Chapter 6 – The Simplest Short-Run Macro Model

6.1 Desired Aggregate Expenditure

Desired Expenditure
Economists use the same letter without the subscript a to indicate the same
categories:
- desired consumption C
- desired investment I
- desired government purchases G
- desired net exports (X – IM)

The actual values of the categories of expenditure are indicated by Ca, Ia, Ga
and (Xa - IMa).

What does “desired” mean?

It is not just a list of what consumers would buy if they had no monetary
constraints.
- It is what consumers and firms would like to purchase given their real-world
budget constraints and market prices – it is realistic.

Desired Aggregate Expenditure - The sum of desired or planned spending on

domestic output (by households, firms, government, and foreigners)
AE = C + I + G + (X – IM)

Autonomous Expenditures
- Elements of AE that DO NOT change systematically with national
income (output)
Induced Expenditures
- Components of AE that do not change systematically in response to
changes in national income.

Assumptions of the simplest short-run macro model:

- There is no trade with other countries  closed economy.
- There is no government  no taxes, which means…
- The price level is constant.
By simplifying the model, we are better able to understand its structure and
therefore how more complex versions of the model work.

Desired Consumption Expenditure

Disposable Income: household income – taxes
Saving: disposable income not spent on consumption

The Consumption Function

- It is the relationship between desired consumption expenditure and all
the variables that determine it.
 - Desired consumption is determined by  disposable income, wealth,
interest rates, and expectations about the future.

Figure 6-1 Consumption and Disposable Income in Canada, 1981-2020

(Source: Based on author’s calculations using data from Statistics Canada,

Table 36-10-0112-01.)

Figure 6-2 The Consumption and Saving Functions

Disposabl Desired Desire APC MPC =
e Income Consumptio d = ΔYD ΔC ΔC/ΔY
(YD) Saving C/YD
n (C) D
(S)
0 30 −30 — 30 24 0.8
30 54 −24 1.80 120 96 0.8
150 150 0 1.00 150 120 0.8
300 270 30 0.90 150 120 0.8
450 390 60 0.87 75 60 0.8
525 450 75 0.86 75 60 0.8
Blan Blan
600 510 90 0.85 Blank
k k
Average Propensity to Consume
APC = C / YD
- APC falls as disposable income rises.

Marginal Propensity to Consume

MPC = C / YD

- The MPC is the slope of the consumption function.

- The constant slope of the consumption function shows that the MPC is
the same at any level of disposable income.

The Saving Function

Concept: Households decide how much to consume and how much to save

Average Propensity to Save

APS = S / YD

Marginal Propensity to Save (MPS)

MPS = S / YD

Figure 6-3 Shifts in the Consumption Function

The consumption function shifts upward with an increase in wealth, a
decrease in interest rates, or an increase in optimism about the future.

The consumption function shifts

upward with an increase in
wealth, a decrease in interest rates, or an increase in optimism about the
future.

Desired Investment Expenditure

- The three categories of investment
 inventory accumulation
 residential construction
 new plant and equipment.
- Investment expenditure is:
1. the most volatile component of GDP and
2. strongly associated with aggregate economic fluctuations.
- Determinants of desired investment expenditure are:
1. the real interest rate
2. changes in the level of sales
3. business confidence.
The current level of real GDP is not an important determinant of current
desired investment.

Figure 6-4 The Volatility of Private-Sector Investment, 1981–2020

The major components of private-sector investment fluctuate considerably
as a share of GDP. The recessions of 1982, 1991, 2009, and 2020 are evident
from the reductions in investment. These data exclude investment by
government and non-profit institutions, which combined are quite stable and
amount to about 4 percent of GDP. Note that the category “plant and
equipment” includes investment in intellectual property (IP) products, which
result from research and development (R&D) activities.
(Source: Based on author’s calculations using data from Statistics Canada,
Table 36-10-0104-01.)

SIMPLIFYING ASSUMPTION: Investment as autonomous expenditure

Figure 6-5 Desired Investment as Autonomous Expenditure

The Aggregate Expenditure Function

 The aggregate expenditure (AE) function relates the level of desired
aggregate expenditure to the level of actual national income.
 In the absence of government and international trade, desired
aggregate expenditure is equal to desired consumption plus desired
investment:
AE = C + I

Example
The consumption function is C = 30 +
(0.8)Y
The investment function is I = 75
The AE function is AE = C + I
= 30 + (0.8)Y + 75
= 105 + (0.8)Y

The slope of the AE function is the

marginal propensity to spend, which in
this simple model, is just the marginal
propensity to consume.
 The aggregate
expenditure function
relates desired aggregate
expenditure to actual
national income. The
curve AE in the figure
plots the data from the
first and last columns of
the accompanying table.
Its intercept, which in this
case is $105 billion,
shows the sum of
autonomous consumption
and autonomous
investment. The slope of AE is equal to the marginal propensity to spend,
which in this simple economy is just the marginal propensity to consume.

6.2 Equilibrium National Income

 If desired aggregate expenditure exceeds actual income, inventories
are falling and there is pressure for actual national income to rise.
 If desired aggregate expenditure is less than actual income,
inventories are rising and there is pressure for actual national income
to fall.
 The equilibrium level of national income occurs when desired
aggregate expenditure equals actual national income.

Table 6-1 Equilibrium National Income (data from Figure 6-6)

National income is in equilibrium when desired aggregate expenditure equal
actual national income.

Figure 6-7 Equilibrium National Income

• The equilibrium condition occurs when AE = Y.
• If actual Y < Y0, desired AE will exceed national income, and output will
rise.

Equilibrium national income is that level of national income where desired

aggregate expenditure equals actual national income. If actual national
income is below Y0, desired aggregate expenditure will exceed national
income, and output will rise. If actual national income is above Y0, desired
aggregate expenditure will be less than national income, and production will
fall. Only when national income is equal to Y0 will the economy be in
equilibrium, as shown at E0.

6.3 Changes in Equilibrium National Income

Figure 6-8 Shifts in the Aggregate Expenditure Function
 - A parallel shift in AE - A change in the slope of AE

• What determines the size of the change in national income?

The Multiplier

 – The simple multiplier is the ratio of the change in equilibrium

national income to the change in autonomous expenditure that
brought it about, calculated for a constant price level.
 – In the simple macro model, the multiplier is greater than 1.

• z is the marginal propensity to spend out of national income

Figure 6-9 The Simple Multiplier

• A is the change in autonomous expenditure

Simple multiplier  Y = 1
A 1-z

- The larger the marginal propensity to spend, the steeper the AE

Figure 6-10 The Size of the Simple Multiplier

function and the larger is the simple multiplier.

 Households’ and firms’ expectations about the future state of the
Economic Fluctuations as Self-Fulfilling Prophecies

economy influence desired consumption and desired investment.



Changes in desired aggregate expenditure will, through the multiplier

process, lead to changes in national income.


This link between expectations and national income suggests that

expectations about a healthy economy can actually produce a healthy


economy—what economists call a self-fulfilling prophecy.

Imagine that firms begin to feel optimist about future economic
prospects.


This optimism may lead them to increase their desired investment,

which shifts up the economy’s AE function.


The upward shift in the AE function increases national income.

If enough firms are optimistic and take actions based on that


optimism, their actions will create the economic situation that they


expected.