This document provides an overview of a basic macroeconomic model for determining GDP in the short-run. It explains that GDP is determined by aggregate expenditure, which includes consumption, investment, government spending, and net exports. Consumption depends on disposable income and wealth, while investment depends on interest rates and business confidence. Equilibrium GDP occurs when aggregate expenditure equals total output.
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2 determination of gdp in the short run
1. A Basic Model of the
Determination of GDP in the
Short Term
Chapter 16
2. Learning Outcomes
The macroeconomic theory that we now study
explains the deviation of actual from potential
GDP, that is the GDP gap.
The determination of GDP in the short run depends
on the behaviour of key categories of aggregate
spending: consumption, investment, government
spending, and net exports.
3. Learning Outcomes
Consumption spending depends on disposable income
and wealth.
Investment spending depends on real interest rates
and business confidence.
A necessary condition for GDP to be in equilibrium is
that desired domestic spending equals actual output.
4. What Determines Aggregate Expenditure
Desired aggregate expenditure includes desired
consumption, desired investment, and desired
government expenditures, plus desired net
exports.
It is the amount that economic agents want to
spend on purchasing the national product.
In this chapter we consider only consumption and
investment.
A BASIC MODEL OF THE DETERMINATION OF GDP
5. What Determines Aggregate Expenditure
A change in personal disposable income leads to a
change in private consumption and saving.
The responsiveness of these changes is measured
by the marginal propensity to consume [MPC] and
the marginal propensity to save [MPS], which are
both positive and sum to one.
This indicates that, by definition, all disposable
income is either spent on consumption or saved.
A BASIC MODEL OF THE DETERMINATION OF GDP
6. A change in wealth tends to cause a change in the
allocation of disposable income between
consumption and saving. The change in
consumption is positively related to the change in
wealth, while the change in saving is negatively
related to this change.
Consumption is negatively related to change in
interest rates.
A BASIC MODEL OF THE DETERMINATION OF GDP
7. Investment consists of inventory accumulation,
residential housing construction and business fixed
capital formation.
Investment depends, among other things, on real
interest rates and business confidence.
Higher the interest rates lower the level of desired
inventory of goods and material, lower the spending
for residential construction and lower the investment
in fixed capital.
Current profits which largely finance capital formation
are an important determinant of investment
In our simple theory investment is treated as
autonomous, or exogenous, as is the constant term in
the consumption function, called autonomous
consumption.
The part of consumption that responds to changes in
income is called induced spending.
A BASIC MODEL OF THE DETERMINATION OF GDP
8. Equilibrium GDP
At the equilibrium level of GDP, purchasers wish
to buy exactly the amount of national output that
is being produced.
At GDP above equilibrium, desired expenditure
falls short of national output, and output will
sooner or later be curtailed.
A BASIC MODEL OF THE DETERMINATION OF GDP
9. Equilibrium GDP
At GDP below equilibrium, desired expenditure
exceeds national output, and output will sooner or
later be increased.
In a closed economy with no government, desired
saving equals desired investment at equilibrium
GDP.
A BASIC MODEL OF THE DETERMINATION OF GDP
10. Equilibrium GDP is represented
graphically by the point at which the
aggregate expenditure curve cuts the 450
line, that is, where total desired
expenditure equals total output.
This is the same level of GDP at which
the saving function intersects the
investment function.
A BASIC MODEL OF THE DETERMINATION OF GDP
11. Changes in GDP
With a constant price level, equilibrium
GDP is increased by a rise in the desired
consumption or investment expenditure
that is associated with each level of
national income.
Equilibrium GDP is decreased by a fall in
desired spending.
A BASIC MODEL OF THE DETERMINATION OF GDP
12. Changes in GDP
The magnitude of the effect on GDP of
shifts in autonomous expenditure is given
by the multiplier.
It is defined as K = Y/A, where A is the
change in autonomous spending and Y
the resulting increase in GDP.
A BASIC MODEL OF THE DETERMINATION OF GDP
13. The simple multiplier is the multiplier
when the price level is constant.
It is equal to 1/[1 - z], where z is the
marginal propensity to spend out of
national income.
Thus the larger z is, the larger is the
multiplier. It is a basic prediction of
macroeconomics that the simple
multiplier, relating £1 worth of increased
spending on domestic output to the
resulting increase in GDP, is greater than
unity.
