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Y. • When M, V, P, and Y are changing, then %ΔM + %ΔV = %ΔP + %ΔY, where • • Δ means “change in.” In the long run, V is constant, so %ΔV = 0. Furthermore, in the long run Y tends toward YP, so %ΔM = %ΔP. In the short run, V is not constant, so changes in the money supply can affect the level of income. T R Y I T! The Case in Point on velocity in the Confederacy during the Civil War shows that, assuming real GDP in the South was constant, velocity rose. What happened to money demand? Why did it change? 11.3 Monetary Policy and the Equation of Exchange 471 Chapter 11 Monetary Policy and the Fed Case in Point: Velocity and the Confederacy The Union and the Confederacy financed their respective efforts during the Civil War largely through the issue of paper money. The Union roughly doubled its money supply through this process, and the Confederacy printed enough “Confederates” to increase the money supply in the South 20-fold from 1861 to 1865. That huge increase in the money supply boosted the price level in the Confederacy dramatically. It rose from an index of 100 in 1861 to 9,200 in 1865. Estimates of real GDP in the South during the Civil War are unavailable, but it could hardly have increased very much. Although production undoubtedly rose early in the period, the South lost considerable capital and an appalling number of men killed in battle. Let us suppose that real GDP over the entire period remained constant. For the price level to rise 92-fold with a 20-fold increase in the money supply, there must have been a 4.6-fold increase in velocity. People in the South must have reduced their demand for Confederates. An account of an exchange for eggs in 1864 from the diary of Mary Chestnut illustrates how eager people in the South were to part with their Confederate money. It also suggests that other commodities had assumed much greater relative value: “She asked me 20 dollars for five dozen eggs and then said she would take it in “Confederate.” Then I would have given her 100 dollars as easily. But if she had taken my offer of yarn! I haggle in yarn for the millionth part of a thread! … When they ask for Confederate money, I never stop to chafer [bargain or argue
]. I give them 20 or 50 dollars cheerfully for anything.” Sources: C. Vann Woodward, ed., Mary Chestnut’s Civil War (New Haven, CT: Yale University Press, 1981), 749. Money and price data from E. M. Lerner, “Money, 11.3 Monetary Policy and the Equation of Exchange 472 Chapter 11 Monetary Policy and the Fed Prices, and Wages in the Confederacy, 1861–1865,” Journal of Political Economy 63 (February 1955): 20–40 People in the South must have reduced their demand for money. The fall in money demand was probably due to the expectation that the price level would continue to rise. In periods of high inflation, people try to get rid of money quickly because it loses value rapidly. 11.3 Monetary Policy and the Equation of Exchange 473 Chapter 11 Monetary Policy and the Fed 11.4 Review and Practice Summary Part of the Fed’s power stems from the fact that it has no legislative mandate to seek particular goals. That leaves the Fed free to set its own goals. In recent years, its primary goal has seemed to be the maintenance of an inflation rate below 2% to 3%. Given success in meeting that goal, the Fed has used its tools to stimulate the economy to close recessionary gaps. Once the Fed has made a choice to undertake an expansionary or contractionary policy, we can trace the impact of that policy on the economy. There are a number of problems in the use of monetary policy. These include various types of lags, the issue of the choice of targets in conducting monetary policy, political pressures placed on the process of policy setting, and uncertainty as to how great an impact the Fed’s policy decisions have on macroeconomic variables. We highlighted the difficulties for monetary policy if the economy is in or near a liquidity trap and discussed the use of quantitative easing and credit easing in such situations. If people have rational expectations and respond to those expectations in their wage and price choices, then changes in monetary policy may have no effect on real GDP. We saw in this chapter that the money supply is related to the level of nominal GDP by the equation of exchange. A crucial issue in that relationship is the stability of the velocity of money and of real GDP. If the velocity of money were constant, nominal GDP could change only if the money supply changed, and a change in the money supply would produce an equal percentage change in nominal GDP. If velocity were constant and real GDP were at
its potential level, then the price level would change by about the same percentage as the money supply. While these predictions seem to hold up in the long run, there is less support for them when we look at macroeconomic behavior in the short run. Nonetheless, policy makers must be mindful of these long-run relationships as they formulate policies for the short run. 474 Chapter 11 Monetary Policy and the Fed. Suppose the Fed were required to conduct monetary policy so as to hold the unemployment rate below 4%, the goal specified in the Humphrey–Hawkins Act. What implications would this have for the economy? 2. The statutes of the recently established European Central Bank (ECB) state that its primary objective is to maintain price stability. How does this charter differ from that of the Fed? What significance does it have for monetary policy? 3. Do you think the Fed should be given a clearer legislative mandate concerning macroeconomic goals? If so, what should it be? 4. Referring to the Case in Point on targeting, what difference does it make whether the target is the inflation rate of the past year or the expected inflation rate over the next year? 5. In a speech in January 1995,Speech by Alan Greenspan before the Board of Directors of the National Association of Home Builders, January 28, 1995. Federal Reserve Chairman Alan Greenspan used a transportation metaphor to describe some of the difficulties of implementing monetary policy. He referred to the criticism levied against the Fed for shifting in 1994 to an anti-inflation, contractionary policy when the inflation rate was still quite low: “To successfully navigate a bend in the river, the barge must begin the turn well before the bend is reached. Even so, currents are always changing and even an experienced crew cannot foresee all the events that might occur as the river is being navigated. A year ago, the Fed began its turn (a shift toward an expansionary monetary policy), and it was successful.” Mr. Greenspan was referring, of course, to the problem of lags. What kind of lag do you think he had in mind? What do you suppose the reference to changing currents means? 6. In a speech in August 1999,Alan Greenspan, “New challenges for monetary policy,” speech delivered before a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming, on August 27, 1999. Mr. Greenspan was famous for his convoluted speech, which listeners often found difficult to understand. CBS correspondent
Andrea Mitchell, to whom Mr. Greenspan is married, once joked that he had proposed to her 11.4 Review and Practice 475 Chapter 11 Monetary Policy and the Fed three times and that she had not understood what he was talking about on his first two efforts. Mr. Greenspan said, We no longer have the luxury to look primarily to the flow of goods and services, as conventionally estimated, when evaluating the macroeconomic environment in which monetary policy must function. There are important—but extremely difficult—questions surrounding the behavior of asset prices and the implications of this behavior for the decisions of households and businesses. The asset price that Mr. Greenspan was referring to was the U.S. stock market, which had been rising sharply in the weeks and months preceding this speech. Inflation and unemployment were both low at that time. What issues concerning the conduct of monetary policy was Mr. Greenspan raising? 7. Suppose we observed an economy in which changes in the money supply produce no changes whatever in nominal GDP. What could we conclude about velocity? 8. Suppose price levels were falling 10% per day. How would this affect the demand for money? How would it affect velocity? What can you conclude about the role of velocity during periods of rapid price change? 9. Suppose investment increases and the money supply does not change. Use the model of aggregate demand and aggregate supply to predict the impact of such an increase on nominal GDP. Now what happens in terms of the variables in the equation of exchange? 10. The text notes that prior to August 1997 (when it began specifying a target value for the federal funds rate), the FOMC adopted directives calling for the trading desk at the New York Federal Reserve Bank to increase, decrease, or maintain the existing degree of pressure on reserve positions. On the meeting dates given in the first column, the FOMC voted to decrease pressure on reserve positions (that is, adopt a more expansionary policy). On the meeting dates given in the second column, it voted to increase reserve pressure: July 5–6, 1995 February 3–4, 1994 December 19, 1995 January 31–February 1, 1995 January 30–31, 1996 March 25, 1997 11.4 Review and Practice 476 Chapter 11 Monetary Policy and the Fed Recent minutes of the FOMC can be found at the Federal Reserve Board of Governors website. Pick one of these dates on which a decrease in reserve pressure was ordered and one on which an increase was ordered and find out why that particular policy was chosen. 11
. Since August 1997, the Fed has simply set a specific target for the federal funds rate. The four dates below show the first four times after August 1997 that the Fed voted to set a new target for the federal funds rate on the following dates: September 29, 1998 November 17, 1998 June 29, 1999 August 24, 1999 Pick one of these dates and find out why it chose to change its target for the federal funds rate on that date. 12. Four meetings in 2008 at which the Fed changed the target for the federal funds rate are shown below. January 30, 2008 March 18, 2008 October 8, 2008 October 29, 2008 Pick one of these dates and find out why it chose to change its target for the federal funds rate on that date. 13. The text notes that a 10% increase in the money supply may not increase the price level by 10% in the short run. Explain why. 14. Trace the impact of an expansionary monetary policy on bond prices, interest rates, investment, the exchange rate, net exports, real GDP, and the price level. Illustrate your analysis graphically. 15. Trace the impact of a contractionary monetary policy on bond prices, interest rates, investment, the exchange rate, net exports, real GDP, and the price level. Illustrate your analysis graphically. 11.4 Review and Practice 477 Chapter 11 Monetary Policy and the Fed. Here are annual values for M2 and for nominal GDP (all figures are in billions of dollars) for the mid-1990s. Year M2 Nominal GDP 1993 3,482.0 $6,657.4 1994 3,498.1 7,072.2 1995 3,642.1 7,397.7 1996 3,820.5 7,816.9 1997 4,034.1 8,304.3 a. Compute the velocity for each year. b. Compute the fraction of nominal GDP that was being held as money. c. What is your conclusion about the stability of velocity in this five-year period? 2. Here are annual values for M2 and for nominal GDP (all figures are in billions of dollars) for the mid-2000s. Year M2 Nominal GDP 2003 6,055.5 $10,960.8 2004 6,400.7 11,685.9 2005 6,659.7 12,421.9 2006 7,012.3 13,178.4 2007 7,404.3 13,807.5 a.
Compute the velocity for each year. b. Compute the fraction of nominal GDP that was being held as money. c. What is your conclusion about the stability of velocity in this five-year period? 11.4 Review and Practice 478 Chapter 11 Monetary Policy and the Fed 3. The following data show M1 for the years 1993 to 1997, respectively (all figures are in billions of dollars): 1,129.6; 1,150.7; 1,127.4; 1,081.3; 1,072.5. a. Compute the M1 velocity for these years. (Nominal GDP for b. these years is shown in problem 1.) If you were going to use a money target, would M1 or M2 have been preferable during the 1990s? Explain your reasoning. 4. The following data show M1 for the years 2003 to 2007, respectively (all figures are in billions of dollars): 1,306.1; 1,376.3; 1,374.5; 1,366.5; 1,366.5 a. Compute the M1 velocity for these years. (Nominal GDP for b. these years is shown in problem 2.) If you were going to use a money target, would M1 or M2 have been preferable during the 2000s? Explain your reasoning. 5. Assume a hypothetical economy in which the velocity is constant at 2 and real GDP is always at a constant potential of $4,000. Suppose the money supply is $1,000 in the first year, $1,100 in the second year, $1,200 in the third year, and $1,300 in the fourth year. a. Using the equation of exchange, compute the price level in each year. b. Compute the inflation rate for each year. c. Explain why inflation varies, even though the money supply d. e. rises by $100 each year. If the central bank wanted to keep inflation at zero, what should it have done to the money supply each year? If the central bank wanted to keep inflation at 10% each year, what money supply should it have targeted in each year? 6. Suppose the velocity of money is constant and potential output grows by 3% per year. By what percentage should the money supply grow in order to achieve the following inflation rate targets? 11.4 Review and Practice 479 Chapter 11 Monetary Policy and the Fed a. 0% b. 1% c
. 2% 7. Suppose the velocity of money is constant and potential output grows by 5% per year. For each of the following money supply growth rates, what will the inflation rate be? a. 4% b. 5% c. 6% 8. Suppose that a country whose money supply grew by about 20% a year over the long run had an annual inflation rate of about 20% and that a country whose money supply grew by about 50% a year had an annual inflation rate of about 50%. Explain this finding in terms of the equation of exchange. 11.4 Review and Practice 480 Chapter 12 Government and Fiscal Policy Start Up: A Massive Stimulus Shaken by the severity of both the recession that began in December 2007 and the financial crisis that occurred in the fall of 2008, Congress passed a huge $784 billion stimulus package in February 2009. President Obama described the measure as only “the beginning” of what the federal government ultimately would do to right the economy. Over a quarter of the American Recovery and Reinvestment Act (ARRA) was for a variety of temporary tax rebates and credits for individuals and firms. For example, each worker making less than $75,000 a year received $400 ($800 for a working couple earning up to $150,000) as a kind of rebate for payroll taxes. That works out to $8 a week. Qualifying college students became eligible for $2,500 tax credits for educational expenses. During a certain period, a first-time homebuyer was eligible for a tax credit. The other roughly three-quarters of the ARRA were for a variety of government spending programs, including temporary transfers to state and local governments, extended unemployment insurance and other transfers to people (such as food stamps), and increased infrastructure spending. The president said that the measure would “ignite spending by businesses and consumers … and make the investment necessary for lasting growth and economic prosperity.”Barack Obama, Weekly Address of the President to the Nation, February 14, 2009, available at http://www.whitehouse.gov/blog/09/02/14/A-major-milestone/. Shortly after the passage of the ARRA, Congress passed the Cash for Clunkers program, which for a limited period of time allowed car buyers to trade in less-fuel-efficient cars for rebates of up to $4,500 toward buying new cars that met certain higher fuelefficiency standards. The ARRA illustrates an important difficulty of using fiscal policy in
an effort to stabilize economic activity. It was passed over a year after the recession began. Only about 20% of the spending called for by the legislation took place in 2009, rising to about two-thirds through the middle of 2010. It was a guess what state the economy would be in then. As it turned out, the recession had officially ended, but there was still a large recessionary gap, and unemployment was still a major concern. There was a great deal of media controversy about how effective the policy had been and whether the resulting increase in national debt was worth it. Concern over the 481 Chapter 12 Government and Fiscal Policy expanded size of the federal government created by the stimulus measures became a rallying cry for the Tea Party movement. A fiscal stimulus package of over $150 billion had already been tried earlier in February 2008 under President George W. Bush. It included $100 billion in temporary tax rebates to households—up to $600 for individuals and $1,200 for couples—and over $50 billion in tax breaks for businesses. The boost to aggregate demand seemed slight—consumers saved much of their rebate money. In November 2008, unemployment insurance benefits were extended for seven additional weeks, in recognition of the growing unemployment problem. President Obama argued that his proposals for dealing with the economy in the short term would, coincidentally, also promote long-term economic health. Some critics argued for a greater focus on actual tax cuts while others were concerned about whether the spending would focus on getting the greatest employment increase or be driven by political considerations. How do government tax and expenditure policies affect real GDP and the price level? Why do economists differ so sharply in assessing the likely impact of such policies? Can fiscal policy be used to stabilize the economy in the short run? What are the long-run effects of government spending and taxing? We begin with a look at the government’s budget to see how it spends the tax revenue it collects. Clearly, the government’s budget is not always in balance, so we will also look at government deficits and debt. We will then look at how fiscal policy works to stabilize the economy, distinguishing between built-in stabilization methods and discretionary measures. We will end the chapter with a discussion of why fiscal policy is so controversial. As in the previous chapter on monetary policy, our primary focus will be U.S. policy. However, the tools available to governments around the world are quite similar, as are the issues surrounding the use of fiscal policy. 482 Chapter 12 Government and Fiscal Policy 12
.1 Government and the Economy. Understand the major components of U.S. government spending and sources of government revenues. 2. Define the terms budget surplus, budget deficit, balanced budget, and national debt, and discuss their trends over time in the United States. We begin our analysis of fiscal policy with an examination of government purchases, transfer payments, and taxes in the U.S. economy. Government Purchases The government-purchases component of aggregate demand includes all purchases by government agencies of goods and services produced by firms, as well as direct production by government agencies themselves. When the federal government buys staples and staplers, the transaction is part of government purchases. The production of educational and research services by public colleges and universities is also counted in the government-purchases component of GDP. While government spending has grown over time, government purchases as a share of GDP declined from over 20% until the early 1990s to under 18% in 2001. Since then, though, the percentage of government purchases in GDP began to increase back toward 20% and then beyond. This first occurred as military spending picked up, and then, more recently, it rose even further during the 2007–2009 recession. Figure 12.1 "Federal, State, and Local Purchases Relative to GDP, 1960–2011" shows federal as well as state and local government purchases as a percentage of GDP from 1960 to 2011. Notice the changes that have occurred over this period. In 1960, the federal government accounted for the majority share of total purchases. Since then, however, federal purchases have fallen by almost half relative to GDP, while state and local purchases relative to GDP have risen. 483 Chapter 12 Government and Fiscal Policy Figure 12.1 Federal, State, and Local Purchases Relative to GDP, 1960–2011 Government purchases were generally above 20% of GDP from 1960 until the early 1990s and then below 20% of GDP until the 2007-2009 recession. The share of government purchases in GDP began rising in the 21st century. Source: Bureau of Economic Analysis, NIPA Table 1.1 and 3.1 (revised February 29, 2012). Transfer Payments A transfer payment1 is the provision of aid or money to an individual who is not required to provide anything in exchange for the payment. Social Security and welfare benefits are examples of transfer payments. During the 2007-2009 recession, transfers rose. A number of changes have influenced transfer payments over the past several decades. First, they increased rapidly during the late 1960s and
early 1970s. This was the period in which federal programs such as Medicare (health insurance for the elderly) and Medicaid (health insurance for the poor) were created and other programs were expanded. 1. The provision of aid or money to an individual who is not required to provide anything in exchange. Figure 12.2 "Federal, State, and Local Transfer Payments as a Percentage of GDP, 1960–2011" shows that transfer payment spending by the federal government and by state and local governments has risen as a percentage of GDP. In 1960, such 12.1 Government and the Economy 484 Chapter 12 Government and Fiscal Policy spending totaled about 6% of GDP; by 2009, it had risen to about 18%. The federal government accounts for the bulk of transfer payment spending in the United States. Figure 12.2 Federal, State, and Local Transfer Payments as a Percentage of GDP, 1960–2011 The chart shows transfer payment spending as a percentage of GDP from 1960 through 2011. This spending rose dramatically relative to GDP during the late 1960s and the 1970s as federal programs expanded. More recently, sharp increases in health-care costs have driven upward the spending for transfer payment programs such as Medicare and Medicaid. Transfer payments fluctuate with the business cycle, rising in times of recession and falling during times of expansion. As such, they rose sharply during the deep 2007-2009 recession. Source: Bureau of Economic Analysis, NIPA Table 1.1, 3.2, and 3.3 (revised February 29, 2012). Transfer payment spending relative to GDP tends to fluctuate with the business cycle. Transfer payments fell during the late 1970s, a period of expansion, then rose as the economy slipped into a recessionary gap during the 1979–1982 period. Transfer payments fell during the expansion that began late in 1982, then began rising in 1989 as the expansion began to slow. Transfer payments continued to rise relative to GDP during the recessions of 1990–1991 and 2001–2002 and then fell as the economy entered expansionary phases after each of those recessions. During the 2007—2009 recession, transfer payments rose again. 12.1 Government and the Economy 485 Chapter 12 Government and Fiscal Policy When economic activity falls, incomes fall, people lose jobs, and more people qualify for aid. People qualify to receive welfare benefits, such as cash, food stamps, or Medicaid, only if their income falls below a certain level. They qualify for unemployment compensation by losing their jobs. More people qualify for transfer payments during recessions. When the
economy expands, incomes and employment rise, and fewer people qualify for welfare or unemployment benefits. Spending for those programs therefore tends to fall during an expansion. Figure 12.3 "Government Spending as a Percentage of GDP, 1960–2011" summarizes trends in government spending since 1960. It shows three categories of government spending relative to GDP: government purchases, transfer payments, and net interest. Net interest includes payments of interest by governments at all levels on money borrowed, less interest earned on saving. Figure 12.3 Government Spending as a Percentage of GDP, 1960–2011 This chart shows three major categories of government spending as percentages of GDP: government purchases, transfer payments, and net interest. Source: Bureau of Economic Analysis, NIPA Table 1.1 and 3.1 (revised February 29, 2012). 12.1 Government and the Economy 486 Chapter 12 Government and Fiscal Policy Taxes Taxes affect the relationship between real GDP and personal disposable income; they therefore affect consumption. They also influence investment decisions. Taxes imposed on firms affect the profitability of investment decisions and therefore affect the levels of investment firms will choose. Payroll taxes imposed on firms affect the costs of hiring workers; they therefore have an impact on employment and on the real wages earned by workers. The bulk of federal receipts come from the personal income tax and from payroll taxes. State and local tax receipts are dominated by property taxes and sales taxes. The federal government, as well as state and local governments, also collects taxes imposed on business firms, such as taxes on corporate profits. Figure 12.4 "The Composition of Federal, State, and Local Revenues" shows the composition of federal, state, and local receipts in a recent year. Figure 12.4 The Composition of Federal, State, and Local Revenues Federal receipts come primarily from payroll taxes and from personal taxes such as the personal income tax. State and local tax receipts come from a variety of sources; the most important are property taxes, sales taxes, income taxes, and grants from the federal government. Data are for third-quarter 2011, in billions of dollars, seasonally adjusted at annual rates. Source: Bureau of Economic Analysis, NIPA Table 3.2 and 3.3 (revised February 29, 2012). 12.1 Government and the Economy 487 Chapter 12 Government and Fiscal Policy The Government Budget Balance The government’s budget balance is the difference between the government’s revenues and its expenditures. A budget surplus2 occurs if government revenues exceed expenditures. A budget deficit
3 occurs if government expenditures exceed revenues. The minus sign is often omitted when reporting a deficit. If the budget surplus equals zero, we say the government has a balanced budget4. Figure 12.5 "Government Revenue and Expenditure as a Percentage of GDP, 1960–2011" compares federal, state, and local government revenues to expenditures relative to GDP since 1960. The government’s budget was generally in surplus in the 1960s, then mostly in deficit since, except for a brief period between 1998 and 2001. Bear in mind that these data are for all levels of government. Figure 12.5 Government Revenue and Expenditure as a Percentage of GDP, 1960–2011 2. Situation that occurs if government revenues exceed expenditures. 3. Situation that occurs if government expenditures exceed revenues. 4. Situation that occurs if the budget surplus equals zero. The government’s budget was generally in surplus in the 1960s, then mostly in deficit since, except for a brief period between 1998 and 2001. Source: Bureau of Economic Analysis, NIPA Table 1.1 and 3.1 (revised February 29, 2012). The administration of George W. Bush saw a large increase in the federal deficit. In part, this was the result of the government’s response to the terrorist attacks in 12.1 Government and the Economy 488 Chapter 12 Government and Fiscal Policy 2001. It also results, however, from large increases in federal spending at all levels together with tax cuts in 2001, 2002, and 2003. The federal deficit grew even larger during the administration of Barack Obama. The increase stemmed from both reduced revenues and increased spending resulting from the recession that began in 2007 and the stimulus. The National Debt The national debt5 is the sum of all past federal deficits, minus any surpluses. Figure 12.6 "The National Debt and the Economy, 1929–2010" shows the national debt as a percentage of GDP. It suggests that, relative to the level of economic activity, the debt is well below the levels reached during World War II. The ratio of debt to GDP rose from 1981 to 1996 and fell in the last years of the 20th century; it began rising again in 2002 and has risen substantially since the recession that began in 2007. Figure 12.6 The National Debt and the Economy, 1929–2010 The national debt relative to GDP is much smaller today than it was during World War II. The ratio of debt to GDP rose from 1981 to 1996 and fell in the last years of the 20th century; it began
rising again in 2002, markedly so in 2009 and 2010. Sources: Data for 1929–1938 from Historical Statistics of the United States, Colonial Times to 1957—not strictly comparable with later data. Data for remaining years from Office of Management and Budget, Budget of the United States Government, Fiscal Year 2012, Historical Tables. 5. The sum of all past federal deficits, minus any surpluses. 12.1 Government and the Economy 489 Chapter 12 Government and Fiscal Policy Judged by international standards, the U.S. national debt relative to its GDP is above average. Figure 12.7 "Debts and Deficits for 32 Nations, 2010" shows national debt as a percentage of GDP for 32 countries in 2010. It also shows deficits or surpluses as a percentage of GDP. In an intense struggle between the Republican-majority U.S. House of Representatives and the Obama administration and the Democratic-majority U.S. Senate in the summer of 2011 that almost resulted in a government shutdown, the Budget Control Act of 2011 resulted in a $1 trillion deficit reduction for the current fiscal year with additional reductions of $1.2–1.5 trillion scheduled to follow. The one thing that all politicians seem to agree on is that this measure will not be enough to put the U.S. government deficit and debt back onto a sustainable longterm path. The various factions differ on what mix of spending cuts and tax increases should be used to control the deficit and debt over the long term. They also disagree on when these changes should take place, given the still-fragile state of the U.S. economy in 2012. Figure 12.7 Debts and Deficits for 32 Nations, 2010 The chart shows national debt as a percentage of GDP and deficits or surpluses as a percentage of GDP in 2010. The national debt of the United States relative to its GDP was above average among these nations. 12.1 Government and the Economy 490 Chapter 12 Government and Fiscal Policy Source: Organisation for Economic Co-operation and Development (OECD). Factbook 2011–2012: Economic, Environmental and Social Statistics. OECD Publishing, 2011 • Over the last 50 years, government purchases fell from about 20% of U.S. GDP to below 20%, but have been rising over the last decade. • Transfer payment spending has risen sharply, both in absolute terms and as a percentage of real GDP since 1960. • The bulk of federal revenues comes from income and payroll taxes. State and local revenues consist primarily of
sales and property taxes. • The government budget balance is the difference between government revenues and government expenditures. • The national debt is the sum of all past federal deficits minus any surpluses. T R Y I T! What happens to the national debt when there is a budget surplus? What happens to it when there is a budget deficit? What happens to the national debt if there is a decrease in a surplus? What happens to it if the deficit falls? 12.1 Government and the Economy 491 Chapter 12 Government and Fiscal Policy Case in Point: Generational Accounting One method of assessing the degree to which current fiscal policies affect future generations is through a device introduced in the early 1990s called generational accounting. It measures the impact of current fiscal policies on different generations in the economy, including future generations. Generational accounting is now practiced by governments in many countries, including the United States and the European Union. As populations age, the burden of current fiscal policy is increasingly borne by younger people in the population. In most countries, economists computing generational accounts have found that people age 40 or below will pay more in taxes than they receive in transfer payments, while those age 60 or above will receive more in transfers than they pay in taxes. The differences are huge. According to a recent study by Jagadeesh Gokhale, summarized in the table below, in 2004 in the United States, a male age 30 could expect to pay $201,300 more than he receives in government transfers during his lifetime, while another male age 75 could expect to receive $171,100 more in transfers than he paid in taxes during his lifetime. That is a difference of $372,400! For future generations, those born after the year 2004, the difference is even more staggering. A male born after the year 2005 can expect to pay $332,200 more in taxes than he will receive in transfer payments. For a woman, the differences are also large but not as great. A woman age 30 in 2004 could expect to pay $30,200 more in taxes than she will receive in transfers during her lifetime, while a woman age 75 could expect to receive transfers of $184,100 in excess of her lifetime tax burden. The table below gives generational accounting estimates for the United States for the year 2004 for males and females. Figures shown are in thousands of 2004 dollars. Notice that the net burden on females is much lower than for males. That is because women live longer than men and thus receive Social Security 12.1 Government and the Economy 492 Chapter
12 Government and Fiscal Policy and Medicare benefits over a longer period of time. Women also have lower labor force participation rates and earn less than men, and pay lower taxes as a result. Year of birth Age in 2004 Male Female 2005 (future born) 2004 (newborn) 1989 1974 1959 1944 1929 1914 −1 0 15 30 45 60 75 90 333.2 26.0 104.3 185.7 201.3 8.1 42.0 30.2 67.8 −54.1 −162.6 −189.4 −171.1 −184.1 −65.0 −69.2 Generational accounting has its critics—for example, the table above only measures direct taxes and transfers but omits benefits from government spending on public goods and services. In addition, government spending programs can be modified, which would alter the impact on future generations. Nonetheless, it does help to focus attention on the sustainability of current fiscal policies. Can future generations pay for Social Security, Medicare, and other retirement and health care spending as currently configured? Should they be asked to do so? Source: Jagadeesh Gokhale, “Generational Accounting,” The New Palgrave Dictionary of Economics Online, 2nd ed., 2008 budget surplus leads to a decline in national debt; a budget deficit causes the national debt to grow. If there is a decrease in a budget surplus, national debt still declines but by less than it would have had the surplus not gotten smaller. If there is a decrease in the budget deficit, the national debt still grows, but by less than it would have if the deficit had not gotten smaller. 12.1 Government and the Economy 493 Chapter 12 Government and Fiscal Policy 12.2 The Use of Fiscal Policy to Stabilize the Economy. Define automatic stabilizers and explain how they work. 2. Explain and illustrate graphically how discretionary fiscal policy works and compare the changes in aggregate demand that result from changes in government purchases, income taxes, and transfer payments. Fiscal policy—the use of government expenditures and taxes to influence the level of economic activity—is the government counterpart to monetary policy. Like monetary policy, it can be used in an effort to close a recessionary or an inflationary gap. Some tax and expenditure programs change automatically with the level of economic activity. We will examine these first. Then we will look at how discretionary fiscal policies work. Four examples of discretionary fiscal policy choices were the tax cuts introduced by the Kennedy, Reagan, and George W. Bush
administrations and the increase in government purchases proposed by President Clinton in 1993. The 2009 fiscal stimulus bill passed in the first months of the administration of Barack Obama included both tax rebates and spending increases. All were designed to stimulate aggregate demand and close recessionary gaps. Automatic Stabilizers Certain government expenditure and taxation policies tend to insulate individuals from the impact of shocks to the economy. Transfer payments have this effect. Because more people become eligible for income supplements when income is falling, transfer payments reduce the effect of a change in real GDP on disposable personal income and thus help to insulate households from the impact of the change. Income taxes also have this effect. As incomes fall, people pay less in income taxes. Any government program that tends to reduce fluctuations in GDP automatically is called an automatic stabilizer6. Automatic stabilizers tend to increase GDP when it is falling and reduce GDP when it is rising. 494 6. Any government program that tends to reduce fluctuations in GDP automatically. Chapter 12 Government and Fiscal Policy To see how automatic stabilizers work, consider the decline in real GDP that occurred during the recession of 1990–1991. Real GDP fell 1.6% from the peak to the trough of that recession. The reduction in economic activity automatically reduced tax payments, reducing the impact of the downturn on disposable personal income. Furthermore, the reduction in incomes increased transfer payment spending, boosting disposable personal income further. Real disposable personal income thus fell by only 0.9% during the 1990—1991 recession, a much smaller percentage than the reduction in real GDP. Rising transfer payments and falling tax collections helped cushion households from the impact of the recession and kept real GDP from falling as much as it would have otherwise. Automatic stabilizers have emerged as key elements of fiscal policy. Increases in income tax rates and unemployment benefits have enhanced their importance as automatic stabilizers. The introduction in the 1960s and 1970s of means-tested federal transfer payments, in which individuals qualify depending on their income, added to the nation’s arsenal of automatic stabilizers. The advantage of automatic stabilizers is suggested by their name. As soon as income starts to change, they go to work. Because they affect disposable personal income directly, and because changes in disposable personal income are closely linked to changes in consumption, automatic stabilizers act swiftly to reduce the degree of changes in real GDP. It is important to note that changes in expenditures and taxes that occur through automatic stabilizers do not shift the aggregate demand curve. Because they are automatic, their operation is already incorporated in the curve itself
. Discretionary Fiscal Policy Tools As we begin to look at deliberate government efforts to stabilize the economy through fiscal policy choices, we note that most of the government’s taxing and spending is for purposes other than economic stabilization. For example, the increase in defense spending in the early 1980s under President Ronald Reagan and in the administration of George W. Bush were undertaken primarily to promote national security. That the increased spending affected real GDP and employment was a by-product. The effect of such changes on real GDP and the price level is secondary, but it cannot be ignored. Our focus here, however, is on discretionary fiscal policy that is undertaken with the intention of stabilizing the economy. As we have seen, the tax cuts introduced by the Bush administration were justified as expansionary measures. Discretionary government spending and tax policies can be used to shift aggregate demand. Expansionary fiscal policy might consist of an increase in government 12.2 The Use of Fiscal Policy to Stabilize the Economy 495 Chapter 12 Government and Fiscal Policy purchases or transfer payments, a reduction in taxes, or a combination of these tools to shift the aggregate demand curve to the right. A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left. Figure 12.8 "Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand" illustrates the use of fiscal policy to shift aggregate demand in response to a recessionary gap and an inflationary gap. In Panel (a), the economy produces a real GDP of Y1, which is below its potential level of Yp. An expansionary fiscal policy seeks to shift aggregate demand to AD2 in order to close the gap. In Panel (b), the economy initially has an inflationary gap at Y1. A contractionary fiscal policy seeks to reduce aggregate demand to AD2 and close the gap. Now we shall look at how specific fiscal policy options work. In our preliminary analysis of the effects of fiscal policy on the economy, we will assume that at a given price level these policies do not affect interest rates or exchange rates. We will relax that assumption later in the chapter. Figure 12.8 Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand In Panel (a), the economy faces a recessionary gap (YP − Y1). An expansionary fiscal policy seeks to shift aggregate demand to AD2 to close the gap. In Panel (b), the economy faces
an inflationary gap (Y1 − YP). A contractionary fiscal policy seeks to reduce aggregate demand to AD2 to close the gap. 12.2 The Use of Fiscal Policy to Stabilize the Economy 496 Chapter 12 Government and Fiscal Policy Changes in Government Purchases One policy through which the government could seek to shift the aggregate demand curve is a change in government purchases. We learned that the aggregate demand curve shifts to the right by an amount equal to the initial change in government purchases times the multiplier. This multiplied effect of a change in government purchases occurs because the increase in government purchases increases income, which in turn increases consumption. Then, part of the impact of the increase in aggregate demand is absorbed by higher prices, preventing the full increase in real GDP that would have occurred if the price level did not rise. Figure 12.9 "An Increase in Government Purchases" shows the effect of an increase in government purchases of $200 billion. The initial price level is P1 and the initial equilibrium real GDP is $12,000 billion. Suppose the multiplier is 2. The $200 billion increase in government purchases increases the total quantity of goods and services demanded, at a price level of P1, by $400 billion (the $200 billion increase in government purchases times the multiplier) to $12,400 billion. The aggregate demand thus shifts to the right by that amount to AD2. The equilibrium level of real GDP rises to $12,300 billion, and the price level rises to P2. A reduction in government purchases would have the opposite effect. The aggregate demand curve would shift to the left by an amount equal to the initial change in government purchases times the multiplier. Real GDP and the price level would fall. Figure 12.9 An Increase in Government Purchases The economy shown here is initially in equilibrium at a real GDP of $12,000 billion and a price level of P1. An increase of $200 billion in the level of government purchases (ΔG) shifts the aggregate demand curve to the right by $400 billion to AD2. The equilibrium level of real GDP 12.2 The Use of Fiscal Policy to Stabilize the Economy 497 Chapter 12 Government and Fiscal Policy Changes in Business Taxes rises to $12,300 billion, while the price level rises to P2. One of the first fiscal policy measures undertaken by the Kennedy administration in the 1960s was an investment tax credit. An investment tax credit allows a firm to reduce its tax liability by a percentage of the investment it undert
akes during a particular period. With an investment tax credit of 10%, for example, a firm that engaged in $1 million worth of investment during a year could reduce its tax liability for that year by $100,000. The investment tax credit introduced by the Kennedy administration was later repealed. It was reintroduced during the Reagan administration in 1981, then abolished by the Tax Reform Act of 1986. President Clinton called for a new investment tax credit in 1993 as part of his job stimulus proposal, but that proposal was rejected by Congress. The Bush administration reinstated the investment tax credit as part of its tax cut package. An investment tax credit is intended, of course, to stimulate additional private sector investment. A reduction in the tax rate on corporate profits would be likely to have a similar effect. Conversely, an increase in the corporate income tax rate or a reduction in an investment tax credit could be expected to reduce investment. A change in investment affects the aggregate demand curve in precisely the same manner as a change in government purchases. It shifts the aggregate demand curve by an amount equal to the initial change in investment times the multiplier. An increase in the investment tax credit, or a reduction in corporate income tax rates, will increase investment and shift the aggregate demand curve to the right. Real GDP and the price level will rise. A reduction in the investment tax credit, or an increase in corporate income tax rates, will reduce investment and shift the aggregate demand curve to the left. Real GDP and the price level will fall.Investment also affects the long-run aggregate supply curve, since a change in the capital stock changes the potential level of real GDP. We examined this earlier in the chapter on economic growth. Changes in Income Taxes Income taxes affect the consumption component of aggregate demand. An increase in income taxes reduces disposable personal income and thus reduces consumption (but by less than the change in disposable personal income). That shifts the aggregate demand curve leftward by an amount equal to the initial change in consumption that the change in income taxes produces times the multiplier.A change in tax rates will change the value of the multiplier. The reason is explained 12.2 The Use of Fiscal Policy to Stabilize the Economy 498 Chapter 12 Government and Fiscal Policy in another chapter. A reduction in income taxes increases disposable personal income, increases consumption (but by less than the change in disposable personal income), and increases aggregate demand. Suppose, for example, that income taxes are reduced by $200 billion. Only some of the increase in disposable personal income will be used for consumption and the rest
will be saved. Suppose the initial increase in consumption is $180 billion. Then the shift in the aggregate demand curve will be a multiple of $180 billion; if the multiplier is 2, aggregate demand will shift to the right by $360 billion. Thus, as compared to the $200-billion increase in government purchases that we saw in Figure 12.9 "An Increase in Government Purchases", the shift in the aggregate demand curve due to an income tax cut is somewhat less, as is the effect on real GDP and the price level. Changes in Transfer Payments Changes in transfer payments, like changes in income taxes, alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand. A change in transfer payments will thus shift the aggregate demand curve because it will affect consumption. Because consumption will change by less than the change in disposable personal income, a change in transfer payments of some amount will result in a smaller change in real GDP than would a change in government purchases of the same amount. As with income taxes, a $200-billion increase in transfer payments will shift the aggregate demand curve to the right by less than the $200-billion increase in government purchases that we saw in Figure 12.9 "An Increase in Government Purchases". Table 12.1 "Fiscal Policy in the United States Since 1964" summarizes U.S. fiscal policies undertaken to shift aggregate demand since the 1964 tax cuts. We see that expansionary policies have been chosen in response to recessionary gaps and that contractionary policies have been chosen in response to inflationary gaps. Changes in government purchases and in taxes have been the primary tools of fiscal policy in the United States. Table 12.1 Fiscal Policy in the United States Since 1964 Year Situation Policy response 1968 Inflationary gap A temporary tax increase, first recommended by President Johnson’s Council of Economic Advisers in 1965, goes into effect. This one-time surcharge of 10% is added to individual income tax liabilities. 12.2 The Use of Fiscal Policy to Stabilize the Economy 499 Chapter 12 Government and Fiscal Policy Year Situation Policy response 1969 1975 Inflationary gap President Nixon, facing a continued inflationary gap, orders cuts in government purchases. Recessionary gap President Ford, facing a recession induced by an OPEC oil-price increase, proposes a temporary 10% tax cut. It is passed almost immediately and goes into effect within two months. 1981 Recessionary gap 1992 Recessionary gap 1993 Recessionary gap 2001 Recessionary gap President Reagan had campaigned on a
platform of increased defense spending and a sharp cut in income taxes. The tax cuts are approved in 1981 and are implemented over a period of three years. The increased defense spending begins in 1981. While the Reagan administration rejects the use of fiscal policy as a stabilization tool, its policies tend to increase aggregate demand early in the 1980s. President Bush had rejected the use of expansionary fiscal policy during the recession of 1990–1991. Indeed, he agreed late in 1990 to a cut in government purchases and a tax increase. In a campaign year, however, he orders a cut in withholding rates designed to increase disposable personal income in 1992 and to boost consumption. President Clinton calls for a $16-billion jobs package consisting of increased government purchases and tax cuts aimed at stimulating investment. The president says the plan will create 500,000 new jobs. The measure is rejected by Congress. President Bush campaigned to reduce taxes in order to reduce the size of government and encourage long-term growth. When he took office in 2001, the economy was weak and the $1.35-billion tax cut was aimed at both long-term tax relief and at stimulating the economy in the short term. It included, for example, a personal income tax rebate of $300 to $600 per household. With unemployment still high a couple of years into the expansion, another tax cut was passed in 2003. 2008 2009 Recessionary gap Fiscal stimulus package of $150 billion to spur economy. It included $100 billion in tax rebates and $50 billion in tax cuts for businesses. Recessionary gap Fiscal stimulus package of $784 billion included tax rebates and increased government spending passed in early days of President Obama’s administration. 2010–2012 Recessionary gap Extensions of the payroll tax reduction and unemployment insurance benefits continued. 12.2 The Use of Fiscal Policy to Stabilize the Economy 500 Chapter 12 Government and Fiscal Policy • Discretionary fiscal policy may be either expansionary or contractionary. • A change in government purchases shifts the aggregate demand curve at a given price level by an amount equal to the initial change in government purchases times the multiplier. The change in real GDP, however, will be reduced by the fact that the price level will change. • A change in income taxes or government transfer payments shifts the aggregate demand curve by a multiple of the initial change in consumption (which is less than the change in personal disposable income) that the change in income taxes or transfer payments causes. Then, the change in real GDP will be reduced by the fact that the price level will
