Short-Run Macroeconomic Principles

The Economy in the Short Run

  • Short Run Definitions:

    • Microeconomics: The short run is a period where at least one factor of production (e.g., plant size, capital equipment) is fixed, while others (like labor, raw materials) can be varied. This means firms cannot immediately adjust their production capacity.

    • Macroeconomics: The short run is a period during which prices of goods and services and wages of labor have not fully adjusted to changes or shocks in the economy. This price and wage 'stickiness' allows for deviations from full employment and potential output gaps.

  • Simplifying Assumptions for Macroeconomic Model:

    • These assumptions are often made to create a baseline simple aggregate expenditure model for easier analysis, which can be expanded later to include more complexities.

    1. Closed economy (no trade): Assumes no imports (IM) or exports (X). This simplifies the aggregate expenditure equation to AE = C + I + G. It means all spending is on domestically produced goods.

    2. No government (no taxes): Assumes no government spending (G) and no taxes. This implies that disposable income (YD) is equal to national income (Y), and the AE equation further simplifies to AE = C + I.

    3. Constant price level: Assumes that firms are willing to supply any amount of output demanded at the existing price level. This means there is no inflation or deflation in the short-run analysis, focusing solely on changes in real output.

  • Key Economic Variables:

    • To understand the overall health and performance of the economy, it is crucial to analyze the determination of real GDP (the total output of goods and services), the general price level (affecting inflation or deflation), and the level of unemployment (reflecting labor market conditions and resource utilization).

  • Desired Aggregate Expenditure (AE):

    • Desired aggregate expenditure represents the total planned spending on domestically produced goods and services by all sectors of the economy.

    • Equation form: AE = C + I + G + (X - IM).

      • C: Desired consumption expenditure by households.

      • I: Desired investment expenditure by firms (including planned changes in inventories).

      • G: Desired government purchases of goods and services.

      • (X - IM): Desired net exports (exports minus imports).

    • Distinction between desired (planned) and actual expenditures: Actual expenditure (Y) is always equal to actual output, meaning everything produced is either bought or ends up as unplanned inventory. However, desired expenditure (AE) may differ from actual output/income generated in the economy. This difference drives firms to adjust production.

  • Equilibrium National Income:

    • This is the level of national income (Y) where total desired aggregate expenditure (AE) exactly equals the actual national income (or total output) produced in the economy (AE = Y).

    • At equilibrium, there are no unplanned changes in inventories, meaning firms have no incentive to either increase or decrease their production levels, leading to a stable state.

    • If AE > Y, desired spending exceeds current output, leading to an unplanned rundown of inventories, signaling firms to increase production.

    • If AE < Y, desired spending is less than current output, leading to an unplanned accumulation of inventories, signaling firms to decrease production.

  • Components of Desired Expenditure:

    • Induced Expenditures: These are components of spending that change as national income changes. They move in the same direction as income. For example, household consumption (C) and imports (IM) are typically induced, increasing as disposable income (and thus national income) rises. Induced expenditures determine the slope of the AE function.

    • Autonomous Expenditures: These are components of spending that do not directly depend on the current level of national income. They represent the baseline level of spending. Examples include a constant base level of consumption (term 'a' in the consumption function), most investment (I), government spending (G), and exports (X). Changes in autonomous expenditures cause vertical shifts in the entire AE function.

  • Consumption Function:

    • The consumption function describes the relationship between desired consumption expenditure and its key determinants:

      • Disposable income (YD): The primary determinant; as YD increases, households tend to increase their desired consumption.

      • Wealth: Higher household wealth (e.g., value of financial assets, real estate) generally leads to increased consumption, even at a given income level (the 'wealth effect').

      • Interest rates: Lower real interest rates can reduce the cost of borrowing for consumers, encouraging consumption of durable goods, and may reduce the incentive to save, shifting spending to the present.

      • Future expectations: Optimistic expectations about future income or economic conditions tend to increase current consumption, while pessimistic outlooks may lead to increased saving and reduced current consumption.

