Economics NINTH EDITION Chapter 11 The Income-Expenditure Model Prepared by Brock Williams Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 11.1 A SIMPLE INCOME-EXPENDITURE MODEL (1 of 3) 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 11.1 A SIMPLE INCOME-EXPENDITURE MODEL (2 of 3) Equilibrium Output At equilibrium output y*, total demand y* equals output y* • Planned expenditures Another term for total demand for goods and services • Equilibrium output The level of GDP at which planned expenditure equals the amount that is produced equilibrium output = y* = C + I = planned expenditures Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 11.1 A SIMPLE INCOME-EXPENDITURE MODEL (3 of 3) 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 11.2 THE CONSUMPTION FUNCTION (2 of 3) Consumer Spending and Income The consumption function relates desired consumer spending to the level of income Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved ▼FIGURE 11.5 Moments of the Consumption Function Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 11.2 THE CONSUMPTION FUNCTION (3 of 3) 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION FALLING HOME PRICES, THE WEALTH EFFECT, AND DECREASED CONSUMER SPENDING APPLYING THE CONCEPTS #1: How 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 11.5 Exports and imports (2 of 2) Output is determined when the demand for domestic goods equals output Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved ▼FIGURE 11.13 How Increases in Exports and Imports Affect U.S GDP Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPLICATION THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A COUNTRY’S OUTPUT APPLYING THE CONCEPTS #4: How 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 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 Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved KEY TERMS Autonomous consumption Consumption function Equilibrium output Marginal propensity to consume (MPC) Marginal propensity to import Planned expenditures Savings function Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) Formula for Equilibrium Output Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (1 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) The Multiplier for Investment For the original level of investment at I0, we have For a new level of investment at I1, we have Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (2 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) The Multiplier for Investment Substituting for the levels of output, we have Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (3 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) The Multiplier for Investment Finally, because (I1 − I0) is the change in investment, ΔI, we can write Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (4 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) 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: Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (5 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) Government Spending and Taxes Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (6 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) 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: Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (7 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) Balanced-Budget Multiplier Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (8 APPENDIX a FORMULAS FOR EQUILIBRIUM INCOME AND THE MULTIPLIER of 9) Equilibrium Output with Government Spending, Taxes, and the Foreign Sector Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved (9 ... 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... demand and production would fall If output were lower (y2), it would fall short of demand and production would rise Copyright © 2017, 2015, 2012 Pearson Education, Inc All Rights Reserved 11. 2... Reserved 11. 1 A SIMPLE INCOME-EXPENDITURE MODEL (2 of 3) Equilibrium Output At equilibrium output y*, total demand y* equals output y* • Planned expenditures Another term for total demand for goods and