change. • A change in government purchases has a larger impact on the aggregate demand curve than does an equal change in income taxes or transfers. • Changes in business tax rates, including an investment tax credit, can be used to influence the level of investment and thus the level of aggregate demand. T R Y I T! Suppose the economy has an inflationary gap. What fiscal policies might be used to close the gap? Using the model of aggregate demand and aggregate supply, illustrate the effect of these policies. 12.2 The Use of Fiscal Policy to Stabilize the Economy 501 Chapter 12 Government and Fiscal Policy Case in Point: How Large Is the Fiscal Multiplier? There is a wide range of opinions among economists regarding the size of the fiscal multiplier. In 2011, the American Economic Association’s Journal of Economic Literature published three papers on this topic in a special section titled “Forum: The Multiplier.” The papers provide at least two-and-a-half different answers! In her paper titled “Can Government Purchases Stimulate the Economy?,” Valerie Ramey concludes that the size of the government purchases multiplier depends on many factors but that, when the increase in government purchases is temporary and financed by government borrowing, the multiplier “is probably between 0.8 and 1.5. Reasonable people can argue, however, that the data do not reject 0.5 to 2.” This is quite a wide range. In “An Empirical Analysis of the Revival of Fiscal Activism in the 2000s,” John Taylor argues that the various components of the recent fiscal packages (tax cuts, aid to states, and increased government purchases) had little effect on the economy—implying a multiplier of zero or nearly so. Using aggregate quarterly data simulations for the 2000s, he argues that transfers and tax cuts were used by households to increase saving, that the increase in government purchases were too small to have made much of a difference, and that state and local governments used their stimulus dollars for transfers or to reduce their borrowing. In “On Measuring the Effects of Fiscal Policy in Recessions,” Jonathan Parker essentially argues that the statistical models built to date are ultimately inadequate and that we will only be able to get at the answer as better and more refined studies are conducted. Noting that the multiplier effect of fiscal policy is likely to depend on the state of the economy, he concludes that “an important difficulty with further investigation is the limited macro
economic 12.2 The Use of Fiscal Policy to Stabilize the Economy 502 Chapter 12 Government and Fiscal Policy data available on the effects of policy in recessions (or deep recessions).” Perhaps we need a few more Great Recessions in order to figure this out. In another American Economic Association publication, the Journal of Economic Perspectives, Alan Auerbach, William Gale, and Benjamin Harris provide an extensive review of the variety in multiplier estimates, which they acknowledge is “embarrassingly large” after so many years of trying to measure it. Concerning the 2009 American Recovery and Reinvestment Act, though, they write, “If a fiscal stimulus were ever to be considered appropriate, the beginning of 2009 was such a time.…In these circumstances, our judgment is that a fiscal expansion carried much smaller risks than the lack of one would have.” Sources: Alan J. Auerbach, William G. Gale, and Benjamin H. Harris, “Activist Fiscal Policy,” Journal of Economic Perspectives 24, no. 4 (Fall 2010): 141–64; Jonathan A. Parker, “On Measuring the Effects of Fiscal Policy in Recessions,” Journal of Economic Literature 49, no. 3 (September 2011): 703–18; Valerie A. Ramey, “Can Government Purchases Stimulate the Economy?,” Journal of Economic Literature 49, no. 3 (September 2011): 673–85; John B. Taylor, “An Empirical Analysis of the Revival of Fiscal Activism in the 2000s,” Journal of Economic Literature 49, no. 3 (September 2011): 686–702 Fiscal policies that could be used to close an inflationary gap include reductions in government purchases and transfer payments and increases in taxes. As shown in Panel (b) of Figure 12.8 "Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand", the goal would be to shift the aggregate demand curve to the left so that it will intersect the short-run aggregate supply curve at YP. 12.2 The Use of Fiscal Policy to Stabilize the Economy 503 Chapter 12 Government and Fiscal Policy 12.3 Issues in Fiscal Policy. Explain how the various kinds of lags influence the effectiveness of discretionary fiscal policy. 2. Explain and illustrate graphically how crowding out (and its reverse) influences the impact of expansionary or contractionary fiscal policy. 3. Discuss the controversy concerning which types of
fiscal policies to use, including the arguments from supply-side economics. The discussion in the previous section about the use of fiscal policy to close gaps suggests that economies can be easily stabilized by government actions to shift the aggregate demand curve. However, as we discovered with monetary policy in the previous chapter, government attempts at stabilization are fraught with difficulties. Lags Discretionary fiscal policy is subject to the same lags that we discussed for monetary policy. It takes some time for policy makers to realize that a recessionary or an inflationary gap exists—the recognition lag. Recognition lags stem largely from the difficulty of collecting economic data in a timely and accurate fashion. The current recession was not identified until October 2008, when the Business Cycle Dating Committee of the National Bureau of Economic Research announced that it had begun in December 2007. Then, more time elapses before a fiscal policy, such as a change in government purchases or a change in taxes, is agreed to and put into effect—the implementation lag. Finally, still more time goes by before the policy has its full effect on aggregate demand—the impact lag. Changes in fiscal policy are likely to involve a particularly long implementation lag. A tax cut was proposed to presidential candidate John F. Kennedy in 1960 as a means of ending the recession that year. He recommended it to Congress in 1962. It was not passed until 1964, three years after the recession had ended. Some economists have concluded that the long implementation lag for discretionary fiscal policy makes this stabilization tool ineffective. Fortunately, automatic stabilizers respond automatically to changes in the economy. They thus avoid not only the implementation lag but also the recognition lag. 504 Chapter 12 Government and Fiscal Policy The implementation lag results partly from the nature of bureaucracy itself. The CBO estimate that only a portion of the spending for the stimulus plan passed in 2009 will be spent in the next two years is an example of the implementation lag. Government spending requires bureaucratic approval of that spending. For example, a portion of the stimulus plan must go through the Department of Energy. One division of the department focuses on approving loan guarantees for energysaving industrial projects. It was created early in 2007 as part of another effort to stimulate economic activity. A Minnesota company, Sage Electrochromics, has developed a process for producing windows that can be darkened or lightened on demand to reduce energy use in buildings. Sage applied two years ago for a guarantee on a loan of $66 million to build a plant that would employ 250 workers. Its application has not been approved. In fact, the loan approval
division, which will be crucial for projects in the stimulus plan, has never approved any application made to it in its two years in existence! Energy Secretary Steven Chu, a Nobel Prize-winning physicist, recognizes the urgency of the problem. In an interview with the Wall Street Journal, Dr. Chu said that his agency would have to do better. “Otherwise, it’s just going to be a bust,” he said.Stephen Power and Neil King, Jr., “Next Challenge on Stimulus: Spending All That Money,” Wall Street Journal, February 13, 2009, p. A1. Crowding Out Because an expansionary fiscal policy either increases government spending or reduces revenues, it increases the government budget deficit or reduces the surplus. A contractionary policy is likely to reduce a deficit or increase a surplus. In either case, fiscal policy thus affects the bond market. Our analysis of monetary policy showed that developments in the bond market can affect investment and net exports. We shall find in this section that the same is true for fiscal policy. Figure 12.10 "An Expansionary Fiscal Policy and Crowding Out" shows the impact of an expansionary fiscal policy: an increase in government purchases. The increase in government purchases increases the deficit or reduces the surplus. In either case, the Treasury will sell more bonds than it would have otherwise, shifting the supply curve for bonds to the right in Panel (a). That reduces the price of bonds, raising the interest rate. The increase in the interest rate reduces the quantity of private investment demanded. The higher interest rate increases the demand for and reduces the supply of dollars in the foreign exchange market, raising the exchange rate in Panel (b). A higher exchange rate reduces net exports. Panel (c) shows the effects of all these changes on the aggregate demand curve. Before the change in government purchases, the economy is in equilibrium at a real GDP of Y1, determined by the intersection of AD1 and the short-run aggregate supply curve. 12.3 Issues in Fiscal Policy 505 Chapter 12 Government and Fiscal Policy The increase in government expenditures would shift the curve outward to AD2 if there were no adverse impact on investment and net exports. But the reduction in investment and net exports partially offsets this increase. Taking the reduction in investment and net exports into account means that the aggregate demand curve shifts only to AD3. The tendency for an expansionary fiscal policy to reduce other components of aggregate demand is called crowding out7. In the short run, this policy leads to an
increase in real GDP to Y2 and a higher price level, P2. Figure 12.10 An Expansionary Fiscal Policy and Crowding Out In Panel (a), increased government purchases are financed through the sale of bonds, lowering their price to Pb Panel (b), the higher interest rate causes the exchange rate to rise, reducing net exports. Increased government purchases would shift the aggregate demand curve to AD2 in Panel (c) if there were no crowding out. Crowding out of investment and net exports, however, causes the aggregate demand curve to shift only to AD3. Then a higher price level means that GDP rises only to Y2. 2. In 7. The tendency for an expansionary fiscal policy to reduce other components of aggregate demand. Crowding out reduces the effectiveness of any expansionary fiscal policy, whether it be an increase in government purchases, an increase in transfer payments, or a reduction in income taxes. Each of these policies increases the deficit and thus 12.3 Issues in Fiscal Policy 506 Chapter 12 Government and Fiscal Policy increases government borrowing. The supply of bonds increases, interest rates rise, investment falls, the exchange rate rises, and net exports fall. Note, however, that it is private investment that is crowded out. The expansionary fiscal policy could take the form of an increase in the investment component of government purchases. As we have learned, some government purchases are for goods, such as office supplies, and services. But the government can also purchase investment items, such as roads and schools. In that case, government investment may be crowding out private investment. The reverse of crowding out occurs with a contractionary fiscal policy—a cut in government purchases or transfer payments, or an increase in taxes. Such policies reduce the deficit (or increase the surplus) and thus reduce government borrowing, shifting the supply curve for bonds to the left. Interest rates drop, inducing a greater quantity of investment. Lower interest rates also reduce the demand for and increase the supply of dollars, lowering the exchange rate and boosting net exports. This phenomenon is known as “crowding in8.” Crowding out and crowding in clearly weaken the impact of fiscal policy. An expansionary fiscal policy has less punch; a contractionary policy puts less of a damper on economic activity. Some economists argue that these forces are so powerful that a change in fiscal policy will have no effect on aggregate demand. Because empirical studies have been inconclusive, the extent of crowding out (and its reverse) remains
a very controversial area of study. Also, the fact that government deficits today may reduce the capital stock that would otherwise be available to future generations does not imply that such deficits are wrong. If, for example, the deficits are used to finance public sector investment, then the reduction in private capital provided to the future is offset by the increased provision of public sector capital. Future generations may have fewer office buildings but more schools. Choice of Policy Suppose Congress and the president agree that something needs to be done to close a recessionary gap. We have learned that fiscal policies that increase government purchases, reduce taxes, or increase transfer payments—or do a combination of these—all have the potential, theoretically, to raise real GDP. The government must decide which kind of fiscal policy to employ. Because the decision makers who determine fiscal policy are all elected politicians, the choice among the policy options available is an intensely political matter, often reflecting the ideology of the politicians. 8. The tendency for a contractionary fiscal policy to increase other components of aggregate demand. 12.3 Issues in Fiscal Policy 507 Chapter 12 Government and Fiscal Policy For example, those who believe that government is too big would argue for tax cuts to close recessionary gaps and for spending cuts to close inflationary gaps. Those who believe that the private sector has failed to provide adequately a host of services that would benefit society, such as better education or public transportation systems, tend to advocate increases in government purchases to close recessionary gaps and tax increases to close inflationary gaps. Another area of contention comes from those who believe that fiscal policy should be constructed primarily so as to promote long-term growth. Supply-side economics9 is the school of thought that promotes the use of fiscal policy to stimulate long-run aggregate supply. Supply-side economists advocate reducing tax rates in order to encourage people to work more or more individuals to work and providing investment tax credits to stimulate capital formation. While there is considerable debate over how strong the supply-side effects are in relation to the demand-side effects, such considerations may affect the choice of policies. Supply-siders tend to favor tax cuts over increases in government purchases or increases in transfer payments. President Reagan advocated tax cuts in 1981 on the basis of their supply-side effects. Coupled with increased defense spending in the early 1980s, fiscal policy under Mr. Reagan clearly stimulated aggregate demand by increasing both consumption and investment. Falling inflation and accelerated growth are signs that supply-side factors may also have been at work during that period. President George W. Bush
’s chief economic adviser, N. Gregory Mankiw, argued that the Bush tax cuts would encourage economic growth, a supply-side argument. Mr. Bush’s next chief economic adviser, Ben Bernanke, who became the next chairman of the Federal Reserve Board in 2006, made a similar argument and urged that the Bush tax cuts be made permanent. Finally, even when there is agreement to stimulate the economy, say through increasing government expenditures on highways, the how question remains. How should the expenditures be allocated? Specifically, which states should the highways run through? Each member of Congress has a political stake in the outcome. These types of considerations make the implementation lag particularly long for fiscal policy. 9. The school of thought that promotes the use of fiscal policy to stimulate long-run aggregate supply. 12.3 Issues in Fiscal Policy 508 Chapter 12 Government and Fiscal Policy • Discretionary fiscal policy involves the same kind of lags as monetary policy. However, the implementation lag in fiscal policy is likely to be more pronounced, while the impact lag is likely to be less pronounced. • Expansionary fiscal policy may result in the crowding out of private investment and net exports, reducing the impact of the policy. Similarly, contractionary policy may “crowd in” additional investment and net exports, reducing the contractionary impact of the policy. • Supply-side economics stresses the use of fiscal policy to stimulate economic growth. Advocates of supply-side economics generally favor tax cuts to stimulate economic growth. T R Y I T! Do the following hypothetical situations tend to enhance or make more difficult the use of fiscal policy as a stabilization tool? 1. Better and more speedily available data on the state of the economy 2. A finding that private sector investment spending is not much affected by interest rate changes 3. A finding that the supply-side effects of a tax cut are substantial 12.3 Issues in Fiscal Policy 509 Chapter 12 Government and Fiscal Policy Case in Point: Crowding Out in Canada In an intriguing study, economist Baotai Wang examined the degree of crowding out of Canadian private investment as a result of government expenditures from 1961–2000. What made Professor Wang’s analysis unusual was that he divided Canadian government expenditures into five categories: expenditures for health and education, expenditures for capital and infrastructure, expenditures for the protection of persons and property (which included defense spending), expenditures for debt services, and expenditures for government and social services. Mr. Wang found that only government expenditures for capital and infrastructure crowded
out private investment. While these expenditures reduced private investment, they represented increased public sector investment for things such as highways and ports. Expenditures for health and education actually “crowded in” private sector investment. These expenditures, Mr. Wang argued, represented increases in human capital. Such increases complement returns on private sector investment and therefore increase it. Mr. Wang found that Canadian government expenditures for debt service, the protection of persons and property, and for government and social services had no effect on private sector investment. He argued that expenditures for protection of persons and property may involve some crowding out, but that they also stimulated private investment by firms winning government contracts for defense purchases. The same explanation could be applied to government expenditures for government and social services. These also include an element of investment in human capital. 12.3 Issues in Fiscal Policy 510 Chapter 12 Government and Fiscal Policy His results suggest that crowding out depends on the nature of spending done by the government. Some kinds of spending clearly did not crowd out private sector investment in Canada. Source: Baotai Wang, “Effects of Government Expenditure on Private Investment: Canadian Empirical Evidence,” Empirical Economics 30, no. 2 (September 2005): 493–504. Data on the economy that are more accurate and more speedily 2. available should enhance the use of fiscal policy by reducing the length of the recognition lag. If private sector investment does not respond much to interest rate changes, then there will be less crowding out when expansionary policies are undertaken. That is, the rising interest rates that accompany expansionary fiscal policy will not reduce investment spending much, making the shift in the aggregate demand curve to the right greater than it would be otherwise. Also, the use of contractionary fiscal policy would be more effective, since the fall in interest rates would “invite in” less investment spending, making the shift in the aggregate demand curve to the left greater than it would otherwise be. 3. Large supply-side effects enhance the impact of tax cuts. For a given expansionary policy, without the supply-side effects, GDP would advance only to the point where the aggregate demand curve intersects the short-run aggregate supply curve. With the supply-side effects, both the short-run and long-run aggregate supply curves shift to the right. The intersection of the AD curve with the now increased short-run aggregate supply curve will be farther to the right than it would have been in the absence of the supply-side effects
. The potential level of real GDP will also increase. 12.3 Issues in Fiscal Policy 511 Chapter 12 Government and Fiscal Policy 12.4 Review and Practice Summary The government sector plays a major role in the economy. The spending, tax, and transfer policies of local, state, and federal agencies affect aggregate demand and aggregate supply and thus affect the level of real GDP and the price level. An expansionary policy tends to increase real GDP. Such a policy could be used to close a recessionary gap. A contractionary fiscal policy tends to reduce real GDP. A contractionary policy could be used to close an inflationary gap. Government purchases of goods and services have a direct impact on aggregate demand. An increase in government purchases shifts the aggregate demand curve by the amount of the initial change in government purchases times the multiplier. Changes in personal income taxes or in the level of transfer payments affect disposable personal income. They change consumption, though initially by less than the amount of the change in taxes or transfers. They thus cause somewhat smaller shifts in the aggregate demand curve than do equal changes in government purchases. There are several issues in the use of fiscal policies for stabilization purposes. They include lags associated with fiscal policy, crowding out, the choice of which fiscal policy tool to use, and the possible burdens of accumulating national debt. 512 Chapter 12 Government and Fiscal Policy. What is the difference between government expenditures and government purchases? How do the two variables differ in terms of their effect on GDP? 2. Federally funded student aid programs generally reduce benefits by $1 for every $1 that recipients earn. Do such programs represent government purchases or transfer payments? Are they automatic stabilizers? 3. Crowding out reduces the degree to which a change in government purchases influences the level of economic activity. Is it a form of automatic stabilizer? 4. Why is it important to try to determine the size of the fiscal policy multiplier? 5. Suppose an economy has an inflationary gap. How does the government’s actual budget deficit or surplus compare to the deficit or surplus it would have at potential output? 6. Suppose the president was given the authority to increase or decrease federal spending by as much as $100 billion in order to stabilize economic activity. Do you think this would tend to make the economy more or less stable? 7. Suppose the government increases purchases in an economy with a recessionary gap. How would this policy affect bond prices, interest rates, investment, net exports, real GDP, and the price level? Show your results
graphically. 8. Suppose the government cuts transfer payments in an economy with an inflationary gap. How would this policy affect bond prices, interest rates, investment, the exchange rate, net exports, real GDP, and the price level? Show your results graphically. 9. Suppose that at the same time the government undertakes expansionary fiscal policy, such as a cut in taxes, the Fed undertakes contractionary monetary policy. How would this policy affect bond prices, interest rates, investment, net exports, real GDP, and the price level? Show your results graphically. 10. Given the nature of the implementation lag discussed in the text, discuss possible measures that might reduce the lag. 12.4 Review and Practice 513 Chapter 12 Government and Fiscal Policy. Look up the table on Federal Receipts and Outlays, by Major Category, in the most recent Economic Report of the President available in your library or on the Internet. a. Complete the following table: Category Total outlays Percentage of total outlays National defense International affairs Health Medicare Income security Social Security Net interest Other b. Construct a pie chart showing the percentages of spending for each category in the total. 2. Look up the table on ownership of U.S. Treasury securities in the most recent Economic Report of the President available on the Internet. a. Make a pie chart showing the percentage owned by various groups in the earliest year shown in the table. b. Make a pie chart showing the percentage owned by various groups in the most recent year shown in the table. c. What are some of the major changes in ownership of U.S. government debt over the period? 12.4 Review and Practice 514 Chapter 12 Government and Fiscal Policy 3. Suppose a country has a national debt of $5,000 billion, a GDP of $10,000 billion, and a budget deficit of $100 billion. a. How much will its new national debt be? b. Compute its debt-GDP ratio. c. Suppose its GDP grows by 1% in the next year and the budget deficit is again $100 billion. Compute its new level of national debt and its new debt-GDP ratio. 4. Suppose a country’s debt rises by 10% and its GDP rises by 12%. a. What happens to the debt-GDP ratio? b. Does the relative level of the initial values affect your answer? 5. The data below show a country’s national debt and its prime lending rate. Year National
debt (billions of $) Lending rate (%) 1992 1993 1994 1995 1996 1997 4,064 4,411 4,692 4,973 5,224 5,413 6.0 6.0 8.5 8.7 8.3 8.5 a. Plot the relationship between national debt and the lending rate. b. Based on your graph, does crowding out appear to be a problem? 6. Suppose a country increases government purchases by $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is $5,000 billion. a. In which direction will the aggregate demand curve shift and by how much? 12.4 Review and Practice 515 Chapter 12 Government and Fiscal Policy b. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve. 7. Suppose a country decreases government purchases by $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is $5,000 billion. a. In which direction will the aggregate demand curve shift and by how much? b. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve. 8. Suppose a country decreases income taxes by $100 billion, and this leads to an increase in consumption spending of $90 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is $5,000 billion. a. In which direction will the aggregate demand curve shift and by how much? b. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve. 9. Suppose a country increases income taxes by $100 billion, and this leads to a decrease in consumption spending of $90 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is $5,000 billion. a. In which direction will the aggregate demand curve shift and by how much? b. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve. 10. Suppose a country institutes an investment tax credit, and this leads to an increase in investment spending of $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is $5,000 billion. a. In which direction will the aggregate demand curve shift and by how much? b. Explain using a graph why the change in real GDP
