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Chapter 6

The Simplest Short-Run Macro Model

6.1 Desired Aggregate Expenditure

• The actual values of the various categories of expenditure are indicated by Ca , Ia , Ga , and (Xa − IMa ).

• Economists use the same letters without the subscript “a” to indicate the desired expenditure in the same categories:

– desired consumption, C

– desired investment, I –

desired government purchases, G

– desired net exports, (X – IM)

• What Does “Desired” Really Mean?

– “Desired” expenditure is not just a list of what consumers and firms would buy if they had no constraints on their spending—it is much more
realistic than that.

– Desired expenditure is what consumers and firms would like to purchase, given their real-world constraints of income and market prices.

• The sum of desired or planned spending on domestic output by households, firms, governments, and foreigners is desired aggregate expenditure.

AE = C + I + G + (X − IM)

• Elements of aggregate expenditure that do not change systematically with national income are called autonomous expenditures.

• Components of aggregate expenditure that do change systematically in response to changes in national income are called induced expenditures.

• Assumptions of the simplest short-run macro model:

– there is no trade with other countries—that is, the economy we are studying is a closed economy;

– there is no government—and hence no taxes; and

– the price level is constant.

• By simplifying the model we are better able to understand its structure and therefore how more complex versions of the model work.
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Desired Consumption Expenditure

• Disposable income = household income ‒ taxes

• Saving ‒ disposable income not spend on consumption.

• The Consumption Function

– The consumption function is the relationship between desired consumption expenditure and all the variables that determine it.

– Desired consumption is determined by: disposable income, wealth, interest rates, and expectations about the future.

Figure 6-2 The Consumption and Saving Functions

Desired Consumption Expenditure

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• Average propensity to consume

(APC) APC = C / YD

– Note that APC falls as disposable income rises.

• Marginal propensity to consume (MPC)

MPC = C / YD

– The MPC is the slope of the consumption function.

– The constant slope of the consumption function shows that the MPC is the same at any level of disposable income.

The Saving Function

• Households decide how much to consume and how much to save.

• Average propensity to save (APS):

APS = S / YD

• Marginal propensity to save (MPS):

MPS = S / YD

• Because all disposable income is either spent or saved, it follows that the fractions of income consumed and saved must account for all income:

APC + APS = 1

• It also follows that the fractions of any increment to income consumed and saved must account for all of that increment:

MPC + MPS = 1
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Figure 6-3(i) Shifts in the Consumption Function

• The consumption function shifts upward with an increase in wealth, a decrease in interest rates, or an increase in optimism about the future.

(i) The consumption function shifts upward with an increase in wealth, a decrease in interest rates, or an increase in optimism about the future

Figure 6-3(ii) Shifts in the Consumption Function

• The saving function shifts downward with an increase in wealth, a decrease in interest rates, or an increase in optimism about the future.

(ii) The saving function shifts downward with an increase in wealth, a decrease in interest rates, or an increase in optimism about the future.
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Desired Investment Expenditure

• The three categories of investment are inventory accumulation, residential construction, and new plant and equipment.

• Investment expenditure is

(1) the most volatile component of GDP, and

(2) strongly associated with aggregate economic fluctuations.

• Determinants of desired investment expenditure are

(1) the real interest rate,

(2) changes in the level of sales, and

(3) business confidence.

• The current level of real GDP is not an important determinant of current desired investment.

NOTE (figure 6-4):

The major components of private-sector investment fluctuate considerably as a share of GDP. The recessions of 1982, 1991, 2009, and 2020
are evident from the reductions in investment. These data exclude investment by governmentand non-profit institutions, which combined are quite
stable and amount to about 4 percent of GDP. Note that thecategory “plant and equipment” includes investment in intellectual property (IP) products,
which result from researchand development (R&D) activities.

Desired Investment Expenditure

• SIMPLIFYING ASSUMPTION: Investment as autonomous expenditure

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The Aggregate Expenditure Function

• The aggregate expenditure (AE) function relates the level of desired aggregate expenditure to the level of actual national income.

• In the absence of government and international trade, desired aggregate expenditure is equal to desired consumption plus desired investment:

AE = C + I

Example:

• The consumption function is: C = 30 + (0.8)Y

• The investment function is: I = 75

• The AE function is: AE = C + I

= 30 + (0.8)Y+ 75

= 105 + (0.8)Y

Figure 6-6 The Aggregate Expenditure Function

• The slope of the AE function is the marginal propensity to spend, which in this simple model, is just the marginal propensity to consume.

The aggregate expenditure function relates desired aggregate expenditure to actual national income. The curve AE in the figure plots the data
from the first and last columns of the accompanying table. Its intercept, which in this case is $105 billion, shows the sum of autonomous
consumption and autonomous investment. The slope of AE is equal to the marginal propensity to spend, which in this simple economy is just the
marginal propensity to consume.

6.2 Equilibrium National Income

• If desired aggregate expenditure exceeds actual income, inventories are falling and there is pressure for actual national income to rise.

• If desired aggregate expenditure is less than actual income, inventories are rising and there is pressure for actual national income to fall.

• The equilibrium level of national income occurs when desired aggregate expenditure equals actual national income.
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Table 6-1 Equilibrium National Income

• National income is in equilibrium when desired aggregate expenditure equal actual national income.

Figure 6-7 Equilibrium National Income

• The equilibrium condition occurs when AE = Y.

• If actual Y < Y0, desired AE will exceed national income, and output will rise.

• If actual Y > Y0 , desired AE will be less than national income, and production will fall.

• Only when Y = Y0 will the economy be in equilibrium, (E0 ).

Equilibrium national income is that level of national income where desired aggregate expenditure equals actual national income. If actual
national income is below Y0 , desired aggregate expenditure will exceed national income, and output will rise. If actual national income is above Y0 ,
desired aggregate expenditure will be less than national income, and production will fall. Only when national income is equal to Y0 will the economy
be in equilibrium, as shown at E0 .
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6.3 Changes in Equilibrium National Income

• One shift is when the AE function shifts parallel to itself.

• Another possible shift is when there is a change in the slope of the AE function.

Figure 6-8 Shifts in the Aggregate Expenditure Function

The Multiplier

• What determines the size of the change in national income?

– The simple multiplier is the ratio of the change in equilibrium national income to the change in autonomous expenditure that brought it about,
calculated for a constant price level.

– In the simple macro model, the multiplier is greater than 1.

Figure 6-9 The Simple Multiplier

• z is the marginal propensity to spend out of national income

• A is the change in autonomous expenditure

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Figure 6-10 The Size of the Simple Multiplier

• The larger the marginal propensity to spend, the steeper the AE function and the larger is the simple multiplier.

Economic Fluctuations as Self-Fulfilling Prophecies

• Households’ and firms’ expectations about the future state of the economy influence desired consumption and desired investment.

• Changes in desired aggregate expenditure will, through the multiplier process, lead to changes in national income.

• This link between expectations and national income suggests that expectations about a healthy economy can actually produce a healthy economy—
what economists call a self-fulfilling prophecy.
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• Imagine that firms begin to feel optimist about future economic prospects.

• This optimism may lead them to increase their desired investment, which shifts up the economy’s AE function.

• The upward shift in the AE function increases national income.

• If enough firms are optimistic and take actions based on that optimism, their actions will create the economic situation that they expected.