A BASIC MODEL OF THE DETERMINATION OF GDP
15. A trough is characterized by high
unemployment and a level of demand that is
low in relation to the economy’s capacity to
produce.
Recovery is characterised by run down
equipment being replaced, employment,
income and consumer spending all beginning
to rise and expectations becoming more
favorable.
A peak is the top of a cycle. At the peak
existing capacity is utilized to a high degree.
Recession is defined as a fall in real GDP for
two quarters in succession. It is a phase of
downturn in economic activity.
17. 500 1000 1500
450
450
2000
500
1000
1500
2000
(i). Consumption Function [£ million]
Real Disposable Income
C S
500 1000 1500 2000
The Consumption and Saving Functions
-500
-100
0
250
500
Real Disposable Income
(ii). Saving Function [£ million]
Note: Initially, at zero income consumers are drawing down on existing
savings / assets .
19. The consumption and saving
functions
Both consumption and saving rise as disposable
income rises.
Line C relates desired consumption to disposable
income.
Its slope is the marginal propensity to consume (MPC).
Saving is all disposable income that is not spent on
consumption.
The relationship between disposable income and
desired saving is shown by line S.
20. The consumption and saving
functions
Its slope is the marginal propensity to save (MPS).
Any given amount of disposable income must be
accounted for by consumption plus saving.
Consumption and saving schedules (Table) show
the numerical values of desired consumption and
saving at each level of income, and correspond to
the C and S lines in the figure.
22. 1000 2000 3000 4000
1000
2000
3000
Real National Income Function [GDP] [£m]
350
An Aggregate Expenditure Function
4000
5000
AE
5000
23. An aggregate expenditure function
The aggregate expenditure function relates total
desired expenditure to national income.
Here desired expenditure is the sum of desired
consumption and desired investment.
It is assumed that desired investment is £250
million while consumption is £100 million plus 0.8
times income.
So when income is zero there is autonomous
expenditure of £350 million.
The marginal propensity to spend is 0.8.
25. 0
1000 2000
1000
2000
3000
Real National Income [GDP] [£m]
350
[i]. An Aggregate Expenditure Function[AE = Y]
3000
450
450
[AE = Y]
S
I
[ii]. Saving Function[S = I]
Real National Income [GDP] [£m]
3000
2000
1000
500
-100
-500
0
Desired
saving
(£m)
250
Y0
Equilibrium GDP
Y0
E0
26. GDP is in equilibrium where aggregate desired
expenditure (AE) equals national output.
In the figure equilibrium GDP occurs at E0 where
AE intersects the 450 line.
If GDP is below Y0 desired AE will exceed national
output and production will rise.
Equilibrium GDP
27. If GDP is above Y0 desired AE will be less than
national output and production will fall.
When saving is the only withdrawal and
investment is the only injection, the equilibrium
level of GDP is also that where saving equals
investment.
Equilibrium GDP
31. The simple multiplier
An increase in the autonomous component of
desired aggregate expenditure increases
equilibrium GDP by a multiple of the initial
increase.
The initial equilibrium is at E0, where AE0
intersects the 450 line. Here desired
expenditure equals national output.
32. The simple multiplier
An increase in autonomous expenditure of A
then shifts the AE function up to AE1.
Because desired spending is now greater that
output, production and GDP will rise.
Equilibrium occurs when GDP rises to Y1.
Here desired expenditure e1 equals output Y1.
35. A numerical example of the multiplier
Assuming that the marginal propensity to
spend out of national income is 0.8 and there
is an autonomous expenditure increase of
£100m.
National income and output initially rises by
£100m.
36. A numerical example of the multiplier
Those receiving £100m in income then spend
£80m.
This £80m of income leads to further spending
of £64m.
This £64m of income lead to a further increase
in spending of £51.2m.
If we carry on this process it will converge to
an extra income and output totalling £500m.
The multiplier in this case is 5.
37. A BASIC MODEL OF THE DETERMINATION
OF GDP
The macroeconomic problem: inflation and
unemployment
Models of the short-term determination of GDP
explain why actual GDP deviates from potential GDP.
Actual GDP above potential can be associated with
inflation, while actual GDP below potential is
associated with unemployment and lost output.
38. A BASIC MODEL OF THE DETERMINATION
OF GDP
Key Assumptions
For simplicity we aggregate all industrial sectors into
one, so the economy produces only one type of
output good.
We explain GDP determination through the major
expenditure categories: private consumption,
investment, government consumption, and net
exports.