most important variables that determine the level of net expOrts are: a. The price level in the United States relative to the price levels in other countries. 13. The growth rate of GDP in the United States relative to the growth rates of GDP in other countries. c. The exchange rate between the dollar and other currencies. Graphing Maereeeonemie Egaiiiiai‘iam We” W16 if; . Showing a Recession on the 45¢«Line magma: We can use a graph called the 45°—line diagram to illustrate macroeconomic equilibrium. Since macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP, we know that allpoints of macroeconomic equilibrium must lie along the 45° line. Every point of macroeconomic equilibrium is on the 45° line, where pianned expenditure equals GDP. At points above the line, planned aggregate expenditure is greater than GDP. At points below the line, planned aggregate expenditure is less than GDP. When the aggregate expenditure line intersects the 45° line at a level of GDP below potential real GDP, the economy is in recession. 5) Whafirever l5 Progasma .. x; )I\ .ll “é”? Mk..- 3," {"0 ' E \“ :- in?“ E ‘ ‘..w.a~ c9 ‘ «AT-n fl.) 3 * J j : g \ m,“ l‘ \a‘ W, H; wr‘ f“ E ' He- ; \i i “We \\ \ i "'9' E g i t 2 s a l 1" z‘ E " -— ‘ = ‘ .... 1. \L , ’ 5H“: ; m i 2 2 ¥ ’ x m: : 1 J {.— fi “2.5:? a x i ( -\ : - . =. ; - r i z 1 “J Q . ‘3 n . \L {iii-1* (30: z; ‘ l « ‘ r l‘ E s L f ( g i '1 5 1‘ .1,- :l g : Rd f "8‘. : t :1 '2 r g 1 i 1-..»; ‘ “v” 2 _ i a f ‘s i z ‘ A \xrwaryfi'fl‘ffl :1 if DP ' i - rfinp “f :3 in - quJPKkag-‘gg \FW 5) \\/ $2912: B. 'i’he impertant Roie nf inventories - Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories. 0 If firms accumulate excess inventories, then even if spending quickly returns to its normal levels, firms will have to sell these excess inventories before they can return to producing at normal leveis. - In the early twentieth century, the inability of many firms to control their inventories contributed to the length and severity of recessions. {3. A Numerieai fixampie of Marreeennnmir Equilibrium - In forecasting real GDP, economists rely on quantitative modeis of the economy. a Table 23-3 shows several hypothetical combinations of real GDP and planned aggregate expenditure. 0 Numerically, macroeconomic equilibrium occurs when consumption along with planned investment, government purchases, and net exports equals GDP. 'fhe Muitipiier Effect A. A ¥orrnnla for the Muitipiier 0 An autonomous change is a change in expenditure not caused by a change in income. 0 An induced change is a change in aggregate expenditure caused by a change in income. 0 An autonomous change in expenditure wili cause rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure wili have a multiplier effect on equilibrium GDP. . 0 Autonomous expenditure refers to expenditure that does not depend on the level of GDP. 0 The multiplier is the increase in equilibrium real GDP divided by the increase in autonomous expenditure. 0 Multiplier effect refers to the process by which. an increase in autonomous expenditure leads to a larger increase in real GDP. The general formula for the muitiplier is: 1 x 373‘. E>5 : {awv'ron a m 3 : \ m' Ag)? 3 .\ $696) \%0 5;?“ < «EVad wmauMKanWMm.‘ M.M.mm.mmwamWWm ; a — - 3 L‘ mwwg m? Pa..%_1'=w3 \00 + («43730 01?) L (fix-39%??? I G/‘flfiwi: i 555‘:- ' muHx‘phe-‘r c. i ‘M a- I‘m ow‘ {MELFrE-Efifi ‘WVJVF‘PW" 3" ML”; 5:3 a . 394 Arm: . . Change in equilibrium real GDP 1 Multiplier: e——_—— — —— Change in autonomous expenditure 1— MPC 5. Snmmarizing the Multiplier Effect Note four key points about the multiplier effect: c]. The multiplier effect occurs both when autonomous expenditure increases and when it decreases. e. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. f. The larger the marginal propensity to consume, the larger the value of the multiplier. g. The formula for the multiplier overstates the true value of the multiplier. The Aggregate Demand Curve 0 Changes in the price level lead to changes in the equilibrium real GDP. 0 Increases in the price level cause a reduction in consumption, investment, and net exports. - This causes the aggregate expenditure function to shift down on the 45°—line diagram, leading to a lower equilibrium real GDP. 0 A decrease in the price level leads to a higher equilibrium real GDP. 0 The aggregate demand curve shows the relationship between the price level and the level of aggregate expenditure, holding constant all factors that affect aggregate expenditure other than the price level. - The aggregate demand curve (AD) is a curve showing the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure. _ C, Wqu i i P l—‘f ‘ 5 5’23, w. sisawctmtma go? 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Chapter 11 Notes - Chapter 31 flatput and Expenditure in...

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