EKN 120 – Chapter 16 pdf - Lecture notes 16 PDF

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

EKN$$120$–$Macroeconomics$$ $Chapter$16$–$$The$Aggregate$Expenditure$Model$$$$ ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

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Two most critical questions in Macroeconomics: i. What determines the level of GDP, given a Nation’s production Capacity? ii. What causes real GDP to rise in one period and to fall in another? The Keynesian Cross: The amount of goods and services produced is directly depended on the level on the level of aggregate expenditures. Fall of aggregate expenditures = Fall in Employment

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.1! The$Consumption$and$Investment$Schedules$$

16.1.1! Equilibrium$or$Y:$Y=C+I$$$ i.!

In a private closed economy, tow components that add up to the aggregate expenditure/income/ GDP (Y) – Gross Investment (I) and Consumption (C) ii.! Y=C + I iii.! Y = C0 + cYd + I iv.! Investment Schedule •! Showing the amounts business firms collectively intend to invest o! Planned Investment •! Investment at each level of GDP

16.1.2! Tabular$Analysis$$ 16.1.2.1!Real Domestic Output (Yd) i.! Column 1- Various possible levels of total output (real GDP) in private sector ii.! Producers are willing to offer any of these 10 levels of output if they can expect to receive an identical level of income from the sale of that output 16.1.2.2!Aggregate Expenditures (Income Y) i.! Aggregate Expenditure= C+I •! At each income level

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] ! 16.1.2.3!Equilibrium GDP i.! Which total output is the economy capable of sustaining? ii.! Equilibrium Output whose production creates total spending just sufficient to purchase that Output iii.! Total Goods Produced (GDP) = Total Goods Purchased (C + I)

16.1.2.4!Mathematical Calculations

16.1.2 i.! ii.!

No other level of GDP other than the equilibrium can be sustained GDP Below Equilibrium: •! Spending > Production o! Businesses would adjust to the change until equilibrium is reached o! Increase in production = Increase in output = Increase in employment iii.! GDP Above Equilibrium: •! Spending < Production o! Businesses will have to cut on production to avoid the inability to cover their costs o! Decline in production = decline in output = decline in employment

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.1.3! Graphical$Analysis$$ i.!

The Aggregate Expenditure Line C+I shows that total spending rises with income and output (GDP) – but not as much as income rides. •! Due to the Marginal Propensity to consume o! Slope of C is less than 1 Ø฀! A part of any increase in income would rather be saved than spent •! Since the aggregate expenditure line in parallel to the consumption line o! The slope of the aggregate expenditure line also equals MPC for the economy and is less than 1 ii.! The Equilibrium Level of GDP •! Determined by the intersection of the 45 line and the aggregate expenditure schedule o! The intersection locates the only point at which aggregate expenditure (Vertical axis) = GDP (Horizontal Axis)

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.2 ! Other$Fe Other$Features$of$Equilibrium$GDP atures$of$Equilibrium$GDP atures$of$Equilibrium$GDP$$ Two more Characteristics of Equilibrium GDP:

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Saving and Planned Investment as equal a. Leakage b. Injection There are no unplanned changes in inventories

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16.2.1! Saving$Equals$Planned$Investment$ 16.2.1.1!Leakage$ i.! Saving is a leakage (withdrawal) from the income-expenditure stream $ ii.! Causes Consumption < Total Output $ 16.2.1.2!Injection$ i.! Not all goods are sold to consumers – some output is sold to other businesses as capital goods $ ii.! Investment = purchases of capital goods $ •! Thus an injection of spending into the income-expenditure stream$ 16.2.1.3!Disequilibrium $ i.! Leakage > Injection $ •! C+I< GDP $ •! Will reduce real GDP $ ii.! Injection> Leakage $ •! C+I>GDP $ •! Will increase real GDP $ 16.2.1.4!Mathematical Calculations$

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.2.2! No$Unplanned$Changes$in$Inventories$

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16.2.2.1!No Unplanned Changes in Inventories at Equilibrium i.! As part if investment plans – businesses ↑ or ↓ levels of inventories •! Y = C+I and S=I ii.! Unplanned Changes in Inventories play a very important role in achieving the equilibrium iii.! Change in inventories from part of investment •! Above Equilibrium : Actual Investment = Planned Investment + Unplanned Increase in Inventories •! Because a firm cannot earn profits by accumulating unwanted inventories, the unplanned increase in inventories will prompt businesses to cut back employment and production o! GDP will fall to it’s Equilibrium Ø฀! Unplanned Changes in Inventories = 0 •! Below Equilibrium : Actual Investment/Savings = Planned Investment - Unplanned Decrease in Inventories •! Firms must disinvest •! The unplanned Decline in inventories, resulting from excess of sales over production, will encourage firms to expand production o! GDP will rise to equilibrium Ø฀! Unplanned Changes in Inventories = 0 iv.! Differences between investment and saving can occur and bring about changes in equilibrium GDP •! Planned investment and Savings •! Equilibrium is only when o! Investment = Savings •! But when unplanned changes in inventories are considered o! Investment = Savings Ø฀! Investment = Planned Investment + Unplanned Investment a.! Unplanned changes in inventories act as a balancing item that equates the actual amounts saved and invested at any period

