Annotated Chapter 6 Lecture Notes PDF

MOUNT ROYAL UNIVERSITY Econ1103: Principles of Macroeconomics Professor: B. Kusi-Sekyere, PhD Chapter 6 The Simple Short-Run Macroeconomic Model with Demand-Determined Output (Closed Economy without Government Sector) MRU: Econ1103 Principles of Macroeconomics: B.K-S 1 Wha...

MOUNT ROYAL UNIVERSITY Econ1103: Principles of Macroeconomics Professor: B. Kusi-Sekyere, PhD Chapter 6 The Simple Short-Run Macroeconomic Model with Demand-Determined Output (Closed Economy without Government Sector) MRU: Econ1103 Principles of Macroeconomics: B.K-S 1 What We Study in Chapters 6 & 7 We model the national economy based on the Keynesian view that Aggregate Demand determines Output and employment: a) Components of Aggregate Expenditures b) Equilibrium rate of Output c) How Economy Adjusts Towards Equilibrium d) How to Increase the Equilibrium output MRU: Econ1103 Principles of Macroeconomics: B.K-S 2 1 Some Definitions Based on Chapter 5 Uses for Disposable Income: YD = C + S A. Average Propensity to Consume (APC) is the fraction of household’s disposable income (YD) spent (rather than saved): C APC  YD B. Average Propensity to Save (APS) is the fraction of household’s disposable income saved (rather than spent): S APS  MRU: Econ1103 B.K-S YD 3 Since YD = C + S: APC + APS = 1 so, and e.g: if APC = 0.76, then if APS = 0.18, then MRU: Econ1103 Principles of Macroeconomics: B.K-S 4 2 C. Marginal Propensity to Consume (MPC) is the fraction each additional dollar of disposable income that households spend: C MPC  YD D. Marginal Propensity to Save (MPS) is the fraction of each additional dollar of disposable income that households save S MPS  YD MRU: Econ1103 Principles of Macroeconomics: B.K-S 5 Since ΔYD = ΔC + ΔS: MPC + MPS = 1 so, and e.g: if MPC = 0.64, then if MPS = 0.32, then MRU: Econ1103 Principles of Macroeconomics: B.K-S 6 3 Example: If households’ income increased from $154,897 to $161,580 and consumption expenditures increased from $128,600 to $132,745, then: Year 1: Income (YD1): $154,897 Consumption (C1): $128,600 Year 2: Income (YD2): $161,580 Consumption (C2): $132,745 APC1 = C1/YD1 = $128,600/$154,897 = 0.8302 APS1 = 1 – APC1 = 1 - 0.8302 = 0.1698 APC2 = C2/YD2 = $132,745/$161,580 = 0.8215 APS2 = 1 - APC2 = 1 - 0.8215 = 0.1785 MRU: Econ1103 Principles of Macroeconomics: B.K-S 7 Year 1: Income (YD1): $154,897 Consumption (C1): $128,600 Year 2: Income (YD2): $161,580 Consumption (C2): $132,745 Change in C, ΔC = C2 – C1 = $132,745 - $128,600 = $4,145 Change in YD, ΔYD = YD2 – YD1 = $161,580 - $154,897 = $6,683 MPC1 = ΔC / ΔYD = $4,145/$6,683 = 0.6202 MPS = 1 - MPC = 1 - 0.6202 = 0.3798 MRU: Econ1103 Principles of Macroeconomics: B.K-S 8 4  The Simple Short-Run Macroeconomic Model with Demand-Determined Output Aggregate Expenditures (AE) is the amount buyers would spend on the nation’s output. So, in the short term, producers base production decisions on anticipated AE. The sustainable (equilibrium) Output (Y) is the rate such that GDP = P.Y = AE Therefore, to understand what drives the business cycle (output, employment, income, etc.), we must understand what drives AE. MRU: Econ1103 Principles of Macroeconomics: B.K-S 9 In Chapter 5, we wrote the components of Aggregate Expenditures as: AE = C + I + G + X – IM Chapter 6: Closed Economy with no Government Sector Closed Economy means no foreign sector: X; IM No government sector means: G; Taxes So, AE = C + I MRU: Econ1103 Principles of Macroeconomics: B.K-S 10 5  What Determines Household Consumption Expenditures (C)? Personal Disposable Income (YD or DI) Households’ Wealth (W) Households’ Expectations or Consumer confidence (HEx) Real Interest Rates (r) Household Debt (D) Taxes, (T, which affect YD); etc. MRU: Econ1103 Principles of Macroeconomics: B.K-S 11 Consumption Expenditures (C) depends positively on Disposable Income: 1980-2002 MRU: Econ1103 Principles of Macroeconomics: B.K-S 12 6  The chart above suggests the Consumption curve is linear with a form like: C = C0 + mpc(YD) C C = C0 + mpc(YD) slope = mpc C0 YD Autonomous Consumption (C0) is households’ spending that do not come from current year’s disposable income; e.g. spending from households’ savings, loans, gifts, etc. 13 MRU: Econ1103 Principles of Macroeconomics: B.K-S The Consumption Equation C  C 0  mpc (YD ) Example: 𝑪 𝟔𝟔𝟖 𝟎. 𝟔𝟐𝒀𝑫 the slope of the Consumption Curve, mpc = 0.62. The vertical intercept is C0 = 668. Autonomous Consumption (C0) is households’ spending that do not come from current year’s disposable income; e.g. spending from households’ savings, loans, gifts, etc. MRU: Econ1103 Principles of Macroeconomics: B.K-S 14 7  The Consumption Equation: C = C0 + (mpc)YD For Example: C = 668 + 0.62YD C C = C0 + (mpc)YD C = 668 + 0.62YD C0 = 668 YD 15 MRU: Econ1103 Principles of Macroeconomics: B.K-S A change in Disposable Income Moves the Economy Along the Existing Consumption Curve – the curve does not shift. C B C = 668 + 0.62YD 1,226 A 1,195 C0=668 850 900 YD($billion) 16 MRU: Econ1103 Principles of Macroeconomics: B.K-S 8 What Shifts the Consumption Curve? Households’ Wealth (+) Consumer confidence (+) Real Interest Rates (-) Household Debt (-) Note: All these factors affect autonomous consumption expenditures (C0), and thereby shift the consumption curve. MRU: Econ1103 Principles of Macroeconomics: B.K-S 17 Graph: A change in factors other than YD shifts the entire Consumption Curve: C3 C C1 C2 YD 18 MRU: Econ1103 Principles of Macroeconomics: B.K-S 9  Create the Personal Saving Equation from the relation: YD = C + S, which means S = YD - C YD S C Figure 6-1 Consumption, Disposable Income, and Personal Saving: Canada,1981–2020 MRU: Econ1103 Principles of Macroeconomics: B.K-S 19 The Private-Sector Saving Equation (S) S = S0 + mps(YD), S0 = – C0 and mps = (1– mpc) S = -C0 + (1-mpc)(YD) Example Given C = 668 + 0.62YD S0 = – 668 and mps = (1– 0.62) = 0.38 S = -668 + 0.38YD MRU: Econ1103 Principles of Macroeconomics: B.K-S 20 10 Let’s Practice Writing the Missing Equation 1. C = 540 + 0.74YD S= 2. C = 962 + 0.65YD S= 3. S = -835 + 0.18YD C= MRU: Econ1103 Principles of Macroeconomics: B.K-S 21 Break-Even Disposable Income (YDBE) is the level of disposable income where households spend exactly their disposable income – no more, no less; That is, at the break-even disposable income (YDBE): C = YD and, S = 0 MRU: Econ1103 Principles of Macroeconomics: B.K-S 22 11 Example: Calculate the Break-even disposable income if the consumption equation is: C = 668 + 0.62YD MRU: Econ1103 Principles of Macroeconomics: B.K-S 23 The 45o Line reflects the same numbers on both horizontal and vertical axes: 45o Line: C=YD 600 600 450 So, we can also 450 measure YD vertically on Consumption 300 300 the 45o Line: 150 30 45º 150 300 450 600 Real YD 24 MRU: Econ1103 Principles of Macroeconomics: B.K-S 12 Characteristics of the Consumption