PRINCIPLES OF

MACROECONOMICS

PART III The Core of Macroeconomic Theory

TENTH

EDITION

CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Prepared by: Fernando Quijano & Shelly

1 ofTefft

11

PART III The Core of Macroeconomic Theory

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

2 of 41

III

PART

PART III The Core of Macroeconomic Theory

The Core of

Macroeconomic

Theory

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

3 of 41

The level of GDP, the overall price level, and the level of employment

—three chief concerns of macroeconomists—are influenced by events

in three broadly defined “markets”:

PART III The Core of Macroeconomic Theory

Goods-and-services market

Financial (money) market

Labor market

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

4 of 41

PART III The Core of Macroeconomic Theory

FIGURE III.1 The Core of Macroeconomic Theory

We build up the macroeconomy slowly.

In Chapters 8 and 9, we examine the market for goods and services.

In Chapters 10 and 11, we examine the money market.

Then in Chapter 12, we bring the two markets together, in so doing explaining the links between

aggregate output (Y) and the interest rate (r), and derive the aggregate demand curve.

In Chapter 13, we introduce the aggregate supply curve and determine the price level (P).

We then explain in Chapter 14 how the labor market fits into the macroeconomic picture.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

5 of 41

Aggregate

Expenditure and

Equilibrium Output

8

CHAPTER OUTLINE

The Keynesian Theory of Consumption

Other Determinants of Consumption

Planned Investment (I)

The Determination of Equilibrium Output (Income)

The Saving/Investment Approach to Equilibrium

Adjustment to Equilibrium

PART III The Core of Macroeconomic Theory

The Multiplier

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

The Multiplier Equation

The Size of the Multiplier in the Real World

Looking Ahead

Appendix: Deriving the Multiplier Algebraically

6 of 41

aggregate output The total quantity of goods and services produced

(or supplied) in an economy in a given period.

PART III The Core of Macroeconomic Theory

aggregate income The total income received by all factors of

production in a given period.

In any given period, there is an exact equality between aggregate output

(production) and aggregate income. You should be reminded of this fact

whenever you encounter the combined term aggregate output (income) (Y).

aggregate output (income) (Y) A combined term used to remind you

of the exact equality between aggregate output and aggregate income.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

7 of 41

The Keynesian Theory of Consumption

consumption function The relationship between consumption and income.

FIGURE 8.1 A Consumption

Function for a Household

PART III The Core of Macroeconomic Theory

A consumption function for an

individual household shows the

level of consumption at each

level of household income.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

8 of 41

PART III The Core of Macroeconomic Theory

To explain aggregate spending behavior, economists speculate

that an increase in aggregate income in a given period will result in

an increase in aggregate consumption in all of the following

instances, except:

a.

When household wealth increases.

b.

When interest rates rise.

c.

When households form positive expectations about the

future.

d.

None of the above. In all of the cases above, aggregate

consumption will rise.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

9 of 41

PART III The Core of Macroeconomic Theory

To explain aggregate spending behavior, economists speculate

that an increase in aggregate income in a given period will result in

an increase in aggregate consumption in all of the following

instances, except:

a.

When household wealth increases.

b.

When interest rates rise.

c.

When households form positive expectations about the

future.

d.

None of the above. In all of the cases above, aggregate

consumption will rise.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

10 of 41

The Keynesian Theory of Consumption

With a straight line consumption curve, we can use the following equation to

describe the curve:

C = a + bY

PART III The Core of Macroeconomic Theory

FIGURE 8.2 An Aggregate

Consumption

Function

The aggregate

consumption function

shows the level of aggregate

consumption at each level of

aggregate income.

The upward slope indicates that

higher levels of income lead to

higher levels of consumption

spending.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

11 of 41

The Keynesian Theory of Consumption

marginal propensity to consume (MPC) That fraction of a change in income

that is consumed, or spent.

marginal propensity to consume ≡ slope of consumption function ≡

∆C

∆Y

PART III The Core of Macroeconomic Theory

aggregate saving (S) The part of aggregate income that is not consumed.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

S≡Y–C

12 of 41

PART III The Core of Macroeconomic Theory

When aggregate consumption is plotted along a straight line, C = a

+ bY, an increase in income results in an increase in consumption

equal to:

a.

b.

b.

b times ΔY.

c.

a times ΔY.

d.

a + b.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

13 of 41

PART III The Core of Macroeconomic Theory

When aggregate consumption is plotted along a straight line, C = a

+ bY, an increase in income results in an increase in consumption

equal to:

a.

b.

b.

b times ΔY.

c.

a times ΔY.

d.

a + b.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

14 of 41

The Keynesian Theory of Consumption

identity Something that is always true.

marginal propensity to save (MPS) That fraction of a change in income that

is saved.

MPC + MPS ≡ 1

PART III The Core of Macroeconomic Theory

Because the MPC and the MPS are important concepts, it may help to review

their definitions.

The marginal propensity to consume (MPC) is the fraction of an increase in

income that is consumed (or the fraction of a decrease in income that comes

out of consumption).

The marginal propensity to save (MPS) is the fraction of an increase in income

that is saved (or the fraction of a decrease in income that comes out of saving).

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

15 of 41

The Keynesian Theory of Consumption

FIGURE 8.3 The Aggregate

Consumption Function Derived from the

Equation C = 100 + .75Y

In this simple consumption function,

consumption is 100 at an income of

zero.

As income rises, so does

consumption.

For every 100 increase in income,

consumption rises by 75.

The slope of the line is .75.

PART III The Core of Macroeconomic Theory

Aggregate

Income, Y

Aggregate

Consumption, C

0

100

80

160

100

175

200

250

400

400

600

550

800

700

1,000

850

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

16 of 41

The Keynesian Theory of Consumption

FIGURE 8.4 Deriving the Saving Function

from the Consumption Function in Figure 8.3

PART III The Core of Macroeconomic Theory

Because S ≡ Y – C, it is easy to derive the

saving function from the consumption

function.

A 45° line drawn from the origin can be

used as a convenient tool to compare

consumption and income graphically.

At Y = 200, consumption is 250.

The 45° line shows us that consumption is

larger than income by 50.

Thus, S ≡ Y – C = −50.

At Y = 800, consumption is less than

income by 100.

Thus, S = 100 when Y = 800.

C

=

S

Y

−

AGGREGATE

AGGREGATE

AGGREGATE

CONSUMPTION

SAVING

INCOME

0

100

-100

80

160

-80

100

175

-75

200

250

-50

400

400

0

600

550

50

800

700

100

1,000

850

150

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

17 of 41

PART III The Core of Macroeconomic Theory

Fill in the blanks. Where the consumption function is below the 45°

line, consumption is ________ than income, and saving is

________.

a.

more; positive

b.

more; negative

c.

less; positive

d.

less; negative

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

18 of 41

PART III The Core of Macroeconomic Theory

Fill in the blanks. Where the consumption function is below the 45°

line, consumption is ________ than income, and saving is

________.

a.

more; positive

b.

more; negative

c.

less; positive

d.

less; negative

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

19 of 41

The Keynesian Theory of Consumption

Other Determinants of Consumption

The assumption that consumption depends only on income is obviously

a simplification.

PART III The Core of Macroeconomic Theory

In practice, the decisions of households on how much to consume in a

given period are also affected by their wealth, by the interest rate, and

by their expectations of the future.

Households with higher wealth are likely to spend more, other things

being equal, than households with less wealth.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

20 of 41

E C O N O M I C S I N PRACTI C E

Behavioral Biases in Saving Behavior

PART III The Core of Macroeconomic Theory

Economists have generally

assumed that people make their

saving decisions rationally, just as

they make other decisions about

choices in consumption and the

labor market.

Saving decisions involve thinking

about trade-offs between present

and future consumption.

Recent work in behavioral

economics has highlighted the role of psychological biases in saving behavior

and has demonstrated that seemingly small changes in the way saving

programs are designed can result in big behavioral changes.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

21 of 41

Planned Investment (I)

planned investment (I) Those additions to capital stock and

inventory that are planned by firms.

actual investment The actual amount of investment that takes

place; it includes items such as unplanned changes in inventories.

PART III The Core of Macroeconomic Theory

FIGURE 8.5 The Planned Investment

Function

For the time being, we will assume

that planned investment is fixed.

It does not change when income

changes, so its graph is a

horizontal line.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

22 of 41

The Determination of Equilibrium Output (Income)

equilibrium Occurs when there is no tendency for change. In

the macroeconomic goods market, equilibrium occurs when

planned aggregate expenditure is equal to aggregate output.

PART III The Core of Macroeconomic Theory

planned aggregate expenditure (AE) The total amount the

economy plans to spend in a given period. Equal to

consumption plus planned investment: AE ≡ C + I.

Y>C+I

aggregate output > planned aggregate expenditure

C+I>Y

planned aggregate expenditure > aggregate output

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

23 of 41

The Determination of Equilibrium Output (Income)

TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium.

The Figures in Column 2 Are Based on the Equation C = 100 + .75Y.

(1)

(2)

(3)

(4)

(5)

(6)

PART III The Core of Macroeconomic Theory

Unplanned

Planned

Inventory

Aggregate

Aggregate

Output

Aggregate

Planned

Expenditure (AE) Change

Equilibrium?

Y − (C + I)

(Income) (Y) Consumption (C) Investment (I)

C+I

(Y = AE?)

100

175

25

200

− 100

No

200

250

25

275

− 75

No

400

400

25

425

− 25

No

500

475

25

500

0

Yes

600

550

25

575

+ 25

No

800

700

25

725

+ 75

No

1,000

850

25

875

+ 125

No

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

24 of 41

The Determination of Equilibrium Output (Income)

FIGURE 8.6 Equilibrium

Aggregate Output

PART III The Core of Macroeconomic Theory

Equilibrium occurs when

planned aggregate expenditure

and aggregate output are equal.

Planned aggregate expenditure

is the sum of consumption

spending and planned

investment spending.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

25 of 41

MACROECONOMICS

PART III The Core of Macroeconomic Theory

TENTH

EDITION

CASE FAIR OSTER

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

Prepared by: Fernando Quijano & Shelly

1 ofTefft

11

PART III The Core of Macroeconomic Theory

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

2 of 41

III

PART

PART III The Core of Macroeconomic Theory

The Core of

Macroeconomic

Theory

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

3 of 41

The level of GDP, the overall price level, and the level of employment

—three chief concerns of macroeconomists—are influenced by events

in three broadly defined “markets”:

PART III The Core of Macroeconomic Theory

Goods-and-services market

Financial (money) market

Labor market

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

4 of 41

PART III The Core of Macroeconomic Theory

FIGURE III.1 The Core of Macroeconomic Theory

We build up the macroeconomy slowly.

In Chapters 8 and 9, we examine the market for goods and services.

In Chapters 10 and 11, we examine the money market.

Then in Chapter 12, we bring the two markets together, in so doing explaining the links between

aggregate output (Y) and the interest rate (r), and derive the aggregate demand curve.

In Chapter 13, we introduce the aggregate supply curve and determine the price level (P).

We then explain in Chapter 14 how the labor market fits into the macroeconomic picture.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

5 of 41

Aggregate

Expenditure and

Equilibrium Output

8

CHAPTER OUTLINE

The Keynesian Theory of Consumption

Other Determinants of Consumption

Planned Investment (I)

The Determination of Equilibrium Output (Income)

The Saving/Investment Approach to Equilibrium

Adjustment to Equilibrium

PART III The Core of Macroeconomic Theory

The Multiplier

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

The Multiplier Equation

The Size of the Multiplier in the Real World

Looking Ahead

Appendix: Deriving the Multiplier Algebraically

6 of 41

aggregate output The total quantity of goods and services produced

(or supplied) in an economy in a given period.

PART III The Core of Macroeconomic Theory

aggregate income The total income received by all factors of

production in a given period.

In any given period, there is an exact equality between aggregate output

(production) and aggregate income. You should be reminded of this fact

whenever you encounter the combined term aggregate output (income) (Y).

aggregate output (income) (Y) A combined term used to remind you

of the exact equality between aggregate output and aggregate income.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

7 of 41

The Keynesian Theory of Consumption

consumption function The relationship between consumption and income.

FIGURE 8.1 A Consumption

Function for a Household

PART III The Core of Macroeconomic Theory

A consumption function for an

individual household shows the

level of consumption at each

level of household income.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

8 of 41

PART III The Core of Macroeconomic Theory

To explain aggregate spending behavior, economists speculate

that an increase in aggregate income in a given period will result in

an increase in aggregate consumption in all of the following

instances, except:

a.

When household wealth increases.

b.

When interest rates rise.

c.

When households form positive expectations about the

future.

d.

None of the above. In all of the cases above, aggregate

consumption will rise.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

9 of 41

PART III The Core of Macroeconomic Theory

To explain aggregate spending behavior, economists speculate

that an increase in aggregate income in a given period will result in

an increase in aggregate consumption in all of the following

instances, except:

a.

When household wealth increases.

b.

When interest rates rise.

c.

When households form positive expectations about the

future.

d.

None of the above. In all of the cases above, aggregate

consumption will rise.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

10 of 41

The Keynesian Theory of Consumption

With a straight line consumption curve, we can use the following equation to

describe the curve:

C = a + bY

PART III The Core of Macroeconomic Theory

FIGURE 8.2 An Aggregate

Consumption

Function

The aggregate

consumption function

shows the level of aggregate

consumption at each level of

aggregate income.

The upward slope indicates that

higher levels of income lead to

higher levels of consumption

spending.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

11 of 41

The Keynesian Theory of Consumption

marginal propensity to consume (MPC) That fraction of a change in income

that is consumed, or spent.

marginal propensity to consume ≡ slope of consumption function ≡

∆C

∆Y

PART III The Core of Macroeconomic Theory

aggregate saving (S) The part of aggregate income that is not consumed.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

S≡Y–C

12 of 41

PART III The Core of Macroeconomic Theory

When aggregate consumption is plotted along a straight line, C = a

+ bY, an increase in income results in an increase in consumption

equal to:

a.

b.

b.

b times ΔY.

c.

a times ΔY.

d.

a + b.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

13 of 41

PART III The Core of Macroeconomic Theory

When aggregate consumption is plotted along a straight line, C = a

+ bY, an increase in income results in an increase in consumption

equal to:

a.

b.

b.

b times ΔY.

c.

a times ΔY.

d.

a + b.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

14 of 41

The Keynesian Theory of Consumption

identity Something that is always true.

marginal propensity to save (MPS) That fraction of a change in income that

is saved.

MPC + MPS ≡ 1

PART III The Core of Macroeconomic Theory

Because the MPC and the MPS are important concepts, it may help to review

their definitions.

The marginal propensity to consume (MPC) is the fraction of an increase in

income that is consumed (or the fraction of a decrease in income that comes

out of consumption).

The marginal propensity to save (MPS) is the fraction of an increase in income

that is saved (or the fraction of a decrease in income that comes out of saving).

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

15 of 41

The Keynesian Theory of Consumption

FIGURE 8.3 The Aggregate

Consumption Function Derived from the

Equation C = 100 + .75Y

In this simple consumption function,

consumption is 100 at an income of

zero.

As income rises, so does

consumption.

For every 100 increase in income,

consumption rises by 75.

The slope of the line is .75.

PART III The Core of Macroeconomic Theory

Aggregate

Income, Y

Aggregate

Consumption, C

0

100

80

160

100

175

200

250

400

400

600

550

800

700

1,000

850

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

16 of 41

The Keynesian Theory of Consumption

FIGURE 8.4 Deriving the Saving Function

from the Consumption Function in Figure 8.3

PART III The Core of Macroeconomic Theory

Because S ≡ Y – C, it is easy to derive the

saving function from the consumption

function.

A 45° line drawn from the origin can be

used as a convenient tool to compare

consumption and income graphically.

At Y = 200, consumption is 250.

The 45° line shows us that consumption is

larger than income by 50.

Thus, S ≡ Y – C = −50.

At Y = 800, consumption is less than

income by 100.

Thus, S = 100 when Y = 800.

C

=

S

Y

−

AGGREGATE

AGGREGATE

AGGREGATE

CONSUMPTION

SAVING

INCOME

0

100

-100

80

160

-80

100

175

-75

200

250

-50

400

400

0

600

550

50

800

700

100

1,000

850

150

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

17 of 41

PART III The Core of Macroeconomic Theory

Fill in the blanks. Where the consumption function is below the 45°

line, consumption is ________ than income, and saving is

________.

a.

more; positive

b.

more; negative

c.

less; positive

d.

less; negative

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

18 of 41

PART III The Core of Macroeconomic Theory

Fill in the blanks. Where the consumption function is below the 45°

line, consumption is ________ than income, and saving is

________.

a.

more; positive

b.

more; negative

c.

less; positive

d.

less; negative

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

19 of 41

The Keynesian Theory of Consumption

Other Determinants of Consumption

The assumption that consumption depends only on income is obviously

a simplification.

PART III The Core of Macroeconomic Theory

In practice, the decisions of households on how much to consume in a

given period are also affected by their wealth, by the interest rate, and

by their expectations of the future.

Households with higher wealth are likely to spend more, other things

being equal, than households with less wealth.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

20 of 41

E C O N O M I C S I N PRACTI C E

Behavioral Biases in Saving Behavior

PART III The Core of Macroeconomic Theory

Economists have generally

assumed that people make their

saving decisions rationally, just as

they make other decisions about

choices in consumption and the

labor market.

Saving decisions involve thinking

about trade-offs between present

and future consumption.

Recent work in behavioral

economics has highlighted the role of psychological biases in saving behavior

and has demonstrated that seemingly small changes in the way saving

programs are designed can result in big behavioral changes.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

21 of 41

Planned Investment (I)

planned investment (I) Those additions to capital stock and

inventory that are planned by firms.

actual investment The actual amount of investment that takes

place; it includes items such as unplanned changes in inventories.

PART III The Core of Macroeconomic Theory

FIGURE 8.5 The Planned Investment

Function

For the time being, we will assume

that planned investment is fixed.

It does not change when income

changes, so its graph is a

horizontal line.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

22 of 41

The Determination of Equilibrium Output (Income)

equilibrium Occurs when there is no tendency for change. In

the macroeconomic goods market, equilibrium occurs when

planned aggregate expenditure is equal to aggregate output.

PART III The Core of Macroeconomic Theory

planned aggregate expenditure (AE) The total amount the

economy plans to spend in a given period. Equal to

consumption plus planned investment: AE ≡ C + I.

Y>C+I

aggregate output > planned aggregate expenditure

C+I>Y

planned aggregate expenditure > aggregate output

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

23 of 41

The Determination of Equilibrium Output (Income)

TABLE 8.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium.

The Figures in Column 2 Are Based on the Equation C = 100 + .75Y.

(1)

(2)

(3)

(4)

(5)

(6)

PART III The Core of Macroeconomic Theory

Unplanned

Planned

Inventory

Aggregate

Aggregate

Output

Aggregate

Planned

Expenditure (AE) Change

Equilibrium?

Y − (C + I)

(Income) (Y) Consumption (C) Investment (I)

C+I

(Y = AE?)

100

175

25

200

− 100

No

200

250

25

275

− 75

No

400

400

25

425

− 25

No

500

475

25

500

0

Yes

600

550

25

575

+ 25

No

800

700

25

725

+ 75

No

1,000

850

25

875

+ 125

No

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

24 of 41

The Determination of Equilibrium Output (Income)

FIGURE 8.6 Equilibrium

Aggregate Output

PART III The Core of Macroeconomic Theory

Equilibrium occurs when

planned aggregate expenditure

and aggregate output are equal.

Planned aggregate expenditure

is the sum of consumption

spending and planned

investment spending.

© 2012 Pearson Education, Inc. Publishing as Prentice Hall

25 of 41

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