is likely to be smaller than the shift in the aggregate demand curve. 12.4 Review and Practice 516 Chapter 12 Government and Fiscal Policy 11. Suppose a country repeals an investment tax credit, and this leads to a decrease in investment spending of $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is $5,000 billion. a. In which direction will the aggregate demand curve shift and by how much? b. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve. 12. Explain why the shifts in the aggregate demand curves in questions 7 through 11 above are the same or different in absolute value. 12.4 Review and Practice 517 Chapter 13 Consumption and the Aggregate Expenditures Model Start Up: A Dismal 2008 for Retailers 2008 turned out to be the worst holiday shopping season in decades. Why? U.S. consumers were battered from many directions. Housing prices had fallen nearly 20% over the year. The stock market had fallen over 40%. Interest rates were falling, but credit was extremely hard to come by. By December, consumer confidence hit an all-time low amid concerns of rising unemployment. Cutting back seemed like the best defense for weathering this tough environment. Consumption accounts for the bulk of aggregate demand in the United States and in other countries. In this chapter, we will examine the determinants of consumption and introduce a new model, the aggregate expenditures model, which will give insights into the aggregate demand curve. Any change in aggregate demand causes a change in income, and a change in income causes a change in consumption—which changes aggregate demand and thus income and thus consumption. The aggregate expenditures model will help us to unravel the important relationship between consumption and real GDP. 518 Chapter 13 Consumption and the Aggregate Expenditures Model 13.1 Determining the Level of Consumption. Explain and graph the consumption function and the saving function, explain what the slopes of these curves represent, and explain how the two are related to each other. 2. Compare the current income hypothesis with the permanent income hypothesis, and use each to predict the effect that temporary versus permanent changes in income will have on consumption. 3. Discuss two factors that can cause the consumption function to shift upward or downward. J. R. McCulloch, an economist of the early nineteenth century, wrote, “Consumption … is, in fact, the object of industry.”J. R. Mc Culloch, A Discourse
on the Rise, Progress, Peculiar Objects, and Importance, of Political Economy: Containing the Outline of a Course of Lectures on the Principles and Doctrines of That Science (Edinburgh: Archibald Constable, 1824), 103. Goods and services are produced so that people can use them. The factors that determine consumption thus determine how successful an economy is in fulfilling its ultimate purpose: providing goods and services for people. So, consumption is not just important because it is such a large component of economic activity. It is important because, as McCulloch said, consumption is at the heart of the economy’s fundamental purpose. Consumption and Disposable Personal Income It seems reasonable to expect that consumption spending by households will be closely related to their disposable personal income, which equals the income households receive less the taxes they pay. Note that disposable personal income and GDP are not the same thing. GDP is a measure of total income; disposable personal income is the income households have available to spend during a specified period. Real values of disposable personal income and consumption per year from 1960 through 2011 are plotted in Figure 13.1 "The Relationship between Consumption and Disposable Personal Income, 1960–2011". The data suggest that consumption generally changes in the same direction as does disposable personal income. 519 Chapter 13 Consumption and the Aggregate Expenditures Model The relationship between consumption and disposable personal income is called the consumption function1. It can be represented algebraically as an equation, as a schedule in a table, or as a curve on a graph. Figure 13.1 The Relationship between Consumption and Disposable Personal Income, 1960–2011 Plots of consumption and disposable personal income over time suggest that consumption increases as disposable personal income increases. Source: U. S. Department of Commerce, Bureau of Economic Analysis, NIPA Tables 1.1.6 and 2.1 (revised February 29, 2012). Figure 13.2 "Plotting a Consumption Function" illustrates the consumption function. The relationship between consumption and disposable personal income that we encountered in Figure 13.1 "The Relationship between Consumption and Disposable Personal Income, 1960–2011" is evident in the table and in the curve: consumption in any period increases as disposable personal income increases in that period. The slope of the consumption function tells us by how much. Consider points C and D. When disposable personal income (Yd) rises by $500 billion, consumption rises by $400 billion. More generally, the slope equals the change in
consumption divided by the change in disposable personal income. The ratio of the change in consumption (ΔC) to the change in disposable personal income (ΔYd) is the marginal propensity to consume2 (MPC). The Greek letter delta (Δ) is used to denote “change in.” 1. The relationship between consumption and disposable personal income. 2. The ratio of the change in consumption (ΔC) to the change in disposable personal income (ΔYd). 13.1 Determining the Level of Consumption 520 Chapter 13 Consumption and the Aggregate Expenditures Model Equation 13.1 MPC = ΔC ΔY d In this case, the marginal propensity to consume equals $400/$500 = 0.8. It can be interpreted as the fraction of an extra $1 of disposable personal income that people spend on consumption. Thus, if a person with an MPC of 0.8 received an extra $1,000 of disposable personal income, that person’s consumption would rise by $0.80 for each extra $1 of disposable personal income, or $800. We can also express the consumption function as an equation Equation 13.2 C = $300 billion + 0.8Y d Figure 13.2 Plotting a Consumption Function 13.1 Determining the Level of Consumption 521 Chapter 13 Consumption and the Aggregate Expenditures Model The consumption function relates consumption C to disposable personal income Yd. The equation for the consumption function shown here in tabular and graphical form is C = $300 billion + 0.8Yd. Heads Up! It is important to note carefully the definition of the marginal propensity to consume. It is the change in consumption divided by the change in disposable personal income. It is not the level of consumption divided by the level of disposable personal income. Using Equation 13.2, at a level of disposable personal income of $500 billion, for example, the level of consumption will be $700 billion so that the ratio of consumption to disposable personal income will be 1.4, while the marginal propensity to consume remains 0.8. The marginal propensity to consume is, as its name implies, a marginal concept. It tells us what will happen to an additional dollar of personal disposable income. Notice from the curve in Figure 13.2 "Plotting a Consumption Function" that when disposable personal income equals 0, consumption is $300 billion. The vertical intercept of the consumption function is thus $300 billion. Then, for
every $500 billion increase in disposable personal income, consumption rises by $400 billion. Because the consumption function in our example is linear, its slope is the same between any two points. In this case, the slope of the consumption function, which is the same as the marginal propensity to consume, is 0.8 all along its length. We can use the consumption function to show the relationship between personal saving and disposable personal income. Personal saving3 is disposable personal income not spent on consumption during a particular period; the value of personal saving for any period is found by subtracting consumption from disposable personal income for that period: Equation 13.3 Personal saving = disposable personal income − consumption The saving function4 relates personal saving in any period to disposable personal income in that period. Personal saving is not the only form of saving—firms and government agencies may save as well. In this chapter, however, our focus is on the 3. Disposable personal income not spent on consumption during a particular period. 4. The relationship between personal saving in any period and disposable personal income in that period. 13.1 Determining the Level of Consumption 522 Chapter 13 Consumption and the Aggregate Expenditures Model choice households make between using disposable personal income for consumption or for personal saving. Figure 13.3 "Consumption and Personal Saving" shows how the consumption function and the saving function are related. Personal saving is calculated by subtracting values for consumption from values for disposable personal income, as shown in the table. The values for personal saving are then plotted in the graph. Notice that a 45-degree line has been added to the graph. At every point on the 45-degree line, the value on the vertical axis equals that on the horizontal axis. The consumption function intersects the 45-degree line at an income of $1,500 billion (point D). At this point, consumption equals disposable personal income and personal saving equals 0 (point D′ on the graph of personal saving). Using the graph to find personal saving at other levels of disposable personal income, we subtract the value of consumption, given by the consumption function, from disposable personal income, given by the 45-degree line. Figure 13.3 Consumption and Personal Saving Personal saving equals disposable personal income minus consumption. The table gives hypothetical values for these variables. The consumption function is plotted in the upper part of the graph. At points along the 45-degree line, the values on the two axes are equal; we can measure personal saving as the distance between the 45-degree
line and consumption. The curve of the saving function is in the lower portion of the graph. 13.1 Determining the Level of Consumption 523 Chapter 13 Consumption and the Aggregate Expenditures Model At a disposable personal income of $2,000 billion, for example, consumption is $1,900 billion (point E). Personal saving equals $100 billion (point E′)—the vertical distance between the 45-degree line and the consumption function. At an income of $500 billion, consumption totals $700 billion (point B). The consumption function lies above the 45-degree line at this point; personal saving is −$200 billion (point B′). A negative value for saving means that consumption exceeds disposable personal income; it must have come from saving accumulated in the past, from selling assets, or from borrowing. Notice that for every $500 billion increase in disposable personal income, personal saving rises by $100 billion. Consider points C′ and D′ in Figure 13.3 "Consumption and Personal Saving". When disposable personal income rises by $500 billion, personal saving rises by $100 billion. More generally, the slope of the saving function equals the change in personal saving divided by the change in disposable personal income. The ratio of the change in personal saving (ΔS) to the change in disposable personal income (ΔYd) is the marginal propensity to save5 (MPS). Equation 13.4 MPS = ΔS ΔY d In this case, the marginal propensity to save equals $100/$500 = 0.2. It can be interpreted as the fraction of an extra $1 of disposable personal income that people save. Thus, if a person with an MPS of 0.2 received an extra $1,000 of disposable personal income, that person’s saving would rise by $0.20 for each extra $1 of disposable personal income, or $200. Since people have only two choices of what to do with additional disposable personal income—that is, they can use it either for consumption or for personal saving—the fraction of disposable personal income that people consume (MPC) plus the fraction of disposable personal income that people save (MPS) must add to 1: Equation 13.5 MPC + MPS = 1 Current versus Permanent Income The discussion so far has related consumption in a particular period to income in that same period. The current income hypothesis6 holds that consumption in any one period depends on income during that period, or current income. 5
. The ratio of the change in personal saving (ΔS) to the change in disposable personal income (ΔYd). 6. Consumption in any one period depends on income during that period. 13.1 Determining the Level of Consumption 524 Chapter 13 Consumption and the Aggregate Expenditures Model Although it seems obvious that consumption should be related to disposable personal income, it is not so obvious that consumers base their consumption in any one period on the income they receive during that period. In buying a new car, for example, consumers might base their decision not only on their current income but on the income they expect to receive during the three or four years they expect to be making payments on the car. Parents who purchase a college education for their children might base their decision on their own expected lifetime income. Indeed, it seems likely that virtually all consumption choices could be affected by expectations of income over a very long period. One reason people save is to provide funds to live on during their retirement years. Another is to build an estate they can leave to their heirs through bequests. The amount people save for their retirement or for bequests depends on the income they expect to receive for the rest of their lives. For these and other reasons, then, personal saving (and thus consumption) in any one year is influenced by permanent income. Permanent income7 is the average annual income people expect to receive for the rest of their lives. People who have the same current income but different permanent incomes might reach very different saving decisions. Someone with a relatively low current income but a high permanent income (a college student planning to go to medical school, for example) might save little or nothing now, expecting to save for retirement and for bequests later. A person with the same low income but no expectation of higher income later might try to save some money now to provide for retirement or bequests later. Because a decision to save a certain amount determines how much will be available for consumption, consumption decisions can also be affected by expected lifetime income. Thus, an alternative approach to explaining consumption behavior is the permanent income hypothesis8, which assumes that consumption in any period depends on permanent income. An important implication of the permanent income hypothesis is that a change in income regarded as temporary will not affect consumption much, since it will have little effect on average lifetime income; a change regarded as permanent will have an effect. The current income hypothesis, though, predicts that it does not matter whether consumers view a change in disposable personal income as permanent or
temporary; they will move along the consumption function and change consumption accordingly. The question of whether permanent or current income is a determinant of consumption arose in 1992 when President George H. W. Bush ordered a change in the withholding rate for personal income taxes. Workers have a fraction of their paychecks withheld for taxes each pay period; Mr. Bush directed that this fraction be reduced in 1992. The change in the withholding rate did not change income tax rates; by withholding less in 1992, taxpayers would either receive smaller refund 7. The average annual income people expect to receive for the rest of their lives. 8. Consumption in any period depends on permanent income. 13.1 Determining the Level of Consumption 525 Chapter 13 Consumption and the Aggregate Expenditures Model checks in 1993 or owe more taxes. The change thus left taxpayers’ permanent income unaffected. President Bush’s measure was designed to increase aggregate demand and close the recessionary gap created by the 1990–1991 recession. Economists who subscribed to the permanent income hypothesis predicted that the change would not have any effect on consumption. Those who subscribed to the current income hypothesis predicted that the measure would boost consumption substantially in 1992. A survey of households taken during this period suggested that households planned to spend about 43% of the temporary increase in disposable personal income produced by the withholding experiment.Matthew D. Shapiro and Joel Slemrod, “Consumer Response to the Timing of Income: Evidence from a Change in Tax Withholding,” American Economic Review 85 (March 1995): 274–83. That is considerably less than would be predicted by the current income hypothesis, but more than the zero change predicted by the permanent income hypothesis. This result, together with related evidence, suggests that temporary changes in income can affect consumption, but that changes regarded as permanent will have a much stronger impact. Many of the tax cuts passed during the administration of President George W. Bush are set to expire at the end of 2012. The proposal to make these tax cuts permanent is aimed toward having a stronger impact on consumption, since tax cuts regarded as permanent have larger effects than do changes regarded as temporary. Other Determinants of Consumption The consumption function graphed in Figure 13.2 "Plotting a Consumption Function" and Figure 13.3 "Consumption and Personal Saving" relates consumption spending to the level of disposable personal income. Changes in disposable personal income cause movements along this curve; they do not shift the curve. The curve shifts when other determinants of consumption change. Examples of changes that could shift the
consumption function are changes in real wealth and changes in expectations. Figure 13.4 "Shifts in the Consumption Function" illustrates how these changes can cause shifts in the curve. 13.1 Determining the Level of Consumption 526 Chapter 13 Consumption and the Aggregate Expenditures Model Figure 13.4 Shifts in the Consumption Function An increase in the level of consumption at each level of disposable personal income shifts the consumption function upward in Panel (a). Among the events that would shift the curve upward are an increase in real wealth and an increase in consumer confidence. A reduction in the level of consumption at each level of disposable personal income shifts the curve downward in Panel (b). The events that could shift the curve downward include a reduction in real wealth and a decline in consumer confidence. Changes in Real Wealth An increase in stock and bond prices, for example, would make holders of these assets wealthier, and they would be likely to increase their consumption. An increase in real wealth shifts the consumption function upward, as illustrated in Panel (a) of Figure 13.4 "Shifts in the Consumption Function". A reduction in real wealth shifts it downward, as shown in Panel (b). A change in the price level changes real wealth. We learned in an earlier chapter that the relationship among the price level, real wealth, and consumption is called the wealth effect. A reduction in the price level increases real wealth and shifts the consumption function upward, as shown in Panel (a). An increase in the price level shifts the curve downward, as shown in Panel (b). Changes in Expectations Consumers are likely to be more willing to spend money when they are optimistic about the future. Surveyors attempt to gauge this optimism using “consumer confidence” surveys that ask respondents to report whether they are optimistic or pessimistic about their own economic situation and about the prospects for the 13.1 Determining the Level of Consumption 527 Chapter 13 Consumption and the Aggregate Expenditures Model economy as a whole. An increase in consumer optimism tends to shift the consumption function upward as in Panel (a) of Figure 13.4 "Shifts in the Consumption Function"; an increase in pessimism tends to shift it downward as in Panel (b). The sharp reduction in consumer confidence in 2008 and early in 2009 contributed to a downward shift in the consumption function and thus to the severity of the recession. The relationship between consumption and consumer expectations concerning future economic conditions tends to be a form of self-fulfilling prophecy. If consumers expect economic conditions to worsen, they will cut
their consumption—and economic conditions will worsen! Political leaders often try to persuade people that economic prospects are good. In part, such efforts are an attempt to increase economic activity by boosting consumption • Consumption is closely related to disposable personal income and is represented by the consumption function, which can be presented in a table, in a graph, or in an equation. • Personal saving is disposable personal income not spent on consumption. • The marginal propensity to consume is MPC = ΔC/ΔYd and the marginal propensity to save is MPS = ΔS/ΔYd. The sum of the MPC and MPS is 1. • The current income hypothesis holds that consumption is a function of current disposable personal income, whereas the permanent income hypothesis holds that consumption is a function of permanent income, which is the income households expect to receive annually during their lifetime. The permanent income hypothesis predicts that a temporary change in income will have a smaller effect on consumption than is predicted by the current income hypothesis. • Other factors that affect consumption include real wealth and expectations. 13.1 Determining the Level of Consumption 528 Chapter 13 Consumption and the Aggregate Expenditures Model T R Y I T! For each of the following events, draw a curve representing the consumption function and show how the event would affect the curve. 1. A sharp increase in stock prices increases the real wealth of most households. 2. Consumers decide that a recession is ahead and that their incomes are likely to fall. 3. The price level falls. 13.1 Determining the Level of Consumption 529 Chapter 13 Consumption and the Aggregate Expenditures Model Case in Point: Consumption and the Tax Rebate of 2001 The first round of the Bush tax cuts was passed in 2001. Democrats in Congress insisted on a rebate aimed at stimulating consumption. In the summer of 2001, rebates of $300 per single taxpayer and of $600 for married couples were distributed. The Department of Treasury reported that 92 million people received the rebates. While the rebates were intended to stimulate consumption, the extent to which the tax rebates stimulated consumption, especially during the recession, is an empirical question. It is difficult to analyze the impact of a tax rebate that is a single event experienced by all households at the same time. If spending does change at that moment, is it because of the tax rebate or because of some other event that occurred at that time? Fortunately for researchers Sumit Agarwal, Chunlin Liu, and Nicholas Souleles, using data from credit card accounts
, the 2001 tax rebate checks were distributed over 10 successive weeks from July to September of 2001. The timing of receipt was random, since it was based on the next-to-last digit of one’s Social Security number, and taxpayers were informed well in advance that the checks were coming. The researchers found that consumers initially saved much of their rebates, by paying down their credit card debts, but over a nine-month period, spending increased to about 40% of the rebate. They also found that consumers who were most liquidity constrained (for example, close to their credit card debt limits) spent more than consumers who were less constrained. The researchers thus conclude that their findings do not support the permanent income hypothesis, since consumers responded to spending based on when they received their checks and because the results indicate that consumers do respond to what they call “lumpy” changes in income, such as 13.1 Determining the Level of Consumption 530 Chapter 13 Consumption and the Aggregate Expenditures Model those generated by a tax rebate. In other words, current income does seem to matter. Two other studies of the 2001 tax rebate reached somewhat different conclusions. Using survey data, researchers Matthew D. Shapiro and Joel Slemrod estimated an MPC of about one-third. They note that this low increased spending is particularly surprising, since the rebate was part of a general tax cut that was expected to last a long time. At the other end, David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles, using yet another data set, found that looking over a six-month period, the MPC was about two-thirds. So, while there is disagreement on the size of the MPC, all conclude that the impact was non-negligible. Sources: Sumit Agarwal, Chunlin Liu, and Nicholas S. Souleles, “The Reaction of Consumer Spending and Debt to Tax Rebates—Evidence from Consumer Credit Data,” NBER Working Paper No. 13694, December 2007; David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles, “Household Expenditure and the Income Tax Rebates of 2001,” American Economic Review 96, no. 5 (December 2006): 1589–1610; Matthew D. Shapiro and Joel Slemrod, “Consumer Response to Tax Rebates,” American Economic Review 93, no. 1 (March 2003): 381–96; and Matthew
