Long Run Growth and Short Run

Aggregate Expenditure
Colin F. Bullock
 Long Run Growth
• Small differences in long run growth make
significant differences (compare 2% and 3% over
50 years). (100 → 269 or 438)
• Output growth; the rate of growth of output in
the entire economy
• Per capita output growth is the rate of growth per
person in the entire economy ie the rate of
growth of Q/N.
• Productivity growth is the rate of growth of
output per worker ie the rate of growth of Q/L
 Productivity and Participation
• If population grows faster than output, per capita
GDP falls
• Q/N = Q/L x L/N => g Q/N = g Q/L + g L/N ie growth
rate of output per head is equal to the rate of
growth of output per worker (labour
productivity) plus the rate of growth of the labour
force as a fraction of the population.
• Participation influenced by minimum working
age, retirement age, years of schooling,
participation of women.
 Productivity
• Output is dependent on labour (human capital) ,
capital (physical) , and natural resources,
entrepreneurship, management and technology.
• The contribution of labour is dependent on
population growth, the percentage of the
population in the labour force, and average
labour productivity: the education and training of
workers, the quantity and quality of the capital
stock that workers use in production, the state of
technology, enterprise etc..
• Health, education, R&D and the capacity to adapt
technology are important to long run growth.
 Short Term Fluctuations; Business
Cycle
• The long term growth rate is an average trend
and the economy, in the short run, may fluctuate
around that trend.
• The business cycle moves from a peak (beginning
of recession), through a recession, a trough (end
of recession), a boom and back to a peak.
• Informal definition of a a recession; negative
growth (economy contracts) for at least two
consecutive quarters
• Depression, a severe and protracted recession
• Boom; a particularly strong and protracted
expansion
 Potential Output or GDP
• Potential output also known as full employment
output is the maximum sustainable level of
output that the economy can produce
• Potential output is the maximum sustainable
amount of output ( or real GDP).
• Note “maximum sustainable” as output can
exceed potential but not indefinitely.
• Economic fluctuations may be due to changes in
potential output but will more likely be caused by
fluctuations of actual output around potential
output.
 Output Gap
• Defined as the difference between actual output
and potential output; Y-Y*, where Y* is potential
output.
• Y<Y* is a negative output or recessionary or
deflationary gap where resources are not fully
employed; associated with cyclical
unemployment.
• Y>Y* is a positive output or expansionary or
inflationary gap where resources are utilized at
above normal rates resulting in inflation.
Deflationary Output Gap
Inflationary Output Gap
 The Nature of Macroeconomic Policy
• To enhance the long run potential growth
through policy to enhance human capital,
facilitate investment in physical capital, and
develop or adapt technology.
• Short run stabilization policy; to manage
aggregate demand to minimize deflationary and
inflationary gaps.
• Use of fiscal policy (government expenditure and
taxation), and monetary policy (money supply
and interest rates) for short run stabilization
 Aggregate Expenditure
• Planned Aggregate Expenditure :
PAE = C + I+ G + X - M
• C = C0 + bY , I = I0 , G = G0, X = X0, M= mY
0 < b < 1 and 0 < m < 1
• In (simple) closed economy without
Government, PAE=Y=C+I or I = (Y-C) =S and Y =
C+S
 Determinants of Consumption
• Income
• Wealth
• Interest Rates
• Price
• Expectations about future income
Consumption and Income
Consumption Function
Movements Along vs. Shifts of the
Consumption Function
• A change in income  a movement along the
consumption function
• A change in any non-income determinant  a
shift of the entire function, that is, a change in
autonomous consumption
 Non-Income Determinants of
Consumption
• Wealth – an increase will cause the
consumption function to shift upwards
• Interest Rates – a decrease will cause the
consumption function to shift upwards
• Prices – a decrease will cause the function to
shift upwards
• Expectations – positive expectations will shift
the function upwards
The Marginal Propensity to Consume (MPC) and
Marginal Propensity to Save (MPS)
• b = slope of the consumption function = MPC
= fraction of the change in income that is spent
on consumption =∆C/∆Y
0 < MPC < 1
• Y=C+I=C+S
∆Y = ∆C + ∆S and ∆Y/∆Y = ∆C/∆Y + ∆S/∆Y
1 = mpc + mps
mps = 1- mpc
where mps is the fraction of a change in income that is
saved.
Income, Consumption, Saving
 The Saving Function
• Recall Y = C + I = C + S
• C = Co + bY
• From first bullet, S = Y – C = Y - (Co + bY)
= Y – Co – bY = -Co + (1 – b)Y
• Observe that the intercept is the negative of
the intercept of the consumption function and
the slope is (1 – mpc)
• E.g. C = 200 + 0.75Y → S =Y – C = Y- 200 -0.75Y
= -200 + 0.25Y
 The 45 Degree (450) Line
• A straight line that bisects the 900 angle at the origin
is at an angle of 450 to both the vertical (y) and
horizontal (x) axes.
