increase
Chapter 11: • “Moore’s Law” states that the capacity of semiconductors doubles every two years • In this chapter we will explore the causes of the business cycle by examining the effect of changes in total spending on real GDP • When total spending in the economy (aggregate expenditure (AE)) and total production of good and services increase by the same amount o Most firms will sell what they expected to sell, and won’t change the production or the number of workers they hire • When total spending in an economy increases more than the production of goods and services o Firms will increase production and hire more workers • When total spending does not increase as much as total production o Firms will cut back on production and lay off workers, and the economy moves to a recession • Aggregate expenditure (AE): the total amount of spending in the economy: the sum of consumption, planned investment, gov’t purchases, and net exports 11.1 The Aggregate Expenditure Model • Aggregate expenditure model: a macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant o Can help us understand the relationships among the different economic variable o In any particular year, the level of GDP is determined mainly by the level of aggregate expenditure • The relationship between the changes in aggregate expenditures and changes in GDP were first studied during the Great Depression in the 1930s • There are four components of aggregate expenditure that
together equal GDP o Consumption (C): spending by households on goods and services (cars and haircuts) o Planned investment (I): planned spending by firms on capital goods (factories, office buildings, machine tools) and by households on new homes o Gov’t Purchases (G): spending by local, state, and federal gov’t on goods and services (aircraft carriers, bridges, salaries of FBI agents) o Net exports (NX): spending by foreign firms and households on goods and services produced in the U.S. minus spending by U.S. firms and households on goods and services produced in other countries Aggregate expenditure (AE) = Consumption (C) + Planned Investment (I) + Gov’t Purchases (G) + Net Exports (NX) • It is key to remember that the investments are “planned” and that the amount that businesses plan to spend on investment can be different from the amount they actually spend o Inventories: goods that have been produced but not yet sold o Change in inventories are included as port of investment spending, along with spending on machinery, equipment, office buildings, and factories o The difference is that the amount a business expects to spend on machinery and office buildings will be equal to what they actually spend, but the amount businesses plan to spend on inventories may be different from the amount they actually spend o Unplanned increase in inventories = actual investment spending > planned investment spending o Unplanned decrease in inventories = actual investment spending < planned investment spending o So, actual investment will equal planned investment only when there is no unplanned change in inventories
• Macroeconomic equilibrium occurs where total spending = total production or GDP • When aggregate expenditure > GDP, the total amount of spending in the economy is greater than the total amount of production o Businesses will sell more goods and services then they had expected • If there is an unexpected increase in sales of a particular product a manager will likely do what? o Order more of the product to increase inventory o Hire more workers • If the increase in sales effects multiple products then GDP and total employment will begin to increase o When aggregate expenditure is greater than GDP, inventories will decline, and GDP and total employment will increase • If aggregate expenditure < GDP, then spending will be less than production o Businesses will sell fewer goods and services than expected and inventories will rise • If the decrease in sales effects multiple products, GDP and total employment will decrease o When aggregate expenditure is less than GDP, inventories will increase, and GDP and total employment will decrease • Increases and decreases in AE cause the year-to-year changes we see in GDP o If economists forecast that AE will decline in the future, then they are saying that GDP will decline and the economy will enter a recession § If a recession is expected, then the federal gov’t may implement macroeconomic policies in an attempt to head off the decrease in expenditure and keep the economy from falling into a recession o Increase/Decrease in GDP is directly correlated to the increase/decrease in wages, profits, and job opportunities
11.2 Determining the Level of Aggregate Expenditure in the Economy The variables that determine each of the four components of aggregate expenditure • Consumption o Follows a smooth upward trend o Five most important variable that determine the level of consumption 1. Current Disposable Income a. The most important determinant of consumption b. Disposable income is the income remaining to households after they have paid the personal income tax and received gov’t transfer payments (SS) i. For most households, the higher their disposable income, the more they spend c. Macroeconomic consumption is the total consumption of all U.S. households i. Consumption increases when the current disposable income of households increases and the opposite happens if consumption decreases 2. Household Wealth a. A households wealth is the value of its assets – the value of its liabilities b. A households assets include: home, stock and bond holdings, and bank accounts c. A households liabilities include: any loans that it owes d. Increase/decrease in household wealth causes an increase/decrease in consumption e. Shares of stock is also important in determining household wealth i. As stock prices increase, household wealth increases, and so does consumption f. Permanent increases in wealth have a larger impact than temporary increases
