Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-1 CHAPTER 9 The Income-Expenditure Framework: Consumption and the Multiplier

Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.9-1

CHAPTER 9

The Income-Expenditure Framework: Consumption and the

Multiplier


Questions

• What are “sticky” prices?• What factors might make prices

sticky?• When prices are sticky, what

determines the level of real GDP in the short run?


Questions

• When prices are sticky, what happens to real GDP if some component of aggregate demand falls?

• When prices are sticky, what happens to real GDP if some component of aggregate demand rises?

• What determines the size of the spending multiplier?


Real GDP in U.S. History• The flexible-price model does not give

a complete picture of the macroeconomy– real GDP does not always grow by the

same rate as potential output– the unemployment rate is not always at

the natural rate– inflation is not always steady


Figure 9.1 - Real GDP per Worker and Potential Output, 1960-2000


Business Cycles• Fluctuations in economic growth are

called business cycles• A business cycle has two phases

– expansion or boom• production, employment, and prices all grow

rapidly

– recession or depression• production falls, unemployment rises, and

inflation falls


Business Cycles• To understand business cycles, we need

a model that does not always guarantee full employment

• We will no longer assume that prices are flexible

• Instead, prices will be assumed to be “sticky”– they will remain fixed at predetermined

levels as businesses expand or contract production


A Decrease in Autonomous Consumption (C0)

• Suppose that autonomous consumption falls from $2,000 billion to $1,800 billion per year

• In the flexible-price model, real GDP would be unaffected– the economy would remain at full

employment– real GDP would equal potential output


Figure 9.2 - Labor Market Equilibrium



• In the flexible-price model, a fall in consumption means an increase in savings– the real interest rate falls– the equilibrium level of investment and

net exports increases by $200 billion per year


Figure 9.3 - The Effect on Savings of a Fall in Consumption Spending in the Flexible-Price

Model



• Under the flexible-price model, the decline in the real interest rate will lead to a decline in the velocity of money– the price level will fall



• In the flexible-price model, the consequences of a fall in consumers’ desired baseline consumption are– a drop in consumption– an increase in savings– a decline in the real interest rate– a rise in investment– a rise in the value of the exchange rate– a decline in the price level



• In the sticky-price model, a drop in consumption leads to a drop in aggregate demand

• As businesses see the demand for their products falling, they cut back production– they will fire some of their workers– incomes will fall



• In the sticky-price model, a drop in consumption does not lead to an increase in savings– the increase in savings (from the fall in

consumption) is exactly offset by a decrease in savings (from the fall in income)

• The real interest rate is unaffected– no change in investment or net exports


Figure 9.4 - The Effect on Savings of a Fall in Consumption Spending in the Sticky-Price

Model



• In the sticky-price model, the consequences of a fall in consumers’ desired baseline consumption are – a drop in consumption– a decline in production– a decline in employment– a decrease in national income– no change in the real interest rate,

investment, or the exchange rate


Expectations• Price stickiness causes problems only in

the short run• If individuals had time to foresee and

gradually adjust their wages and prices to changes in aggregate demand, sticky prices would not be a problem– both the stickiness of prices and the failure

to accurately foresee changes are needed to create business cycles


Short Run vs. Long Run• In the short run, prices are sticky

– shifts in policy or in the economic environment that affect the level of aggregate demand will affect real GDP and employment

• In the long run, prices are flexible– individuals have time to react and adjust

to changes in policy or the economic environment

– real GDP and employment are unaffected


Why Prices Are Sticky• Menu costs are costs associated with

changing prices– changing prices can be costly for a

variety of reasons– managers and workers may prefer to

keep prices and wages stable as long as the shocks that affect the economy are relatively small