• At every point along that 450 line the value on the y
axis is equal to the value on the x axis
• At every point above the line the value on the
vertical axis is greater than the value on the
horizontal axis
• At every point below the line, the value on the
vertical axis is less than the value on the horizontal
axis
Income, Consumption, Saving
 Determinants of Investment
• Aggregate Income
• Business Confidence
• Technological Change
• The real interest rate
• Tax Provisions
Exogenous Investment
 Non-Income Determinants of
Planned Investment (IP)
• Business Confidence – an ↑ in business
confidence will ↑ planned Investment (IP)
• Technological Change – Improvements in
technology will ↑ Ip
• Real Interest Rate – a ↓ in the real interest
rate will ↑ Ip
• Tax Credits – an ↑ in tax credits for
investment will ↑ Ip
Planned Aggregate Expenditure
(C + IP)
Equilibrium Aggregate Output
 Circular Flow , Injections and
Withdrawals
• Circular flow of income is between households
(spending on goods and services) and firm
(paying incomes to households for factor
services.
• Injections are earnings of households that do not
result from spending of firms or earnings of firms
not from the spending of households (I, G, X)
• Withdrawals are incomes of households or firms
that are not passed on through respending in the
circular flow (S, T, M)
 Equilibrium in the Circular Flow
• The circular flow of income is in equilibrium
where there is no tendency for it to either
increase or decrease.
• Injections increase the circular flow
• Withdrawals reduce the circular flow
• The circular flow is in equilibrium where
withdrawals are equal to injections;
(S+T+M)=(I+G+X)
• In closed economy without Government
equilibrium is where S =I
The Saving Investment Approach
The Paradox of Thrift
 Algebra of Income

• Y = C + I = C0 + bY + I0
Y – bY = C0 + I0
Y(1 – b) = C0 + I0
Y = (C0 + I0 ) x 1/( 1 – b)
Multiplier Graph
 Algebra of the Multiplier I
• Recall Y = (C0 +I0)/(1-b) = AE x 1/(1-b)
Therefore ∆Y =∆AE x 1/(1-b)
= (∆C0 + ∆I0) x 1/(1-b)
If ∆C0 = 0 Then ∆Y = ∆I0 x 1/(1-b)
= ∆I0 x k
Where k = 1/(1-b) is the multiplier for a closed
economy without government.
Note 0 < b < 1 → k > 1
 Algebra of the Multiplier II
• In closed economy without government,
equilibrium in aggregate expenditure may be
alternatively expressed as S = I
The maintenance of equilibrium requires that
a change in S is matched by a change in I
Therefore ∆S = ∆I and ∆S/∆Y = ∆I/∆Y
Therefore ∆Y = ∆I x 1/(S∆/∆Y) =∆I x 1/mps
Where k = 1/mps = 1/(1-mpc) = 1/(1-b)
 Intuition of the Multiplier
• The multiplier is dependent on subsequent
rounds of respending based on the mpc.
• The change in income from an initial $25
change in investment is:
$25+(.75x$25)+(.752x$25)+(.753x$25)+……………
+(.75nx$25)
$25(1+.75+.752+.753+…….+.75n)=$25x1/1-.75
=$25x4.
 EXAMPLE
• In a closed economy without Government,
consumption is given by C = 500 + 0.8Y and I=50.
Find a) the equilibrium level of income b) The
multiplier c) The equilibrium level of income if I
increases by 25 d) The equilibrium level of
income if the mps increases to 0.4 e) The
equilibrium level of income if saving at zero
income increases to minus 400. (Assume all
changes from the original C and I)
 Answers a) and b)
• a) Y = C + I = 500 + 0.8Y + 50
Y (1 -0.8) = 550
Y = 1/(1-0.8) x 550
= 5 x 550 = 2750
b) k = 1/(1- mpc) = 1 / (1 – 0.8) = 5
or If I increases by 25 then Y = 500+0.8Y+50+25
→ Y(1-0.8) = 575 and Y = 575x1/(1- 0.8) =2875
→ k = ∆ Y / ∆AE = (2875-2750)/25 = 5
 Answers c) and d)
• C) Y2 = C + I + ∆I = 500 + 0.8Y + 50 + 25
Y2 ( 1 – 0.8) = 500 + 50 + 25
Y2 = 1(1-0.8)x575 = 5 x 575 = 2875
or ∆Y = k x ∆ AE = 5 x 25 = 125
Y2 = Y1 + ∆Y = 2750 + 125 = 2875
d) mps = 1–mpc => mpc= 1–mps = 1-0.4 = 0.6
Y2 = (1/ 1-0.6) x 550 =2.5 x 550 = 1375
 Answer e)
e) Saving at zero income is equal to minus consumption
( -C) at zero income => consumption at zero income
is equal to minus consumption at zero income.
When consumption at zero income was 500, saving
was -500. If saving at zero income increases
(becomes less negative) to -400, then consumption
falls from 500 to 400.
Solve Y = 400 + 0.8 Y + 50 for Y
or Y2 = Y1 + ∆Y where ∆Y = k x ∆AE and ∆AE = -100
 Readings
• Baumol & Blinder Chs 24-26
• Frank & Bernanke Chs 19, 22, 23
• Case fair Oster Chs 22 &23