i. It is estimated that for every permanent $1 increase in household wealth, consumption spending will increase by between 4-5 cents per year o Housing Wealth = the market value of houses – the value of loans people have taken out to pay for the houses o Only consumers who intend to sell their current house and buy a smaller one because they are “empty nesters” (children have left home) will benefit from an increase in housing prices o Many economic variable rise and fall at the same time during the business cycle and it’s because of this that economists sometime have difficulty determining whether movements in one variable are causing movements in another o So it’s hard to determine effect of changes in housing wealth on consumption spending 3. Expected Future Income a. Most people prefer to keep consumption stable from year to year, even if their income fluctuates significantly like a salesperson who earns most of their income from commissions i. They might have high-income in some years and lower income in others b. It is because of this that it is best to keep consumption steady, rather than increasing it during good years and decreasing during bad ones i. It’s hard to always tell what type of year we will have (good or bad) regarding income c. Current income explains current consumption well only when current income is not unusually high or low compared to expected future income 4. The Price Level a. Price level measures the average prices of goods and services in the economy b. An increase in the price of one product in terms of quantity demanded of that product is different from the effect of an increase in the price level on total spending by households on goods and services
c. As the price level rises, the real value of your wealth declines and so does your consumption d. As the price level falls, the real value of your wealth increases and so does your consumption 5. Interest Rate a. When the interest rate is high, the reward for saving is increased, and households are likely to save more and spend less b. Because households are concerned with the payments they will make or receive after the effects of inflation are taken into account consumption spending depends on the real interest rate c. Spending on durable goods is most likely to be affected by changes in interest rate because a high real interest rate increase the cost of spending financed by borrowing • Because changes in consumption depend on changes in disposable income, we can say that consumption is a function of disposable income • Consumption Function: the relationship between consumption spending and disposable income • Marginal propensity to consume (MPC): the slope of the consumption function: the amount by which consumption spending changes when disposable income changes Change in consumption (C) MPC= Change in disposable income (YD) • We can also use the MPC to determine how much consumption will change as income changes Change in consumption = Change in disposable income x MPC •
GDP and national income can be used interchangeably
Net taxes = Taxes – gov’t transfer payments Disposable income = National income – Net taxes National income = GDP = Disposable income + Net taxes
• Net taxes are not a constant amount because they are affected by changes in income o As income rises, net taxes rise because some taxes, such as personal income tax, increase and some gov’t transfer payments, such as gov’t payments to unemployed workers, fall • National income and disposable income differ by a constant amount, so changes in the two numbers always gives us the same value o We can calculate MPC using either the change in national income or the change in disposable income and always get the same value • Households either spend their income, save it, or use it to pay taxes National Income (Y) = Consumption (C) + Saving (S) + Taxes (T) • When national income increases, there must be some combination of an increase in consumption, an increase in savings, and an increase in taxes Change in national income = change in consumption + change in saving + change in taxes • Marginal propensity to save (MPS): is the amount by which saving increases when disposable income increases and measure the MPS as the change in saving divided by the change in disposable income o When taxes are constant, the marginal propensity to consume + the marginal propensity to save must equal 1 § They must add up to 1 because part of any increase in income is consumed, and whatever remains must be saved •
Planned Investment
• Doesn’t follow a smooth upward trend like consumption • Investment declined significantly during the recessions of recent years • The four most important variables that determine the level of investment are: 1. Expectations of future profitability a. Investment goods, such as factories, office buildings, and machinery and equipment, are long lived i. As well as residential construction b. A firm is unlikely to build a new factory unless it is optimistic that the demand for its product will remain strong for a period of at least several years c. In a recession, many firms postpone buying investment goods even if the demand is strong because they are afraid that the recession may become worse d. In an expansion, firms may become optimistic and begin to increase spending on investment goods even before the demand for their own product has increased i. The optimism or pessimism of firms is an important determinant of investment spending 2. Interest Rate a. Business investments is financed by borrowing i. Corporate bonds or receiving loans from banks b. Households also borrow to finance most of their spending on new homes c. The higher the interest rate, the more expensive it is for firms and households to borrow d. Inverse relationship between the real interest rate and investment spending i. A higher real interest rate results in less spending, and a lower real interest rate results in more investment spending
