• The income-expenditure model focuses on changes in the level of output or real GDP.

• It is useful for understanding economic fluctuations in the short run when prices do not change very much.

• It is less useful in the intermediate or longer run, when prices do adjust to economic conditions.

11.1 A Simple Income-Expenditure Model

Equilibrium Output

• Planned Expenditures: Another term for total demand for goods and services. ****

• Equilibrium output: The level of GDP at which planned expenditure equals the amount that is produced.

• Equilibrium output - y* (the level of equilibrium output) = C + I = planned expenditures

Adjusting to Equilibrium Output

• At that level of output, more goods and services are being produced than consumers and firms are demanding.

• Firms will react to these piles of goods by cutting back on production.

• The equilibrium level of output occurs where planned expenditures equal production.

11.2 The Consumption Function

Consumer Spending and Income

• Consumption Function: The relationship between consumption spending and the level of income

• Autonomous Consumption: The part of consumption that does not depend on income.

• Marginal Propensity to Consume (MPC): The fraction of additional income that is spent.

Changes in the Consumption Function

• The consumption function is determined by the level of autonomous consumption and by the MPC.

• Increases in consumer wealth will cause an increase in autonomous consumption.

• Increases in consumer confidence will increase autonomous consumption.

• A change in the marginal propensity to consume will cause a change in the slope of the consumption function.

11.3 Equilibrium Output and the Consumption Function

• Equilibrium output = (autonomous consumption + investment)/(1-MPC)

Saving and Investment

• Equilibrium output is determined at the level of income where savings equal investment.

• Savings function: The relationship between the level of saving and the level of income.

• Total savings will increase with the level of GDP.

Understanding the Multiplier

• Multiplier = 1/(1-MPC)

• The multiplier occurs because the initial increase in investment spending increases income, which leads to higher consumer spending.

• With a higher MPC, the increase in consumer spending will be greater because consumers will spend a higher fraction of the additional income they receive as the multiplier increases.

• With a higher MPC, the eventual increase in output will be greater, and therefore so will the multiplier.

• One implication of the multiplier is that the effect of any change in investment “multiplies” throughout the economy.

11.4 Government Spending and Taxation

• Using taxes and spending to influence the level of GDP in the short run is known as Keynesian fiscal policy.

Fiscal Multipliers

• Planned expenditures including government = C + I + G

• The multiplier for government spending = 1/(1-MPC)

• Government programs affect households’ disposable personal income -income that ultimately flows back to households after subtraction from their income of any taxes paid and after addition to their income of any transfer payments they receive, such as Social Security, unemployment insurance, or welfare.

• Consumption model with taxes → C = Ca + b(y-T)

• Tax multiplier = -MPC/(1-MPC)

• Economists call the multiplier for government spending and taxes the balanced-budget multiplier because equal changes in government spending and taxes will not unbalance the budget.

Using Fiscal Multipliers

• An increase in government spending will increase total planned expenditures for goods and services.

• Cutting taxes will increase the after-tax income of consumers and will also lead to an increase in planned expenditures for goods and services.

• Policymakers need to take into account the multipliers for government spending and taxes as they develop policies.

• The idea that governments should use active fiscal policy to combat recession was argued forcibly by John Maynard Keynes in the 1930s.

• One of his controversial ideas was that governments should stimulate the economy even if they spent money on wasteful projects.

Understanding Automatic Stabilizers

• The automatic stabilizers prevent consumption from falling as much in bad times and from rising as much in good times.

• This stabilizes the economy without any need for decision from Congress or the White House.

• Another important factor in promoting the stability of the economy is firms’ knowledge that the federal government will be taking action to stabilize the economy.

• In recent decades, changes in firms; inventory management practices have also contributed to the stability of the economy.

• Firms would be forced to cut production even further to reduce their stock of inventories, if there was an unexpected shock that slowed the economy. This additional decrease in demand was known as the inventory cycle.

11.5 Exports and Imports

• Exports affect GDP through their influence on how other countries demand goods and services produced in the United States.

• An increase in exports means there’s an increase in the demand for goods produced in the United States.

• Consumers will import more goods as their income rises.

• M = my, where m is a fraction known as marginal propensity to import.

• Marginal propensity to import: The fraction of additional income that is spent on imports.

11.6 The Income-Expenditure Model and the Aggregate-Demand Curve

• As a consequence of the increased demand for goods and services arising from a lower price level, we show a higher level of planned expenditure, C1 + I1, and a higher level of equilibrium output.

• At any price level, the income-expenditure model determines the level of equilibrium output and the corresponding point on the aggregate demand curve.

• In general, increases in planned expenditures that are not directly caused by changes in prices will shift the aggregate demand curve to the right, decreases in planned expenditures will shift the curve to the left.