D. Shapiro and Joel Slemrod, “Did the 2001 Rebate Stimulate Spending? Evidence from Taxpayer Surveys," NBER Tax Policy & the Economy 17, no. 1 (2003): 83–109. A sharp increase in stock prices makes people wealthier and shifts the consumption function upward, as in Panel (a) of Figure 13.4 "Shifts in the Consumption Function". 2. This would be reported as a reduction in consumer confidence. Consumers are likely to respond by reducing their purchases, particularly of durable items such as cars and washing machines. The consumption function will shift downward, as in Panel (b) of Figure 13.4 "Shifts in the Consumption Function". 3. A reduction in the price level increases real wealth and thus boosts consumption. The consumption function will shift upward, as in Panel (a) of Figure 13.4 "Shifts in the Consumption Function". 13.1 Determining the Level of Consumption 531 Chapter 13 Consumption and the Aggregate Expenditures Model 13.2 The Aggregate Expenditures Model. Explain and illustrate the aggregate expenditures model and the concept of equilibrium real GDP. 2. Distinguish between autonomous and induced aggregate expenditures and explain why a change in autonomous expenditures leads to a multiplied change in equilibrium real GDP. 3. Discuss how adding taxes, government purchases, and net exports to a simplified aggregate expenditures model affects the multiplier and hence the impact on real GDP that arises from an initial change in autonomous expenditures. The consumption function relates the level of consumption in a period to the level of disposable personal income in that period. In this section, we incorporate other components of aggregate demand: investment, government purchases, and net exports. In doing so, we shall develop a new model of the determination of equilibrium real GDP, the aggregate expenditures model9. This model relates aggregate expenditures10, which equal the sum of planned levels of consumption, investment, government purchases, and net exports at a given price level, to the level of real GDP. We shall see that people, firms, and government agencies may not always spend what they had planned to spend. If so, then actual real GDP will not be the same as aggregate expenditures, and the economy will not be at the equilibrium level of real GDP. One purpose of examining the aggregate expenditures model is to gain a deeper understanding of the “ripple effects” from a change in one or more components of aggregate demand. As we saw in the chapter that introduced the aggregate demand and aggregate supply model, a change in investment,
government purchases, or net exports leads to greater production; this creates additional income for households, which induces additional consumption, leading to more production, more income, more consumption, and so on. The aggregate expenditures model provides a context within which this series of ripple effects can be better understood. A second reason for introducing the model is that we can use it to derive the aggregate demand curve for the model of aggregate demand and aggregate supply. To see how the aggregate expenditures model works, we begin with a very simplified model in which there is neither a government sector nor a foreign sector. 532 9. Model that relates aggregate expenditures to the level of real GDP. 10. The sum of planned levels of consumption, investment, government purchases, and net exports at a given price level. Chapter 13 Consumption and the Aggregate Expenditures Model Then we use the findings based on this simplified model to build a more realistic model. The equations for the simplified economy are easier to work with, and we can readily apply the conclusions reached from analyzing a simplified economy to draw conclusions about a more realistic one. The Aggregate Expenditures Model: A Simplified View To develop a simple model, we assume that there are only two components of aggregate expenditures: consumption and investment. In the chapter on measuring total output and income, we learned that real gross domestic product and real gross domestic income are the same thing. With no government or foreign sector, gross domestic income in this economy and disposable personal income would be nearly the same. To simplify further, we will assume that depreciation and undistributed corporate profits (retained earnings) are zero. Thus, for this example, we assume that disposable personal income and real GDP are identical. Finally, we shall also assume that the only component of aggregate expenditures that may not be at the planned level is investment. Firms determine a level of investment they intend to make in each period. The level of investment firms intend to make in a period is called planned investment11. Some investment is unplanned. Suppose, for example, that firms produce and expect to sell more goods during a period than they actually sell. The unsold goods will be added to the firms’ inventories, and they will thus be counted as part of investment. Unplanned investment12 is investment during a period that firms did not intend to make. It is also possible that firms may sell more than they had expected. In this case, inventories will fall below what firms expected, in which case, unplanned investment would be negative. Investment during a period equals the
sum of planned investment (IP) and unplanned investment (IU). Equation 13.6 I = IP + IU 11. The level of investment firms intend to make in a period. 12. Investment during a period that firms did not intend to make. 13. Expenditures that do not vary with the level of real GDP. We shall find that planned and unplanned investment play key roles in the aggregate expenditures model. Autonomous and Induced Aggregate Expenditures Economists distinguish two types of expenditures. Expenditures that do not vary with the level of real GDP are called autonomous aggregate expenditures13. In our example, we assume that planned investment expenditures are autonomous. Expenditures that vary with real GDP are called induced aggregate 13.2 The Aggregate Expenditures Model 533 Chapter 13 Consumption and the Aggregate Expenditures Model expenditures14. Consumption spending that rises with real GDP is an example of an induced aggregate expenditure. Figure 13.5 "Autonomous and Induced Aggregate Expenditures" illustrates the difference between autonomous and induced aggregate expenditures. With real GDP on the horizontal axis and aggregate expenditures on the vertical axis, autonomous aggregate expenditures are shown as a horizontal line in Panel (a). A curve showing induced aggregate expenditures has a slope greater than zero; the value of an induced aggregate expenditure changes with changes in real GDP. Panel (b) shows induced aggregate expenditures that are positively related to real GDP. Figure 13.5 Autonomous and Induced Aggregate Expenditures Autonomous aggregate expenditures do not vary with the level of real GDP; induced aggregate expenditures do. Autonomous aggregate expenditures are shown by the horizontal line in Panel (a). Induced aggregate expenditures vary with real GDP, as in Panel (b). Autonomous and Induced Consumption The concept of the marginal propensity to consume suggests that consumption contains induced aggregate expenditures; an increase in real GDP raises consumption. But consumption contains an autonomous component as well. The level of consumption at the intersection of the consumption function and the vertical axis is regarded as autonomous consumption; this level of spending would occur regardless of the level of real GDP. Consider the consumption function we used in deriving the schedule and curve illustrated in Figure 13.2 "Plotting a Consumption Function": 14. Expenditures that vary with real GDP. 13.2 The Aggregate Expenditures Model 534 Chapter 13 Consumption and the Aggregate Expenditures Model C = $300 billion + 0.8Y We can omit the subscript on disposable personal income because of the simplifications we have made in this section, and the symbol Y can
be thought of as representing both disposable personal income and GDP. Because we assume that the price level in the aggregate expenditures model is constant, GDP equals real GDP. At every level of real GDP, consumption includes $300 billion in autonomous aggregate expenditures. It will also contain expenditures “induced” by the level of real GDP. At a level of real GDP of $2,000 billion, for example, consumption equals $1,900 billion: $300 billion in autonomous aggregate expenditures and $1,600 billion in consumption induced by the $2,000 billion level of real GDP. Figure 13.6 "Autonomous and Induced Consumption" illustrates these two components of consumption. Autonomous consumption, Ca, which is always $300 billion, is shown in Panel (a); its equation is Equation 13.7 Ca = $300 billion Induced consumption Ci is shown in Panel (b); its equation is Equation 13.8 Ci = 0.8Y The consumption function is given by the sum of Equation 13.7 and Equation 13.8; it is shown in Panel (c) of Figure 13.6 "Autonomous and Induced Consumption". It is the same as the equation C = $300 billion + 0.8Yd, since in this simple example, Y and Yd are the same. 13.2 The Aggregate Expenditures Model 535 Chapter 13 Consumption and the Aggregate Expenditures Model Figure 13.6 Autonomous and Induced Consumption Consumption has an autonomous component and an induced component. In Panel (a), autonomous consumption Ca equals $300 billion at every level of real GDP. Panel (b) shows induced consumption Ci. Total consumption C is shown in Panel (c). Plotting the Aggregate Expenditures Curve In this simplified economy, investment is the only other component of aggregate expenditures. We shall assume that investment is autonomous and that firms plan to invest $1,100 billion per year. Equation 13.9 IP = $1,100 billion The level of planned investment is unaffected by the level of real GDP. 15. The relationship of aggregate expenditures to the value of real GDP. Aggregate expenditures equal the sum of consumption C and planned investment IP. The aggregate expenditures function15 is the relationship of aggregate 13.2 The Aggregate Expenditures Model 536 Chapter 13 Consumption and the Aggregate Expenditures Model expenditures to the value of real GDP. It can be represented with an equation, as a table, or as a curve. We begin with the definition of
aggregate expenditures AE when there is no government or foreign sector: Equation 13.10 AE = C + IP Substituting the information from above on consumption and planned investment yields (throughout this discussion all values are in billions of base-year dollars) AE = $300 + 0.8Y + $1,100 or Equation 13.11 AE = $1,400 + 0.8Y Equation 13.11 is the algebraic representation of the aggregate expenditures function. We shall use this equation to determine the equilibrium level of real GDP in the aggregate expenditures model. It is important to keep in mind that aggregate expenditures measure total planned spending at each level of real GDP (for any given price level). Real GDP is total production. Aggregate expenditures and real GDP need not be equal, and indeed will not be equal except when the economy is operating at its equilibrium level, as we will see in the next section. In Equation 13.11, the autonomous component of aggregate expenditures is $1,400 billion, and the induced component is 0.8Y. We shall plot this aggregate expenditures function. To do so, we arbitrarily select various levels of real GDP and then use Equation 13.10 to compute aggregate expenditures at each level. At a level of real GDP of $6,000 billion, for example, aggregate expenditures equal $6,200 billion: AE = $1,400 + 0.8 ($6,000) = $6,200 The table in Figure 13.7 "Plotting the Aggregate Expenditures Curve" shows the values of aggregate expenditures at various levels of real GDP. Based on these values, we plot the aggregate expenditures curve. To obtain each value for 13.2 The Aggregate Expenditures Model 537 Chapter 13 Consumption and the Aggregate Expenditures Model aggregate expenditures, we simply insert the corresponding value for real GDP into Equation 13.11. The value at which the aggregate expenditures curve intersects the vertical axis corresponds to the level of autonomous aggregate expenditures. In our example, autonomous aggregate expenditures equal $1,400 billion. That figure includes $1,100 billion in planned investment, which is assumed to be autonomous, and $300 billion in autonomous consumption expenditure. Figure 13.7 Plotting the Aggregate Expenditures Curve Values for aggregate expenditures AE are computed by inserting values for real GDP into Equation 13.10; these are given in the aggregate expenditures schedule. The point at which the aggregate expenditures curve intersects the vertical axis is the value of autonomous aggregate expenditures,
here $1,400 billion. The slope of this aggregate expenditures curve is 0.8. The Slope of the Aggregate Expenditures Curve The slope of the aggregate expenditures curve, given by the change in aggregate expenditures divided by the change in real GDP between any two points, measures the additional expenditures induced by increases in real GDP. The slope for the aggregate expenditures curve in Figure 13.7 "Plotting the Aggregate Expenditures Curve" is shown for points B and C: it is 0.8. 13.2 The Aggregate Expenditures Model 538 Chapter 13 Consumption and the Aggregate Expenditures Model In Figure 13.7 "Plotting the Aggregate Expenditures Curve", the slope of the aggregate expenditures curve equals the marginal propensity to consume. This is because we have assumed that the only other expenditure, planned investment, is autonomous and that real GDP and disposable personal income are identical. Changes in real GDP thus affect only consumption in this simplified economy. Equilibrium in the Aggregate Expenditures Model Real GDP is a measure of the total output of firms. Aggregate expenditures equal total planned spending on that output. Equilibrium in the model occurs where aggregate expenditures in some period equal real GDP in that period. One way to think about equilibrium is to recognize that firms, except for some inventory that they plan to hold, produce goods and services with the intention of selling them. Aggregate expenditures consist of what people, firms, and government agencies plan to spend. If the economy is at its equilibrium real GDP, then firms are selling what they plan to sell (that is, there are no unplanned changes in inventories). Figure 13.8 "Determining Equilibrium in the Aggregate Expenditures Model" illustrates the concept of equilibrium in the aggregate expenditures model. A 45-degree line connects all the points at which the values on the two axes, representing aggregate expenditures and real GDP, are equal. Equilibrium must occur at some point along this 45-degree line. The point at which the aggregate expenditures curve crosses the 45-degree line is the equilibrium real GDP, here achieved at a real GDP of $7,000 billion. 13.2 The Aggregate Expenditures Model 539 Chapter 13 Consumption and the Aggregate Expenditures Model Figure 13.8 Determining Equilibrium in the Aggregate Expenditures Model The 45-degree line shows all the points at which aggregate expenditures AE equal real GDP, as required for equilibrium. The equilibrium solution occurs where the AE curve crosses the 45-degree line, at a real GDP
of $7,000 billion. Equation 13.11 tells us that at a real GDP of $7,000 billion, the sum of consumption and planned investment is $7,000 billion—precisely the level of output firms produced. At that level of output, firms sell what they planned to sell and keep inventories that they planned to keep. A real GDP of $7,000 billion represents equilibrium in the sense that it generates an equal level of aggregate expenditures. If firms were to produce a real GDP greater than $7,000 billion per year, aggregate expenditures would fall short of real GDP. At a level of real GDP of $9,000 billion per year, for example, aggregate expenditures equal $8,600 billion. Firms would be left with $400 billion worth of goods they intended to sell but did not. Their actual level of investment would be $400 billion greater than their planned level of investment. With those unsold goods on hand (that is, with an unplanned increase in inventories), firms would be likely to cut their output, moving the economy toward its equilibrium GDP of $7,000 billion. If firms were to produce $5,000 billion, aggregate expenditures would be $5,400 billion. Consumers and firms would 13.2 The Aggregate Expenditures Model 540 Chapter 13 Consumption and the Aggregate Expenditures Model demand more than was produced; firms would respond by reducing their inventories below the planned level (that is, there would be an unplanned decrease in inventories) and increasing their output in subsequent periods, again moving the economy toward its equilibrium real GDP of $7,000 billion. Figure 13.9 "Adjusting to Equilibrium Real GDP" shows possible levels of real GDP in the economy for the aggregate expenditures function illustrated in Figure 13.8 "Determining Equilibrium in the Aggregate Expenditures Model". It shows the level of aggregate expenditures at various levels of real GDP and the direction in which real GDP will change whenever AE does not equal real GDP. At any level of real GDP other than the equilibrium level, there is unplanned investment. Figure 13.9 Adjusting to Equilibrium Real GDP Each level of real GDP will result in a particular amount of aggregate expenditures. If aggregate expenditures are less than the level of real GDP, firms will reduce their output and real GDP will fall. If aggregate expenditures exceed real GDP, then firms will increase their output and real GDP will rise. If aggregate expenditures equal real GDP, then firms will leave their output unchanged
; we have achieved equilibrium in the aggregate expenditures model. At equilibrium, there is no unplanned investment. Here, that occurs at a real GDP of $7,000 billion. Changes in Aggregate Expenditures: The Multiplier In the aggregate expenditures model, equilibrium is found at the level of real GDP at which the aggregate expenditures curve crosses the 45-degree line. It follows that a shift in the curve will change equilibrium real GDP. Here we will examine the magnitude of such changes. Figure 13.10 "A Change in Autonomous Aggregate Expenditures Changes Equilibrium Real GDP" begins with the aggregate expenditures curve shown in Figure 13.8 "Determining Equilibrium in the Aggregate Expenditures Model". Now suppose that planned investment increases from the original value of $1,100 billion to a new value of $1,400 billion—an increase of $300 billion. This increase in planned investment shifts the aggregate expenditures curve upward by $300 billion, all other things unchanged. Notice, however, that the new aggregate expenditures 13.2 The Aggregate Expenditures Model 541 Chapter 13 Consumption and the Aggregate Expenditures Model curve intersects the 45-degree line at a real GDP of $8,500 billion. The $300 billion increase in planned investment has produced an increase in equilibrium real GDP of $1,500 billion. Figure 13.10 A Change in Autonomous Aggregate Expenditures Changes Equilibrium Real GDP An increase of $300 billion in planned investment raises the aggregate expenditures curve by $300 billion. The $300 billion increase in planned investment results in an increase in equilibrium real GDP of $1,500 billion. How could an increase in aggregate expenditures of $300 billion produce an increase in equilibrium real GDP of $1,500 billion? The answer lies in the operation of the multiplier. Because firms have increased their demand for investment goods (that is, for capital) by $300 billion, the firms that produce those goods will have $300 billion in additional orders. They will produce $300 billion in additional real GDP and, given our simplifying assumption, $300 billion in additional disposable personal income. But in this economy, each $1 of additional real GDP induces $0.80 in additional consumption. The $300 billion increase in autonomous aggregate expenditures initially induces $240 billion (= 0.8 × $300 billion) in additional consumption. 13.2 The Aggregate Expenditures Model 542 Chapter 13 Consumption and the Aggregate Expenditures Model The $240 billion in additional consumption boosts production, creating
another $240 billion in real GDP. But that second round of increase in real GDP induces $192 billion (= 0.8 × $240) in additional consumption, creating still more production, still more income, and still more consumption. Eventually (after many additional rounds of increases in induced consumption), the $300 billion increase in aggregate expenditures will result in a $1,500 billion increase in equilibrium real GDP. Table 13.1 "The Multiplied Effect of an Increase in Autonomous Aggregate Expenditures" shows the multiplied effect of a $300 billion increase in autonomous aggregate expenditures, assuming each $1 of additional real GDP induces $0.80 in additional consumption. Table 13.1 The Multiplied Effect of an Increase in Autonomous Aggregate Expenditures Round of spending Increase in real GDP (billions of dollars 10 11 12 Subsequent rounds Total increase in real GDP $300 240 192 154 123 98 79 63 50 40 32 26 +103 $1,500 The size of the additional rounds of expenditure is based on the slope of the aggregate expenditures function, which in this example is simply the marginal propensity to consume. Had the slope been flatter (if the marginal propensity to consume were smaller), the additional rounds of spending would have been smaller. A steeper slope would mean that the additional rounds of spending would have been larger. 13.2 The Aggregate Expenditures Model 543 Chapter 13 Consumption and the Aggregate Expenditures Model This process could also work in reverse. That is, a decrease in planned investment would lead to a multiplied decrease in real GDP. A reduction in planned investment would reduce the incomes of some households. They would reduce their consumption by the MPC times the reduction in their income. That, in turn, would reduce incomes for households that would have received the spending by the first group of households. The process continues, thus multiplying the impact of the reduction in aggregate expenditures resulting from the reduction in planned investment. Computation of the Multiplier The multiplier16 is the number by which we multiply an initial change in aggregate demand to get the full amount of the shift in the aggregate demand curve. Because the multiplier shows the amount by which the aggregate demand curve shifts at a given price level, and the aggregate expenditures model assumes a given price level, we can use the aggregate expenditures model to derive the multiplier explicitly. Let Yeq be the equilibrium level of real GDP in the aggregate expenditures model, and let A be autonomous aggregate expenditures. Then the multiplier is Equation 13.12 Multiplier = ΔY eq
ΔA⎯ ⎯⎯ In the example we have just discussed, a change in autonomous aggregate expenditures of $300 billion produced a change in equilibrium real GDP of $1,500 billion. The value of the multiplier is therefore $1,500/$300 = 5. The multiplier effect works because a change in autonomous aggregate expenditures causes a change in real GDP and disposable personal income, inducing a further change in the level of aggregate expenditures, which creates still more GDP and thus an even higher level of aggregate expenditures. The degree to which a given change in real GDP induces a change in aggregate expenditures is given in this simplified economy by the marginal propensity to consume, which, in this case, is the slope of the aggregate expenditures curve. The slope of the aggregate expenditures curve is thus linked to the size of the multiplier. We turn now to an investigation of the relationship between the marginal propensity to consume and the multiplier. 16. The number by which we multiply an initial change in aggregate demand to get the full amount of the shift in the aggregate demand curve. 13.2 The Aggregate Expenditures Model 544 Chapter 13 Consumption and the Aggregate Expenditures Model The Marginal Propensity to Consume and the Multiplier We can compute the multiplier for this simplified economy from the marginal propensity to consume. We know that the amount by which equilibrium real GDP will change as a result of a change in aggregate expenditures consists of two parts: the change in autonomous aggregate expenditures itself, ΔA⎯ ⎯⎯, and the induced change in spending. This induced change equals the marginal propensity to consume times the change in equilibrium real GDP, ΔYeq. Thus Equation 13.13 ΔY eq = ΔA⎯ ⎯⎯ + MPC ΔY eq Subtract the MPCΔYeq term from both sides of the equation: ΔY eq − MPC ΔY eq = ΔA⎯ ⎯⎯ Factor out the ΔYeq term on the left: ΔY eq (1 − MPC) = ΔA⎯ ⎯⎯ Finally, solve for the multiplier ΔY eq/ΔA⎯ ⎯⎯ by dividing both sides of the equation above by ΔA and by dividing both sides by (1 − MPC). We get the following: Equation 13.14 ΔY eq ΔA⎯ ⎯⎯ = 1 1 − MP
C We thus compute the multiplier by taking 1 minus the marginal propensity to consume, then dividing the result into 1. In our example, the marginal propensity to consume is 0.8; the multiplier is 5, as we have already seen [multiplier = 1/(1 − MPC) = 1/(1 − 0.8) = 1/0.2 = 5]. Since the sum of the marginal propensity to consume and the marginal propensity to save is 1, the denominator on the right-hand side of Equation 13.13 is equivalent to the MPS, and the multiplier could also be expressed as 1/MPS. 13.2 The Aggregate Expenditures Model 545 Chapter 13 Consumption and the Aggregate Expenditures Model Equation 13.15 Multiplier = 1 MPS We can rearrange terms in Equation 13.14 to use the multiplier to compute the impact of a change in autonomous aggregate expenditures. We simply multiply both sides of the equation by A⎯ ⎯⎯ to obtain the following: Equation 13.16 ΔY eq = ΔA⎯ ⎯⎯ 1 − MPC The change in the equilibrium level of income in the aggregate expenditures model (remember that the model assumes a constant price level) equals the change in autonomous aggregate expenditures times the multiplier. Thus, the greater the multiplier, the greater will be the impact on income of a change in autonomous aggregate expenditures. The Aggregate Expenditures Model in a More Realistic Economy Four conclusions emerge from our application of the aggregate expenditures model to the simplified economy presented so far. These conclusions can be applied to a more realistic view of the economy. 1. The aggregate expenditures function relates aggregate expenditures to real GDP. The intercept of the aggregate expenditures curve shows the level of autonomous aggregate expenditures. The slope of the aggregate expenditures curve shows how much increases in real GDP induce additional aggregate expenditures. 2. Equilibrium real GDP occurs where aggregate expenditures equal real GDP. 3. A change in autonomous aggregate expenditures changes equilibrium real GDP by a multiple of the change in autonomous aggregate expenditures. 4. The size of the multiplier depends on the slope of the aggregate expenditures curve. The steeper the aggregate expenditures curve, the larger the multiplier; the flatter the aggregate expenditures curve, the smaller the multiplier. 13.2 The Aggregate Expenditures Model 546 Chapter 13 Consumption and the Aggregate Expenditures Model These four points still hold as we add the two other components of aggregate expenditures—government purchases and net exports—and