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.3! Changes$in$Equilibrium$GDP$and$The$ Multiplier Multiplier$$ i.!

In private closed economy the equilibrium GDP will change in response to changes in either the investment schedule or the consumption schedule. •! Changes in the investment schedule usually are the main sources of instability

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The above figure shows the effect of change in investment spending on the equilibrium real GDP – NB see figure 16.3 pg. 329 •! Increase in the expected rate of return on investment or Decrease in Real Interest Rate – Increase in Investment o! Upward shift of investment schedule o! Will increase aggregate expenditure o! Raise Equilibrium Real GDP iii.! The Multiplier •! Change in Output / Change of Expected Rate of Return or Real Interest Rate •! Once the change occurs in saving and expenditure – the equilibrium in reached I’d!Advise!to!do!the!“Quick!Quiz”!16.4! o! Savings and Investments are equal o! No unplanned changes in inventories

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

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In a private closed economy, equilibrium GDP occurs when aggregate expenditures equal real domestic output (Y = C +I) At equilibrium GDP, savings equals planned Investment (S = I) and unplanned changes in inventories are 0 Actual Investment consists of a planned investment + Unplanned changes in inventories and is always equal to saving in a private closed economy Through the multiplier effect, an initial change in investment spending can cause a magnified change in domestic output and income

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.4 !Adding$the$Public$Sector$ Assumption 1 : Government purchases are independent for the rest of the GPD – do not affect the consumption or investment. Assumption 2: Net Tax Revenue (Total Tax – “Negative Tax” (transfer payments)) are personal tax only.

16.4.1! Government$Purchases$and$Equilibrium$GDP$$ 16.4.1.1!Tabular Example $ i.! Addition to government spending will result in higher aggregate expenditure $ •! Eventual increase in Equilibrium GDP $ ii.! Government spending is also subject to the multiplier$ 16.4.1.2!Graphical Analysis$

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16.4.1.3!Mathematical Calculations

Suggestion:!Make!sure!you!can!do!all! the!calculations.!! Thoroughly!go!through!the!examples! on!page!331!in!the!prescribed!text! book.!!

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.4.2! Taxation$and$Equilibrium$GDP$$ 16.4.2.1!Tabular Example $ i.! Increase of taxes will result in consumers having less money to spend (disposable income) $ ii.! Thus resulting in a lower GDP; MPC and MPS$ iii.! Effect of Taxes on the Equilibrium GDP$

•! Calculate the aggregate expenditures again (C + I + G) and compare to total spending after tax vs. before tax – the difference would be the difference in GDP 16.4.2.2!Graphical Analysis

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16.4.2.3!Mathematical Calculation i.! There are always three ways of calculating the change in GDP •! Expenditure model Suggestion:!Make!sure!you!can!do!all! the!calculations.!! o! Y = C + I + G Thoroughly!go!through!the!examples! •! Interjection leakage on!page!334!in!the!prescribed!text! o! S + T = I + G book!and!all!“Quick!Quizzes”.!! •! Multiplier o! New Y + Y1 + ∇Y ( the triangle is just the wrong way around – it represents change) 16.4.2.4!Differential Impacts i.! ∇ in G and ∇T does not result in the same ∇ in GDP ii.! Balanced Multiplier effect – Increasing both G and T may not always stimulate the GDP iii.! If we were to allow tax to be calculated as a % on income rather than an “lump sum” •! The consumption and savings will change at a fixed rate – effecting the multiplier. Disposable income: Yd = (1-t) Y

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Multiplier!=!1/1Oc!No!Tax! Multiplier!=!1/1Oc(1Ot)!Tax!

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.5! Adding$International$Trade$$

16.5.1! Net$Exports$and$Aggregate$Expenditures$$ 16.5.1.1!Net Export Schedule$ i.! Exports: Create Domestic Production, income & employment$ •! Forms part of our aggregate expenditure $ ii.!