3. Taxes a. Firms focus on the profits that remain after they have paid taxes i. Federal gov’t imposes a corporate income tax on the profits corporations earn, including profits from the new buildings, equipment, and other investment goods they purchase ii. An increase/reduction in the corporate income tax decreases/increases the after-tax profitability of investment spending iii. Investment tax incentives increase investment spending by giving incentives to firms via tax reduction when they spend on new investment goods 4. Cash Flow a. Most firms don’t borrow to finance spending on new factories, machinery, and equipment, instead they use their own funds b. Cash Flow: difference between the cash revenues received by a firm and the cash spending by the firm c. The largest contributor to cash flow is profit i. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment 1. This is hurt during a recession because they have less ability to finance spending on new factories or machinery and equipment § During recessions, firms and households cut back on spending on durable goods such as computers and get by with their existing machines and software § Government Purchases § Total gov’t purchases include all spending by federal, local, and state governments for goods and services § Doesn’t include o Transfer payments and SS payments by the federal gov’t
o Pension payments to retired police officers and firefighters by local gov’t because the gov’t doesn’t receive a good or service in return § Net Exports § Net exports = exports – imports § Net exports usually increase when the U.S. economy is in recession (although it happened to only a minor extent during the 2001 recession) and falls when the U.S. economy is expanding § The three most important variables that determine the level of net exports are: 1. The Price Level in the U.S. Relative to the Price Levels in Other Countries a. If inflation in the U.S. is lower than the inflation in other countries, prices of U.S. products increase more slowly than the prices of products of other countries i. Slower increase in the U.S. price level increases the demand for U.S. products relative to the demand for foreign products ii. So, U.S. exports increase and U.S. imports decrease, which increase net exports b. The opposite happens during periods when the inflation rate in the U.S. is higher than other countries 2. The Growth Rate of GDP in the U.S. Relative to the Growth Rates of GDP in Other Countries a. As GDP increases in the U.S the incomes of households rise, leading them to increase their purchases of goods and services b. When incomes rise faster in the U.S. than in other countries, U.S. consumers’ purchases of foreign goods and services increase faster than foreign consumers’ purchases of U.S. goods and services i. As a result, net exports fall c. When incomes in the U.S. rise more slowly than incomes in other countries, net exports rise 3. The Exchange Rate between the Dollar and Other Currencies
a. As the value of the U.S. dollar rises, the foreign currency price of U.S. products sold in other counties rises, and the dollar price of foreign products sold in the U.S. falls b. An increase in the value of the dollar will reduce exports and increase imports, so net exports will fall c. A decrease in the value of the dollar will increase exports and reduce imports, so net exports will rise 11.3 Graphing Macroeconomic Equilibrium • We can use a graph called the 450 line diagram to illustrate macroeconomic equilibrium o Also referred to as the Keynesian cross because it is based on the analysis of John Maynard Keynes • Because macroeconomic equilibrium occurs where planned AE equals GDP, we know that all point of macroeconomic equilibrium must lie along the 450 line o For all points above the 450 line, planned AE > GDP o For all points below the 450 line, planned AE < GDP • Only one of these points will represent the actual level of equilibrium real GDP, given the actual level of planned real expenditure o To determine this point, we need to draw a line on the graph to show the aggregate expenditure function, which shows us the amount of planned AE that will occur at every level of national income • Changes in GDP have a much greater impact on consumption than on planned investment, gov’t purchases, or net exports • Whenever total spending is greater than total production, firms’ inventories fall • We ideally want equilibrium to occur at potential real GDP, where firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment o For equilibrium to occur at the level of potential real GDP,