recognize that government not only spends but also collects taxes. We look first at the effect of adding taxes to the aggregate expenditures model and then at the effect of adding government purchases and net exports. Taxes and the Aggregate Expenditure Function Suppose that the only difference between real GDP and disposable personal income is personal income taxes. Let us see what happens to the slope of the aggregate expenditures function. As before, we assume that the marginal propensity to consume is 0.8, but we now add the assumption that income taxes take ¼ of real GDP. This means that for every additional $1 of real GDP, disposable personal income rises by $0.75 and, in turn, consumption rises by $0.60 (= 0.8 × $0.75). In the simplified model in which disposable personal income and real GDP were the same, an additional $1 of real GDP raised consumption by $0.80. The slope of the aggregate expenditures curve was 0.8, the marginal propensity to consume. Now, as a result of taxes, the aggregate expenditures curve will be flatter than the one shown in Figure 13.7 "Plotting the Aggregate Expenditures Curve" and Figure 13.9 "Adjusting to Equilibrium Real GDP". In this example, the slope will be 0.6; an additional $1 of real GDP will increase consumption by $0.60. Other things the same, the multiplier will be smaller than it was in the simplified economy in which disposable personal income and real GDP were identical. The wedge between disposable personal income and real GDP created by taxes means that the additional rounds of spending induced by a change in autonomous aggregate expenditures will be smaller than if there were no taxes. Hence, the multiplied effect of any change in autonomous aggregate expenditures is smaller. The Addition of Government Purchases and Net Exports Suppose that government purchases and net exports are autonomous. If so, they enter the aggregate expenditures function in the same way that investment did. Compared to the simplified aggregate expenditures model, the aggregate expenditures curve shifts up by the amount of government purchases and net exports.An even more realistic view of the economy might assume that imports are induced, since as a country’s real GDP rises it will buy more goods and services, some of which will be imports. In that case, the slope of the aggregate expenditures curve would change. 13.2 The Aggregate Expenditures Model 547 Chapter 13 Consumption and the Aggregate Expenditures Model Figure 13.11 "The Aggregate Expenditures Function: Comparison of a
Simplified Economy and a More Realistic Economy" shows the difference between the aggregate expenditures model of the simplified economy in Figure 13.8 "Determining Equilibrium in the Aggregate Expenditures Model" and a more realistic view of the economy. Panel (a) shows an AE curve for an economy with only consumption and investment expenditures. In Panel (b), the AE curve includes all four components of aggregate expenditures. Figure 13.11 The Aggregate Expenditures Function: Comparison of a Simplified Economy and a More Realistic Economy Panel (a) shows an aggregate expenditures curve for a simplified view of the economy; Panel (b) shows an aggregate expenditures curve for a more realistic model. The AE curve in Panel (b) has a higher intercept than the AE curve in Panel (a) because of the additional components of autonomous aggregate expenditures in a more realistic view of the economy. The slope of the AE curve in Panel (b) is flatter than the slope of the AE curve in Panel (a). In a simplified economy, the slope of the AE curve is the marginal propensity to consume (MPC). In a more realistic view of the economy, it is less than the MPC because of the difference between real GDP and disposable personal income. There are two major differences between the aggregate expenditures curves shown in the two panels. Notice first that the intercept of the AE curve in Panel (b) is higher than that of the AE curve in Panel (a). The reason is that, in addition to the autonomous part of consumption and planned investment, there are two other components of aggregate expenditures—government purchases and net exports—that we have also assumed are autonomous. Thus, the intercept of the aggregate expenditures curve in Panel (b) is the sum of the four autonomous aggregate expenditures components: consumption (Ca), planned investment (IP), government purchases (G), and net exports (Xn). In Panel (a), the intercept includes only the first two components. 13.2 The Aggregate Expenditures Model 548 Chapter 13 Consumption and the Aggregate Expenditures Model Second, notice that the slope of the aggregate expenditures curve is flatter for the more realistic economy in Panel (b) than it is for the simplified economy in Panel (a). This can be seen by comparing the slope of the aggregate expenditures curve between points A and B in Panel (a) to the slope of the aggregate expenditures curve between points A′ and B′ in Panel (b). Between both sets of points, real GDP changes by the same amount, $
1,000 billion. In Panel (a), consumption rises by $800 billion, whereas in Panel (b) consumption rises by only $600 billion. This difference occurs because, in the more realistic view of the economy, households have only a fraction of real GDP available as disposable personal income. Thus, for a given change in real GDP, consumption rises by a smaller amount. Let us examine what happens to equilibrium real GDP in each case if there is a shift in autonomous aggregate expenditures, such as an increase in planned investment, as shown in Figure 13.12 "A Change in Autonomous Aggregate Expenditures: Comparison of a Simplified Economy and a More Realistic Economy". In both panels, the initial level of equilibrium real GDP is the same, Y1. Equilibrium real GDP occurs where the given aggregate expenditures curve intersects the 45-degree line. The aggregate expenditures curve shifts up by the same amount—ΔA is the same in both panels. The new level of equilibrium real GDP occurs where the new AE curve intersects the 45-degree line. In Panel (a), we see that the new level of equilibrium real GDP rises to Y2, but in Panel (b) it rises only to Y3. Since the same change in autonomous aggregate expenditures led to a greater increase in equilibrium real GDP in Panel (a) than in Panel (b), the multiplier for the more realistic model of the economy must be smaller. The multiplier is smaller, of course, because the slope of the aggregate expenditures curve is flatter. Figure 13.12 A Change in Autonomous Aggregate Expenditures: Comparison of a Simplified Economy and a More Realistic Economy 13.2 The Aggregate Expenditures Model 549 Chapter 13 Consumption and the Aggregate Expenditures Model In Panels (a) and (b), equilibrium real GDP is initially Y1. Then autonomous aggregate expenditures rise by the same amount, ΔIP. In Panel (a), the upward shift in the AE curve leads to a new level of equilibrium real GDP of Y2; in Panel (b) equilibrium real GDP rises to Y3. Because equilibrium real GDP rises by more in Panel (a) than in Panel (b), the multiplier in the simplified economy is greater than in the more realistic one • The aggregate expenditures model relates aggregate expenditures to real GDP. Equilibrium in the model occurs where aggregate expenditures equal real GDP and is found graphically at the intersection of the aggregate expenditures curve and the 45-degree line. • Economists distinguish between autonomous and induced
aggregate expenditures. The former do not vary with GDP; the latter do. • Equilibrium in the aggregate expenditures model implies that unintended investment equals zero. • A change in autonomous aggregate expenditures leads to a change in equilibrium real GDP, which is a multiple of the change in autonomous aggregate expenditures. • The size of the multiplier depends on the slope of the aggregate expenditures curve. In general, the steeper the aggregate expenditures curve, the greater the multiplier. The flatter the aggregate expenditures curve, the smaller the multiplier. Income taxes tend to flatten the aggregate expenditures curve. • 13.2 The Aggregate Expenditures Model 550 Chapter 13 Consumption and the Aggregate Expenditures Model T R Y I T! Suppose you are given the following data for an economy. All data are in billions of dollars. Y is actual real GDP, and C, IP, G, and Xn are the consumption, planned investment, government purchases, and net exports components of aggregate expenditures, respectively. Y C Ip G Xn $0 $800 $1,000 $1,400 −$200 2,500 2,300 1,000 1,400 −200 5,000 3,800 1,000 1,400 −200 7,500 5,300 1,000 1,400 −200 10,000 6,800 1,000 1,400 −200 1. Plot the corresponding aggregate expenditures curve and draw in the 45-degree line. 2. What is the intercept of the AE curve? What is its slope? 3. Determine the equilibrium level of real GDP. 4. Now suppose that net exports fall by $1,000 billion and that this is the only change in autonomous aggregate expenditures. Plot the new aggregate expenditures curve. What is the new equilibrium level of real GDP? 5. What is the value of the multiplier? 13.2 The Aggregate Expenditures Model 551 Chapter 13 Consumption and the Aggregate Expenditures Model Case in Point: Fiscal Policy in the Kennedy Administration It was the first time expansionary fiscal policy had ever been proposed. The economy had slipped into a recession in 1960. Presidential candidate John Kennedy received proposals from several economists that year for a tax cut aimed at stimulating the economy. As a candidate, he was unconvinced. But, as president he proposed the tax cut in 1962. His chief economic adviser, Walter Heller, defended the tax cut idea before Congress and introduced what was politically a novel concept: the multiplier. In testimony to the Senate Subcommittee on Employment and Manpower, Mr. Heller
predicted that a $10 billion cut in personal income taxes would boost consumption “by over $9 billion.” To assess the ultimate impact of the tax cut, Mr. Heller applied the aggregate expenditures model. He rounded the increased consumption off to $9 billion and explained, “This is far from the end of the matter. The higher production of consumer goods to meet this extra spending would mean extra employment, higher payrolls, higher profits, and higher farm and professional and service incomes. This added purchasing power would generate still further increases in spending and incomes. … The initial rise of $9 billion, plus this extra consumption spending and extra output of consumer goods, would add over $18 billion to our annual GDP.” 13.2 The Aggregate Expenditures Model 552 Chapter 13 Consumption and the Aggregate Expenditures Model We can summarize this continuing process by saying that a “multiplier” of approximately 2 has been applied to the direct increment of consumption spending. Mr. Heller also predicted that proposed cuts in corporate income tax rates would increase investment by about $6 billion. The total change in autonomous aggregate expenditures would thus be $15 billion: $9 billion in consumption and $6 billion in investment. He predicted that the total increase in equilibrium GDP would be $30 billion, the amount the Council of Economic Advisers had estimated would be necessary to reach full employment. In the end, the tax cut was not passed until 1964, after President Kennedy’s assassination in 1963. While the Council of Economic Advisers concluded that the tax cut had worked as advertised, it came long after the economy had recovered and tended to push the economy into an inflationary gap. As we will see in later chapters, the tax cut helped push the economy into a period of rising inflation. Source: Economic Report of the President 1964 (Washington, DC: U.S. Government Printing Office, 1964), 172–73. 13.2 The Aggregate Expenditures Model 553 Chapter 13 Consumption and the Aggregate Expenditures Model. The aggregate expenditures curve is plotted in the accompanying chart as AE1. 2. The intercept of the AE1 curve is $3,000. It is the amount of aggregate expenditures (C + IP + G + Xn) when real GDP is zero. The slope of the AE1 curve is 0.6. It can be found by determining the amount of aggregate expenditures for any two levels of real GDP and then by dividing the change in aggregate expenditures by the change in real GDP over the
interval. For example, between real GDP of $2,500 and $5,000, aggregate expenditures go from $4,500 to $6,000. Thus, ΔAE 1 ΔY = $6,000 − $4,500 $5,000 − $2,500 = $1,500 $2,500 = 0.6 3. The equilibrium level of real GDP is $7,500. It can be found by determining the intersection of AE1 and the 45-degree line. At Y = $7,500, AE1 = $5,300 + 1,000 + 1,400 − 200 = $7,500. 4. A reduction of net exports of $1,000 shifts the aggregate expenditures curve down by $1,000 to AE2. The equilibrium real GDP falls from $7,500 to $5,000. The new aggregate expenditures curve, AE2, intersects the 45-degree line at real GDP of $5,000. 5. The multiplier is 2.5 [= (−$2,500)/(−$1,000)]. 13.2 The Aggregate Expenditures Model 554 Chapter 13 Consumption and the Aggregate Expenditures Model 13.3 Aggregate Expenditures and Aggregate Demand. Explain and illustrate how a change in the price level affects the aggregate expenditures curve. 2. Explain and illustrate how to derive an aggregate demand curve from the aggregate expenditures curve for different price levels. 3. Explain and illustrate how an increase or decrease in autonomous aggregate expenditures affects the aggregate demand curve. We can use the aggregate expenditures model to gain greater insight into the aggregate demand curve. In this section we shall see how to derive the aggregate demand curve from the aggregate expenditures model. We shall also see how to apply the analysis of multiplier effects in the aggregate expenditures model to the aggregate demand–aggregate supply model. Aggregate Expenditures Curves and Price Levels An aggregate expenditures curve assumes a fixed price level. If the price level were to change, the levels of consumption, investment, and net exports would all change, producing a new aggregate expenditures curve and a new equilibrium solution in the aggregate expenditures model. A change in the price level changes people’s real wealth. Suppose, for example, that your wealth includes $10,000 in a bond account. An increase in the price level would reduce the real value of this money, reduce your real wealth, and thus reduce your consumption. Similarly, a reduction in the price level would increase the real value of money
holdings and thus increase real wealth and consumption. The tendency for price level changes to change real wealth and consumption is called the wealth effect17. 17. The tendency for price level changes to change real wealth and consumption. 18. The tendency for a higher price level to reduce the real quantity of money, raise interest rates, and reduce investment. Because changes in the price level also affect the real quantity of money, we can expect a change in the price level to change the interest rate. A reduction in the price level will increase the real quantity of money and thus lower the interest rate. A lower interest rate, all other things unchanged, will increase the level of investment. Similarly, a higher price level reduces the real quantity of money, raises interest rates, and reduces investment. This is called the interest rate effect18. 555 Chapter 13 Consumption and the Aggregate Expenditures Model Finally, a change in the domestic price level will affect exports and imports. A higher price level makes a country’s exports fall and imports rise, reducing net exports. A lower price level will increase exports and reduce imports, increasing net exports. This impact of different price levels on the level of net exports is called the international trade effect19. Panel (a) of Figure 13.13 "From Aggregate Expenditures to Aggregate Demand" shows three possible aggregate expenditures curves for three different price levels. For example, the aggregate expenditures curve labeled AEP=1.0 is the aggregate expenditures curve for an economy with a price level of 1.0. Since that aggregate expenditures curve crosses the 45-degree line at $6,000 billion, equilibrium real GDP is $6,000 billion at that price level. At a lower price level, aggregate expenditures would rise because of the wealth effect, the interest rate effect, and the international trade effect. Assume that at every level of real GDP, a reduction in the price level to 0.5 would boost aggregate expenditures by $2,000 billion to AEP = 0.5, and an increase in the price level from 1.0 to 1.5 would reduce aggregate expenditures by $2,000 billion. The aggregate expenditures curve for a price level of 1.5 is shown as AEP=1.5. There is a different aggregate expenditures curve, and a different level of equilibrium real GDP, for each of these three price levels. A price level of 1.5 produces equilibrium at point A, a price level of 1.0 does so at point B, and a price level of 0.
5 does so at point C. More generally, there will be a different level of equilibrium real GDP for every price level; the higher the price level, the lower the equilibrium value of real GDP. 19. The impact of different price levels on the level of net exports. 13.3 Aggregate Expenditures and Aggregate Demand 556 Chapter 13 Consumption and the Aggregate Expenditures Model Figure 13.13 From Aggregate Expenditures to Aggregate Demand Because there is a different aggregate expenditures curve for each price level, there is a different equilibrium real GDP for each price level. Panel (a) shows aggregate expenditures curves for three different price levels. Panel (b) shows that the aggregate demand curve, which shows the quantity of goods and services demanded at each price level, can thus be derived from the aggregate expenditures model. The aggregate expenditures curve for a price level of 1.0, for example, intersects the 45-degree line in Panel (a) at point B, producing an equilibrium real GDP of $6,000 billion. We can thus plot point B′ on the aggregate demand curve in Panel (b), which shows that at a price level of 1.0, a real GDP of $6,000 billion is demanded. Panel (b) of Figure 13.13 "From Aggregate Expenditures to Aggregate Demand" shows how an aggregate demand curve can be derived from the aggregate expenditures curves for different price levels. The equilibrium real GDP associated with each price level in the aggregate expenditures model is plotted as a point showing the price level and the quantity of goods and services demanded (measured as real GDP). At a price level of 1.0, for example, the equilibrium level of real GDP in the aggregate expenditures model in Panel (a) is $6,000 billion at point B. That means $6,000 billion worth of goods and services is demanded; point B' on the aggregate demand curve in Panel (b) corresponds to a real GDP demanded of $6,000 billion and a price level of 1.0. At a price level of 0.5 the equilibrium GDP demanded is $10,000 billion at point C', and at a price level of 1.5 the equilibrium real GDP demanded is $2,000 billion at point A'. The aggregate demand curve thus 13.3 Aggregate Expenditures and Aggregate Demand 557 Chapter 13 Consumption and the Aggregate Expenditures Model shows the equilibrium real GDP from the aggregate expenditures model at each price level. The Multiplier and Changes in Agg
regate Demand In the aggregate expenditures model, a change in autonomous aggregate expenditures changes equilibrium real GDP by the multiplier times the change in autonomous aggregate expenditures. That model, however, assumes a constant price level. How can we incorporate the concept of the multiplier into the model of aggregate demand and aggregate supply? Consider the aggregate expenditures curves given in Panel (a) of Figure 13.14 "Changes in Aggregate Demand", each of which corresponds to a particular price level. Suppose net exports rise by $1,000 billion. Such a change increases aggregate expenditures at each price level by $1,000 billion. A $1,000-billion increase in net exports shifts each of the aggregate expenditures curves up by $1,000 billion, to AE′P=1.0 and AE′P=1.5. That changes the equilibrium real GDP associated with each price level; it thus shifts the aggregate demand curve to AD2 in Panel (b). In the aggregate expenditures model, equilibrium real GDP changes by an amount equal to the initial change in autonomous aggregate expenditures times the multiplier, so the aggregate demand curve shifts by the same amount. In this example, we assume the multiplier is 2. The aggregate demand curve thus shifts to the right by $2,000 billion, two times the $1,000-billion change in autonomous aggregate expenditures. Figure 13.14 Changes in Aggregate Demand 13.3 Aggregate Expenditures and Aggregate Demand 558 Chapter 13 Consumption and the Aggregate Expenditures Model The aggregate expenditures curves for price levels of 1.0 and 1.5 are the same as in Figure 13.13 "From Aggregate Expenditures to Aggregate Demand", as is the aggregate demand curve. Now suppose a $1,000-billion increase in net exports shifts each of the aggregate expenditures curves up; AEP=1.0, for example, rises to AE′P=1.0. The aggregate demand curve thus shifts to the right by $2,000 billion, the change in aggregate expenditures times the multiplier, assumed to be 2 in this example. In general, any change in autonomous aggregate expenditures shifts the aggregate demand curve. The amount of the shift is always equal to the change in autonomous aggregate expenditures times the multiplier. An increase in autonomous aggregate expenditures shifts the aggregate demand curve to the right; a reduction shifts it to the left • There will be a different aggregate expenditures curve for each price level. • Aggregate expenditures will vary with the price level because of the wealth effect, the interest rate effect
, and the international trade effect. The higher the price level, the lower the aggregate expenditures curve and the lower the equilibrium level of real GDP. The lower the price level, the higher the aggregate expenditures curve and the higher the equilibrium level of real GDP. • A change in autonomous aggregate expenditures shifts the aggregate expenditures curve for each price level. That shifts the aggregate demand curve by an amount equal to the change in autonomous aggregate expenditures times the multiplier. T R Y I T! Sketch three aggregate expenditures curves for price levels of P1, P2, and P3, where P1 is the lowest price level and P3 the highest (you do not have numbers for this exercise; simply sketch curves of the appropriate shape). Label the equilibrium levels of real GDP Y1, Y2, and Y3. Now draw the aggregate demand curve implied by your analysis, labeling points that correspond to P1, P2, and P3 and Y1, Y2, and Y3. You can use Figure 13.13 "From Aggregate Expenditures to Aggregate Demand" as a model for your work. 13.3 Aggregate Expenditures and Aggregate Demand 559 Chapter 13 Consumption and the Aggregate Expenditures Model Case in Point: Predicting the Impact of Alternative Fiscal Policies Using a large-scale model of the U.S. economy to simulate the effects of government policies, Princeton University professor Alan Blinder and Moody Analytics chief economist Mark Zandi concluded that the expansionary fiscal, monetary, and other policies aimed at relieving the financial crisis (such as the Troubled Asset Relief Program, or TARP) worked together from 2008 onward to effectively combat the Great Recession and probably kept it from turning into the Great Depression 2.0. Specifically, they estimated that U.S. GDP would have fallen about 12% peak-to-trough and that the unemployment rate would have hit 16.5% without these policies, instead of GDP declining about 4% and the unemployment rate reaching about 10%. While they attribute the bulk of the improvement to monetary and other financial policies, they found that fiscal policies also played a substantial role. For example, they concluded that fiscal stimulus added more than 3% to real GDP in 2010. How much did the different components of the fiscal policies contribute? The following table provides estimates for the multiplied effects of various stimulus measures that were considered. In general, they estimate a stronger “bang for the buck,” or multiplier, from spending increases than from tax cuts. Tax cuts Nonrefundable
lump-sum tax rebate Refundable lump-sum tax rebate Temporary tax cuts Payroll tax holiday Across-the-board tax cut Bang for the buck 1.01 1.22 1.24 1.02 13.3 Aggregate Expenditures and Aggregate Demand 560 Chapter 13 Consumption and the Aggregate Expenditures Model Accelerated depreciation Permanent tax cuts Extend alternative minimum tax patch Make Bush income tax cuts permanent Make dividend and capital gains tax cuts permanent Spending increases Extending UI benefits Temporary increase in food stamps General aid to state governments Increased infrastructure spending 0.25 0.51 0.32 0.32 1.61 1.74 1.41 1.57 While Blinder and Zandy acknowledge that no one can know for sure what would have happened without the policy responses and that not all aspects of the programs were perfectly designed or implemented, they feel strongly that the aggressive policies were, overall, appropriate and worth taking. Source: Alan S. Blinder and Mark Zandi, “How the Great Recession Was Brought to an End,” Moody’s Economy.com, July 27, 2010. 13.3 Aggregate Expenditures and Aggregate Demand 561 Chapter 13 Consumption and the Aggregate Expenditures Model The lowest price level, P1, corresponds to the highest AE curve, AEP = P1, as shown. This suggests a downward-sloping aggregate demand curve. Points A, B, and C on the AE curve correspond to points A′, B′, and C′ on the AD curve, respectively. 13.3 Aggregate Expenditures and Aggregate Demand 562 Chapter 13 Consumption and the Aggregate Expenditures Model 13.4 Review and Practice 563 Chapter 13 Consumption and the Aggregate Expenditures Model Summary This chapter presented the aggregate expenditures model. Aggregate expenditures are the sum of planned levels of consumption, investment, government purchases, and net exports at a given price level. The aggregate expenditures model relates aggregate expenditures to the level of real GDP. We began by observing the close relationship between consumption and disposable personal income. A consumption function shows this relationship. The saving function can be derived from the consumption function. The time period over which income is considered to be a determinant of consumption is important. The current income hypothesis holds that consumption in one period is a function of income in that same period. The permanent income hypothesis holds that consumption in a period is a function of permanent income. An important implication of the permanent income hypothesis is that the marginal propensity to consume will be smaller for temporary than
