Economics principles tools and applications 9th by sullivan sheffrin perez chapter 11

11.1 A SIMPLE INCOME-EXPENDITURE MODEL 2 of 3 Equilibrium OutputAt equilibrium output y*, total demand y* equals output y*... All Rights ReservedChanges in the Consumption Function Two f

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Economics

NINTH EDITION

Chapter 11

The Income-Expenditure

Model

Prepared by Brock Williams

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Learning Objectives

11.1 Discuss the income-expenditure model.

11.2 Identify the two key components of the consumption function.

11.3 Calculate equilibrium income in a simple model.

11.4 Explain how government spending and taxes affect equilibrium income.

11.5 Discuss the role of exports and imports in determining equilibrium income.

11.6 Explain how the aggregate demand curve is related to the income-expenditure model.

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Equilibrium Output

At any point on the 45° line, the distance

to the horizontal axis is the same as the distance to the vertical axis

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11.1 A SIMPLE INCOME-EXPENDITURE MODEL (2 of 3) Equilibrium Output

At equilibrium output y*, total demand y* equals output y*.

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Adjusting to Equilibrium Output

Equilibrium output (y*) is determined at a, where demand intersects the 45° line.

If output were higher (y1), it would exceed demand and production would fall

If output were lower (y2), it would fall short of demand and production would rise.

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11.2 THE CONSUMPTION FUNCTION (1 of 3)

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

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Consumer Spending and Income

The consumption function relates desired consumer spending

to the level of income

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▼FIGURE 11.5

Moments of the Consumption Function

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Changes in the Consumption Function

Two factors that can cause autonomous consumption to change:

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

• Increases in consumer confidence will increase autonomous consumption

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APPLICATION 1

FALLING HOME PRICES, THE WEALTH EFFECT, AND DECREASED CONSUMER SPENDING

APPLYING THE CONCEPTS #1: How do changes in the value of homes affect consumer spending?

Home equity is the difference between the home value and what is owed on the mortgage

• The largest component of net wealth for most families

• Changes in home equity like other forms of wealth affect consumer spending

From 1997 to mid-2006 housing prices rose by about 90 percent and consumer wealth grew by $6.5 trillion

This ended in 2006 as housing prices began to fall

According to a review of studies by the Congressional Budget Office, each $1 decline in consumer wealth would lower consumption spending between $.02 and $.07, or $21 to $72 billion of spending

This would reduce economic growth 0.1 to 0.5 percent during 2007

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11.3 EQUILIBRIUM OUTPUT AND

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Saving and Investment

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Saving and Investment

Equilibrium output is determined at the level of output, y*, where savings

equals investment

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Understanding the Multiplier

When investment increases from I0 to I1, equilibrium output increases from y0

to y1.

The change in output (Δy) is greater than the change in investment (ΔI).

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APPLICATION 2

MULTIPLIERS IN GOOD TIMES AND BAD

APPLYING THE CONCEPTS #2: Are multipliers for government spending higher during recessions?

•

A common belief is that fiscal multipliers are larger during recessions, when there is more slack in the economy But, it is quite difficult to estimate

government multipliers accurately

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11.4 GOVERNMENT SPENDING AND TAXATION (1 of 5)

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•

Fiscal Multipliers

The consumption function with taxes is

The formula for the tax multiplier is

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11.4 GOVERNMENT SPENDING

AND TAXATION (3 of 5)

Using Fiscal Multipliers

Although it is very simple, our income-expenditure model illustrates some important lessons:

• 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

In the long run, of course, we are better off if government spends the money wisely, such as on needed infrastructure such as roads and bridges This is an example of the principle of opportunity cost

PRINCIPLE OF OPPORTUNITY COST

The opportunity cost of something is what you sacrifice to get it.

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APPLICATION 3

THE BROKEN WINDOW FALLACY AND KENSESIAN ECONOMICS

APPLYING THE CONCEPTS #3: How does Keynesian Economics change our normal ideas of economic scarcity?

