Aggregate Expenditures: Discuss the aggregate spending approach to macroeconomic equilibrium. This is sometimes termed Keynesian Economics (after John Maynard Keynes, rhymes with rains). What is macroeconomic equilibrium? What are the major spending components. What’s the difference between actual and potential gdp and why is that difference important. What’s the importance of a multiplier? How does the the economy move from one equilibrium to another given a spending change? Explain equilibrium from a savings and investment perspective. ________________________________________

________________________________________ CHAPTER 23 Output and Expenditure in the Short Run 1. Learning Objectives Students should be able to: €¢ Show and explain how macroeconomic equilibrium is determined in the aggregate expenditure model. €¢ Discuss the determinants of the four components of aggregate expenditure and define the marginal prsity to consume and the marginal prsity to save. €¢ Use a 45°-line diagram to illustrate macroeconomic equilibrium. €¢ Calculate a numerical example of macroeconomic equilibrium. €¢ Define the multiplier effect and use it to calculate changes in equilibrium GDP. €¢ Explain the relationship between the aggregate demand curve and aggregate expenditure. 2. Chapter Summary The business cycle involves the interaction of many economic variables. It is essential to understand how macroeconomic equilibrium is determined in the aggregate expenditure model. The aggregate expenditure model focuses on the relationship between total spending and real GDP in the short run, assuming the price level is constant. In any particular year, the level of GDP is determined by the level of total spending, or aggregate expenditure, in the economy. The four components of aggregate expenditure are consumption (C), planned investment (I), government purchases (G), and net exports (NX). When aggregate expenditure is greater than GDP, there is an unplanned decrease in inventories, and GDP and total employment will increase. When aggregate expenditure is less than GDP, there is an unplanned increase in inventories, and GDP and total employment will decline. When aggregate expenditure is equal to GDP, firms will sell what they expected to sell, production and employment will be unchanged, and the economy will be in macroeconomic equilibrium. The five determinants of consumption are current disposable income, household wealth, expected future income, the price level, and the interest rate. The consumption function is the relationship between consumption and disposable income. The marginal prsity to consume (MPC) is the change in consumption divided by the change in disposable income. The marginal prsity to save is the change in saving divided by the change in disposable income. The determinants of planned investment are expectations of future profitability, the real interest rate, taxes, and cash flow, which is the difference between the cash revenues received by the firm and the cash spending by the firm. Government purchases include spending by the federal government and by local and state governments for goods and services. Government purchases do not include transfer payments, such as Social Security payments by the federal government or pension payments by local governments to retired police officers and firefighters. The three determinants of net exports are the price level in the United States relative to the price levels in other countries, the growth rate of GDP in the United States relative to the growth rates of GDP in other countries, and the exchange rate between the dollar and other currencies. The 45°-line diagram shows all the points where aggregate expenditure equals real GDP. On the 45°-line diagram, macroeconomic equilibrium occurs where the line representing the aggregate expenditure function crosses the 45° line. Numerically, macroeconomic equilibrium occurs when consumption combined with planned investment, government purchases, and net exports equals GDP. An autonomous change is a change in expenditure not caused by a change in income. An induced change is a change in aggregate expenditure caused by a change in income. An autonomous change in expenditure will cause rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure will have a multiplier effect on equilibrium GDP. The multiplier is the ratio of the change in equilibrium GDP to the change in autonomous expenditure. Increases in the price level cause a reduction in consumption, investment, and net exports. This causes the aggregate expenditure function to shift down on the 45°-line diagram, leading to a lower equilibrium real GDP. A decrease in the price level leads to a higher equilibrium real GDP. The aggregate demand curve shows the relationship between the price level and the level of aggregate expenditure, holding constant all factors that affect aggregate expenditure other than the price level. 2. Chapter Outline Demand Forecasts Backfire at Cisco Systems The effects of a slowdown in the total amount of spending on the U.S. economy in the first quarter of 2001 are analyzed in the ing case. In the 1990s, many firms investing in equipment to establish a Web site or to use the fiber optic cable networks being built overestimated how profitable their investments in this equipment would be. Cisco Systems, Inc., the leading seller of hardware for computer networks, was taken by surprise by the decline in demand for its routers, switches, and other equipment during the first quarter of 2001. Cisco benefited greatly from the increased spending on information technology in the 1990s. During the first quarter of 2001, Cisco had sold much less than it had forecast. Firms far removed from the Internet and telecommunications, such as General Motors and Ford, were also experiencing problems. The Aggregate Expenditure Model 1. The business cycle involves the interaction of many economic variables. The relationships among these variables can be understood by developing a simple aggregate expenditure model. A. Aggregate expenditure model is a macroeconomic model that focuses on the relationship between total spending and real GDP, assuming the price level is constant. I. The key idea of this model is that in any particular year, the level of gross domestic product (GDP) is determined mainly by the level of aggregate expenditure. B. In 1936, the English economist John Maynard Keynes published a book, The General Theory of Employment, Interest, and Money, in which he analyzed the relationship between fluctuations in aggregate expenditure and fluctuations in GDP. Keynes identified four categories of aggregate expenditure that together equal GDP: I. Consumption (C): Spending by households on goods and services, such as automobiles and haircuts. II. Planned Investment (I): Planned spending by firms on capital goods, such as factories, office buildings, and machine tools, and by households on new homes. III. Government