for permanent changes in disposable personal income. Changes in real wealth and consumer expectations can affect the consumption function. Such changes shift the curve relating consumption to disposable personal income, the graphical representation of the consumption function; changes in disposable personal income do not shift the curve but cause movements along it. An aggregate expenditures curve shows total planned expenditures at each level of real GDP. This curve is used in the aggregate expenditures model to determine the equilibrium real GDP (at a given price level). A change in autonomous aggregate expenditures produces a multiplier effect that leads to a larger change in equilibrium real GDP. In a simplified economy, with only consumption and investment expenditures, in which the slope of the aggregate expenditures curve is the marginal propensity to consume (MPC), the multiplier is equal to 1/(1 − MPC). Because the sum of the marginal propensity to consume and the marginal propensity to save (MPS) is 1, the multiplier in this simplified model is also equal to 1/MPS. Finally, we derived the aggregate demand curve from the aggregate expenditures model. Each point on the aggregate demand curve corresponds to the equilibrium level of real GDP as derived in the aggregate expenditures model for each price level. The downward slope of the aggregate demand curve (and the shifting of the aggregate expenditures curve at each price level) reflects the wealth effect, the interest rate effect, and the international trade effect. A change in autonomous aggregate expenditures shifts the aggregate demand curve by an amount equal to the change in autonomous aggregate expenditures times the multiplier. In a more realistic aggregate expenditures model that includes all four components of aggregate expenditures (consumption, investment, government purchases, and net exports), the slope of the aggregate expenditures curve shows the additional aggregate expenditures induced by increases in real GDP, and the size of the 13.4 Review and Practice 564 Chapter 13 Consumption and the Aggregate Expenditures Model multiplier depends on the slope of the aggregate expenditures curve. The steeper the aggregate expenditures curve, the larger the multiplier; the flatter the aggregate expenditures curve, the smaller the multiplier. Explain the difference between autonomous and induced expenditures. Give examples of each. 2. The consumption function we studied in the chapter predicted that consumption would sometimes exceed disposable personal income. How could this be? 3. The consumption function can be represented as a table, as an equation, or as a curve. Distinguish among these three representations. 4. The introduction to this chapter described the behavior of consumer spending at the end of 2008. Explain this phenomenon in terms of the analysis presented in this chapter. 5. Explain the
role played by the 45-degree line in the aggregate expenditures model. 6. Your college or university, if it does what many others do, occasionally releases a news story claiming that its impact on the total employment in the local economy is understated by its own employment statistics. If the institution keeps accurate statistics, is that possible? 7. Suppose the level of investment in a certain economy changes when the level of real GDP changes; an increase in real GDP induces an increase in investment, while a reduction in real GDP causes investment to fall. How do you think such behavior would affect the slope of the aggregate expenditures curve? The multiplier? 8. Give an intuitive explanation for how the multiplier works on a reduction in autonomous aggregate expenditures. Why does equilibrium real GDP fall by more than the change in autonomous aggregate expenditures? 9. Explain why the marginal propensity to consume out of a temporary tax rebate would be lower than that for a permanent rebate. 10. Pretend you are a member of the Council of Economic Advisers and are trying to persuade the members of the House Appropriations Committee to purchase $100 billion worth of new materials, in part to stimulate the economy. Explain to the members how the multiplier process will work. 13.4 Review and Practice 565 Chapter 13 Consumption and the Aggregate Expenditures Model. Suppose the following information describes a simple economy. Figures are in billion of dollars. Disposable personal income Consumption 0 100 200 300 100 120 140 160 a. What is the marginal propensity to consume? b. What is the marginal propensity to save? c. Write an equation that describes consumption. d. Write an equation that describes saving. 2. The graph below shows a consumption function. a. When disposable personal income is equal to zero, how much is consumption? b. When disposable personal income is equal to $4,000 billion, how much is consumption? c. At what level of personal disposable income are consumption and disposable personal income equal? d. How much is personal saving when consumption is $2,500 billion? e. How much is personal saving when consumption is $5,000 billion? f. What is the marginal propensity to consume? g. What is the marginal propensity to save? 13.4 Review and Practice 566 Chapter 13 Consumption and the Aggregate Expenditures Model h. Draw the saving function implied by the consumption function above. 3. For the purpose of this exercise, assume that the consumption function is given by C = $500 billion + 0.8Yd. Construct a consumption and saving table
showing how income is divided between consumption and personal saving when disposable personal income (in billions) is $0, $500, $1,000, $1,500, $2,000, $2,500, $3,000, and $3,500. a. Graph your results, placing disposable personal income on the horizontal axis and consumption on the vertical axis. b. What is the value of the marginal propensity to consume? c. What is the value of the marginal propensity to save? 4. The graph below characterizes a simple economy with only two components of aggregate expenditures, consumption and investment. a. How much is planned investment? How do you know? b. Is planned investment autonomous or induced? How do you know? c. How much is autonomous aggregate expenditures? d. What is the value of equilibrium real GDP? e. If real GDP were $2,000 billion, how much would unplanned investment be? How would you expect firms to respond? If real GDP were $4,000 billion, how much would unplanned investment be? How would you expect firms to respond? g. Write an equation for aggregate expenditures based on the f. graph above. h. What is the value of the multiplier in this example? 13.4 Review and Practice 567 Chapter 13 Consumption and the Aggregate Expenditures Model 5. Explain and illustrate graphically how each of the following events affects aggregate expenditures and equilibrium real GDP. In each case, state the nature of the change in aggregate expenditures, and state the relationship between the change in AE and the change in equilibrium real GDP. Investment falls. a. b. Government purchases go up. c. The government sends $1,000 to every person in the United States. d. Real GDP rises by $500 billion. 6. Mary Smith, whose marginal propensity to consume is 0.75, is faced with an unexpected increase in taxes of $1,000. Will she cut back her consumption expenditures by the full $1,000? How will she pay for the higher tax? Explain. 7. The equations below give consumption functions for economies in which planned investment is autonomous and is the only other component of GDP. Compute the marginal propensity to consume and the multiplier for each economy. a. C = $650 + 0.33Y b. C = $180 + 0.9Y c. C = $1,500 d. C = $700 + 0.8Y 8. Suppose that in Economies A and B the only
components of aggregate expenditure are consumption and planned investment. The marginal propensity to consume in Economy A is 0.9, while in Economy B it is 0.7. Both economies experience an increase in planned investment, which is assumed to be autonomous, of $100 billion. Compare the changes in the equilibrium level of real GDP and the shifts in aggregate demand this will produce in the two economies. 9. Assume an economy in which people would spend $200 billion on consumption even if real GDP were zero and, in addition, increase their consumption by $0.50 for each additional $1 of real GDP. Assume further that the sum of planned investment plus government purchases plus net exports is $200 billion regardless of the level of real GDP. a. What is the equilibrium level of income in this economy? 13.4 Review and Practice 568 Chapter 13 Consumption and the Aggregate Expenditures Model b. If the economy is currently operating at an output level of $1,200 billion, what do you predict will happen to real GDP in the future? 10. Suppose the aggregate expenditures curve in Numerical Problem 9 is drawn for a price level of 1.2. A reduction in the price level to 1 increases aggregate expenditures by $400 billion at each level of real GDP. Draw the implied aggregate demand curve. 13.4 Review and Practice 569 Chapter 14 Investment and Economic Activity Start Up: Jittery Firms Slash Investment In the recession that began in late 2007 in the United States, the first main element of GDP that faltered was the part of investment called residential structures. When housing prices started falling in 2006, new home construction slowed down. In 2008, this sector had shrunk by more than 40% from where it had been just a few years earlier. In 2008, the part of investment that reflects business spending on equipment ranging from computers to machines to trucks also turned down. The only major part of investment left standing was business spending on structures—factories, hospitals, office buildings, and such. In late 2008, firms around the world seemed to be trying to outdo each other in announcing cutbacks. Among automakers, it was not just the Detroit 3 cutting back. Toyota announced an indefinite delay in building a Prius hybrid sedan plant in Mississippi.Kate Linebaugh, “Toyota Delays Mississippi Prius Factor Amid Slump,” Wall Street Journal, December 16, 2008, p. B1. Walgreen’s, which had been increasing drugstore locations by about 8% a year,
said it would expand by only about 4% in 2009 and by less than 3% in 2010.Amy Merrick, “Walgreen to Cut Back on Opening New Stores,” Wall Street Journal, December 23, 2008, p. B1. Package carrier FedEx announced a 20% decline in capital spending, on top of suspending pension contributions and cutting salaries.Darren Shannon, “FedEx Takes More Measures to Offset Fiscal Uncertainty,” Aviation Daily, December 19, 2008, p. 6. Even hospitals began scaling back on construction.Reed Abelson, “Hurting for Business,” New York Times, November 7, 2008, p. B1. Companies around the world were announcing similar cutbacks. Consumer electronics maker Sony announced is was not only closing plants but also not moving forward in constructing an LCD television plant in Slovakia.Bettina Wassener, “Sony to Cut 8,000 Workers and Shut Plants,” New York Times, December 10, 2008, p. B8. With the drop in oil prices, oil companies were also cancelling planned projects right and left.Steve LeVine, “Pullback in the Oil Patch,” Business Week, December 8, 2008, p. 60. 570 Chapter 14 Investment and Economic Activity Choices about how much to invest must always be made in the face of uncertainty; firms cannot know what the marketplace has in store. Investment is a gamble; firms that make the gamble hope for a profitable payoff. And, if they are concerned that the payoff may not materialize, they will be quick to take the kinds of actions cited above—to slash investment spending. Private investment plays an important role, not only in the short run, by influencing aggregate demand, but also in the long run, for it influences the rate at which the economy grows. That is, it influences long-run aggregate supply. In this chapter, we will examine factors that determine investment by firms, and we will study its relationship to output in the short run and in the long run. One determinant of investment is public policy; we will examine the ways in which public policy affects investment. Private firms are not the only source of investment; government agencies engage in investment as well. We examined the impact of the public sector on macroeconomic performance in the chapter devoted to fiscal policy. When we refer to “investment” in this chapter, we will be referring to investment carried out in the private sector. 571
Chapter 14 Investment and Economic Activity 14.1 The Role and Nature of Investment. Discuss the components of the investment spending category of GDP and distinguish between gross and net investment. 2. Discuss the relationship between consumption, saving, and investment, and explain the relationship using the production possibilities model. How important is investment? Consider any job you have ever performed. Your productivity in that job was largely determined by the investment choices that had been made before you began to work. If you worked as a clerk in a store, the equipment used in collecting money from customers affected your productivity. It may have been a simple cash register, or a sophisticated computer terminal that scanned purchases and was linked to the store’s computer, which computed the store’s inventory and did an analysis of the store’s sales as you entered each sale. If you have worked for a lawn maintenance firm, the kind of equipment you had to work with influenced your productivity. You were more productive if you had the latest mulching power lawn mowers than if you struggled with a push mower. Whatever the work you might have done, the kind and quality of capital you had to work with strongly influenced your productivity. And that capital was available because investment choices had provided it. Investment adds to the nation’s capital stock. We saw in the chapter on economic growth that an increase in capital shifts the aggregate production function outward, increases the demand for labor, and shifts the long-run aggregate supply curve to the right. Investment therefore affects the economy’s potential output and thus its standard of living in the long run. Investment is a component of aggregate demand. Changes in investment shift the aggregate demand curve and thus change real GDP and the price level in the short run. An increase in investment shifts the aggregate demand curve to the right; a reduction shifts it to the left. Components of Investment Additions to the stock of private capital are called Gross Private Domestic Investment (GPDI). GPDI includes four categories of investment: 572 Chapter 14 Investment and Economic Activity 1. Nonresidential Structures. This category of investment includes the construction of business structures such as private office buildings, warehouses, factories, private hospitals and universities, and other structures in which the production of goods and services takes place. A structure is counted as GPDI only during the period in which it is built. It may be sold several times after being built, but such sales are not counted as investment. Recall that investment is part of GDP, and GDP is the value of
production in any period, not total sales. 2. Nonresidential Equipment and Software. Producers’ equipment includes computers and software, machinery, trucks, cars, and desks, that is, any business equipment that is expected to last more than a year. Equipment and software are counted as investment only in the period in which they are produced. 3. Residential Investment. This category includes all forms of residential construction, whether apartment houses or single-family homes, as well as residential equipment such as computers and software. 4. Change in Private Inventories. Private inventories are considered part of the nation’s capital stock, because those inventories are used to produce other goods. All private inventories are capital; additions to private inventories are thus investment. When private inventories fall, that is recorded as negative investment. Figure 14.1 "Components of Gross Private Domestic Investment, 1995–2011" shows the components of gross private domestic investment from 1995 through 2011. We see that producers’ equipment and software constitute the largest component of GPDI in the United States. Residential investment was the second largest component of GPDI for most of the period shown but it shrank considerably during the 2007–2009 recession and has yet to recover. 14.1 The Role and Nature of Investment 573 Chapter 14 Investment and Economic Activity Figure 14.1 Components of Gross Private Domestic Investment, 1995–2011 This chart shows the levels of each of the four components of gross private domestic investment from 1995 through 2011. Nonresidential equipment and software is the largest component of GPDI and has shown the most substantial growth over the period. Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012). Gross and Net Investment As capital is used, some of it wears out or becomes obsolete; it depreciates (the Commerce Department reports depreciation as “consumption of fixed capital”). Investment adds to the capital stock, and depreciation reduces it. Gross investment minus depreciation is net investment. If gross investment is greater than depreciation in any period, then net investment is positive and the capital stock increases. If gross investment is less than depreciation in any period, then net investment is negative and the capital stock declines. In the official estimates of total output, gross investment (GPDI) minus depreciation equals net private domestic investment (NPDI). The value for NPDI in any period 14.1 The Role and Nature of Investment 574 Chapter 14 Investment and Economic Activity
gives the amount by which the privately held stock of physical capital changed during that period. Figure 14.2 "Gross Private Domestic Investment, Depreciation, and Net Private Domestic Investment, 1990–2011" reports the real values of GPDI, depreciation, and NPDI from 1990 to 2011. We see that the bulk of GPDI replaces capital that has been depreciated. Notice the sharp reductions in NPDI during the recessions of 1990–1991, 2001, and especially 2007–2009. Figure 14.2 Gross Private Domestic Investment, Depreciation, and Net Private Domestic Investment, 1990–2011 The bulk of gross private domestic investment goes to the replacement of capital that has depreciated, as shown by the experience of the past two decades. Source: Bureau of Economic Analysis, NIPA Table 5.2.6 (revised February 29, 2012). The Volatility of Investment Investment, measured as GPDI, is among the most volatile components of GDP. In percentage terms, year-to-year changes in GPDI are far greater than the year-toyear changes in consumption or government purchases. Net exports are also quite volatile, but they represent a much smaller share of GDP. Figure 14.3 "Changes in Components of Real GDP, 1990–2011" compares annual percentage changes in GPDI, 14.1 The Role and Nature of Investment 575 Chapter 14 Investment and Economic Activity personal consumption, and government purchases. Of course, a dollar change in investment will be a much larger change in percentage terms than a dollar change in consumption, which is the largest component of GDP. But compare investment and government purchases: their shares in GDP are comparable, but investment is clearly more volatile. Figure 14.3 Changes in Components of Real GDP, 1990–2011 Annual percentage changes in real GPDI have been much greater than annual percentage changes in the real values of personal consumption or government purchases. Source: Bureau of Economic Analysis, NIPA Table 1.1.1 (revised February 29, 2012). Given that the aggregate demand curve shifts by an amount equal to the multiplier times an initial change in investment, the volatility of investment can cause real GDP to fluctuate in the short run. Downturns in investment may trigger recessions. 14.1 The Role and Nature of Investment 576 Chapter 14 Investment and Economic Activity Investment, Consumption, and Saving Earlier we used the production possibilities curve to illustrate how choices are made about investment, consumption, and saving. Because such choices
are crucial to understanding how investment affects living standards, it will be useful to reexamine them here. Figure 14.4 "The Choice between Consumption and Investment" shows a production possibilities curve for an economy that can produce two kinds of goods: consumption goods and investment goods. An economy operating at point A on PPC1 is using its factors of production fully and efficiently. It is producing CA units of consumption goods and IA units of investment each period. Suppose that depreciation equals IA, so that the quantity of investment each period is just sufficient to replace depreciated capital; net investment equals zero. If there is no change in the labor force, in natural resources, or in technology, the production possibilities curve will remain fixed at PPC1. Now suppose decision makers in this economy decide to sacrifice the production of some consumption goods in favor of greater investment. The economy moves to point B on PPC1. Production of consumption goods falls to CB, and investment rises to IB. Assuming depreciation remains IA, net investment is now positive. As the nation’s capital stock increases, the production possibilities curve shifts outward to PPC2. Once that shift occurs, it will be possible to select a point such as D on the new production possibilities curve. At this point, consumption equals CD, and investment equals ID. By sacrificing consumption early on, the society is able to increase both its consumption and investment in the future. That early reduction in consumption requires an increase in saving. We see that a movement along the production possibilities curve in the direction of the production of more investment goods and fewer consumption goods allows the production of more of both types of goods in the future. Figure 14.4 The Choice between Consumption and Investment A society with production possibilities curve PPC1 could choose to produce at point A, producing CA consumption goods and investment of IA. If depreciation equals IA, then net investment is zero, and the production possibilities curve will not shift, assuming no other determinants of the curve change. By cutting its production of consumption goods and 14.1 The Role and Nature of Investment 577 Chapter 14 Investment and Economic Activity increasing investment to IB, however, the society can, over time, shift its production possibilities curve out to PPC2, making it possible to enjoy greater production of consumption goods in the future Investment adds to the nation’s capital stock. • • Gross private domestic investment includes the construction of nonresidential structures, the production of equipment and software, private residential construction, and changes in inventories. • The
bulk of gross private domestic investment goes to the replacement • • of depreciated capital. Investment is the most volatile component of GDP. Investment represents a choice to postpone consumption—it requires saving. T R Y I T! Which of the following would be counted as gross private domestic investment? 1. Millie hires a contractor to build a new garage for her home. 2. Millie buys a new car for her teenage son. 3. Grandpa buys Tommy a savings bond. 4. General Motors builds a new automobile assembly plant. 14.1 The Role and Nature of Investment 578 Chapter 14 Investment and Economic Activity Case in Point: The Reduction of Private Capital in the Depression and in the Great Recession Net private domestic investment (NPDI) has been negative during only three periods in the last 80 years. During one period, World War II, massive defense spending forced cutbacks in private sector spending. (Recall that government investment is not counted as part of net private domestic investment in the official accounts; production of defense capital thus is not reflected in these figures.) The second period in which NPDI was negative was the Great Depression. Aggregate demand plunged during the first four years of the Depression. As firms cut their output in response to reductions in demand, their need for capital fell as well. They reduced their capital by holding gross private domestic investment below depreciation beginning in 1931. That produced negative net private domestic investment; it remained negative until 1936 and became negative again in 1938. In all, firms reduced the private capital stock by more than $529.5 billion (in 2007 dollars) during the period. 14.1 The Role and Nature of Investment 579 Chapter 14 Investment and Economic Activity A third—very brief and very small—encounter with negative net private domestic investment occurred in 2009, when it fell by $1 billion (in 2005 dollars). The two graphs in this case present a contrast between the Great Depression and the Great Recession. The Great Recession was bad, but the Great Depression was ever so much worse. 14.1 The Role and Nature of Investment 580 Chapter 14 Investment and Economic Activity. A new garage would be part of residential construction and thus part of GPDI. 2. Consumer purchases of cars are part of the consumption component of the GDP accounts and thus not part of GPDI. 3. The purchase of a savings bond is an example of a financial investment. Since it is not an addition to the nation’s capital stock, it is not part of GPDI.