• Austrian economist, Henry Hazlitt, popularized the “Broken Windows” fallacy in economics Imagine that a hoodlum threw a brick through a store window While at first this seems to be a tragedy, the store owner has to hire a firm to fix the window That generates business for the window repair firm and, through a multiplier, additional business throughout the community Was the broken window good for society?

• The fallacy here is that the money that the store owner paid to have the window repaired would have been spent elsewhere in the economy, say on clothing

• Hazlitt applies a similar argument to public spending financed by taxes A government spending program may appear to increase business, but the taxes needed to finance the spending—either paid now or in the future—will mean less business for other firms Government spending and the taxes necessary to finance it will just crowd out other production of goods and services in the economy

• But in the Keynesian world, where resources are underemployed, the story is quite different Here the increase in spending—even financed by taxes—will bring resources that are not being utilized into the economy As long as there is excess capacity in the economy, the extra spending will increase output and not crowd out other goods and services

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11.4 GOVERNMENT SPENDING

AND TAXATION (4 of 5)

Understanding Automatic Stabilizers

After World War II, fluctuations in GDP growth became

considerably smaller

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Understanding Automatic Stabilizers

C = Ca + b(1 − t)y

adjusted MPC = b(1 − t)

An increase in tax rates decreases the slope of the C + I + G line

This lowers output and reduces the multiplier

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11.5 Exports and imports (1 of 2)

To modify our model to include the effects of world spending on exports and U.S spending on imports, we need to take two steps:

1. Add exports, X, as another source of demand for U.S goods and services.

2. Subtract imports, M, from total spending by U.S residents We will assume that imports, like consumption, increase with the level of income.

M = my

The fraction of additional income that is spent on imports

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11.5 Exports and imports (2 of 2)

Output is determined when the demand for domestic goods equals output.

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▼FIGURE 11.13

How Increases in Exports and Imports Affect U.S GDP

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APPLICATION 4

THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A COUNTRY’S OUTPUT

APPLYING THE CONCEPTS #4: How do countries benefit from growth in their trading partners?

From the early 1990s until quite recently, the United States was what economists term the “locomotive” for global growth

• Our demand for foreign products increased

• U.S imports increased along with output during this period

• The increased demand fueled exports in foreign countries and promoted their growth

Studies have shown that the increase in demand for foreign goods was actually more pronounced for developing countries than for developed countries

Conclusion: The United States was truly a locomotive, pulling the developing countries along

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11.6 THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE (1of 2)

As the price level falls from P0 to P1, planned expenditures increase,

which increases the level of output from y0 to y1

The aggregate demand curve shows the combination of prices and

equilibrium output.

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11.6 THE INCOME-EXPENDITURE MODEL AND THE AGGREGATE DEMAND CURVE (2of 2)

As government spending increases from G0 to G1, planned

expenditures increase, which raises output from y0 to y1

At the price level P0, this shifts the aggregate demand curve to the

right, from AD0 to AD1.

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KEY TERMS

Autonomous consumption

Consumption function

Equilibrium output

Marginal propensity to consume (MPC)

Marginal propensity to import

Planned expenditures

Savings function

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APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER (1

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The Multiplier for Investment

For the original level of investment at I0, we have

For a new level of investment at I1, we have

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Substituting for the levels of output, we have

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Finally, because (I1 − I0) is the change in investment, ΔI, we can write

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Another Way to Derive the Formula for the Multiplier

The term in parentheses is an infinite series whose value is equal to

Substituting this value for the infinite series, we have the expression for the multiplier:

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Government Spending and Taxes

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Government Spending and Taxes

Using this formula and the method just outlined, we can find the multiplier for changes in government spending and the multiplier for changes in taxes:

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Balanced-Budget Multiplier

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Equilibrium Output with Government Spending, Taxes, and the Foreign Sector

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