# Economics principles tools and applications 9th by sullivan sheffrin perez chapter 11

Economics

NINTH EDITION

Chapter 11

The
Income-Expenditure
Model
Prepared by Brock Williams

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.

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.

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

11.1 A SIMPLE INCOME-EXPENDITURE MODEL (3 of 3)
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.

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.

11.2 THE CONSUMPTION FUNCTION (2 of 3)

Consumer Spending and Income
The consumption function relates desired consumer spending
to the level of income.

▼FIGURE 11.5
Moments of the Consumption Function

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.

APPLICATION 1

FALLING HOME PRICES, THE WEALTH EFFECT, AND DECREASED CONSUMER SPENDING
APPLYING THE CONCEPTS #1: How do 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.

11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (1 of 4)

Equilibrium output is determined where the C + I line intersects the 45° line.

At that level of output, y*, desired spending equals output.

11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (2 of 4)
Saving and Investment

Savings function
The relationship between the level of saving and the level of income.

S=y−C

y=C+I

y−C=I

S=I

11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (3 of 4)
Saving and Investment
Equilibrium output is determined at the level of output, y*, where savings
equals investment.

11.3 EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION (4 of 4)
Understanding the Multiplier
When investment increases from I0 to I1, equilibrium output increases from y0
to y1.
The change in output (Δy) is greater than the change in investment (ΔI).

APPLICATION 2

MULTIPLIERS IN GOOD TIMES AND BAD
APPLYING THE CONCEPTS #2: Are multipliers for government spending higher during recessions?

A common belief is that fiscal multipliers are larger during recessions, when there is more slack in the economy. But, it is quite difficult to estimate
government multipliers accurately.

Valerie Ramey and Sarah Zubiary find no evidence of greater multipliers during slack times in the U.S.

Daniel Riera-/Crichton, Carlos Veigh, and Guillermo Vuletin found different results. By carefully looking at periods when both government spending increased
and the economy had slower or negative growth, they found the multiplier to be 2.3. This is larger than conventionally calculated multipliers.

11.4 GOVERNMENT SPENDING
AND TAXATION (1 of 5)

Fiscal Multipliers

Planned expenditures including government = C + I +

G

11.4 GOVERNMENT SPENDING
AND TAXATION (2 of 5)

Fiscal Multipliers

The consumption function with taxes is

The formula for the tax multiplier is

11.4 GOVERNMENT SPENDING
AND TAXATION (3 of 5)
Using Fiscal Multipliers
Although it is very simple, our income-expenditure model illustrates some important lessons:

An increase in government spending will increase total planned expenditures for goods and services.

Cutting taxes will increase the after-tax income of consumers and will also lead to an increase in planned expenditures for goods and services.

Policymakers need to take into account the multipliers for government spending and taxes as they develop policies.

In the long run, of course, we are better off if government spends the money wisely, such as on needed infrastructure such as roads and bridges. This is an
example of the principle of opportunity cost.

PRINCIPLE OF OPPORTUNITY COST
The opportunity cost of something is what you sacrifice to get it.

APPLICATION 3

THE BROKEN WINDOW FALLACY AND KENSESIAN ECONOMICS
APPLYING THE CONCEPTS #3: How does Keynesian Economics change our normal ideas of economic scarcity?

Austrian economist, Henry Hazlitt, popularized the “Broken Windows” fallacy in economics. Imagine that a hoodlum threw a brick through a store window. While at first this
seems to be a tragedy, the store owner has to hire a firm to fix the window. That generates business for the window repair firm and, through a multiplier, additional business
throughout the community. Was the broken window good for society?

The fallacy here is that the money that the store owner paid to have the window repaired would have been spent elsewhere in the economy, say on clothing.

Hazlitt applies a similar argument to public spending financed by taxes. A government spending program may appear to increase business, but the taxes needed to finance
the spending—either paid now or in the future—will mean less business for other firms. Government spending and the taxes necessary to finance it will just crowd out other
production of goods and services in the economy.

But in the Keynesian world, where resources are underemployed, the story is quite different. Here the increase in spending—even financed by taxes—will bring resources
that are not being utilized into the economy. As long as there is excess capacity in the economy, the extra spending will increase output and not crowd out other goods and
services.

11.4 GOVERNMENT SPENDING
AND TAXATION (4 of 5)
Understanding Automatic Stabilizers
After World War II, fluctuations in GDP growth became
considerably smaller.

SOURCE: Angus Maddison, Dynamic Forces in Capitalist Development (New York: Oxford University Press, 1991); U.S. Department of Commerce.

11.4 GOVERNMENT SPENDING
AND TAXATION (5 of 5)
Understanding Automatic Stabilizers
C = Ca + b(1 − t)y
adjusted MPC = b(1 − t)

An increase in tax rates decreases the slope of the C + I + G line.

This lowers output and reduces the multiplier.

11.5 Exports and imports (1 of 2)

To modify our model to include the effects of world spending on exports and U.S. spending on imports, we need to take two steps:

1.

Add exports, X, as another source of demand for U.S. goods and services.

2.

Subtract imports, M, from total spending by U.S. residents. We will assume that imports, like consumption, increase with the level of income.
M = my

•.

Marginal propensity to import
The fraction of additional income that is spent on imports.

11.5 Exports and imports (2 of 2)

Output is determined when the demand for domestic goods
equals output.

▼FIGURE 11.13
How Increases in Exports and Imports Affect U.S. GDP

APPLICATION 4

THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND AFFECTS A COUNTRY’S OUTPUT
APPLYING THE CONCEPTS #4: How do 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.