krugman_can_4e_lecture_slides_ch11_macro

Income and Expenditure Overview

• Title: Macroeconomics: Canadian Edition by Krugman, Vitaly Terekhov

Chapter Objectives

• Importance of the multiplier effect: Summarizes how initial changes in spending lead to further changes.

• Understanding the aggregate consumption function.

• Impact of expected future income and aggregate wealth on consumer spending.

• Determinants of investment spending: Distinguishing between planned and unplanned inventory investments.

• The role of inventory adjustments in shifting the economy to a new equilibrium after demand changes.

• Investment spending as a leading economic indicator.

The Multiplier: An Informal Introduction

Key Concepts

• A rise or fall in aggregate expenditures alters income, which creates a further chain of expenditure changes.

• Four simplifying assumptions:

  1. Producers are willing to supply more output at a fixed price.

  2. Interest rates are considered constant.

  3. No government spending or taxes.

  4. No exports or imports.

Impact of Increased Spending

• Home builders spending an extra $10 billion results in:

  • Direct increase in aggregate output by $10 billion.

  • This will subsequently increase profits and wages, further boosting consumer spending and output.

  • Multiple rounds of expenditure increases compounded over time yield substantial total output effects.

Understanding the Marginal Propensities

Marginal Propensity to Consume (MPC)

• Definition: The increase in consumer spending resulting from a $1 rise in disposable income.

• Example: If spending rises by $6 with a $10 increase in income, then:

  • MPC = $6/$10 = 0.6

Marginal Propensity to Save (MPS)

• Definition: The fraction of an additional dollar of income that is saved.

• Relationship: MPS = 1 - MPC.

Total Effect of Increased Investment on Real GDP

• A $100 billion increase in investment spending can lead to an increment in real GDP:

  • Directly increases by $100 billion.

  • Secondary increases calculated as:

    • First-round: MPC × $10 billion,

    • Second-round: MPC × MPC × $10 billion, etc.

  • Total increase formula:

    • Total effect on real GDP = (1 + MPC + MPC² + MPC³ + ...) × $10 billion.

Discussion Questions and Practice

Example Question

• If MPS is 0.2 and investment spending increases by $200, trace total GDP impacts over several rounds.

• Correct Outcome: Total increase in GDP will be $1,000 after various rounds of spending.

The Multiplier Explained

Autonomous Changes

• An autonomous change in aggregate expenditure indicates an initial change at a specific level of real GDP.

• Multiplier Formula:

  • Multiplier = Total change in real GDP / Autonomous change in aggregate expenditure

  • Mathematical Expression:

    • If ΔAE₀ is the autonomous change in aggregate expenditure and ΔY is the change in real GDP:

    • ΔY = (1 / (1 - MPC)) × ΔAE₀.

Consumer Spending Factors

Importance of Consumer Spending

• Constitutes about 60% of total spending on final goods and services.

• Determinants:

  • Current disposable income is the primary factor.

Current Disposable Income

• Definition: Income post-taxes and received government transfers.

• Example Data:

  • 2018 average income = $61,100

  • 2018 average spending = $59,439.

The Consumption Function

Definition and Equation

• Represents how household consumer spending varies with disposable income:

  • c = ac + MPC × yd(where: c = consumer spending, yd = disposable income, ac = autonomous consumer spending).

Insights on MPC

• Recall that MPC = Δc / Δyd implies that for every $1 rise in y, spending increases by MPC × $1.

Aggregate Consumption Function

Definition

• Aggregate consumption function describes the relationship of aggregate disposable income with consumer spending:

  • C = AC + MPC × YD.

Shifts in the Aggregate Consumption Function

Causes of Shifts

• Shifts are instigated by:

  • Changes in expected future disposable income (permanent income hypothesis).

  • Changes in aggregate wealth (life-cycle hypothesis).

Investment Spending

Characteristics

• Though smaller than consumer spending, investment spending drives business cycles.

• Planned Investment Spending defined as the intended investment spending by businesses.

• Influencers:

  • Interest rates

  • Expected future GDP

  • Current production capacity.

Interest Rate and Investment Spending

Relationship

• Investments are pursued only if the expected return surpasses project costs.

  • Higher interest rates fall in investments; conversely, lower rates stimulate more projects.

Expected Future GDP and Investment

• Higher current capacity leads to lower investment spending.

• According to the accelerator principle:

  • Higher GDP growth rates lead to increased planned investments and vice versa.

Inventory Investment

Definitions

• Inventories: Stocks of goods for future sales.

• Inventory investment: Value change in total inventories within a period.

• Unplanned inventory investment occurs when actual sales deviate from expectations.

Income-Expenditure Model

Overview

• The model illustrates how spending changes are multiplied over time.

Equilibrium in Income-Expenditure

Concepts

• The economy achieves equilibrium when planned aggregate expenditure equals actual output, suggesting no unplanned inventory changes are occurring.

The Multiplier Process and Inventory Adjustments

Key Takeaways

• Shifts in planned aggregate expenditure arise from changes in investment spending or consumption functions.

• Reflects on how multiplicative effects on GDP subcur through savings leakage in successive rounds.

The Paradox of Thrift

Definition

• Individual actions to save can cumulatively lead to larger economic downturns if everyone cuts spending simultaneously.

Exports and Imports

Model Implications

• In real scenarios, exports behave as increases in autonomous spending.

• Trade influences the multiplier through imports; hence, the extent of its impact relies on the marginal propensity to import.