PRINCIPLES OF

MACROECONOMICS
TENTH EDITION

PART III The Core of Macroeconomic Theory

CASE FAIR OSTER
Prepared by: Fernando Quijano & Shelly Tefft 1 of 29

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PART III The Core of Macroeconomic Theory

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PART

III

The Core of Macroeconomic Theory
PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall

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The level of GDP, the overall price level, and the level of employment—three chief concerns of macroeconomists—are influenced by events in three broadly defined ―markets‖: Goods-and-services market
PART III The Core of Macroeconomic Theory

Financial (money) market Labor market

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PART III The Core of Macroeconomic Theory

 FIGURE III.1 The Core of Macroeconomic Theory

We build up the macroeconomy slowly. In Chapters 8 and 9, we examine the market for goods and services. In Chapters 10 and 11, we examine the money market. Then in Chapter 12, we bring the two markets together, in so doing explaining the links between aggregate output (Y) and the interest rate (r), and derive the aggregate demand curve. In Chapter 13, we introduce the aggregate supply curve and determine the price level (P). We then explain in Chapter 14 how the labor market fits into the macroeconomic picture.
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Aggregate Expenditure and Equilibrium Output

8
CHAPTER OUTLINE The Keynesian Theory of Consumption
Other Determinants of Consumption

Planned Investment (I) The Determination of Equilibrium Output (Income)
PART III The Core of Macroeconomic Theory

The Saving/Investment Approach to Equilibrium Adjustment to Equilibrium

The Multiplier
The Multiplier Equation The Size of the Multiplier in the Real World

Looking Ahead

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aggregate output The total quantity of goods and services produced (or supplied) in an economy in a given period.

aggregate income The total income received by all factors of production in a given period.

PART III The Core of Macroeconomic Theory

In any given period, there is an exact equality between aggregate output (production) and aggregate income. You should be reminded of this fact whenever you encounter the combined term aggregate output (income) (Y).

aggregate output (income) (Y) A combined term used to remind you of the exact equality between aggregate output and aggregate income.

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The Keynesian Theory of Consumption
consumption function The relationship between consumption and income.

 FIGURE 8.1 A Consumption Function for a Household

A consumption function for an individual household shows the level of consumption at each level of household income.

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PART III The Core of Macroeconomic Theory

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The Keynesian Theory of Consumption
With a straight line consumption curve, we can use the following equation to describe the curve: C = a + bY

 FIGURE 8.2 An Aggregate Consumption Function

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PART III The Core of Macroeconomic Theory

The aggregate consumption function shows the level of aggregate consumption at each level of aggregate income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending.

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The Keynesian Theory of Consumption

marginal propensity to consume (MPC) That fraction of a change in income that is consumed, or spent.

marginal propensity to consume  slope of consumption function 

C Y

PART III The Core of Macroeconomic Theory

aggregate saving (S) The part of aggregate income that is not consumed. S≡Y–C

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The Keynesian Theory of Consumption
identity Something that is always true. marginal propensity to save (MPS) That fraction of a change in income that is saved. MPC + MPS ≡ 1 Because the MPC and the MPS are important concepts, it may help to review their definitions.
PART III The Core of Macroeconomic Theory

The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consumption). The marginal propensity to save (MPS) is the fraction of an increase in income that is saved (or the fraction of a decrease in income that comes out of saving).

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The Keynesian Theory of Consumption
 FIGURE 8.3 The Aggregate Consumption Function Derived from the Equation C = 100 + .75Y

In this simple consumption function, consumption is 100 at an income of zero. As income rises, so does consumption. For every 100 increase in income, consumption rises by 75. The slope of the line is .75.
Aggregate Income, Y
PART III The Core of Macroeconomic Theory

Aggregate Consumption, C 100

0

80
100 200 400 600 800 1,000

160
175 250 400 550 700 850

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The Keynesian Theory of Consumption
 FIGURE 8.4 Deriving the Saving Function from the Consumption Function in Figure 8.3

