Expenditure Model

A Short-Run Model of GDP

  • Understanding the Size of an Economy

    • Determining the size and growth rate of an economy through modeling.

    • Short-run movements in GDP are primarily determined by expenditures (demand side), not supply side factors.

The Expenditure Model

  • Root of the Model

    • Short-run fluctuations in GDP are due to planned aggregate expenditures from:

    • Households

    • Firms

    • Government

    • Foreign sector

    • Major fluctuations stem from changes in durable goods purchases by households and investment components.

Application of the Model

  • Utilizing GDP Determinants

    • Estimate the ideal GDP level for full employment (natural rate of unemployment).

    • Assess whether current planned spending aligns with the ideal GDP level.

    • Guide adjustments to move GDP towards the ideal if discrepancies exist between current and ideal GDP.

Concept of Macroeconomic Equilibrium

  • Definition of Equilibrium

    • Equilibrium occurs when the combined planned spending of all economic agents equals the actual output (Real GDP).

    • Necessary to define planned spending and compare it to actual Real GDP (RGDP).

Importance of Equilibrium

  • Equilibrium Significance

    • When planned spending does not match actual output, agents take actions to realign their plans with reality.

    • Analyze whether actual output adjusts to fulfill plans or planned output adjusts to match actual output using thought experiments.

Specifying Equilibrium Conditions

  • Defining Reality and Planned Spending

    • Reality measured by RGDP (Y) as reported by the BEA.

    • Planned expenditures from all sectors expressed as:
      AEp = C + Ip + G + NX

    • Equilibrium condition:
      Ye = C + I + G + NX = Y = AEp

Detecting Equilibrium Violations

  • Identifying Mismatches

    • Mismatches between plans and reality result in unwanted changes in inventory (denoted as unplanned investment, $I_u$).

    • If
      Y - AEp > 0 , then spending less than expected leads to increasing inventories, thus $Iu > 0$.

    • If
      Y - AE < 0 , spending exceeds expectations leading to falling inventories, thus $I_u < 0$.

Responses to Inventory Changes

  • Adjustments by Firms

    • If $Iu > 0$ then firms reduce output and sell excess stock to realign plans with reality ($Iu = 0$).

    • If $Iu < 0$, firms increase output to replenish stock according to demand until plans again meet reality ($Iu = 0$).

Planned vs. Actual Spending

  • Nature of Output Adjustment

    • If actual spending does not align with planned spending, actual output takes precedence and adjusts to restore alignment.

    • Planned spending ($AE_p$) ultimately drives actual output, not vice versa.

Implications of Analysis

  • Nature of Planned Spending

    • Analyzing planned spending (AEp) is crucial for determining Ye that aligns with it.

    • Compare $Ye$ to the ideal output level, full employment output ($YN$), and adjust $AEp$ until $Ye = Y_N$.

Definitions of Planned Expenditures

  • Components of Planned Expenditures

    • Need to define planned expenditures from all sectors: households, firms, government, and foreign.

    • Actual GDP aggregates these sectors:
      Y = C + I + G + NX

    • Planned spending is defined as:
      AEp = C + Ip + G + NX

    • The difference is in $I$ (investment) and $Ip$ (planned investment), which leads to $Iu$.

Household Consumption Plans

  • Spending from Households

    • Households receive income ($Y$) and allocate it into consumption ($C$) and savings ($S$):
      Y = C + S

    • Consumption ($C$) as a function of income, expressed by:
      C = f(Y)

    • Marginal change in consumption:
      rac{dC}{dY} > 0 .

    • Linear specification of the consumption function:
      C = a + bY

    • Where:

      • $a$: autonomous consumption (intercept, independent of income).

      • $b$: marginal propensity to consume (slope, reflects changes in consumption relative to income).

      • Induced consumption (spending resulting from additional income) represented as $(bY)$.

Saving Defined

  • Saving Dynamics

    • Savings arise when income exceeds consumption.

    • The saving function derived is:
      S = -a + (1-b)Y

    • Where $(1-b)$ represents the marginal propensity to save (MPS).

    • Graphically, saving is shown as the gap between the consumption function and the $C=Y$ reference line.