Curve 45o Line: C=YD YD Consumption (C) APC > 1 Positive Saving C = 668 + 0.62YD C BE C APC < 1 C0=668 Negative APC = 1 Saving YD 45º YDBE YD 1,758 MRU: Econ1103 Principles of Macroeconomics: B.K-S 25 Fully Label Graph. What do the Labeled Segments Represent? C 45o Line Y3D C Y3E C0 DE FD/CF YD MRU: Econ1103 Principles of Macroeconomics: B.K-S 26 13  What determines Gross Business Investment Expenditures (Ig) ? Interest rates (-) Expected rate of profit from business investment (+) Government policy (business taxes industry regulation, etc.) (-) Technological Change (+) Rate of capacity utilization (+) Expectations (Business Confidence) (+) 27 MRU: Econ1103 Principles of Macroeconomics: B.K-S The Investment Demand Curve: Business Investment Expenditures vary inversely with interest rates: r Real Interest Rate (%) A 4% Investment Demand 350 I ($billion) 28 MRU: Econ1103 Principles of Macroeconomics: B.K-S 14  Business Investment Expenditures is autonomous with respect to current year’s output or national income (Y). i.e. I does not depend on current year’s real GDP (Y): Investment ($) 350 I MRU: Econ1103 Real GDP (Y) Principles of Macroeconomics: The Investment Schedule 29 B.K-S The Investment Demand Curve relates Investment (I) to Interest Rates (r). The Investment Schedule relates Investment (I) to National Income (Y). r I 4% A 350 I I 350 I Y Investment Demand Curve Investment Schedule 30 MRU: Econ1103 Principles of Macroeconomics: B.K-S 15  Shift factors for the Gross Business Investment Expenditures (Ig) curve Expected rate of profit from business investment (+) Government policy (business taxes industry regulation, etc.) (-) Technological Change (+) Rate of capacity utilization (+) Expectations (Business Confidence) (+) 31 MRU: Econ1103 Principles of Macroeconomics: B.K-S An increase in a positive shift event (previous slide) shifts the curves up; a decrease in a positive shift event shifts them down. The opposite occurs for a negative shift event: r I (+) I2 4% A (+) 350 I1 I2 (-) (-) I1 I3 I3 350 I Y Investment Demand Curve Investment Schedule 32 MRU: Econ1103 Principles of Macroeconomics: B.K-S 16 Aggregate Expenditures: AE = C + I Aggregate Expenditure: AE = C+I represents how much buyers desire to spend on the country’s output based on income earned producing that output (Y). Aggregate Expenditures is also called Desired Expenditures, or Planned Expenditures. 33 MRU: Econ1103 Principles of Macroeconomics: B.K-S The Aggregate Expenditures Equation - shows how Aggregate Expenditures (AE) depend on national income (Real GDP, Y): AE has the form: AE = A0 + zY o Autonomous expenditures (A0) is the part of Aggregate Expenditures spent from all households’ sources of wealth other than current-year’s income. o Income-induced expenditures (zY) is part of AE spent from current year’s income. 34 MRU: Econ1103 Principles of Macroeconomics: B.K-S 17  HOW TO CREATE THE AE EQUATION Start with the Aggregate Expenditures Identity: AE = C + I Substitute the Consumption equation and I into this identity Add up all constant terms to get A0, and add up all coefficients of Y to get z. Your final equation will look like: AE = A0 + zY (e.g. AE = 850 + 0.8Y) 35 MRU: Econ1103 Principles of Macroeconomics: B.K-S Numerical Example: Create the AE equation for the model: AE = C + I C = 668 + 0.62Yd I = 478. 