A Basic Model of the Determination of GDP in the Short Term Chapter 16

1
A Basic Model of the Determination of GDP in the
Short TermChapter 16

• LIPSEY CHRYSTAL
• ECONOMICS 12e

2
Learning Outcomes

• The macroeconomic theory that we now study
  explains the deviation of actual from potential
  GDP, that is the GDP gap.
• The determination of GDP in the short run depends
  on the behaviour of key categories of aggregate
  spending consumption, investment, government
  spending, and net exports.

3
Learning Outcomes

• Consumption spending depends on disposable income
  and wealth.
• Investment spending depends on real interest
  rates and business confidence.
• A necessary condition for GDP to be in
  equilibrium is that desired domestic spending
  equals actual output.

4
A BASIC MODEL OF THE DETERMINATION OF GDP

• What Determines Aggregate Expenditure
• Desired aggregate expenditure includes desired
  consumption, desired investment, and desired
  government expenditures, 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.

5
A BASIC MODEL OF THE DETERMINATION OF GDP

• What Determines Aggregate Expenditure
• A change in personal disposable income leads to a
  change in 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, which are
  both positive and sum to one.
• This indicates that, by definition, all
  disposable income is either spent on consumption
  or saved.

6
A BASIC MODEL OF THE DETERMINATION OF GDP

• 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.

7
A BASIC MODEL OF THE DETERMINATION OF GDP

• Investment depends, among other things, on real
  interest rates and business confidence. In our
  simple theory investment is treated as
  autonomous, or exogenous, as is the constant term
  in the consumption function, called autonomous
  consumption.
• The part of consumption that responds to changes
  in income is called induced spending.

8
A BASIC MODEL OF THE DETERMINATION OF GDP

• 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 expenditure
  falls short of national output, and output will
  sooner or later be curtailed.

9
A BASIC MODEL OF THE DETERMINATION OF GDP

• Equilibrium GDP
• At GDP below equilibrium, desired expenditure
  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.

10
A BASIC MODEL OF THE DETERMINATION OF GDP

• Equilibrium GDP is represented graphically by the
  point at which the aggregate expenditure curve
  cuts the 450 line, that is, where total desired
  expenditure equals total output.
• This is the same level of GDP at which the saving
  function intersects the investment function.

11
A BASIC MODEL OF THE DETERMINATION OF GDP

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

12
A BASIC MODEL OF THE DETERMINATION OF GDP

• Changes in GDP
• The magnitude of the effect on GDP of shifts in
  autonomous expenditure is given by the
  multiplier.
• It is defined as K ?Y/?A, where ?A is the
  change in autonomous spending and ?Y the
  resulting increase in GDP.

13
A BASIC MODEL OF THE DETERMINATION OF GDP

• The simple multiplier is the multiplier when the
  price level is constant.
• It is equal to 1/1 - z, where z is the marginal
  propensity to spend out of national income.
• Thus the larger z 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.

14
UK real GDP growth, 1886-2014
15
Terminology of Business Cycles
16
Costumers spending and personal disposable
income UK 1948-2008
17
Calculation of average and marginal propensity to
consume
18
The Consumption and Saving Functions
450
2000
500
S
C
1500
250
0
1000
Desired Consumption Expenditure
Desired saving
-100
500
-500
500
1000
1500
2000
450
Real Disposable Income
500
1000
1500
2000
(ii). Saving Function million
Real Disposable Income
(i). Consumption Function million
19
Consumption and savings schedules (millions)
20
The consumption and saving functions

• Both consumption and saving rise as disposable
  income rises.
• Line C relates desired consumption to disposable
  income.
• Its slope is the marginal propensity to consume
  (MPC).
• Saving is all disposable income that is not spent
  on consumption.
• The relationship between disposable income and
  desired saving is shown by line S.

21
The consumption and saving functions

• Its slope is the marginal propensity to save
  (MPS).
• Any given amount of disposable income must be
  accounted for by consumption plus saving.
• Consumption and saving schedules (Table) show the
  numerical values of desired consumption and
  saving at each level of income, and correspond to
  the C and S lines in the figure.

