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CHAPTER
The Short-Run Macro Model
Chapter 11 Part 2
1
What Happens When Things Change?
• Increase in planned investment by $1000
– $1000 increase investment expenditure, IP↑
– creates $1000 additional income, Y↑
– leads to $1000 additional disposable
income, (Y-T) ↑
– MPC ˣ $1000 = additional consumption
spending, C↑
– creates MPC ˣ $1000 additional income, Y↑
– ………
– ………
– Equilibrium GDP rises by a multiple of $1000
2
Increases in Spending after Planned Investment Spending
Increases by $1,000 Billion per Year: MPC = 0.6
3
The Effect of a Change in Investment Spending
An increase in investment spending sets off a chain reaction, leading to successive rounds of
increased spending and income. As shown here, a $1,000 billion increase in investment spending first
causes real GDP to increase by $1,000 billion. Then, with higher incomes, households increase
consumption spending by the MPC times the change in disposable income. In round 2, spending and
GDP increase by another $600 billion. In succeeding rounds, increases in income lead to further
changes in spending, but in each round the increases in income and spending are smaller than in the
4
preceding round.
The Expenditure Multiplier =
∆𝑌
1
=
∆𝐴𝑢𝑡𝑜𝑛𝑜𝑚𝑜𝑢𝑠 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔 1−𝑀𝑃𝐶
• The amount by which equilibrium real GDP
changes as a result of a one-dollar change
in autonomous spending:
• Autonomous consumption spending, ∆C
• Autonomous Investment spending, ∆IP
• Autonomous Government spending, ∆G
• Or Autonomous Net Exports, ∆NX
5
The Expenditure Multiplier
∆Y
∆Autonomous Spending
ΔY =
1
(1−𝑀𝑃𝐶 )
=
1
1−𝑀𝑃𝐶
x ∆𝐴𝑢𝑡𝑜𝑛𝑜𝑚𝑜𝑢𝑠 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔
6
Investment Multiplier
• Increase in investment spending
– Equilibrium GDP rises by a multiple of the
change in spending
• Decrease in investment spending
– Equilibrium GDP falls by a multiple of the
change in spending


1
P
GDP  
 I

 1- MPC  
7
All kinds of Spending Multipliers
• Changes in Ip, G, NX, or a
– Lead to a multiplier effect on GDP
– ∆GDP = The expenditure multiplier × The
initial change in spending


1
P
GDP  


I

1MPC






1
GDP  
 a

 1- MPC  


1
GDP  
 G

 1- MPC  


1
GDP  
 NX

 1- MPC  


1
GDP  
 Spending

 1- MPC  
8
The Higher the MPC the Higher the Multiplier
MPC
Spending Multiplier
0.6
2.5
0.75
4.0
0.8
5.0
0.9
10
9
What Happens When Things Change?
• An increase in Ip, G, NX, or a
– Will shift the aggregate expenditure line
upward by the initial increase in spending
• Equilibrium GDP will rise
• By the initial increase in spending times the
expenditure multiplier
10
A Graphical View of the Multiplier, MPC= 0.6
Real AE
($ billions)
12,000
AE2
AE1
F
10,000
8,000
Consumption
$1,000
Function
6,000
E
Increase in
Equilibrium GDP
= $ 2,500 Billion
4,000
2,000
45°
2,000 4,000 6,000 8,00010,000 12,000
Real GDP
($ billions)
The economy starts off
at point E with
equilibrium real GDP of
$8,000 billion. A $1,000
billion increase in
spending shifts the
aggregate expenditure
line upward by $1,000
billion, triggering the
multiplier process.
Eventually, the
economy will reach a
new equilibrium at
point F, where the new,
higher aggregate
expenditure line
crosses the 45° line. At
F, real GDP is $10,500
billion, an increase of
$2,500 billion.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
The Determination of Equilibrium Output (Income)
The Math
Equilibrium condition: Y = AE
Y=C+I+G
The sectors:
C = 100 + .75(Y – T)
I = 100
T = 100
G = 100
Substitute the sector information into equilibrium
condition:
Y = 100+.75(Y – 100) + 100 + 100
Y = 225 +.75Y
.25Y = 225
Y = 225/.25
Y = 900
What Happens When Things Change?
Increase in G from 100 to 150, MPC = 0.75
Equilibrium GDP rises by a multiple of the
change in spending
1


GDP  
 xG
 1  MPC 
GDP   4  x50  200
Multiplier Process and Economic Stability
• All else equal, the larger the multiplier
– the more unstable the economy
– might be better to say the more responsive the
economy is to a change in autonomous
spending (Ip, G,T, NX, or a)
1


MPC  .6  
  2.5
 1  MPC 
1


MPC  .8  
5
 1  MPC 
14
Multiplier Process and Economic Stability
• Automatic stabilizers
– Features of the economy that reduce the
size of the expenditure multiplier and
diminish the impact of spending changes on
real GDP
– Reduce fluctuations in GDP and
employment
– Economy is more stable in the short run
15
Three Automatic Stabilizers
–Taxes and transfer payments in
actuality depend on income
• We have assumed them to be fixed thus far.
– Imports
– Forward looking Behavior
16
Multiplier Process and Automatic Stabilizers
• Taxes and transfers depend on income
– Income tax system
– As income rises
• Taxes automatically increase and transfers
decrease,
• Causing less additional spending in each round
• Resulting in a smaller multiplier
•http://www.tax-brackets.org/federaltaxtable
• Suppose for every $1,000 increase in income,
the government collects an additional $200 in
taxes and pays out $100 less in transfers
17
Taxes and transfers depend on income
COMPARED to the case where taxes and transfers do not
depend on income:
$0
$0
$1000
$1000
$600
$0
18
Multiplier Process and Automatic Stabilizers
• Imports depend on income
– Increase in income, buy more imported
goods
• Smaller spending on domestic output each
round
– Suppose out of each dollar of additional
consumption spending, 15% goes to
imports and 85% to domestic products.
– MPC domestic = MPC(1- %imports)
= 0.6(0.85) = 0.51
19
Multiplier Process and Automatic Stabilizers
• Forward Looking Behavior
• The MPC and the multiplier will be smaller
when income changes are regarded as
temporary because households will tend to
save temporary changes in income for
spending in later years.
– For example, spend 30% in the current year and
save 70% for later years.
• Do households behave this way? This is
an important macroeconomic question.
20
Forward Looking Behavior
• The MPC and the multiplier will be larger
when income changes are regarded as
permanent.
• For example, spend 90% in current year
Read the Taylor Op-ed in favor of
permanent tax cuts
21
Forward Looking Behavior
MPC =
MPC =
∆C
= 0.3
∆(Ytemp)
∆C
= 0.9
∆(Ypermanent)
A Multiplier of 1.42 versus 10.
22
Multiplier Process and Economic Stability
• Automatic de-stabilizers
– Features of the economy that
• Increases the size of the expenditure
multiplier and enlarge the impact of spending
changes on real GDP
– Increase fluctuations in GDP and
employment
– Economy: less stable in the short run
23
Multiplier Process and Economic Stability
• Consumption Spending. Suppose
household wealth changes with income
– as income rises, increasing wealth will
increase consumption spending
– you get a larger multiplier effect on GDP
• Investment spending
– may change during the multiplier process
– as GDP rises, firms push against capacity
• and increase investment
• larger multiplier effect on GDP
24
Real World Multiplier
• Multiplier takes about 9 to 12 months work
its way through the economy
• Multiplier is around 1.5, It is not
huge!
25
Multiplier Process and Economic Stability
• In the long run, the value of the expenditure
multiplier is zero
• no matter what the change in spending
• the economy will ultimately return to its
potential GDP, just as it would have without the
spending change
• any change in spending will crowd-out other
spending
• There can be some crowding-out in the
short-run, but not total crowding-out. We
cover this later.
26
Case Study: The 2008 to 2013 Recession
and the Continuing Long Slump
• Causes for the recession in the U.S.
1. 2007, spike in oil prices
2. 2007, collapse of the housing bubble
3. 2008, financial crisis
• Think about how each of these causes
affected aggregate expenditure.
27
2008 to 2013: The Recession and Slump
1. spike in oil prices in 2007
– caused decrease spending on automobiles
• AE line shifted downward
– laid-off workers (labor demand shifted to
left)
2. collapse of the housing bubble in 2007
– Rapid fall in home prices: decline in wealth
• decline in autonomous consumption spending
• AE line shifted downward
– investment spending fell (Think why!)
• AE line shifted downward
28
2008 to 2013: The Recession and Slump
3. financial crisis beginning in 2008
– defaults on mortgage payments
– decrease in lending by banks
– fear and gloom
about the economy’s
future
• Households: cut back dramatically on spending
– corporate profits falling
• share prices: began to plummet
• major hit to household wealth
• AE line shifted downward
29
2008 to 2013: The Recession and Slump
• Automatic de-stabilizers:
– falling output (Y) caused falling asset
prices (W)
• Home prices and stock prices fall
– falling asset prices reduce wealth and led
to further decreases in spending and
output
– by the end of the process
• Wealth of U.S. households declined by $14
trillion in a little over a year. The MPC out of
wealth is about 0.04.
30
Consumption Spending: 2006–2009
decline in autonomous consumption spending
caused by decline in wealth and pessimism
31
Investment Spending: 2006–2009
New home construction fell
As Y fell businesses cut back on purchases of new plant and
equipment – automatic de-stabilizer
32
2008 to 2011: The Recession...
• Automatic stabilizers:
– government’s tax revenues fell and
transfer payments rose
• Helping to cushion the decline in disposable
income and maintain spending
– imports declined
• Shifting some of the impact of lower spending
to firms in other countries
33
The Recession of 2008–2009 (a, b)
∆Y= -$685 Billion
34
2008 to 2011: The Recession was global...
• Recession in other countries
– other countries: housing boom and bust
• at the same time
• Lengthy period of low interest rates around
the globe
– Leverage and speculation
– the financial crisis
35
2008 to 2011: The Recession...
• Recession in other countries
– While Germany and Japan did not have
housing bubbles
• they are very dependent on exports
• they experienced severe downturns because
of decline in net exports as countries around
the world imported less
36
The Recession in Other Countries
37
2008 to 2011: The Recession...
• The long slump
• Potential GDP rises each year
– because of growth in both the labor force
and labor productivity
• Returning to the 2007 level of real GDP
by 2010 would not end the slump: by
2010, potential GDP was higher than in
2007
38
The Long Slump
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
39
$1 Trillion
below potential
Potential RGDP
2007 $15 Trillion
Actual RGDP
40
2008 to 2011: The Recession...
• In 2007, the U.S. economy
– was operating at potential output: about
$15,000 billion (2009 dollars)
• In 2011
– we returned to the 2007 output level
– potential GDP: $16,000 billion
• Remain in a slump for many quarters
– even when GDP starts to rise, it has a lot
of catching up to do
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41
Economies Usually Rebound Quickly from Recessions
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
42
2008 to 2011: The Recession...
• A quick end to the slump from the private
sector was unlikely
– investment in new home construction:
dropped
– business investment in new capital
equipment: stagnating
– consumption spending
• Unemployed and employed: cut back on
spending
– exports increased modestly
43
2008 to 2011: The Recession...
• Possible government policy solutions
– Increase government purchases (G)
– Change net taxes (T )
• Cut taxes and increase transfers
• In order to stimulate consumption spending
44