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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
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C H A P T E R 11The Income-ExpenditureModel
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
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
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
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
Changes in the Consumption Function FIGURE 11.5Movements of the Consumption Function
THE CONSUMPTION FUNCTION (cont’d)11.2
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C H A P T E R 11The Income-ExpenditureModel
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.
THE CONSUMPTION FUNCTION (cont’d)11.2
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C H A P T E R 11The Income-ExpenditureModel
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
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C H A P T E R 11The Income-ExpenditureModel
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)
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C H A P T E R 11The Income-ExpenditureModel
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
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C H A P T E R 11The Income-ExpenditureModel
Saving and Investment
EQUILIBRIUM OUTPUT ANDTHE CONSUMPTION FUNCTION (cont’d)11.3
FIGURE 11.7Savings, Investment, and Equilibrium Output
Equilibrium output is determined at the level of output, y*, where savings equals investment.
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C H A P T E R 11The Income-ExpenditureModel
Understanding the Multiplier
FIGURE 11.8The Multiplier
EQUILIBRIUM OUTPUT ANDTHE CONSUMPTION FUNCTION (cont’d)11.3
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)
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C H A P T E R 11The Income-ExpenditureModel
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.
A P P L I C A T I O N 2
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C H A P T E R 11The Income-ExpenditureModel
FIGURE 11.9Government Spending, Taxes, and GDP
Fiscal Multipliersplanned expenditures including government = C + I + G
GOVERNMENT SPENDINGAND TAXATION11.4
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C H A P T E R 11The Income-ExpenditureModel
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)
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C H A P T E R 11The Income-ExpenditureModel
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.
GOVERNMENT SPENDINGAND TAXATION (cont’d)11.4
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.
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C H A P T E R 11The Income-ExpenditureModel
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.
A P P L I C A T I O N 3
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C H A P T E R 11The Income-ExpenditureModel
Understanding Automatic Stabilizers
FIGURE 11.10Growth Rates of U.S. GDP, 1871–2009
GOVERNMENT SPENDINGAND TAXATION (cont’d)11.4
After World War II, fluctuations in GDP growth became considerably smaller.
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C H A P T E R 11The Income-ExpenditureModel
Understanding Automatic Stabilizers
FIGURE 11.11Increase in Tax Rates
C = Ca + b(1 − t)y
adjusted MPC = b(1 − t)
GOVERNMENT SPENDINGAND TAXATION (cont’d)11.4
An increase in tax rates decreases the slope of the C + I + G line.
This lowers output and reduces the multiplier.
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
FIGURE 11.13How Increases in Exports and Imports Affect U.S. GDP
EXPORTS AND IMPORTS (cont’d)11.5
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C H A P T E R 11The Income-ExpenditureModel
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.
A P P L I C A T I O N 4
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
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.
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C H A P T E R 11The Income-ExpenditureModel
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
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C H A P T E R 11The Income-ExpenditureModel
•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
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C H A P T E R 11The Income-ExpenditureModel
•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
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C H A P T E R 11The Income-ExpenditureModel
•The Multiplier for Investment
Substituting for the levels of output, we have
FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)
A P P E N D I X A
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C H A P T E R 11The Income-ExpenditureModel
•The Multiplier for Investment
Finally, because (I1 − I0) is the change in investment, ΔI, we can write
FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)
A P P E N D I X A
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C H A P T E R 11The Income-ExpenditureModel
•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:
FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)
or
A P P E N D I X A
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C H A P T E R 11The Income-ExpenditureModel
•Government Spending and Taxes
FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)
A P P E N D I X A
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C H A P T E R 11The Income-ExpenditureModel
•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:
FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)
A P P E N D I X A
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C H A P T E R 11The Income-ExpenditureModel
•Balanced-Budget Multiplier
FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)
balanced-budget multiplier =1
(1−b)+
−b(1−b)
=(1 − b)
(1 − b)
=1
A P P E N D I X A
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C H A P T E R 11The Income-ExpenditureModel
•Equilibrium Output with Government Spending, Taxes, and the Foreign Sector
FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (cont’d)
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