11-1 copyright © 2012 pearson prentice hall. all rights reserved. c h a p t e r 11 the...

11-1Copyright © 2012 Pearson Prentice Hall. All rights reserved.

C H A P T E R 11The Income-ExpenditureModel

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

The Income-ExpenditureModel

Brock Williams

P R E P A R E D B Y

Heading into the global recession in 2007, the Chinese economy was growing at the extraordinary rate of 11 percent per year.

CHAPTER

11

Copyright © 2012 Pearson Prentice Hall. All rights reserved.



1

2

3

4

How do changes in the value of homes affect consumer spending?

Falling Home Prices, the Wealth Effect, and Decreased Consumer Spending

What evidence does the long historical record provide about multipliers?

Using Long-Term Macro Data to Measure Multipliers

How influential a figure was John Maynard Keynes?

John Maynard Keynes: A World Intellectual

How do countries benefit from growth in their trading partners?

The Locomotive Effect: How Foreign Demand Affects a Country’s Output

A P P L Y I N G T H E C O N C E P T S



Equilibrium Output

A SIMPLE INCOME-EXPENDITURE MODEL

FIGURE 11.1The 45° Line

11.1

At any point on the 45° line, the distanceto the horizontal axis is the same as the distance to the vertical axis.



Equilibrium Output

FIGURE 11.2Determining Equilibrium Output

• equilibrium outputThe level of GDP at which planned expenditure equals the amount that is produced.

equilibrium output = y* = C + I = planned expenditures

A SIMPLE INCOME-EXPENDITURE MODEL (cont’d)11.1

At equilibrium output y*, total demand y* equals output y*.

• planned expendituresAnother term for total demand for goods and services.



Adjusting to Equilibrium Output FIGURE 11.3Equilibrium Output

A SIMPLE INCOME-EXPENDITURE MODEL (cont’d)11.1

Equilibrium output (y*) is determined at a, where demand intersects the 45° line.

If output were higher (y1), it would exceed demand and production would fall.

If output were lower (y2), it would fall short of demand and production would rise.



Consumer Spending and Income

• consumption functionThe relationship between consumption spending and the level of income.

C = Ca + by

• autonomous consumptionThe part of consumption that does not depend on income.

• marginal propensity to consume (MPC)The fraction of additional income thatis spent.

THE CONSUMPTION FUNCTION11.2



Consumer Spending and Income

FIGURE 11.4Consumption Function

THE CONSUMPTION FUNCTION (cont’d)11.2

The consumption function relates desired consumer spending to the level of income.



Changes in the Consumption Function FIGURE 11.5Movements of the Consumption Function




Changes in the Consumption Function

Two factors that can cause autonomous consumption to change:

• Increases in consumer wealth will cause an increase in autonomous consumption.

• Increases in consumer confidence will increase autonomous consumption.




FALLING HOME PRICES, THE WEALTH EFFECT, AND DECREASED CONSUMER SPENDING

APPLYING THE CONCEPTS #1: How do changes in the value of homes affect consumer spending?

Home equity is the difference between the home value and what is owed on the mortgage.

▪ The largest component of net wealth for most families.

▪ Changes in home equity like other forms of wealth affect consumer spending.

From 1997 to mid-2006 housing prices rose by about 90 percent and consumer wealth grew by $6.5 trillion.

This ended in 2006 as housing prices began to fall.

According to a review of studies by the Congressional Budget Office, each $1 decline in consumer wealth would lower consumption spending between $.02 and $.07, or $21 to $72 billion of spending.

This would reduce economic growth 0.1 to 0.5 percent during 2007.

A P P L I C A T I O N 1



FIGURE 11.6Equilibrium Output and the Consumption Function

EQUILIBRIUM OUTPUT ANDTHE CONSUMPTION FUNCTION11.3

Equilibrium output is determined where the C + I line intersects the 45° line. At that level of output, y*, desired spending equals output.

y*=(Ca + I )(1−b)

equilibrium output =(autonomous consumption + investment)

(1−MPC)



Saving and Investment

S = y − C

y = C + I

y − C = I

S = I

• savings functionThe relationship between the level of saving and the level of income.

EQUILIBRIUM OUTPUT ANDTHE CONSUMPTION FUNCTION (cont’d)11.3



Saving and Investment


FIGURE 11.7Savings, Investment, and Equilibrium Output

Equilibrium output is determined at the level of output, y*, where savings equals investment.



Understanding the Multiplier

FIGURE 11.8The Multiplier


When investment increases from I0 to I1, equilibrium output increases from y0 to y1.

The change in output (Δy) is greater than the change in investment (ΔI).

multiplier =1

(1−MPC)



USING LONG-TERM MACRO DATA TO MEASURE MULTIPLIERS

APPLYING THE CONCEPTS #2: What evidence does the long historical record provide about multipliers?

Estimating the effect of multipliers is difficult because governments do not change spending and taxes much during normal economic times.

Looking at periods of major war buildup and aftermath revealed:

▪ Defense spending had a multiplier of less than one so the increase in the economy was less than the government expenditure.

▪ There was evidence that the expenditures crowded out other components of spending.

▪ The multiplier was larger during periods of greater unemployment.




FIGURE 11.9Government Spending, Taxes, and GDP

Fiscal Multipliersplanned expenditures including government = C + I + G

GOVERNMENT SPENDINGAND TAXATION11.4



Fiscal Multipliers

The consumption function with taxes is

The formula for the tax multiplier is

GOVERNMENT SPENDINGAND TAXATION (cont’d)11.4

multiplier for government spending =1

(1−MPC)

C =Ca +b(y−T )

tax multiplier =−MPC

(1−MPC)



Using Fiscal Multipliers

Although it is very simple, our income-expenditure model illustrates some important lessons:

• An increase in government spending will increase total planned expenditures for goods and services.

• Cutting taxes will increase the after-tax income of consumers and will also lead to an increase in planned expenditures for goods and services.

• Policymakers need to take into account the multipliers for government spending and taxes as they develop policies.


In the long run, of course, we are better off if government spends the money wisely, such as on needed infrastructure such as roads and bridges. This is an example of the principle of opportunity cost.

P R I N C I P L E O F O P P O RT U N I T Y C O S T

The opportunity cost of something is what you sacrifice to get it.



JOHN MAYNARD KEYNES: A WORLD INTELLECTUAL

APPLYING THE CONCEPTS #3: How influential a figure was John Maynard Keynes?

At King’s College in Cambridge, Keynes began a lifetime association with an important group of writers and artists, the Bloomsbury group, which included the well-regarded writer Virginia Woolf.

After World War I, he attended the Versailles Peace Conference and wrote a book, The Economic Consequences of the Peace.

▪ It condemned the peace treaty and its negotiators.

▪ This book established Keynes as both a first-rate economic analyst and a brilliant writer.

Between the wars, Keynes wrote his most famous work, The General Theory of Employment, Interest, and Money, which challenged the conventional wisdom that economies would automatically recover from economic downturns.




Understanding Automatic Stabilizers

FIGURE 11.10Growth Rates of U.S. GDP, 1871–2009


After World War II, fluctuations in GDP growth became considerably smaller.



Understanding Automatic Stabilizers

FIGURE 11.11Increase in Tax Rates

C = Ca + b(1 − t)y

adjusted MPC = b(1 − t)


An increase in tax rates decreases the slope of the C + I + G line.

This lowers output and reduces the multiplier.



To modify our model to include the effects of world spending on exports and U.S. spending on imports, we need to take two steps:

M = my

• marginal propensity to importThe fraction of additional income that is spent on imports.

EXPORTS AND IMPORTS11.5

1 Add exports, X, as another source of demand for U.S. goods and services.

2 Subtract imports, M, from total spending by U.S. residents. We will assume that imports, like consumption, increase with the level of income.



FIGURE 11.12U.S. Equilibrium Output in an Open Economy

EXPORTS AND IMPORTS (cont’d)11.5

Output is determined when the demand for domestic goods equals output.



FIGURE 11.13How Increases in Exports and Imports Affect U.S. GDP

EXPORTS AND IMPORTS (cont’d)11.5



THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A COUNTRY’S OUTPUT

APPLYING THE CONCEPTS #4: How do countries benefit from growth in their trading partners?

From the early 1990s until quite recently, the United States was what economists term the “locomotive” for global growth.

• Our demand for foreign products increased.

• U.S. imports increased along with output during this period.

• The increased demand fueled exports in foreign countries and promoted their growth.

Studies have shown that the increase in demand for foreign goods was actually more pronounced for developing countries than for developed countries.

Conclusion: The United States was truly a locomotive, pulling the developing countries along.




THE INCOME-EXPENDITURE MODELAND THE AGGREGATE DEMAND CURVE

FIGURE 11.14Deriving the Aggregate Demand Curve

11.6

As the price level falls from P0 to P1, planned expenditures increase, which increases the level of output from y0 to y1.

The aggregate demand curve shows the combination of prices and equilibrium output.



FIGURE 11.15Shifts in Aggregate Demand

THE INCOME-EXPENDITURE MODELAND THE AGGREGATE DEMAND CURVE (cont’d)

11.6

As government spending increases from G0 to G1,

planned expenditures increase, which raises output from y0 to y1.

At the price level P0, this

shifts the aggregate demand curve to the right, from AD0

to AD1.



autonomous consumption

consumption function

equilibrium output

marginal propensity to consume (MPC)

marginal propensity to import

planned expenditures

savings function

K E Y T E R M S



•Formula for Equilibrium Output

1

3

4

5

FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER

2

A P P E N D I X A



•The Multiplier for Investment

For the original level of investment at I0, we have

For a new level of investment at I1, we have

FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)

A P P E N D I X A




Substituting for the levels of output, we have


A P P E N D I X A




Finally, because (I1 − I0) is the change in investment, ΔI, we can write


A P P E N D I X A



•Another Way to Derive the Formula for the Multiplier

The term in parentheses is an infinite series whose value is equal to

Substituting this value for the infinite series, we have the expression for the multiplier:


or

A P P E N D I X A



•Government Spending and Taxes


A P P E N D I X A



•Government Spending and Taxes

Using this formula and the method just outlined, we can find the multiplier for changes in government spending and the multiplier for changes in taxes:


A P P E N D I X A



•Balanced-Budget Multiplier


balanced-budget multiplier =1

(1−b)+

−b(1−b)

=(1 − b)

(1 − b)

=1

A P P E N D I X A



•Equilibrium Output with Government Spending, Taxes, and the Foreign Sector


C =Ca +b(y−T )

y* =(Ca −bT + I +G + X

[1−(b−m)]

y[1−(b−m)] =Ca −bT + I +G + X

y−(b−m)y=Ca −bT + I +G + X

y =Ca +b(y−T ) + I +G + X−mY

M =mY

A P P E N D I X A

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