36 MRU: Econ1103 Principles of Macroeconomics: B.K-S 18 Characteristics of the AE Equation AE = A0 + zY (the AE equation) Autonomous Expenditures, A0 = C0 + I A0 represents the vertical intercept of the AE curve Marginal propensity to spend (z) is the fraction of each additional dollar of national income that is spent on domestic output. (In chapter 6, z = mpc) z represents the slope of the AE curve. 37 MRU: Econ1103 Principles of Macroeconomics: B.K-S Graph of the AE Equation: AE AE = A0 + zY AE = 1,146 + 0.62Y A0 = C0+I =1,146 Real GDP (Y) 38 MRU: Econ1103 Principles of Macroeconomics: B.K-S 19 - An increase in A0 shifts AE curve up; - A decrease in A0 shifts AE curve down: AE2 AE AE1 A0_2 AE3 A0_1 A0_3 Real GDP (Y) 39 MRU: Econ1103 Principles of Macroeconomics: B.K-S - An increase in z rotates the AE curve up; - A decrease in z rotates the AE curve down: AE AE2(z2) AE1(z1) AE3(z3) A0 Real GDP (Y) 40 MRU: Econ1103 Principles of Macroeconomics: B.K-S 20  Let’s Compare the Consumption curve and the Aggregate Expenditures (AE) curve C C = C0 +mpc(YD) AE AE = A0 + zY AE C ∆AE ∆C ∆Y A0 C0 ∆YD ∆𝑨𝑬 ∆𝑪 𝒔𝒍𝒐𝒑𝒆 𝒛 𝒔𝒍𝒐𝒑𝒆 𝒎𝒑𝒄 ∆𝒀 ∆𝒀𝑫 YD Y Consumption Curve AE Curve 41 MRU: Econ1103 Principles of Macroeconomics: B.K-S Key Assumption: Price Level is Fixed The Model in chapters 6 & 7 assume the General Price Level (GDP Deflator) is fixed. Two implications of this assumption: 1. Nominal GDP is always the same as Real GDP (Y); i.e. Y = GDP 2. Output is demand-determined: At the prevailing fixed price, businesses will supply any output the public demands. So, total demand (AE) alone determines equilibrium output; i.e. Y = AE MRU: Econ1103 Principles of Macroeconomics: B.K-S 42 21  MACROECONOMIC EQUILIBRIUM The economy achieves equilibrium when Aggregate Expenditures (AE) is exactly the same as Real GDP (Y) i.e. Y = AE … (1) So, in equilibrium, Unplanned Inventory Change (UIC), which represents either unsold products, or shortage, is zero: i.e. UIC = Y – AE = 0 … (2) MRU: Econ1103 Principles of Macroeconomics: B.K-S 43 Economy will remain in Equilibrium only if Total Injection Equal Total Leakage PRODUCT INJECTION MARKET LEAKAGE I = 478 S = 478 BUSINESSES HOUSEHOLDS RESOURCE MARKET MRU: Econ1103 Principles of 44 Macroeconomics: B.K-S 22  Summary: Three Ways to Express Macroeconomic Equilibrium In equilibrium: 1. Y = AE 2. UIC = 0 3. Total Injections = Total Leakage I = S (For the chapter 6 model, gross investment expenditures (I) is the only source of injection, and personal saving (S) is the only source of leakage). MRU: Econ1103 Principles of Macroeconomics: B.K-S 45 We can use Three different Methods to determine the Equilibrium Output (Ye) 1. Solve a model 2. Use a formula 3. Read from a table (Note: We will practice this third method in the Chapter 6 Tutorial Worksheets) 46 MRU: Econ1103 Principles of Macroeconomics: B.K-S 23 Method 1: Solve a model to get the Equilibrium Output (Ye ) Step 1: Substitute the equations of C and I into AE = C + I to create the AE equation which has the form: AE=A0+ zY Step 2: Substitute the AE equation into the equilibrium condition, Y = AE Step 3: Solve for Y. 47 MRU: Econ1103 Principles of Macroeconomics: B.K-S Example: Solve the Model for Equilibrium Output AE = C + I C = 668 + 0.62YD I = 478 48 MRU: Econ1103 Principles of Macroeconomics: B.K-S 24 Method 2: Use the Ye Formula 1 Model given Y  e  A0 1 z AE = C + I C = 668 + 0.62YD I = 478 For chapter 6 z = mpc = A 0 = C0 + I = MRU: Econ1103 Principles of Macroeconomics: B.K-S 49 Method 3: Read Equilibrium Value (Ye ) from