Principles of Economics Chapter 23 PDF

Principles of Economics Thirteenth Edition Chapter 23 Aggregate Expenditure and Equilibrium Output Copyright © 2020, 2016, 2011 Pearson Education, Inc. Al...

Principles of Economics Thirteenth Edition Chapter 23 Aggregate Expenditure and Equilibrium Output Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 23 Aggregate Expenditure and Equilibrium Output (1 of 2) aggregate output The total quantity of goods and services produced (or supplied) in an economy in a given period. aggregate income The total income received by all factors of production in a given period. In any given period, there is an exact equality between aggregate output (production) and aggregate income. You should be reminded of this fact whenever you encounter the combined term aggregate output (income). Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 23 Aggregate Expenditure and Equilibrium Output (2 of 2) aggregate output (income) (Y) A combined term used to remind you of the exact equality between aggregate output and aggregate income. You must think in “real terms”: Output Y refers to the quantities of goods and services produced, not the dollars circulating in the economy. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Keynesian Theory of Consumption (1 of 4) In Keynes’s classic The General Theory of Employment, Interest, and Money, current income played the key role in determining consumption levels in the economy. consumption function The relationship between consumption and income. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.1 A Consumption Function for a Household A consumption function for an individual household shows the level of consumption at each level of household income. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.2 An Aggregate Consumption Function The aggregate consumption function shows the level of aggregate consumption at each level of aggregate income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Keynesian Theory of Consumption (2 of 4) We can use the following equation to describe a straight- line consumption curve: C = a + bY marginal propensity to consume (MPC) That fraction of a change in income that is consumed, or spent. DC marginal propensity to consumer º slope of consumption function º DY Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Keynesian Theory of Consumption (3 of 4) aggregate saving (S) The part of aggregate income that is not consumed. S ºY -C The triple equal sign ( º ) means that this equation is an identity, or something that is always true by definition. identity Something that is always true by definition. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Keynesian Theory of Consumption (4 of 4) marginal propensity to save (MPS) That fraction of a change in income that is saved. MPC + MPS º 1 MPC is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consumption). MPS is the fraction of an increase in income that is saved (or the fraction of a decrease in income that comes out of saving). Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.3 The Aggregate Consumption Function Derived from the Equation C = 100 + 0.75Y Aggregate Income, Aggregate Y Consumption, C 0 100 80 160 100 175 200 250 400 400 600 550 800 700 1,000 850 In this simple consumption function, consumption is 100 at an income of zero. As income rises, so does consumption. For every 100 increase in income, consumption rises by 75. The slope of the line is 0.75. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.4 Deriving the Saving Function from the Consumption Function in Figure 23.3 Y - C = S Aggregate Aggregate Aggregate Saving Income Consumption 0 100 −100 80 160 −80 100 175 −75 200 250 −50 400 400 0 600 550 50 800 700 100 1,000 850 150 Because S ºY - C, it is easy to derive the saving function from the consumption function. A 45° line drawn from the origin can be used as a convenient tool to compare consumption and income graphically. At Y = 200, consumption is 250. The 45° line shows us that consumption is larger than income by 50. Thus, S ºY - C = - 50. At Y = 800, consumption is less than income by 100. Thus, S = 100 when Y = 800. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Other Determinants of Consumption In practice, the decisions of households about how much to consume in a given period are also affected by: – Their wealth – The interest rate – Their expectations of the future Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Planned Investment (I) versus Actual Investment Inventory is the stock of goods that a firm has awaiting sale. planned investment (I) Those additions to capital stock and inventory that are planned by firms. actual investment The actual amount of investment that takes place; it includes items such as unplanned changes in inventories. If a firm overestimates how much it will sell in a period, it will end up with more in inventory than it planned to have. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Planned Investment and the Interest Rate (r) Increasing the interest rate, ceteris paribus, is likely to reduce the level of planned investment spending. When the interest rate falls, it becomes less costly to borrow, and more investment projects are likely to be undertaken. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.5 Planned Investment Schedule Planned investment spending is a negative function of the interest rate. An increase in the interest rate from 3% to 6% reduces planned investment from I0 to I1. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Other Determinants of Planned Investment The decision of a firm on how much to invest depends, among other things, on its expectation of future sales. The optimism or pessimism of entrepreneurs about the future course of the economy can have an important effect on current planned investment. Keynes used the phrase animal spirits to describe the feelings of entrepreneurs. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Determination of Equilibrium Output (Income) (1 of 3) equilibrium Occurs when there is no tendency for change. In the macroeconomic goods market, equilibrium occurs when planned aggregate expenditure is equal to aggregate output. planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment: AE º C + I So, equilibrium can also be written: Equilibrium: Y = C + I Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Determination of Equilibrium Output (Income) (2 of 3) Y >C +I aggregate output > planned aggregate expenditure C +I >Y planned aggregate expenditure > aggregate output Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Table 23.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium* (1) (2) (3) (4) (5) (6) Aggregate Aggregate Planned Planned Unplanned Equilibrium? Output Consumption Investment Aggregate Inventory Change (Y − AE?) (Income) (C) (I) Expenditure Y − (C + I) (Y) (AE) C+I 100 175 25 200 −100 No 200 250 25 275 −75 No 400 400 25 425 −25 No 500 475 25 500 0 Yes 600 550 25 575 +25 No 800 700 25 725 +75 No 1,000 850 25 875 +125 No * The figures in column (2) are based on the equation C = 100 + 0.75Y Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.6 Equilibrium Aggregate Output Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned aggregate expenditure is the sum of consumption spending and planned investment spending. The planned aggregate expenditure function crosses the 45° line at a single point, where Y = 500. The point at which the two lines cross is sometimes called the Keynesian cross. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Determination of Equilibrium Output (Income) (3 of 3) Find the equilibrium level of output (income) algebraically: Y =C +I (equilibrium) C = 100 + 0.75Y (consumption function) I = 25 (planned investment) Y = 100  + 0.75  Y + 25  C I Rearranging terms: Y - 0.75Y = 100 + 25 0.25Y + 125 125 Y= = 500 0.25 Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Saving/Investment Approach to Equilibrium Y º C + S, which is an identity. The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when out of equilibrium. By substituting C + S for Y in the equilibrium condition: C+ S = C + I S =I Equilibrium occurs only when planned investment equals saving. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.7 The S = I Approach to Equilibrium Aggregate output is equal to planned aggregate expenditure only when saving equals planned investment (S = I). Saving and planned investment are equal at Y = 500. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Adjustment to Equilibrium If firms react to unplanned inventory reductions (increases) by increasing output, an economy with planned spending greater (less) than output will adjust to equilibrium, with Y higher (lower) than before. Figure 23.6 shows that at any level of output above (below) Y = 500, output will fall (rise) until it reaches equilibrium at Y = 500. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Multiplier multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable. exogenous variable A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes. The size of the multiplier depends on the slope of the planned aggregate expenditure line. The steeper the slope of this line, the greater the change in output for a given change in investment. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 23.8 The Multiplier as Seen in the Planned Aggregate Expenditure Diagram At point A, the economy is in equilibrium at Y = 500. When I increases by 25, planned aggregate expenditure is initially greater than aggregate output. As output rises in response, additional consumption is generated, pushing equilibrium output up by a multiple of the initial increase in I. The new equilibrium is found at point B, where Y = 600. Equilibrium output has increased by 100 (600 − 500), or four times the amount of the increase in planned investment. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Multiplier Equation Recall: MPS = DS DY Because DS must be equal to DI for equilibrium to be restored, we can substitute DI for DS and solve: DI MPS = DY 1 DY = DI ´ 1 - MPS Therefore: 1 1 multiplier º or multiplier º MPS 1 - MPS Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Size of the Multiplier in the Real World The size of the multiplier is reduced when: 1. Tax payments depend on income. 2. We consider Fed behavior regarding the interest rate. 3. We add the price level to the analysis. 4. Imports are introduced. In reality, the size of the multiplier is about 2. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts (1 of 2) actual investment marginal propensity to aggregate income consume (MPC) aggregate output marginal propensity to save (MPS) aggregate output (income) multiplier (Y) planned aggregate aggregate saving (S) expenditure (AE) consumption function planned investment (I) equilibrium Equations: exogenous variable Identity S ºY -C MPC º slope of consumption function º DC ÷ DY Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts (2 of 2) MPC + MPS º 1 AE º C + I Equilibrium condition: Y = AE or Y = C + I Saving/investment approach to equilibrium: S = I Multiplier º 1 ÷ MPS º 1 ÷ 1 - MPC Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Chapter 23 Appendix: Deriving the Multiplier Algebraically Recall our consumption function: C = a + bY In equilibrium: Y =C +I Substituting the first equation into the second: Y = a + bY + I 1 Rearranging terms and solve for Y in terms of I: Y = (a + I ) (1 - b ) æ 1 ö Change I by some amount, DI : DY = DI ´ ç ÷ è 1- b ø æ 1 ö Because b º MPC: DY = DI ´ ç ÷ è 1 - MPC ø 1 The multiplier is: 1 - MPC Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved