, Sixth Edition
Fundamental Question Review
Income and Expenditures Equilibrium
- What does equilibrium mean in macroeconomics?
Equilibrium means that plans and reality coincide, and therefore people have no need to change their behavior. When aggregate expenditures are equal to income, people are planning to buy all that is currently being produced. Inventories stay at the level at which producers like to see them, so there is no need to increase or decrease production. Equilibrium is reached.
- How do aggregate expenditures affect income or real GDP?
Saying that aggregate expenditures exceed real GDP is the same as saying that planned expenditures exceed current output. If people are planning to buy more output than is currently being produced, the goods must come from somewhere. Producers replace their stock from inventories, and inventories fall. Since producers like to see a certain level of inventory, when inventories fall, producers increase production, increasing real GDP.
If aggregate expenditures are less than real GDP, it means that people are planning to buy fewer goods and services than are currently being produced. Since not all goods and services will be sold, inventories will pile up. When producers see inventories building up, they decrease production, and real GDP falls.
- What are the leakages from and injections to spending?
Another way to determine macroeconomic equilibrium is to find where leakages from spending equal injections into spending. If injections are greater than leakages, aggregate expenditures are greater than real GDP. Inventories will fall, production will increase, and the increase in production leads to higher real GDP. If leakages are greater than injections, people are not planning to buy all the output that is produced. Inventories build up, production decreases, and real GDP falls.
Leakages reduce autonomous expenditures. Saving is a leakage from spending. The more households save, the less they spend. Less household spending means less consumption, and consumption is one of the components of aggregate demand. Taxes transfer income away from households, forcing them to consume less, and are another leakage from spending. Imports reduce spending on domestic goods and services, and constitute the third leakage from spending.
Injections into spending parallel the leakages. The saving of households is used by businesses for investment, which increases aggregate expenditures. The taxes collected by the government finance government spending, another component of aggregate expenditures. Besides U.S. spending on foreign goods, there is also foreign spending on U.S. goods. Exports also increase aggregate expenditures.
- Why does equilibrium real GDP change by a multiple of a change in autonomous expenditures?
The basic reason is that the change in expenditures becomes income for someone, who spends part of it and saves part of it. The part that the person spends becomes income to someone else, who saves part and spends part, and so on. To see how this works, let's assume that businesses decide to increase investment by $50 this year. Assume that the MPC is .75 and that this is a closed economy: exports and imports are both equal to zero. During the first round, the increase in investment is income to someone, so income increases by $50. The initial increase in income of $50 induces an increase in consumption of $37.50 (.75 x $50) and an increase in saving of $12.50 (.25 x $50). The $37.50 spent on domestic goods and services becomes income to someone else, who spends $28.13 (.75 x $37.50) and saves $9.38 (.25 x $37.50). The spiral continues, and the increases to income get smaller and smaller. In this example, all the increases in income sum to $200: four times the original increase in autonomous spending.
|Round||Increase inReal GDP||Increase in Consumption||Increase in Saving|
|1-Increase in I of $50||$ 50||$ 37.5 = .75($50)||$12.5|
|2||$ 37.5||$ 28.125 = .75($37.5)||$ 9.375|
|3||$ 28.125||$ 21.09375||$ 7.03125|
|4||$ 21.09375||$ 15.820312||$ 5.273438|
- What is the spending multiplier?
The spending multiplier measures the change in real GDP produced by a change in autonomous expenditures, and is equal to 1/(MPS + MPI).
- What is the relationship between the GDP gap and the recessionary gap?
The GDP gap is the difference between equilibrium GDP and potential GDP. It tells us the change in real GDP needed to get to potential GDP. The recessionary gap tells us the change in autonomous expenditures that is necessary to close the GDP gap.
- How does international trade affect the size of the multiplier?
The simple multiplier understates the true multiplier because it does not take into account the foreign repercussions of domestic spending. If Americans spend money on foreign goods, foreign incomes increase. The increase in foreign incomes increases U.S. exports, but the change in exports is not picked up by the simple multiplier.
- Why does the aggregate expenditures curve shift with changes in the price level?
The aggregate expenditures curve shifts with changes in the price level because of the wealth effect, interest rate effect, and international trade effect. When prices rise, purchasing power falls. Since wealth is a determinant of consumption, consumption falls. Likewise, an increase in prices tends to increase interest rates, and this increase lowers investment spending. Finally, an increase in domestic prices makes domestic goods expensive for foreigners and thus decreases exports. Since consumption, investment, and net exports are all components of aggregate expenditures, aggregate expenditures fall.