PART III The Core of Macroeconomic Theory

Because S ≡ Y – C, it is easy to derive the saving function from the consumption function. A 45° line drawn from the origin can be used as a convenient tool to compare consumption and income graphically. At Y = 200, consumption is 250. The 45° line shows us that consumption is larger than income by 50. Thus, S ≡ Y – C = 50. At Y = 800, consumption is less than income by 100. Thus, S = 100 when Y = 800.
Y  C = S AGGREGATE AGGREGATE AGGREGATE INCOME CONSUMPTION SAVING 0 80 100 200 400 600 100 160 175 250 400 550 -100 -80 -75 -50 0 50

800
1,000

700
850

100
150 13 of 29

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The Keynesian Theory of Consumption
Other Determinants of Consumption The assumption that consumption depends only on income is obviously a simplification. In practice, the decisions of households on how much to consume in a given period are also affected by their wealth, by the interest rate, and by their expectations of the future. Households with higher wealth are likely to spend more, other things being equal, than households with less wealth.

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PART III The Core of Macroeconomic Theory

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EC ON OMIC S IN PRACTICE

Behavioral Biases in Saving Behavior
Economists have generally assumed that people make their saving decisions rationally, just as they make other decisions about choices in consumption and the labor market. Saving decisions involve thinking about trade-offs between present and future consumption. Recent work in behavioral economics has highlighted the role of psychological biases in saving behavior and has demonstrated that seemingly small changes in the way saving programs are designed can result in big behavioral changes.

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PART III The Core of Macroeconomic Theory

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Planned Investment (I)
planned investment (I) Those additions to capital stock and inventory that are planned by firms. actual investment The actual amount of investment that takes place; it includes items such as unplanned changes in inventories.
 FIGURE 8.5 The Planned Investment Function

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PART III The Core of Macroeconomic Theory

For the time being, we will assume that planned investment is fixed. It does not change when income changes, so its graph is a horizontal line.

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The Determination of Equilibrium Output (Income)
equilibrium Occurs when there is no tendency for change. In the macroeconomic goods market, equilibrium occurs when planned aggregate expenditure is equal to aggregate output. planned aggregate expenditure (AE) The total amount the economy plans to spend in a given period. Equal to consumption plus planned investment: AE ≡ C + I.

PART III The Core of Macroeconomic Theory

Y>C+I aggregate output > planned aggregate expenditure C+I>Y planned aggregate expenditure > aggregate output

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The Determination of Equilibrium Output (Income)

TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium. The Figures in Column 2 Are Based on the Equation C = 100 + .75Y. (1) (2) (3) (4) (5) (6)

Planned Unplanned Aggregate Aggregate Inventory Output Aggregate Planned Expenditure (AE) Change Equilibrium? (Income) (Y) Consumption (C) Investment (I) C+I (Y = AE?) Y  (C + I ) 100
PART III The Core of Macroeconomic Theory

175 250 400 475 550 700 850

25 25 25 25 25 25 25

200 275 425 500 575 725 875

 100  75  25 0 + 25 + 75 + 125

No No No Yes No No No

200 400 500 600 800 1,000

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The Determination of Equilibrium Output (Income)

 FIGURE 8.6 Equilibrium Aggregate Output

Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned aggregate expenditure is the sum of consumption spending and planned investment spending.

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PART III The Core of Macroeconomic Theory

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The Determination of Equilibrium Output (Income)
The Saving/Investment Approach to Equilibrium Because aggregate income must be saved or spent, by definition, Y ≡ C + S, which is an identity. The equilibrium condition is Y = C + I, but this is not an identity because it does not hold when we are out of equilibrium. By substituting C + S for Y in the equilibrium condition, we can write:

C+S=C+I
PART III The Core of Macroeconomic Theory

Because we can subtract C from both sides of this equation, we are left with: S=I

Thus, only when planned investment equals saving will there be equilibrium.
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The Determination of Equilibrium Output (Income)
The Saving/Investment Approach to Equilibrium