planned AE must be high enough § Can’t be operating below their normal capacity • If firms accumulate excess inventories, then even if spending quickly returns to its normal levels, firms will have to sell their excess inventories before they can return to producing at normal levels • In forecasting real GDP, economists rely on quantitative models of the economy 11.4 The Multiplier Effect • In figure 11-12 in the book o The increase in planned investment spending has had a multiplied effect on equilibrium real GDP. It’s not only investment spending that will have this multiplied effect; any increase in autonomous expenditure will shift up the AE function and lead to a multiplied increase in equilibrium GDP • Autonomous Expenditure: an expenditure that does not depend on the level of GDP o Planned investment spending, gov’t spending, and net exports are all autonomous expenditures o Consumption is both autonomous and non-autonomous § Non-autonomous means that the component does depend on the level of GDP § If households decide to spend more of their incomes and save less at every level of income, there will be an autonomous increase in consumption spending, and the aggregate expenditure function will shift up § If real GDP increases and households increase their consumption on spending, as indicated by the consumption function, the economy will move up along the aggregate expenditure function, and the increase in consumption spending will be non-autonomous • Multiplier: increase in equilibrium real GDP divided by the
increase in autonomous expenditure • Multiplier Effect: process by which an increase in autonomous expenditure leads to a larger increase in real GDP • To find the value of a multiplier we use this example • A reverse multiplier is what caused the Great Depression • The total change in equilibrium real GDP equals the initial increase in planned investment spending = $100 billion Total change in GDP = $100 billion + MPC x $1000 billion + MPC2 x $100 billion + MPC3 x $100 billion + MPC4 x $100 billion +….. § This expression has an infinite number of similar terms Multiplier = Change in equilibrium real GDP Change in autonomous expenditure • Key points of the multiplier effect o Occurs both when autonomous expenditures increases and when it decreases o Makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be § Because of the multiplier effect, a decline in spending and production in one sector of the economy can lead to declines in spending and production in many other sectors o The larger the MPC, the larger the value of the multiplier o The formula for the multiplier, 1/(1-MPC), is oversimplified because it ignores some real-world complications, such as the effect that increases in GDP have on imports, inflation, interest rates, and individual income taxes • In the short run, if households save more of their income and spend less of it, AE and real GDP will decline • Keynes argues that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession
• The lower incomes in this recession might mean that total saving does not increase despite the attempts by many individuals to increase their own savings o This is known as the Paradox of Thrift because what appears to be something favorable to the long-run performance of the economy might be counterproductive in the short run 11.5 The Aggregate Demand Curve • Increases in the price level cause the aggregate expenditure to fall, and decreases in the price level cause aggregate expenditure to rise • There are three reasons for this inverse relationship o A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect o If the price level in the U.S. rises relative to the price levels of other countries, U.S. exports will become relatively more expensive, and foreign imports will become less expensive, causing net exports to fall § A falling price in the U.S. has the reverse effect o When prices rise, firms and households need more money to finance buying and selling. If the central bank doesn’t increase the money supply, the result will be an increase in the interest rate § This declines firms investment and borrowing • Aggregate Demand Curve (AD): curve that shows 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
together equal GDP o Consumption (C): spending by households on goods and services (cars and haircuts) o Planned investment (I): planned spending by firms on capital goods (factories, office buildings, machine tools) and by households on new homes o Gov’t Purchases (G): spending by local, state, and federal gov’t on goods and services (aircraft carriers, bridges, salaries of FBI agents) o Net exports (NX): spending by foreign firms and households on goods and services produced in the U.S. minus spending by U.S. firms and households on goods and services produced in other countries Aggregate expenditure (AE) = Consumption (C) + Planned Investment (I) + Gov’t Purchases (G) + Net Exports (NX) • It is key to remember that the investments are “planned” and that the amount that businesses plan to spend on investment can be different from the amount they actually spend o Inventories: goods that have been produced but not yet sold o Change in inventories are included as port of investment spending, along with spending on machinery, equipment, office buildings, and factories o The difference is that the amount a business expects to spend on machinery and office buildings will be equal to what they actually spend, but the amount businesses plan to spend on inventories may be different from the amount they actually spend o Unplanned increase in inventories = actual investment spending > planned investment spending o Unplanned decrease in inventories = actual investment spending < planned investment spending o So, actual investment will equal planned investment only when there is no unplanned change in inventories