Saving vs. Dissaving

  • Concepts

    • If at any income level $C > Y$, households deplete savings (dissaving).

    • Conversely, if $C < Y$, households save the remaining income.

Investment from Firms

  • Corporate Spending Behavior

    • Investment by firms is influenced by:

    • Cost of funds.

    • Profitability of capital.

    • Investment ($I$) is typically autonomous:
      I = I_p

    • $I_p$ includes residential and non-residential investment and planned inventory changes.

Saving and Investment Relation

  • Households and Firms

    • Household identity maintains:
      Y = C + S

    • Including firms, we have:
      Y = C + I

    • From this, manipulating terms results in:
      C + S = Y = C + I

    • This leads to the equality:
      S = I

Necessity of Saving for Investment

  • Savings as a Precursor

    • Saving signifies postponing consumption for future expenditures.

    • Investment is analogous; firms save reserves to fund future growth.

    • Thus, saving by households is essential for firm investment.

Equilibrium Dynamics of Saving and Investment

  • Equalizing Behaviors

    • In equilibrium, savings and investments must match:
      S = I

    • Investment comprises planned investment ($Ip$) and unplanned investment ($Iu$), hence:
      S = Ip ext{ when } Iu = 0.

Adding Investment to the Expenditure Graph

  • Graphical Representation

    • Planned investment ($I_p$) is an autonomous component, leading to shifts in the graph similar to autonomous consumption.

    • $I_p$ is represented as a horizontal line on the expenditure graph.

Adjustment of the Expenditure Function

  • New Planned Expenditure Function

    • Expenditure function includes:
      AEp = C + Ip + G

    • Thus, detailed form:
      AEp = a + b(Y-T) + Ip + G

    • Note that increased government spending ($G$) positively affects $AE_p$ while increased taxes ($T$) negatively affects it.

Intercept and Slope Analysis

  • Determining Function Characteristics

    • The slope remains unchanged, while:

    • The intercept is computed from autonomous factors:
      Intercept = a - bT + I_p + G

    • Changes in $a$, $I_p$, or $G$ increase intercept; increases in taxes ($T$) decrease it.

Incorporating the Foreign Sector

  • Net Exports in AIp Function

    • Net exports ($NX$) impact the expenditure plans without dependence on current GDP, starting at $NX = 0$:

    • If $NX > 0$, the intercept increases.

    • If $NX < 0$, the intercept decreases.

    • Comprehensive expenditure expression:
      AEp = a + b(Y-T) + G + Ip + NX

Solving for Equilibrium Size

  • Finding Equilibrium GDP

    • To determine equilibrium GDP ($Ye$), set: Y = AEp and solve for $Y$:
      Y = a + bY - bT + G + I_p + NX

Driving Factors of Equilibrium

  • Dissecting Influences

    • Autonomous spending ($A_p$) can shift due to multiple factors affecting its components.

    • A multiplier, defined as $1/MPS$, reflects the impact of marginal propensity to consume ($b$) on equilibrium shifts.

The Multiplier Effect

  • How Spending Impacts GDP

    • An additional dollar spent can increase $Y_e$ by more than a dollar through sequential rounds of spending.

    • Example: If $A_p$ increases by $1,000 with an MPC of $0.80, the multiplier effect leads to shifts in consumption (C) and further economic activity.

Quantifying Changes in Equilibrium

  • Total Changes from Spending

    • From an initial increase of $1,000:

    • Initial rise: $1,000

    • Resulting consumption increase: $800

    • This causes successive income increases until all spending runs its course.

    • Total change in GDP calculated as:
      ext{total change} = A_p imes ext{multiplier} = 1000 imes 5 = 5000

Evaluating Influences on Output

  • Analyzing Factor Impacts

    • Different factors don't influence output uniformly.

Differentiating Multipliers

  • Tax vs. Spending Multipliers

    • Spending multipliers are amplified by $1/(1-b) = 1/MPS$ affecting $A$, $G$, $I_p$, and $NX$.

    • Tax multipliers are expressed as $(-b/(1-b))$, indicating a smaller effect due to household adjustment behaviors impacting both consumption and savings.

