Chapter 21
The Simplest
Short-
Run Macro
Model
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In this chapter you will learn to
1. Describe the difference between desired expenditure and
actual expenditure.
2. Explain how desired consumption and desired investment
expenditures are determined.
3. Describe the definition of equilibrium national income.
4. Describe the effect of a change in desired expenditure on
equilibrium income, and explain how this change is
reflected by the multiplier.
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Desired Aggregate Expenditure
The national accounts divide actual GDP into its components:
• Ca, Ia , Ga, and NXa.
Total desired expenditure is divided into the same categories:
• desired consumption, C
• desired investment, I
• desired government purchases, G
• desired net exports, NX
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Desired Aggregate Expenditure
The sum is called desired aggregate expenditure:
AE = C + I + G + NX
Two types of expenditures:
- autonomous expenditures do not depend on the level
of national income
- induced expenditures do depend on the level of
national income
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Desired Consumption Expenditure
Two possible uses of disposable income:
- consumption (C) or saving (S)
In the simplest theory, consumption is determined primarily by
current disposable income (YD).
In more advanced theories, individuals are forward looking,
and so consumption depends more on “lifetime” income.
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Figure 21.1 Consumption and
Disposable Income in the United
States, 1980-2005
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Figure 21.2 The Consumption
and Saving Functions
The simple consumption
function is written as:
C = a + bYD
Note: the slope of this
simple consumption
function (b) is less than one.
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Marginal Propensity to Consume
The marginal propensity to consume (MPC) relates the
change in desired consumption to the change in disposable
income that brings it about.
MPC = C/YD
The MPC is the slope of the consumption function.
In the previous diagram, the MPC is the same at any level of
income.
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Average Propensity to Consume
The average propensity to consume (APC) is equal to total
consumption divided by total disposable income.
APC = C/YD
In the previous diagram, the APC falls as the level of
income rises.
EXTENSIONS IN THEORY 21.1
The Theory of the Consumption Function
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The Saving Function
Average propensity to save (APS):
• APS = S/YD
Marginal propensity to save (MPS):
• MPS = S/YD
Since all disposable income is either consumed or saved,
we have:
• APC + APS = 1
• MPC + MPS = 1
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Figure 21.3 Shifts in the
Consumption Function
If consumption function
shifts upward, the saving
function must shift
downward.
What causes a shift?
- wealth
- interest rate
- expectations
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Desired Investment Expenditure
Investment expenditure is the most volatile component of
GDP:
•changes in investment expenditure are strongly
associated with short-run fluctuations
Three important determinants of aggregate investment
expenditure are:
• the real interest rate
• changes in the level of sales
• business confidence
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Figure 21.4 The Volatility of
Investment, 1970–2006
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The Real Interest Rate
The real interest rate is the opportunity cost for:
- investment in new plants and equipment
- investment in inventories
- investment in residential construction
Thus, all three components of desired investment
expenditure are negatively related to the real interest rate,
other things being equal.
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The Real Interest Rate
Changes in Sales
The higher the level of production and sales, the larger the
desired stock of inventories:
- changes in the rate of sales cause temporary bouts
of investment in inventories
Business Confidence
When business confidence improves, firms want to invest now
so as to reap future profits.
Business confidence and consumer confidence may feed off
of one another.
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Figure 21.5 Desired Investment
as Autonomous Expenditure
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The Aggregate Expenditure
Function
The AE function:
- relates desired aggregate expenditure to actual
national income
In the absence of government and international trade, desired
aggregate expenditure is:
AE = C + I
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The Aggregate Expenditure
Function: Example
The consumption function is:
C = 30 + (0.8)Y
The investment function is:
I = 75
The AE function is then given by:
AE = C + I = 30 + (0.8)Y + 75
= 105 + (0.8)Y
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Figure 21.6 The Aggregate
Expenditure Function
The slope of the AE function = marginal propensity to spend:
- in this simple model, it is just MPC
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Equilibrium National Income
If desired aggregate expenditure exceeds actual output:
- what is happening to inventories?
- there is pressure for output to rise
If desired aggregate expenditure is less than actual output:
- what is happening to inventories?
- there is pressure for output to fall
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Table 21.1 Equilibrium
National Income
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Figure 21.7 Equilibrium
National Income
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Equilibrium National Income
In this model, output is 45º
said to be demand line
Desired AE
900 AE
determined.
The equilibrium condition: 600
•
Y = AE(Y)
300
Equilibrium national income
is the level of national 105
income where desired 300 600 900
aggregate expenditure Actual National
equals actual national Income
income.
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Figure 21.8 Shifts in the
Aggregate Expenditure Function
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The Multiplier
The multiplier is a measure of the size of the change in
equilibrium Y that results from a change in autonomous
expenditure.
In our simplest of macro models, the multiplier exceeds
one.
APPLYING ECONOMIC CONCEPTS 21.1
The Multiplier: A Numerical Example
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Figure 21.9 The Simple
Multiplier
Simple multiplier =
Y 1
=
A 1-z
Where z is the marginal
propensity to spend out of
national income and A is
the change in autonomous
expenditure.
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Figure 21.10 The Size of the
Simple Multiplier
The larger is z, the steeper is the AE curve and the larger is the simple
multiplier.
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Economic Fluctuations as
Self-Fulfilling Prophecies
Households and firms base their desired investment and
consumption partly on their expectations of the future:
- changes in expectations can lead to real changes
in the current state of the economy
Example:
- imagine that firms feel optimistic about the future
- this increases their desired investment, shifting up the
AE curve
- this increases Y, justifying the initial optimism
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The Simple Multiplier
EXTENSIONS IN THEORY 21.2
The Algebra of the Simple Multiplier
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