• Macroeconomic equilibrium occurs where total spending = total production or GDP • When aggregate expenditure > GDP, the total amount of spending in the economy is greater than the total amount of production o Businesses will sell more goods and services then they had expected • If there is an unexpected increase in sales of a particular product a manager will likely do what? o Order more of the product to increase inventory o Hire more workers • If the increase in sales effects multiple products then GDP and total employment will begin to increase o When aggregate expenditure is greater than GDP, inventories will decline, and GDP and total employment will increase • If aggregate expenditure < GDP, then spending will be less than production o Businesses will sell fewer goods and services than expected and inventories will rise • If the decrease in sales effects multiple products, GDP and total employment will decrease o When aggregate expenditure is less than GDP, inventories will increase, and GDP and total employment will decrease • Increases and decreases in AE cause the year-to-year changes we see in GDP o If economists forecast that AE will decline in the future, then they are saying that GDP will decline and the economy will enter a recession § If a recession is expected, then the federal gov’t may implement macroeconomic policies in an attempt to head off the decrease in expenditure and keep the economy from falling into a recession o Increase/Decrease in GDP is directly correlated to the increase/decrease in wages, profits, and job opportunities
11.2 Determining the Level of Aggregate Expenditure in the Economy The variables that determine each of the four components of aggregate expenditure • Consumption o Follows a smooth upward trend o Five most important variable that determine the level of consumption 1. Current Disposable Income a. The most important determinant of consumption b. Disposable income is the income remaining to households after they have paid the personal income tax and received gov’t transfer payments (SS) i. For most households, the higher their disposable income, the more they spend c. Macroeconomic consumption is the total consumption of all U.S. households i. Consumption increases when the current disposable income of households increases and the opposite happens if consumption decreases 2. Household Wealth a. A households wealth is the value of its assets – the value of its liabilities b. A households assets include: home, stock and bond holdings, and bank accounts c. A households liabilities include: any loans that it owes d. Increase/decrease in household wealth causes an increase/decrease in consumption e. Shares of stock is also important in determining household wealth i. As stock prices increase, household wealth increases, and so does consumption f. Permanent increases in wealth have a larger impact than temporary increases
i. It is estimated that for every permanent $1 increase in household wealth, consumption spending will increase by between 4-5 cents per year o Housing Wealth = the market value of houses – the value of loans people have taken out to pay for the houses o Only consumers who intend to sell their current house and buy a smaller one because they are “empty nesters” (children have left home) will benefit from an increase in housing prices o Many economic variable rise and fall at the same time during the business cycle and it’s because of this that economists sometime have difficulty determining whether movements in one variable are causing movements in another o So it’s hard to determine effect of changes in housing wealth on consumption spending 3. Expected Future Income a. Most people prefer to keep consumption stable from year to year, even if their income fluctuates significantly like a salesperson who earns most of their income from commissions i. They might have high-income in some years and lower income in others b. It is because of this that it is best to keep consumption steady, rather than increasing it during good years and decreasing during bad ones i. It’s hard to always tell what type of year we will have (good or bad) regarding income c. Current income explains current consumption well only when current income is not unusually high or low compared to expected future income 4. The Price Level a. Price level measures the average prices of goods and services in the economy b. An increase in the price of one product in terms of quantity demanded of that product is different from the effect of an increase in the price level on total spending by households on goods and services
c. As the price level rises, the real value of your wealth declines and so does your consumption d. As the price level falls, the real value of your wealth increases and so does your consumption 5. Interest Rate a. When the interest rate is high, the reward for saving is increased, and households are likely to save more and spend less b. Because households are concerned with the payments they will make or receive after the effects of inflation are taken into account consumption spending depends on the real interest rate c. Spending on durable goods is most likely to be affected by changes in interest rate because a high real interest rate increase the cost of spending financed by borrowing • Because changes in consumption depend on changes in disposable income, we can say that consumption is a function of disposable income • Consumption Function: the relationship between consumption spending and disposable income • Marginal propensity to consume (MPC): the slope of the consumption function: the amount by which consumption spending changes when disposable income changes Change in consumption (C) MPC= Change in disposable income (YD) • We can also use the MPC to determine how much consumption will change as income changes Change in consumption = Change in disposable income x MPC •
GDP and national income can be used interchangeably
Net taxes = Taxes – gov’t transfer payments Disposable income = National income – Net taxes National income = GDP = Disposable income + Net taxes