Graphical Representation of Multiplier Effects

  • Visualizing Changes

    • Graphing the shifts when there are changes in $I_p$ showcases the correlation in equilibrium levels.

Stability of Equilibrium

  • Understanding Stability in the Model

    • A stable equilibrium (Ye) means that unless there's a shift in plans, no other output level can persist due to inventory imbalances.

Challenges in Market Economies

  • Classical Issues Faced

    • Capitalism can lead to income inequality due to productivity-based rewards.

    • Self-interest motives create instabilities in plans, especially in durable goods investment.

    • Stability at $Y_e$ can lead to prolonged involuntary unemployment during weak economic planning phases.

Labor Market Dynamics

  • The Unemployment Dilemma

    • When surplus exists in a market, prices typically adjust to balance supply and demand (e.g., wages declining to eliminate excess labor).

    • However, wages tend to be rigid (sticky), and do not fall easily, causing persistent unemployment despite excess labor.

Economic Challenges from Planned Spending

  • Falling Demand and Output

    • Decrease in planned spending (due to lower saving or confidence) can lead economic output ($Ye$) to fall below full employment output ($YN$).

    • Questions arise regarding government interventions to elevate $AE_p$ back to full employment levels.

Fiscal Policy Interventions

  • Role of Fiscal Changes

    • Fiscal policy manipulates government budgeting to stimulate economic changes.

    • This can include increasing spending or adjusting tax rates to restore private sector spending.

  • Ultimate goal of fiscal policy is to change planned spending so equilibrium GDP moves toward full-employment output

Expansionary Fiscal Policy

  • Addressing Recessionary Gaps

    • If $Ye < YN$, the economy sits in a recessionary gap:

    • Solutions include boosting planned spending through increased $G$, reduced $T$, or both to elevate $AE_p$.

    • The mechanism effectively shifts the AEp line upwards, promoting recovery.

Contractionary Fiscal Policy

  • Mitigating Inflationary Gaps

    • If Ye > YN, the economy faces an inflationary gap:

      • What is an inflationary gap?

        • An inflationary gap occurs when the actual level of output (Ye) exceeds the potential output (YN), leading to increased demand that pushes prices higher, often resulting in inflation. This phenomenon typically arises in a booming economy where resources are fully employed, and any additional demand results in heightened pressure on prices, as firms struggle to meet the excess demand without increasing their costs.

    • Solutions involve curtailing planned spending by reducing G, raising T, or both.

    • The goal is to shift the AEp line downwards, thus stabilizing the economy.

Limitations of Fiscal Policy

  • Challenges in Achieving Optimal Output

    • Fiscal policy works during economic downturns, yet the multiplier remains modest (1.0–1.4).

    • In favorable conditions, multiplier impact can drop to 0.0–0.5.

    • Government expenditure may come at the cost of private sector spending, thus complicating impacts.

Time Delays in Implementation

  • Timing Hurdles of Policy

    • Fiscal policies encounter multiple lags:

    • Recognition lag: Identifying recession initiation and magnitude.

      • A recognition lag is the delay in determining when a recession has begun and how severe it is. It makes fiscal policy harder to implement effectively because policymakers may not identify the problem quickly enough, which delays their response and reduces the ability of fiscal policy to stabilize the economy.

    • Administrative lag: Approval of necessary legislation.

    • Implementation lag: Duration for policy effects to manifest in the economy.

  • The size and growth rate of an economy can be determined through modeling, with short-run GDP movements driven by demand-side factors, primarily planned aggregate expenditures from households, firms, government, and the foreign sector.

  • Equilibrium in the economy occurs when the total planned spending equals actual output, measured as Real GDP (RGDP). Discrepancies between planned spending and RGDP lead to unintended inventory changes, impacting output levels.

  • Key equations include the planned expenditures formula: AEp = C + Ip + G + NX and the equilibrium condition: Ye = C + I + G + NX = Y = AEp .

  • Understanding the relationship between saving and investment is crucial, as they must equal in equilibrium (i.e., S = I ).

  • Fiscal policy plays a role in addressing gaps in equilibrium, with expansionary policies aimed at stimulating the economy during recessions and contractionary policies to mitigate inflation.