a Table: Let’s go to the Chapter 6 Tutorial Worksheets MRU: Econ1103 Principles of Macroeconomics: B.K-S 50 25  Graph: Macroeconomic Equilibrium Y=AE AE AE = A0 + zY E AE = 1,146 + 0.62Y A0=1,146 45º Ye Real GDP (Y) 51 MRU: Econ1103 Principles of Macroeconomics: B.K-S When Economy is NOT in Equilibrium Case A: When Y > Ye Suppose Y = 3,500 Then, AE = 1146 + 0.62(3,500) = 3,316 UIC = Y - AE = 3,500 – 33160 = 184 Output (Y) exceeds Aggregate Expenditures, so businesses cannot sell all output produced. Inventory accumulates (UIC > 0) Businesses will reduce output and Output will fall to the equilibrium rate, Ye. MRU: Econ1103 Principles of Macroeconomics: B.K-S 52 26 When the Economy is not in Equilibrium 45o Line: Y=AE AE AE = 1146 + 0.62Y E A0=1,146 45º Y2 Ye Y1 Real GDP (Y) 2,600 3,015.79 3,500 53 MRU: Econ1103 Principles of Macroeconomics: B.K-S When Economy is NOT in Equilibrium Case B: When Y < Ye Suppose Y = 2,600 Then, AE = 1146 + 0.62(2,600) = 2,758 UIC = Y - AE = 2,600 – 2,758 = -158 Output (Y) is lower than Aggregate Expenditures, so businesses draw product from inventory to sell. Inventory levels fall (UIC < 0) Businesses will increase production and Output will rise to the equilibrium rate, Ye. MRU: Econ1103 Principles of Macroeconomics: B.K-S 54 27  How Can a Country Change its Equilibrium Output? One of two ways: a) Change the marginal propensity to spend (z). This is a more difficult and longer- term approach because the marginal propensity to spend reflects culture and spending habits which change slowly. b) Change autonomous Expenditures (A0). MRU: Econ1103 Principles of Macroeconomics: B.K-S 55 Graph: Changing z to Change Equilibrium Output AE Y=AE AE = A0 + z1Y E1 A0 45º Ye Yp Real GDP (Y) 56 MRU: Econ1103 Principles of Macroeconomics: B.K-S 28 Graph: Changing A0 to Change Equilibrium Output AE Y=AE AE = A0 + zY E1 A0 = C0+I 45º Ye Yp Real GDP (Y) 57 MRU: Econ1103 Principles of Macroeconomics: B.K-S The Multiplier Effect A change in autonomous expenditures changes output by a bigger number. The Expenditures multiplier is the multiple (i.e. number of times) by which a change in Autonomous expenditures (∆A0) changes output (∆Y). There are two formulas to calculate the expenditures multiplier, depending on the information given: MRU: Econ1103 Principles of Macroeconomics: B.K-S 58 29 Formula 1 ∆𝒀 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 ∆𝑨𝟎 For example, suppose a $100m increase in business investment expenditures increased equilibrium output from $4,250m to $4,750m. Then, A0  Y e  The Expenditures Multiplier = MRU: Econ1103 Principles of Macroeconomics: B.K-S 59 Formula 2 𝟏 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆𝒔 𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒊𝒆𝒓 𝟏 𝒛 For Example, in our model, z = 0.62 1 Expenditures multiplier   1 z MRU: Econ1103 Principles of Macroeconomics: B.K-S 60 30  Explaining the Multiplier Effect Each spending creates income for owners of resources employed, which they in turn spend according to their marginal propensity to consume, creating more income for other resource owners, etc. See Next Two Slides  61 MRU: Econ1103 Principles of Macroeconomics: B.K-S The Multiplier process for a $100m increase in Investment (i.e. ΔI=100m) Initial spending increase = $100m 2nd Round Spending = 62 MRU: Econ1103 Principles of Macroeconomics: B.K-S 31 Textbook: Page 146 MRU: Econ1103 Principles of Macroeconomics: B.K-S 63 32