    • Equation form: C = a + bYD

      • a: Autonomous consumption, representing the amount households would consume even if disposable income were zero (financed by dissaving or borrowing).

      • b: The marginal propensity to consume (MPC), which is the slope of the consumption function.

  • Marginal Propensity to Consume (MPC):

    • MPC is defined as the change in desired consumption (∆C) divided by the change in disposable income (∆YD):
      MPC = rac{∆C}{∆YD}.

    • It measures the proportion of an additional dollar of disposable income that households choose to spend on consumption. The value of MPC is always between 0 and 1 (0 < b < 1).

    • Its complement is the Marginal Propensity to Save (MPS), where MPS = rac{∆S}{∆YD} and MPC + MPS = 1.

  • Average Propensity to Consume (APC):

    • APC is the proportion of total disposable income (YD) that is spent on consumption (C):
      APC = rac{C}{YD}.

    • It indicates, on average, how much of each dollar of disposable income is consumed. If APC > 1, households are consuming more than their disposable income (dissaving), while if APC < 1, they are saving a portion.

    • It is related to the Average Propensity to Save (APS), where APS = rac{S}{YD} and APC + APS = 1.

  • Investment Expenditure:

    • Investment is one of the most volatile components of GDP and plays a significant role in determining short-run economic fluctuations and long-run economic growth. It is primarily determined by:

    1. Real interest rates: A lower real interest rate reduces the cost of borrowing for firms, making more investment projects (e.g., new machinery, factories) financially attractive and likely to be undertaken. Thus, lower rates typically stimulate investment.

    2. Level of sales / Output growth: Higher existing sales volumes or optimistic expectations of future sales growth signal a need for increased productive capacity. This encourages firms to invest more in capital goods and expand their operations.

    3. Business confidence / Expectations: The overall sentiment of firms regarding the future state of the economy, anticipated profitability, technological advancements, and government policies profoundly affects investment decisions. High confidence generally leads to higher investment.

  • Multiplier Effect:

    • The multiplier effect describes how an initial change in autonomous desired expenditure (∆A) can lead to a larger ultimate change in equilibrium national income (∆Y).

    • The process involves a continuous cycle: an initial injection of spending becomes income for recipients, who then spend a portion of that new income (determined by the marginal propensity to spend, z) and save/import the rest. The portion spent becomes income for others, who repeat the process, albeit with successively smaller amounts in each round. This chain reaction amplifies the initial change.

    • Formula: Multiplier = rac{∆Y}{∆A} = rac{1}{1 - z} where z represents the marginal propensity to spend out of national income (i.e., the fraction of each additional dollar of income that is spent on domestic output).

  • Equilibrium Shifts:

    • Increase in autonomous expenditure: When any component of autonomous expenditure (e.g., investment, government purchases, autonomous consumption, or exports) increases, the entire AE function shifts upward. At the initial equilibrium income, desired spending now exceeds output (AE > Y). This excess demand prompts firms to increase production, leading to a new, higher equilibrium national income, amplified by the multiplier effect.

    • Decrease in autonomous expenditure: Conversely, a decrease in autonomous expenditure shifts the AE function downward. At the original equilibrium, desired spending is now less than output (AE < Y). This excess supply leads firms to reduce production, resulting in a new, lower equilibrium national income.

  • Market Dynamics:

    • The market dynamic describes the process through which the economy adjusts back to equilibrium when it's initially out of balance, primarily driven by unintended changes in inventories:

      • Excess demand (AE > Y): If desired aggregate expenditure is greater than current output, firms will experience an unplanned depletion of their inventories. This signals them to increase production, which raises national income (Y) until equilibrium is restored.

      • Excess supply (AE < Y): If desired aggregate expenditure is less than current output, firms will face an unplanned accumulation of inventories. This signals them to reduce production, which lowers national income (Y) until equilibrium is restored.

    • This inventory adjustment mechanism ensures that actual output (Y) converges towards the level of desired aggregate expenditure (AE).