 FIGURE 8.7 The S = I Approach to Equilibrium

Aggregate output is equal to planned aggregate expenditure only when saving equals planned investment (S = I). Saving and planned investment are equal at Y = 500.
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The Determination of Equilibrium Output (Income)
Adjustment to Equilibrium The adjustment process will continue as long as output (income) is below planned aggregate expenditure. If firms react to unplanned inventory reductions by increasing output, an economy with planned spending greater than output will adjust to equilibrium, with Y higher than before.
PART III The Core of Macroeconomic Theory

If planned spending is less than output, there will be unplanned increases in inventories. In this case, firms will respond by reducing output. As output falls, income falls, consumption falls, and so on, until equilibrium is restored, with Y lower than before.

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The Multiplier

multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable.

exogenous variable A variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes.

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PART III The Core of Macroeconomic Theory

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The Multiplier
 FIGURE 8.8 The Multiplier as Seen in the Planned Aggregate Expenditure Diagram

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PART III The Core of Macroeconomic Theory

At point A, the economy is in equilibrium at Y = 500. When I increases by 25, planned aggregate expenditure is initially greater than aggregate output. As output rises in response, additional consumption is generated, pushing equilibrium output up by a multiple of the initial increase in I. The new equilibrium is found at point B, where Y = 600. Equilibrium output has increased by 100 (600 - 500), or four times the amount of the increase in planned investment.

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The Multiplier
The Multiplier Equation Recall that the marginal propensity to save (MPS) is the fraction of a change in income that is saved. It is defined as the change in S (∆S) over the change in income (∆Y):

S MPS  Y
Because S must be equal to I for equilibrium to be restored, we can substitute I for S and solve:
PART III The Core of Macroeconomic Theory

1 I Therefore,  Y   I  MPS  MPS Y
It follows that

1 multiplier  , MPS

or

1 multiplier  1  MPC
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EC ON OMIC S IN PRACTICE

The Paradox of Thrift
An interesting paradox can arise when households attempt to increase their saving.
The Paradox of Thrift An increase in planned saving from S0 to S1 causes equilibrium output to decrease from 500 to 300. The decreased consumption that accompanies increased saving leads to a contraction of the economy and to a reduction of income. But at the new equilibrium, saving is the same as it was at the initial equilibrium.

PART III The Core of Macroeconomic Theory

Increased efforts to save have caused a drop in income but no overall change in saving.

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The Multiplier
The Size of the Multiplier in the Real World In considering the size of the multiplier, it is important to realize that the multiplier we derived in this chapter is based on a very simplified picture of the economy. In reality, the size of the multiplier is about 2. That is, a sustained increase in exogenous spending of $10 billion into the U.S. economy can be expected to raise real GDP over time by about $20 billion.
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Looking Ahead

In this chapter, we took the first step toward understanding how the economy works. We assumed that consumption depends on income, that planned investment is fixed, and that there is equilibrium. We discussed how the economy might adjust back to equilibrium when it is out of equilibrium.
PART III The Core of Macroeconomic Theory

We also discussed the effects on equilibrium output from a change in planned investment and derived the multiplier. In the next chapter, we retain these assumptions and add the government to the economy.

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REVIEW TERMS AND CONCEPTS

actual investment aggregate income aggregate output aggregate output (income) (Y)

multiplier

planned aggregate expenditure (AE)
planned investment (I) 1. 2. 3. 4. 5. S≡Y−C
MPC  slope of consumption function  C Y

aggregate saving (S)
consumption function equilibrium
PART III The Core of Macroeconomic Theory

exogenous variable

identity
marginal propensity to consume (MPC) marginal propensity to save (MPS)

MPC + MPS ≡ 1 AE ≡ C + I Equilibrium condition: Y = AE or Y=C+I 6. Saving/investment approach to equilibrium: S = I 7. Multiplier 
1 1  MPS 1 - MPC

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