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GOVERNMENT SPENDING

Analysis of the short run in macroeconomics is concerned with explaining why national output can deviate from its potential level. It is about the GDP gap and how to keep both positive and negative gaps as small as possible—that is, how to keep actual GDP as close as possible to potential GDP.

The long run in macroeconomics is the period it takes the economy to return to the level of potential GDP once it has been disturbed.

There are only two possible uses of disposable income, consumption and saving. So, when each household decides how much to put to one use, it has automatically decided how much to put to the other use.

The term ‘consumption function’ describes the relationship between household consumption spending and the variables that influence it. In the simplest theory, consumption spending is primarily determined by current personal disposable income

The macroeconomic problem: inflation and unemployment

■ Models of the short-term determination of GDP seek to explain why actual GDP deviates from potential GDP.

■ Actual GDP above potential is often associated with inflation, while actual GDP below potential is typically associated with unemployment and lost output.

Key assumptions

■ For simplicity we aggregate all industrial sectors into one, so the economy produces only one type of output. We explain GDP determination through the major spending categories: household consumption, investment, government consumption, and net exports.

What determines aggregate spending?

■ Desired aggregate spending includes desired consumption, desired investment, and desired government spending, plus desired net exports. It is the amount that economic agents want to spend on purchasing the national product. In this chapter we consider only consumption and investment.

■ A change in household disposable income leads to a change in desired private consumption and saving. The responsiveness of these changes is measured by the marginal propensity to consume (MPC) and the marginal propensity to save (MPS). These are both positive and sum to unity, indicating that, by definition, all disposable income is either spent on consumption or saved.

■ A change in wealth tends to cause a change in the allocation of disposable income between consumption and saving. The change in consumption is positively related to the change in wealth, while the change in saving is negatively related to this change.

■ The part of consumption that responds to changes in income is called induced spending.

■ Investment depends, among other things, on real interest rates and business confidence. In our simple theory investment is treated as autonomous, or exogenous, which makes it a constant term in the aggregate expenditure function, called autonomous investment.

Equilibrium GDP

■ At the equilibrium level of GDP, purchasers wish to buy exactly the amount of national output that is being produced. At GDP above equilibrium, desired spending falls short of national output, and output will sooner or later be curtailed. At GDP below equilibrium, desired spending exceeds national output, and output will sooner or later be increased.

■ In a closed economy with no government, desired saving equals desired investment at equilibrium GDP.

■ Equilibrium GDP is represented graphically by the point at which the aggregate spending curve cuts the 45° line—that is, where total desired spending equals total output. In the present simplified model, this is the same level of GDP at which the saving function intersects the investment function.

Changes in GDP

■ With a constant price level, equilibrium GDP is increased by a rise in the desired consumption or investment spending that is associated with each level of GDP. Equilibrium GDP is decreased by a fall in desired spending.

■ The magnitude of the effect on GDP of shifts in autonomous spending is given by the multiplier. It is defined as K = ΔY/ΔA, where ΔA is the change in autonomous spending and ΔY is the resulting increase in GDP.

■ The simple multiplier is the multiplier when the price level is constant. It is equal to 1/(1 – c), where c is the marginal propensity to spend out of GDP. Thus, the larger c is, the larger is the multiplier. It is a basic prediction of macroeconomics that the simple multiplier, relating £1 worth of increased spending on domestic output to the resulting increase in GDP, is greater than unity.