• Net taxes are not a constant amount because they are affected by changes in income o As income rises, net taxes rise because some taxes, such as personal income tax, increase and some gov’t transfer payments, such as gov’t payments to unemployed workers, fall • National income and disposable income differ by a constant amount, so changes in the two numbers always gives us the same value o We can calculate MPC using either the change in national income or the change in disposable income and always get the same value • Households either spend their income, save it, or use it to pay taxes National Income (Y) = Consumption (C) + Saving (S) + Taxes (T) • When national income increases, there must be some combination of an increase in consumption, an increase in savings, and an increase in taxes Change in national income = change in consumption + change in saving + change in taxes • Marginal propensity to save (MPS): is the amount by which saving increases when disposable income increases and measure the MPS as the change in saving divided by the change in disposable income o When taxes are constant, the marginal propensity to consume + the marginal propensity to save must equal 1 § They must add up to 1 because part of any increase in income is consumed, and whatever remains must be saved •
Planned Investment
• Doesn’t follow a smooth upward trend like consumption • Investment declined significantly during the recessions of recent years • The four most important variables that determine the level of investment are: 1. Expectations of future profitability a. Investment goods, such as factories, office buildings, and machinery and equipment, are long lived i. As well as residential construction b. A firm is unlikely to build a new factory unless it is optimistic that the demand for its product will remain strong for a period of at least several years c. In a recession, many firms postpone buying investment goods even if the demand is strong because they are afraid that the recession may become worse d. In an expansion, firms may become optimistic and begin to increase spending on investment goods even before the demand for their own product has increased i. The optimism or pessimism of firms is an important determinant of investment spending 2. Interest Rate a. Business investments is financed by borrowing i. Corporate bonds or receiving loans from banks b. Households also borrow to finance most of their spending on new homes c. The higher the interest rate, the more expensive it is for firms and households to borrow d. Inverse relationship between the real interest rate and investment spending i. A higher real interest rate results in less spending, and a lower real interest rate results in more investment spending
3. Taxes a. Firms focus on the profits that remain after they have paid taxes i. Federal gov’t imposes a corporate income tax on the profits corporations earn, including profits from the new buildings, equipment, and other investment goods they purchase ii. An increase/reduction in the corporate income tax decreases/increases the after-tax profitability of investment spending iii. Investment tax incentives increase investment spending by giving incentives to firms via tax reduction when they spend on new investment goods 4. Cash Flow a. Most firms don’t borrow to finance spending on new factories, machinery, and equipment, instead they use their own funds b. Cash Flow: difference between the cash revenues received by a firm and the cash spending by the firm c. The largest contributor to cash flow is profit i. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment 1. This is hurt during a recession because they have less ability to finance spending on new factories or machinery and equipment § During recessions, firms and households cut back on spending on durable goods such as computers and get by with their existing machines and software § Government Purchases § Total gov’t purchases include all spending by federal, local, and state governments for goods and services § Doesn’t include o Transfer payments and SS payments by the federal gov’t
o Pension payments to retired police officers and firefighters by local gov’t because the gov’t doesn’t receive a good or service in return § Net Exports § Net exports = exports – imports § Net exports usually increase when the U.S. economy is in recession (although it happened to only a minor extent during the 2001 recession) and falls when the U.S. economy is expanding § The three most important variables that determine the level of net exports are: 1. The Price Level in the U.S. Relative to the Price Levels in Other Countries a. If inflation in the U.S. is lower than the inflation in other countries, prices of U.S. products increase more slowly than the prices of products of other countries i. Slower increase in the U.S. price level increases the demand for U.S. products relative to the demand for foreign products ii. So, U.S. exports increase and U.S. imports decrease, which increase net exports b. The opposite happens during periods when the inflation rate in the U.S. is higher than other countries 2. The Growth Rate of GDP in the U.S. Relative to the Growth Rates of GDP in Other Countries a. As GDP increases in the U.S the incomes of households rise, leading them to increase their purchases of goods and services b. When incomes rise faster in the U.S. than in other countries, U.S. consumers’ purchases of foreign goods and services increase faster than foreign consumers’ purchases of U.S. goods and services i. As a result, net exports fall c. When incomes in the U.S. rise more slowly than incomes in other countries, net exports rise 3. The Exchange Rate between the Dollar and Other Currencies