Why Prices Are Sticky• Managers and workers lack full

information about the state of the economy

• They may confuse changes in economy-wide spending with changes in demand for their particular products– cut production rather than cutting the

price of the product


Why Prices Are Sticky• The level of prices is often determined

by “what is fair”• Work effort and work intensity depend

on whether or not workers feel that they are treated fairly– most managers are reluctant to cut wages– if wages are sticky, firms will adjust

employment when aggregate demand changes


Why Prices Are Sticky• Managers and workers may suffer

from money illusion– confuse changes in nominal prices with

changes in real prices• firms react to higher nominal prices by

believing that it is profitable to produce more• workers react to higher nominal wages by

searching more intensively for jobs and working more hours


The Multiplier Process• If prices are sticky, higher aggregate

demand boosts production• Incomes rise• Higher incomes give a further boost to

production which increases aggregate demand even more


Figure 9.5 - The Multiplier Process


Building Up Aggregate Demand• Aggregate demand (planned

expenditure) has four components– consumption (C)– investment (I)– government purchases (G)– net exports (NX)

NXGICE


The Consumption Function• As incomes rise, consumption

spending rises– less than dollar for dollar

• The share of an extra dollar of income that shows up as additional consumption is equal to the marginal propensity to consume times the share of income that escapes taxation

t)Y-(1CCC y0


Figure 9.6 - The Consumption Function and the Marginal Propensity to Consume


The Consumption Function• The slope of the consumption function

is smaller than the marginal propensity to consume (Cy)– because of the tax system, a one-dollar

increase in national income means less than a one-dollar increase in disposable income


Figure 9.7 - Consumption as a Function of After-Tax Disposable Income


The Consumption Function• Example

– Cy = 0.75

– t = 0.40– when Y = $8 trillion, C = $5.5 trillion

t)Y-(1CCC y0

0.4)Y-0.75(1CC 0

0.45YCC 0

0.45($8)C$5.5 0

$3.6C$5.5 0

$1.9C0

0.45Y$1.9C


Other Components of Aggregate Demand

• Investment is determined by the real interest rate and assessments of profitability made by firms’ managers

• Government purchases is set by politics

rIII r0


Other Components of Aggregate Demand

• Net exports are equal to gross exports minus imports– gross exports are a function of the real

exchange rate () and the level of foreign real GDP (Yf)

YIM-)XY(XIM-GXNX yf

f


Figure 9.8 - Components of Aggregate Demand, 1995


Components of Expenditure• The components of aggregate

demand can be divided into two groups– autonomous spending (A)

• components of aggregate demand that do not depend directly on national income

– the marginal propensity to expend (MPE) times the level of national income (Y)


Components of Expenditure

• A = autonomous expenditure [A=C0+I+G+GX]

• MPE=marginal propensity to expend [MPE=Cy(1-t)-IMy]

]IM-[GXGIt)Y]-(1C[CE yy0

]YIM-t)-(1[CGX]GI[CE yy0

YMPEAE


Figure 9.9 - The Income-Expenditure Diagram


The Income-Expenditure Diagram

• The intercept of the planned expenditure or aggregate demand line is the level of autonomous spending (A)– a change in the value of any component

of autonomous spending will shift the planned expenditure line up or down


Figure 9.10 - An Increase in Autonomous Spending


The Income-Expenditure Diagram

• The slope of the planned expenditure or aggregate demand line is the marginal propensity to expend (MPE)– changes in the marginal propensity to

consume (Cy), the tax rate (t), or in the propensity to spend on imports (IMy) will change the MPE and the slope of the planned expenditure line


Figure 9.11 - An Increase in the Marginal Propensity to Expend


Calculating the MPE• Example

– Cy = 0.75

– t = 0.40

– IMy = 0.15

]IM-t)-(1[CMPE yy

0.15]-0.40)-[0.75(1MPE

0.300.15]-[0.45MPE


Sticky-Price Equilibrium• The economy will be in equilibrium

when planned expenditure equals real GDP– there will be no short-run forces pushing

for an immediate expansion or contraction of national income, real GDP, and aggregate demand


Figure 9.12 - Equilibrium in the Income-Expenditure Diagram, 1996


Sticky-Price Equilibrium• Equilibrium occurs when planned

expenditure (E) is equal to real GDP (Y)