Purchases (G): Spending by local, state, and federal governments on goods and services, such as aircraft carriers, bridges, and the salaries of FBI agents. IV. Net Exports (NX): Spending by foreign firms and households on goods and services produced in the United States minus spending by U.S. firms and households on goods and services produced in other countries. C. Inventories referred to goods that have been produced but not yet sold. I. Businesses always spend the amount they planned on machinery and office buildings, but the amount businesses plan to spend on inventories may be different from the amount they actually spend. II. Actual investment will equal planned investment only when there is no unplanned change in inventories. D. Macroeconomic equilibrium occurs where total spending, or aggregate expenditure, equals total production, or GDP. I. When aggregate expenditure is greater than GDP, inventories will decline and GDP and total employment will increase. II. When aggregate expenditure is less than GDP, inventories will increase and GDP and total employment will decrease. III. When economists forecast that aggregate expenditure is likely to decline, the federal government may implement macroeconomic policies in an attempt to head off the fall in expenditure and keep the economy from falling into recession. Determining the Level of Aggregate Expenditure in the Economy 1. There are four components of aggregate expenditure. A. Consumption is the largest component of aggregate expenditure. There are five most important variables that determine the level of consumption: I. Current disposable income II. Household wealth III. Expected future income IV. The price level V. The interest rate B. The consumption function refers to the relationship between consumption spending and disposable income. C. The marginal prsity to consume (MPC) is the slope of the consumption function and refers to the amount by which consumption spending increases when disposable income increases. D. The marginal prsity to save (MPS) refers to the change in saving divided by the change in disposable income. 2. Planned Investment A. The four most important variables that determine the level of investment are: I. Expectations of future profitability i. The optimism or pessimism of firms is an important determinant of investment spending. II. The interest rate i. A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. III. Taxes i. The federal government imposes a corporate income tax on the profits corporations earn, including profits from the new buildings, equipment, and other investment goods they purchase. A reduction in the corporate income tax increases the after-tax profitability of investment spending. ii. Investment tax incentives increase investment spending. IV. Cash flow i. Cash flow is the difference between the cash revenues received by the firm and the cash spending by the firm. ii. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment. 3. Government Purchases A. Government purchases grew steadily for most of the 1979-2004 period, with the exception of the mid-1990s when concern about the federal budget deficit caused real government purchases to fall for three years, beginning in 1992. 4. Net Exports A. Net exports refers to the value of spending by foreign firms and households on goods and services produced in the United States, subtracting the value of spending by U.S. firms and households on goods and services produced in other countries. B. The three most important variables that determine the level of net exports are these: I. The price level in the United States relative to the price levels in other countries. II. The growth rate of GDP in the United States relative to the growth rates of GDP in other countries. III. The exchange rate between the dollar and other currencies. Graphing Macroeconomic Equilibrium 1. We can use a graph called the 450-line diagram to illustrate macroeconomic equilibrium. Sincemacroeconomic equilibrium occurs where planned aggregate expenditure equals GDP, we know that all points of macroeconomic equilibrium must lie along the 450 line. 2. Every point of macroeconomic equilibrium is on the 450 line, where planned expenditure equals GDP. At points above the line, planned aggregate expenditure is greater than GDP. At points below the line, planned aggregate expenditure is less than GDP. 3. When the aggregate expenditure line intersects the 450 line at a level of GDP below potential real GDP, the economy is in recession. 4. Whenever planned aggregate expenditure is less than real GDP, some firms will experience an unplanned increase in inventories. If firms accumulate excess inventories, then even if spending quickly returns to its normal levels, firms will have to sell these excess inventories before they can return to producing at normal levels. In the early twentieth century, the inability of many firms to control their inventories contributed to the length and severity of recessions. A Numerical Example of Macroeconomic Equilibrium Numerically, macroeconomic equilibrium occurs when consumption along with planned investment, government purchases, and net exports equals GDP. The Multiplier Effect 1. An autonomous change is a change in expenditure not caused by a change in income. An induced change is a change in aggregate expenditure caused by a change in income. An autonomous change in expenditure will cause rounds of induced changes in expenditure. Therefore, an autonomous change in expenditure will have a multiplier effect on equilibrium GDP. A. Autonomous expenditure refers to expenditure that does not depend on the level of GDP. B. Multiplier is the increase in equilibrium real GDP divided by the increase in autonomous expenditure. C. Multiplier effect refers to the process by which an increase in autonomous expenditure leads to a larger increase in real GDP. Note four key points about the multiplier effect: I. The multiplier effect occurs both when autonomous expenditure increases and when it decreases. II. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. III. The larger the marginal prsity to consume, the larger the value of the multiplier. IV. The formula for the multiplier overstates the true value of the multiplier. The Aggregate Demand Curve 1. Changes in the price level lead to changes in the equilibrium real GDP. A. Increases in the price level cause a reduction in consumption, investment, and net exports. This causes the aggregate expenditure function to shift down on the 45°-line diagram, leading to a lower equilibrium real GDP. B. A decrease in the price level leads to a higher equilibrium real GDP. The aggregate demand curve shows the relationship between the price level and the level of aggregate expenditure, holding constant all factors that affect aggregate expenditure other than the price level. C. TheAggregate demand curve (AD) is a curve showing 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.