a. As the value of the U.S. dollar rises, the foreign currency price of U.S. products sold in other counties rises, and the dollar price of foreign products sold in the U.S. falls b. An increase in the value of the dollar will reduce exports and increase imports, so net exports will fall c. A decrease in the value of the dollar will increase exports and reduce imports, so net exports will rise 11.3 Graphing Macroeconomic Equilibrium • We can use a graph called the 450 line diagram to illustrate macroeconomic equilibrium o Also referred to as the Keynesian cross because it is based on the analysis of John Maynard Keynes • Because macroeconomic equilibrium occurs where planned AE equals GDP, we know that all point of macroeconomic equilibrium must lie along the 450 line o For all points above the 450 line, planned AE > GDP o For all points below the 450 line, planned AE < GDP • Only one of these points will represent the actual level of equilibrium real GDP, given the actual level of planned real expenditure o To determine this point, we need to draw a line on the graph to show the aggregate expenditure function, which shows us the amount of planned AE that will occur at every level of national income • Changes in GDP have a much greater impact on consumption than on planned investment, gov’t purchases, or net exports • Whenever total spending is greater than total production, firms’ inventories fall • We ideally want equilibrium to occur at potential real GDP, where firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment o For equilibrium to occur at the level of potential real GDP,
planned AE must be high enough § Can’t be operating below their normal capacity • If firms accumulate excess inventories, then even if spending quickly returns to its normal levels, firms will have to sell their excess inventories before they can return to producing at normal levels • In forecasting real GDP, economists rely on quantitative models of the economy 11.4 The Multiplier Effect • In figure 11-12 in the book o The increase in planned investment spending has had a multiplied effect on equilibrium real GDP. It’s not only investment spending that will have this multiplied effect; any increase in autonomous expenditure will shift up the AE function and lead to a multiplied increase in equilibrium GDP • Autonomous Expenditure: an expenditure that does not depend on the level of GDP o Planned investment spending, gov’t spending, and net exports are all autonomous expenditures o Consumption is both autonomous and non-autonomous § Non-autonomous means that the component does depend on the level of GDP § If households decide to spend more of their incomes and save less at every level of income, there will be an autonomous increase in consumption spending, and the aggregate expenditure function will shift up § If real GDP increases and households increase their consumption on spending, as indicated by the consumption function, the economy will move up along the aggregate expenditure function, and the increase in consumption spending will be non-autonomous • Multiplier: increase in equilibrium real GDP divided by the
increase in autonomous expenditure • Multiplier Effect: process by which an increase in autonomous expenditure leads to a larger increase in real GDP • To find the value of a multiplier we use this example • A reverse multiplier is what caused the Great Depression • The total change in equilibrium real GDP equals the initial increase in planned investment spending = $100 billion Total change in GDP = $100 billion + MPC x $1000 billion + MPC2 x $100 billion + MPC3 x $100 billion + MPC4 x $100 billion +….. § This expression has an infinite number of similar terms Multiplier = Change in equilibrium real GDP Change in autonomous expenditure • Key points of the multiplier effect o Occurs both when autonomous expenditures increases and when it decreases o Makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be § Because of the multiplier effect, a decline in spending and production in one sector of the economy can lead to declines in spending and production in many other sectors o The larger the MPC, the larger the value of the multiplier o The formula for the multiplier, 1/(1-MPC), is oversimplified because it ignores some real-world complications, such as the effect that increases in GDP have on imports, inflation, interest rates, and individual income taxes • In the short run, if households save more of their income and spend less of it, AE and real GDP will decline • Keynes argues that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession
• The lower incomes in this recession might mean that total saving does not increase despite the attempts by many individuals to increase their own savings o This is known as the Paradox of Thrift because what appears to be something favorable to the long-run performance of the economy might be counterproductive in the short run 11.5 The Aggregate Demand Curve • Increases in the price level cause the aggregate expenditure to fall, and decreases in the price level cause aggregate expenditure to rise • There are three reasons for this inverse relationship o A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect o If the price level in the U.S. rises relative to the price levels of other countries, U.S. exports will become relatively more expensive, and foreign imports will become less expensive, causing net exports to fall § A falling price in the U.S. has the reverse effect o When prices rise, firms and households need more money to finance buying and selling. If the central bank doesn’t increase the money supply, the result will be an increase in the interest rate § This declines firms investment and borrowing • Aggregate Demand Curve (AD): curve that shows 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