YMPEAEY

MPE-1A

EY

• Example– A = $5,600 billion– MPE = 0.30

billion $8,0000.70

$5,600EY


Sticky-Price Equilibrium• If the economy is not on the 45-

degree line, the economy is not in equilibrium– planned expenditure (E) does not equal

real GDP (Y)

• If Y>E– there is excess supply of goods

• If Y<E– there is excess demand for goods


Figure 9.13 - Inventory Adjustment and Equilibrium: Goods Market Equilibrium and

the Income-Expenditure Diagram


Inventory Adjustment• Excess supply

– production > aggregate demand– inventories are rising rapidly– firms will cut production

• Excess demand– production < aggregate demand– inventories are being depleted– firms will expand production


Figure 9.14 - The Inventory Adjustment Process: An Income-Expenditure Diagram


The Multiplier• Suppose that autonomous spending

increases– the planned expenditure line will shift up– planned expenditure > national income

• inventories would fall• businesses would boost production

– how much production would expand depends on the magnitude of the change in autonomous spending and the value of the multiplier


Figure 9.17 - The Multiplier Effect


The Multiplier• The value of the multiplier depends on

the slope of the planned expenditure line– the higher is the MPE, the steeper is the

planned expenditure line and the greater is the multiplier


Figure 9.18 - Determining the Size of the Multiplier


The Multiplier• Equilibrium means that

MPE-1A

EY

AMPE-11

EY

A]IM-t)-(1[C-1

1EY

yy


The Multiplier• 1/[1-MPE] is the multiplier

– it multiplies the upward shift in the planned expenditure line into a change in the equilibrium level of real GDP, total income, and aggregate demand

– because autonomous spending is influenced by many factors, almost every change in economic policy or the economic environment will set the multiplier process in motion


The Multiplier• Example

– A = $5.6 trillion– MPE = 0.3

trillion $9.0EY

A = $0.1 trillion trillion $9.143EY

1.430.1

0.143AY

multiplier

1.430.71

MPE-11

multiplier


The Multiplier• One factor that tends to minimize the

multiplier is the government’s fiscal automatic stabilizers– proportional taxes– social welfare programs

• An economy that is more open to world trade will have a smaller multiplier than a less open economy


Chapter Summary• Business-cycle fluctuations can push

real GDP away from potential output and unemployment far away from its average rate

• If prices were perfectly and instantaneously flexible, there would be no such thing as business cycle fluctuations– models in which prices are sticky must

play a large role in macroeconomics


Chapter Summary• There are a number of reasons that

prices might be sticky– menu costs, imperfect information,

concerns of fairness, or money illusion– there is no overwhelming evidence as to

which is most important

• In the short run, while prices are sticky, the level of real GDP is determined by the level of aggregate demand


Chapter Summary• The short-run equilibrium level of real

GDP is that level at which aggregate demand (as a function of national income) is equal to the level of national income (real GDP)

• Two quantities summarize planned expenditure as a function of total income– the level of autonomous spending and the

marginal propensity to expend (MPE)


Chapter Summary• The level of autonomous spending is

the intercept of the planned expenditure function on the income-expenditure diagram– tells us what the level of planned

expenditure would be if national income was zero


Chapter Summary• The MPE is the slope of the planned

expenditure function on the income-expenditure diagram– tells us how much planned expenditure

increases for each one dollar increase in national income


Chapter Summary• The value of the MPE depends on the

tax rate (t), the marginal propensity to consume (Cy), and the share of spending on imports (IMy)

yy IM-t)-(1CMPE


Chapter Summary• In the simple macro models, an

increase in any component of autonomous spending causes a more than proportional increase in real GDP– the result is the multiplier process

• The size of the multiplier depends on the MPE

MPE-11

AY

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Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 9-1 CHAPTER 9 The Income-Expenditure Framework: Consumption and the Multiplier