22
The aggregate spending function in a closed
economy with no government (million)
23
An Aggregate Expenditure Function
5000
AE
Desired Expenditure (m)
4000
3000
2000
1000
350
1000
2000
3000
4000
5000
Real National Income Function GDP m
24
An aggregate expenditure function

• The aggregate expenditure function relates total
  desired expenditure to national income.
• Here desired expenditure is the sum of desired
  consumption and desired investment.
• It is assumed that desired investment is 250
  million while consumption is 100 million plus
  0.8 times income.
• So when income is zero there is autonomous
  expenditure of 350 million.
• The marginal propensity to spend is 0.8.

25
The determination of equilibrium GDP (million)
26
Equilibrium GDP
ii. Saving FunctionS I
i. An Aggregate Expenditure FunctionAE Y
500
3000
S
450 AE Y
I
250
E0
2000
0
-100
Desired aggregate expenditure (m)
-500
Desired saving (m)
1000
Y0
3000
2000
1000
Real National Income GDP m
350
450
0
Y0
1000
2000
3000
Real National Income GDP m
27
Equilibrium GDP

• GDP is in equilibrium where aggregate desired
  expenditure (AE) equals national output.
• In the figure equilibrium GDP occurs at E0 where
  AE intersects the 450 line.
• If GDP is below Y0 desired AE will exceed
  national output and production will rise.

28
Equilibrium GDP

• If GDP is above Y0 desired AE will be less than
  national output and production will fall.
• When saving is the only withdrawal and investment
  is the only injection, the equilibrium level of
  GDP is also that where saving equals investment.

29
The Simple Multiplier
AE Y
Desired Expenditure
450
Real National Income GDP
0
30
The Simple Multiplier
AE Y
Desired Expenditure
AE0
e0
E0
450
Y0
Real National Income GDP
0
31
The Simple Multiplier
AE Y
AE1
E1
e1
a
e1
Desired Expenditure
AE0
?A
e0
E0
?Y
450
Y0
Y1
Real National Income GDP
0
32
The simple multiplier

• An increase in the autonomous component of
  desired aggregate expenditure increases
  equilibrium GDP by a multiple of the initial
  increase.
• The initial equilibrium is at E0, where AE0
  intersects the 450 line. Here desired expenditure
  equals national output.

33
The simple multiplier

• An increase in autonomous expenditure of ?A then
  shifts the AE function up to AE1.
• Because desired spending is now greater that
  output, production and GDP will rise.
• Equilibrium occurs when GDP rises to Y1.
• Here desired expenditure e1 equals output Y1.

34
The multiplier A numerical example
35
The multiplier A numerical example
36
A numerical example of the multiplier

• Assuming that the marginal propensity to spend
  out of national income is 0.8 and there is an
  autonomous expenditure increase of 100m.
• National income and output initially rises by
  100m.

37
A numerical example of the multiplier

• Those receiving 100m in income then spend 80m.
• This 80m of income leads to further spending of
  64m.
• This 64m of income lead to a further increase in
  spending of 51.2m.
• If we carry on this process it will converge to
  an extra income and output totalling 500m.
• The multiplier in this case is 5.

38
UK Household savings as a of GDP (1955Q1 to
2009Q3)
39
Total UK Business Investment(1955Q1 to 2009Q1)
40
A BASIC MODEL OF THE DETERMINATION OF GDP

• The macroeconomic problem inflation and
  unemployment
• Models of the short-term determination of GDP
  explain why actual GDP deviates from potential
  GDP.
• Actual GDP above potential can be associated with
  inflation, while actual GDP below potential is
  associated with unemployment and lost output.

41
A BASIC MODEL OF THE DETERMINATION OF GDP

• Key Assumptions
• For simplicity we aggregate all industrial
  sectors into one, so the economy produces only
  one type of output good.
• We explain GDP determination through the major
  expenditure categories private consumption,
  investment, government consumption, and net
  exports.