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Hubbard Macro Sg 11

Hubbard Macro Sg 11

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Chapter11 (23)
Output and Expenditure in the
Short Run
Chapter Summary
Chapter 10 examined the determinants of long-run economic growth. In the short run, however, the
economy experiences fluctuations in economic activity, or business cycles, around the long-run upward
trend in real GDP. Aggregate expenditure (AE) is the total amount of spending in the economy. The
aggregate expenditure model focuses on the relationship between total spending and real GDP in the
short run, assuming that the price level is constant. The four components of aggregate expenditure are:
1. consumption (C)
2. planned investment (I)
3. government purchases (G)
4. net exports (NX)
When aggregate expenditure is greater than GDP, there is an unplanned decrease ininventories, which
are goods that have been produced but not yet sold, and GDP and total employment will increase.
The five determinants of consumption are:
1. current disposable income
2. household wealth
3. expected future income
4. the price level
5. the interest rate
The consumption function is the relationship between consumption and disposable income. The
marginal propensity to consume (MPC) is the change in consumption divided by the change in
disposable income. The marginal propensity to save (MPS) 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 a firm and the cash spending by the firm.
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. The economy is in recession when the aggregate expenditure line intersects
the 45° line at a level of GDP that is below potential GDP.
Autonomous expenditure is expenditure that does not depend on the level of GDP. An autonomous
change is a change in expenditure not caused by a change in income. An induced change is a change in
CHAPTER 11 (23)|Output and Expenditure in the Short Run
282
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 effect is the process by which an increase in
autonomous expenditure leads to a larger increase in real GDP. Themultiplier 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.
Learning Objectives
When you finish this chapter, you should be able to:
1.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 (which are goods produced but not yet sold), 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. Only when aggregate
expenditure is equal to GDP will businesses sell what they expected to sell, production and
employment will be unchanged, and the economy will be in macroeconomic equilibrium.
2.Discuss the determinants of the four components of aggregate expenditure and define the
marginal propensity to consume and the marginal propensity to save. 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
income. The marginal propensity to consume is the change in consumption divided by the change in
income. The marginal propensity to save is the change in saving divided by the change in 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 fire fighters. Net exports are purchases by foreign
businesses and households of goods and services produced in the United States minus the purchases
by U.S. businesses and households of goods and services produced in other countries. 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.
3.Use a 45o-line diagram to illustrate macroeconomic equilibrium. The 45o-line diagram shows all
the points where aggregate expenditure equals real GDP. On the 45o-line diagram, macroeconomic
equilibrium occurs where the line representing the aggregate expenditure function crosses the 45o
line.
CHAPTER 11 (23)|Output and Expenditure in the Short Run283
4.Define the multiplier effect and use it to calculate changes in equilibrium GDP. An autonomous
change is a change in expenditure not caused by a change in income. An induced change in
expenditure is a change in 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 multiplied effect on equilibrium GDP. The multiplier is the ratio of the
change in equilibrium GDP to the change in autonomous expenditure. The formula for the multiplier
is 1/(1 MPC), whereMPC is the marginal propensity to consume.
5.Understand the relationship between the aggregate demand curve and aggregate expenditure.
Increases in the price level cause a reduction in consumption, investment, and net exports. Price
level increases cause the aggregate expenditure function to shift down on the 45o-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 demand expenditure
other than the price level.
Appendix: Apply the algebra of macroeconomic equilibrium. The chapter relies on graphs and
tables to illustrate the aggregate expenditure model of short-run real GDP. The appendix uses
equations to represent the aggregate expenditure model. Your instructor may cover or assign this
appendix.
Chapter Review
Chapter Opener: Fluctuating Demand at Cisco Systems (pages 346-347)
In the spring of 2001, Cisco Systems, a leading seller of hardware for computer networks, discovered that
a slowdown in the economy had reduced the demand for its products. This slowdown in the economy
caused Cisco Systems to reduce its level of production and to reduce its level of employment (from
44,000 employees) by about 6,000 workers. In spring of 2007, Cisco announced record sales and profits
with employment of more than 49,000 employees. Why the difference? In 2001, the economy was
slowing down and in a period or recession. In early 2007, the economy was expanding.
Helpful Study Hint
Read An Inside Look at the end of the chapter for a discussion of the
factors that caused U.S. GDP to change during the first quarter of 2007:
1. a slowdown in residential construction
2. a decline in exports
3. slow growth of business inventories
Suppose that you work part time assembling desktop computers.
Should you be worried about your job if consumer confidence falls?
Economics in YOUR Life! at the start of this chapter poses this question.
Keep the question in mind as you read the chapter. The authors will
answer the question at the end of the chapter.

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