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Imports: Spend income on goods and services from abroad – to avoid overestimation of GDP this must thus be minuses from our exports = NET EXPORTS Y = C + I + G + Xn

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•! Much higher than it would have been in a closed economy iii.! Results in a decrease in available goods domestically •! Yet stimulates production and boost’s the economy’s real GDP 16.5.2.2!Negative Net Exports i.! Imports > Exports ii.! Reduction in Aggregate expenditure thus reduction in GDP iii.! Imports = Increase in Stock off goods available, yet decrease the expenditures on domestically produced

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.5.3! Injections,$ Leakages$ and$ Unplanned$ Changes$ in$ Inventories$ i.!

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Equilibrium GDP: Interjections = Leakages •! S + M + T = I + X + G ii.! The characteristic of “no unplanned inventories” is also followed •! Aggregate Expenditure = GDP o! All goods produced will be bought

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.6 !Equilibrium$vs.$Full Equilibrium$vs.$FullXEmployment$GDP$ XEmployment$GDP$

16.6.1! Recessionary$Expenditure$Gap$ 16.6.1.1!Recessionary Expenditure Gap: the amount at which aggregate expenditures – full employment GDP – fall short of those required to achieve to full employment GDP i.! Inadequate total spending constricts the economy ii.! Graphically: •! Recessionary expenditure gap: vertical distance (full employment GDP) by which the actual aggregate expenditure schedule AE lies below the hypothetical full employment aggregate expenditure schedule

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.6.2! Inflation$Expenditure$Gap$$ 16.6.2.1!Inflationary Expenditure Gap: The amount by which an economy’s aggregate expenditures at the full employment GDP, exceed those just necessary to achieve the full-employment GDP i.! Vertical distance between the actual aggregate expenditure schedule and the hypothetical schedule which would just be sufficient to achieve full employment GDP •! The amount by which the aggregate expenditure schedule would have to shift downward to realize equilibrium at the full employment GDP ii.! The excessive spending will pull up the output prices iii.! Rise of nominal GDP due to higher prices, yet no increase in GDP •! Excessive total spending causes inflation

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] !

16.7! Limitations$of$the$Model$$ 16.7.1.1!Does not show price-level changes$ i.!

Does account for demand pull inflation, yet not how much the price level will rise when aggregate expenditure are extreme relative to the economy’s capacity •! No ways of measuring the rate of inflation 16.7.1.2!Ignores permanent demand-pull inflation i.! Does not explain why demand-pull inflation can occur before reaching full employment 16.7.1.3!Limits real GDP to the full-employment level of output 16.7.1.4!Does not deal with cost-push inflation 16.7.1.5!Does not allow for self-correction

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16.8! Definitions$$ i.!

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Planned Investment: Spending by firms to acquire capital goods and inventories. It is distinguished from unplanned (unexpected) investments which tie up cash in slow moving or unsaleable inventory of finished goods or merchandise. Investment Schedule: schedule that depicts the relationship between INVESTMENT and the level of NATIONAL INCOME. In the short and medium term, the investment schedule would tend to have a positive slope and a positive intercept with the vertical axis, Aggregate Expenditure schedule: Components of Aggregate Expenditure (AE) - defined as the total amount that firms and households plan to spend on goods and services at each level of income. Also, it can be seen that the aggregate expenditure is the sum of expenditures on consumption, investment, government expenses and net exports. Equilibrium GDP: Equilibrium GDP is that output level at which the total amount of goods produced, GDP, is just equal to the total amount of goods purchased. In a world with no government or foreign sector, the amount purchased is C + Ig. Leakage: a leakage is a diversion of funds from some iterative process. For example, in the Keynesian depiction of the circular flow of income and expenditure, leakages are the non-consumption uses of income, including saving, taxes, and imports.

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EKN 120 Chapter 16 Méhan van Huyssteen [email protected] [email protected] ! vi.!

vii.!

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Injection: iinjections means introduction of income into the flow. When households and firms borrow the savings, they constitute injections. I injections increase the flow of income. Injections can take the forms of (a) investment, (b) government spending and (c) exports. So long as leakages are equal to injections circular flow of income ... Recessionary-Expenditure Gap: the amount at which aggregate expenditures – full employment GDP – fall short of those required to achieve to full employment GDP Inflationary-Expenditure Gap: The amount by which an economy’s aggregate expenditures at the full employment GDP, exceed those just necessary to achieve the full-employment GDP

Bibliography J. Janse van Rensburg, C. M. (2015). ECONOMICS - Second South-African Edition (Vol. 2). Maidenhead, Berkshire, UK: McGraw Hill Education. All Definitions are from Investopedia ! ! ! !

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