4. The construction of a new factory is counted in the nonresidential structures component of GPDI. 14.1 The Role and Nature of Investment 581 Chapter 14 Investment and Economic Activity 14.2 Determinants of Investment. Draw a hypothetical investment demand curve, and explain what it shows about the relationship between investment and the interest rate. 2. Discuss the factors that can cause an investment demand curve to shift. We will see in this section that interest rates play a key role in the determination of the desired stock of capital and thus of investment. Because investment is a process through which capital is increased in one period for use in future periods, expectations play an important role in investment as well. Capital is one factor of production, along with labor and natural resources. A decision to invest is a decision to use more capital in producing goods and services. Factors that affect firms’ choices in the mix of capital, labor, and natural resources will affect investment as well. We will also see in this section that public policy affects investment. Some investment is done by government agencies as they add to the public stock of capital. In addition, the tax and regulatory policies chosen by the public sector can affect the investment choices of private firms and individuals. Interest Rates and Investment We often hear reports that low interest rates have stimulated housing construction or that high rates have reduced it. Such reports imply a negative relationship between interest rates and investment in residential structures. This relationship applies to all forms of investment: higher interest rates tend to reduce the quantity of investment, while lower interest rates increase it. To see the relationship between interest rates and investment, suppose you own a small factory and are considering the installation of a solar energy collection system to heat your building. You have determined that the cost of installing the system would be $10,000 and that the system would lower your energy bills by $1,000 per year. To simplify the example, we shall suppose that these savings will continue forever and that the system will never need repair or maintenance. Thus, we need to consider only the $10,000 purchase price and the $1,000 annual savings. 582 Chapter 14 Investment and Economic Activity If the system is installed, it will be an addition to the capital stock and will therefore be counted as investment. Should you purchase the system? Suppose that your business already has the $10,000 on hand. You are considering whether to use the money for the solar energy system or for the purchase of a bond. Your decision to purchase the system or the bond will
depend on the interest rate you could earn on the bond. Putting $10,000 into the solar energy system generates an effective income of $1,000 per year—the saving the system will produce. That is a return of 10% per year. Suppose the bond yields a 12% annual interest. It thus generates interest income of $1,200 per year, enough to pay the $1,000 in heating bills and have $200 left over. At an interest rate of 12%, the bond is the better purchase. If, however, the interest rate on bonds were 8%, then the solar energy system would yield a higher income than the bond. At interest rates below 10%, you will invest in the solar energy system. At interest rates above 10%, you will buy a bond instead. At an interest rate of precisely 10%, it is a toss-up. If you do not have the $10,000 on hand and would need to borrow the money to purchase the solar energy system, the interest rate still governs your decision. At interest rates below 10%, it makes sense to borrow the money and invest in the system. At interest rates above 10%, it does not. In effect, the interest rate represents the opportunity cost of putting funds into the solar energy system rather than into a bond. The cost of putting the $10,000 into the system is the interest you would forgo by not purchasing the bond. At any one time, millions of investment choices hinge on the interest rate. Each decision to invest will make sense at some interest rates but not at others. The higher the interest rate, the fewer potential investments will be justified; the lower the interest rate, the greater the number that will be justified. There is thus a negative relationship between the interest rate and the level of investment. Figure 14.5 "The Investment Demand Curve" shows an investment demand curve1 for the economy—a curve that shows the quantity of investment demanded at each interest rate, with all other determinants of investment unchanged. At an interest rate of 8%, the level of investment is $950 billion per year at point A. At a lower interest rate of 6%, the investment demand curve shows that the quantity of investment demanded will rise to $1,000 billion per year at point B. A reduction in the interest rate thus causes a movement along the investment demand curve. 1. A curve that shows the quantity of investment demanded at each interest rate, with all other determinants of investment unchanged. 14.2 Determinants of Investment 583
Chapter 14 Investment and Economic Activity Figure 14.5 The Investment Demand Curve The investment demand curve shows the volume of investment spending per year at each interest rate, assuming all other determinants of investment are unchanged. The curve shows that as the interest rate falls, the level of investment per year rises. A reduction in the interest rate from 8% to 6%, for example, would increase investment from $950 billion to $1,000 billion per year, all other determinants of investment unchanged. 14.2 Determinants of Investment 584 Chapter 14 Investment and Economic Activity Heads Up! To make sense of the relationship between interest rates and investment, you must remember that investment is an addition to capital, and that capital is something that has been produced in order to produce other goods and services. A bond is not capital. The purchase of a bond is not an investment. We can thus think of purchasing bonds as a financial investment—that is, as an alternative to investment. The more attractive bonds are (i.e., the higher their interest rate), the less attractive investment becomes. If we forget that investment is an addition to the capital stock and that the purchase of a bond is not investment, we can fall into the following kind of error: “Higher interest rates mean a greater return on bonds, so more people will purchase them. Higher interest rates will therefore lead to greater investment.” That is a mistake, of course, because the purchase of a bond is not an investment. Higher interest rates increase the opportunity cost of using funds for investment. They reduce investment. Other Determinants of Investment Demand Perhaps the most important characteristic of the investment demand curve is not its negative slope, but rather the fact that it shifts often. Although investment certainly responds to changes in interest rates, changes in other factors appear to play a more important role in driving investment choices. This section examines eight additional determinants of investment demand: expectations, the level of economic activity, the stock of capital, capacity utilization, the cost of capital goods, other factor costs, technological change, and public policy. A change in any of these can shift the investment demand curve. Expectations A change in the capital stock changes future production capacity. Therefore, plans to change the capital stock depend crucially on expectations. A firm considers likely future sales; a student weighs prospects in different occupations and their required educational and training levels. As expectations change in a way that increases the expected return from investment, the investment demand curve shifts to the right. Similarly, expectations of reduced profitability shift
the investment demand curve to the left. 14.2 Determinants of Investment 585 Chapter 14 Investment and Economic Activity The Level of Economic Activity Firms need capital to produce goods and services. An increase in the level of production is likely to boost demand for capital and thus lead to greater investment. Therefore, an increase in GDP is likely to shift the investment demand curve to the right. To the extent that an increase in GDP boosts investment, the multiplier effect of an initial change in one or more components of aggregate demand will be enhanced. We have already seen that the increase in production that occurs with an initial increase in aggregate demand will increase household incomes, which will increase consumption, thus producing a further increase in aggregate demand. If the increase also induces firms to increase their investment, this multiplier effect will be even stronger. The Stock of Capital The quantity of capital already in use affects the level of investment in two ways. First, because most investment replaces capital that has depreciated, a greater capital stock is likely to lead to more investment; there will be more capital to replace. But second, a greater capital stock can tend to reduce investment. That is because investment occurs to adjust the stock of capital to its desired level. Given that desired level, the amount of investment needed to reach it will be lower when the current capital stock is higher. Suppose, for example, that real estate analysts expect that 100,000 homes will be needed in a particular community by 2010. That will create a boom in construction—and thus in investment—if the current number of houses is 50,000. But it will create hardly a ripple if there are now 99,980 homes. How will these conflicting effects of a larger capital stock sort themselves out? Because most investment occurs to replace existing capital, a larger capital stock is likely to increase investment. But that larger capital stock will certainly act to reduce net investment. The more capital already in place, the less new capital will be required to reach a given level of capital that may be desired. Capacity Utilization The capacity utilization rate2 measures the percentage of the capital stock in use. Because capital generally requires downtime for maintenance and repairs, the measured capacity utilization rate typically falls below 100%. For example, the 2. A measure of the percentage of the capital stock in use. 14.2 Determinants of Investment 586 Chapter 14 Investment and Economic Activity average manufacturing capacity utilization rate was 79.7% for the period from 1972 to 2007. In November 2008 it stood at 72.3. If a
large percentage of the current capital stock is being utilized, firms are more likely to increase investment than they would if a large percentage of the capital stock were sitting idle. During recessions, the capacity utilization rate tends to fall. The fact that firms have more idle capacity then depresses investment even further. During expansions, as the capacity utilization rate rises, firms wanting to produce more often must increase investment to do so. The Cost of Capital Goods The demand curve for investment shows the quantity of investment at each interest rate, all other things unchanged. A change in a variable held constant in drawing this curve shifts the curve. One of those variables is the cost of capital goods themselves. If, for example, the construction cost of new buildings rises, then the quantity of investment at any interest rate is likely to fall. The investment demand curve thus shifts to the left. The $10,000 cost of the solar energy system in the example given earlier certainly affects a decision to purchase it. We saw that buying the system makes sense at interest rates below 10% and does not make sense at interest rates above 10%. If the system costs $5,000, then the interest return on the investment would be 20% (the annual saving of $1,000 divided by the $5,000 initial cost), and the investment would be undertaken at any interest rate below 20%. Other Factor Costs Firms have a range of choices concerning how particular goods can be produced. A factory, for example, might use a sophisticated capital facility and relatively few workers, or it might use more workers and relatively less capital. The choice to use capital will be affected by the cost of the capital goods and the interest rate, but it will also be affected by the cost of labor. As labor costs rise, the demand for capital is likely to increase. Our solar energy collector example suggests that energy costs influence the demand for capital as well. The assumption that the system would save $1,000 per year in energy costs must have been based on the prices of fuel oil, natural gas, and electricity. If these prices were higher, the savings from the solar energy system would be greater, increasing the demand for this form of capital. 14.2 Determinants of Investment 587 Chapter 14 Investment and Economic Activity Technological Change The implementation of new technology often requires new capital. Changes in technology can thus increase the demand for capital. Advances in computer technology have encouraged massive investments in computers. The development of fiber-optic technology for transmitting signals has stimulated huge investments by telephone and
cable television companies. Public Policy Public policy can have significant effects on the demand for capital. Such policies typically seek to affect the cost of capital to firms. The Kennedy administration introduced two such strategies in the early 1960s. One strategy, accelerated depreciation, allowed firms to depreciate capital assets over a very short period of time. They could report artificially high production costs in the first years of an asset’s life and thus report lower profits and pay lower taxes. Accelerated depreciation did not change the actual rate at which assets depreciated, of course, but it cut tax payments during the early years of the assets’ use and thus reduced the cost of holding capital. The second strategy was the investment tax credit, which permitted a firm to reduce its tax liability by a percentage of its investment during a period. A firm acquiring new capital could subtract a fraction of its cost—10% under the Kennedy administration’s plan—from the taxes it owed the government. In effect, the government “paid” 10% of the cost of any new capital; the investment tax credit thus reduced the cost of capital for firms. Though less direct, a third strategy for stimulating investment would be a reduction in taxes on corporate profits (called the corporate income tax). Greater after-tax profits mean that firms can retain a greater portion of any return on an investment. A fourth measure to encourage greater capital accumulation is a capital gains tax rate that allows gains on assets held during a certain period to be taxed at a different rate than other income. When an asset such as a building is sold for more than its purchase price, the seller of the asset is said to have realized a capital gain. Such a gain could be taxed as income under the personal income tax. Alternatively, it could be taxed at a lower rate reserved exclusively for such gains. A lower capital gains tax rate makes assets subject to the tax more attractive. It thus increases the demand for capital. Congress reduced the capital gains tax rate from 28% to 20% in 1996 and reduced the required holding period in 1998. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the capital gains tax further to 15% and also reduced the tax rate on dividends from 38% to 15%. A proposal to eliminate 14.2 Determinants of Investment 588 Chapter 14 Investment and Economic Activity capital gains taxation for smaller firms was considered but dropped before the stimulus bill of 2009 was enacted. Accelerated depreciation, the investment tax credit, and lower taxes on corporate profits and capital gains all
increase the demand for private physical capital. Public policy can also affect the demands for other forms of capital. The federal government subsidizes state and local government production of transportation, education, and many other facilities to encourage greater investment in public sector capital. For example, the federal government pays 90% of the cost of investment by local government in new buses for public transportation • The quantity of investment demanded in any period is negatively related to the interest rate. This relationship is illustrated by the investment demand curve. • A change in the interest rate causes a movement along the investment demand curve. A change in any other determinant of investment causes a shift of the curve. • The other determinants of investment include expectations, the level of economic activity, the stock of capital, the capacity utilization rate, the cost of capital goods, other factor costs, technological change, and public policy. T R Y I T! Show how the investment demand curve would be affected by each of the following: 1. A sharp increase in taxes on profits earned by firms 2. An increase in the minimum wage 3. The expectation that there will be a sharp upsurge in the level of economic activity 4. An increase in the cost of new capital goods 5. An increase in interest rates 6. An increase in the level of economic activity 7. A natural disaster that destroys a significant fraction of the capital stock 14.2 Determinants of Investment 589 Chapter 14 Investment and Economic Activity Case in Point: Assessing the Impact of a One-Year Tax Break on Investment The U.S. economy was expanding in 2004, but there was a feeling that it still was not functioning as well as it could, as job growth was rather sluggish. To try to spur growth, Congress, supported by President Bush, passed a law in 2004 called the American Jobs Creation Act that gave businesses a one-year special tax break on any profits accumulating overseas that were transferred to the United States. Such profits are called repatriated profits and were estimated at the time to be about $800 billion. For 2005, the tax rate on repatriated profits essentially fell from 25% to 5.25%. Did the tax break have the desired effect on the economy? To some extent yes, though business also found other uses for the repatriated funds. There were 843 companies that repatriated $312 billion that qualified for the tax break. The Act thus generated about $18 billion in tax revenue, a higher level than had been expected. Some companies announced they were repatriating profits and continuing to down
size. For example, Colgate-Palmolive brought back $800 million and made known it was closing a third of its factories and eliminating 12% of its workforce. However, other companies’ plans seemed more in line with the objectives of the special tax break—to create jobs and spur investment. For example, spokesman Chuck Mulloy of Intel, which repatriated over $6 billion, said the company was building a $3-billion wafer fabrication facility and spending $345 million on expanding existing facilities. “I can’t say dollar-fordollar how much of the funding for those comes from off-shore cash,” but he felt that the repatriated funds were contributing to Intel’s overall investments. Spokeswoman Margaret Graham of Bausch and Lomb, which makes eye-care products and repatriated $805 million, said, “We plan to use that cash for 14.2 Determinants of Investment 590 Chapter 14 Investment and Economic Activity capital expenditures, investment in research and development, and paying nonofficer compensation.” Analysts are skeptical, though, that the repatriated profits really contributed to investment. The New York Times reported on one study that suggested it had not. Rather, the repatriated funds were used for other purposes, such as stock repurchases. The argument is that the companies made investments that they were planning to make and the repatriated funds essentially freed up funding for other purposes. Sources: Timothy Aeppel, “Tax Break Brings Billion to U.S., But Impact on Hiring Is Unclear,” Wall Street Journal, October 5, 2005, p. A1; Lynnley Browning, “A One-Time Tax Break Saved 843 U.S. Corporations $265 Billion,” New York Times, June 24, 2008, p. C3. The investment demand curve shifts to the left: Panel (b). 2. A higher minimum wage makes labor more expensive. Firms are likely to shift to greater use of capital, so the investment demand curve shifts to the right: Panel (a). 3. The investment demand curve shifts to the right: Panel (a). 4. The investment demand curve shifts to the left: Panel (b). 5. An increase in interest rates causes a movement along the investment demand curve: Panel (c). 6. The investment demand curve shifts to the right: Panel (a). 7. The need to replace capital shifts the investment demand curve to
the right: Panel (a). 14.2 Determinants of Investment 591 Chapter 14 Investment and Economic Activity 14.3 Investment and the Economy. Explain how investment affects aggregate demand. 2. Explain how investment affects economic growth. We shall examine the impact of investment on the economy in the context of the model of aggregate demand and aggregate supply. Investment is a component of aggregate demand; changes in investment shift the aggregate demand curve by the amount of the initial change times the multiplier. Investment changes the capital stock; changes in the capital stock shift the production possibilities curve and the economy’s aggregate production function and thus shift the long- and short-run aggregate supply curves to the right or to the left. Investment and Aggregate Demand In the short run, changes in investment cause aggregate demand to change. Consider, for example, the impact of a reduction in the interest rate, given the investment demand curve (ID). In Figure 14.6 "A Change in Investment and Aggregate Demand", Panel (a), which uses the investment demand curve introduced in Figure 14.5 "The Investment Demand Curve", a reduction in the interest rate from 8% to 6% increases investment by $50 billion per year. Assume that the multiplier is 2. With an increase in investment of $50 billion per year and a multiplier of 2, the aggregate demand curve shifts to the right by $100 billion to AD2 in Panel (b). The quantity of real GDP demanded at each price level thus increases. At a price level of 1.0, for example, the quantity of real GDP demanded rises from $8,000 billion to $8,100 billion per year. 592 Chapter 14 Investment and Economic Activity Figure 14.6 A Change in Investment and Aggregate Demand A reduction in the interest rate from 8% to 6% increases the level of investment by $50 billion per year in Panel (a). With a multiplier of 2, the aggregate demand curve shifts to the right by $100 billion in Panel (b). The total quantity of real GDP demanded increases at each price level. Here, for example, the quantity of real GDP demanded at a price level of 1.0 rises from $8,000 billion per year at point C to $8,100 billion per year at point D. A reduction in investment would shift the aggregate demand curve to the left by an amount equal to the multiplier times the change in investment. The relationship between investment and interest rates is one key to the effectiveness of monetary policy to the economy. When the Fed
seeks to increase aggregate demand, it purchases bonds. That raises bond prices, reduces interest rates, and stimulates investment and aggregate demand as illustrated in Figure 14.6 "A Change in Investment and Aggregate Demand". When the Fed seeks to decrease aggregate demand, it sells bonds. That lowers bond prices, raises interest rates, and reduces investment and aggregate demand. The extent to which investment responds to a change in interest rates is a crucial factor in how effective monetary policy is. Investment and Economic Growth Investment adds to the stock of capital, and the quantity of capital available to an economy is a crucial determinant of its productivity. Investment thus contributes to economic growth. We saw in Figure 14.4 "The Choice between Consumption and Investment" that an increase in an economy’s stock of capital shifts its production possibilities curve outward. (Recall from the chapter on economic growth that it also shifts the economy’s aggregate production function upward.) That also shifts 14.3 Investment and the Economy 593 Chapter 14 Investment and Economic Activity its long-run aggregate supply curve to the right. At the same time, of course, an increase in investment affects aggregate demand, as we saw in Figure 14.6 "A Change in Investment and Aggregate Demand". • Changes in investment shift the aggregate demand curve to the right or left by an amount equal to the initial change in investment times the multiplier. Investment adds to the capital stock; it therefore contributes to economic growth. • T R Y I T! The text notes that rising investment shifts the aggregate demand curve to the right and at the same time shifts the long-run aggregate supply curve to the right by increasing the nation’s stock of physical and human capital. Show this simultaneous shifting in the two curves with three graphs. One graph should show growth in which the price level rises, one graph should show growth in which the price level remains unchanged, and another should show growth with the price level falling. 14.3 Investment and the Economy 594 Chapter 14 Investment and Economic Activity Case in Point: Investment by Businesses Saves the Australian Expansion With consumer and export spending faltering in 2005, increased business investment spending seemed to be keeping the Australian economy afloat. “Corporate Australia is solidly behind the steering wheel of the Australian economy,” said Craig James, an economist for Commonwealth Securities, an Australian Internet securities brokerage firm. “The clear message from the latest investment survey is that corporate Australia is flush with cash and ready to spend,” he continued. The data supported his conclusions
. The level of investment spending in Australia on new buildings, plant, and equipment was 17% higher in 2005 than in 2004. Within the investment category, mining investment, spurred on by high prices for natural resources, was particularly strong. Source: Scott Murdoch, “Equipment Investment Gives Boost to Economy,” Courier Mail (Queensland, Australia), September 2, 2005, Finance section, p. 35. 14.3 Investment and the Economy 595 Chapter 14 Investment and Economic Activity Panel (a) shows AD shifting by more than LRAS; the price level will rise in the long run. Panel (b) shows AD and LRAS shifting by equal amounts; the price level will remain unchanged in the long run. Panel (c) shows LRAS shifting by more than AD; the price level falls in the long run. 14.3 Investment and the Economy 596 Chapter 14 Investment and Economic Activity 14.4 Review and Practice Summary Investment is an addition to the capital stock. Investment may occur as a net addition to capital or as a replacement of depreciated capital. The bulk of investment spending in the United States falls into the latter category. Investment is a highly volatile component of GDP. The decision to save is linked directly to the decision to invest. If a nation is to devote a larger share of its production to investment, then it must devote a smaller share to consumption, all other things unchanged. And that requires people to save more. Investment is affected by the interest rate; the negative relationship between investment and the interest rate is illustrated by the investment demand curve. The position of this curve is affected by expectations, the level of economic activity, the stock of capital, the price of capital, the prices of other factors, technology, and public policy. Because investment is a component of aggregate demand, a change in investment shifts the aggregate demand curve to the right or left. The amount of the shift will equal the initial change in investment times the multiplier. In addition to its impact on aggregate demand, investment can also affect economic growth. Investment shifts the production possibilities curve outward, shifts the economy’s aggregate production function upward, and shifts the long-run aggregate supply curve to the right. 597 Chapter 14 Investment and Economic Activity. Which of the following would be counted as gross private domestic investment? a. General Motors issues 1 million shares of stock. b. Consolidated Construction purchases 1,000 acres of land for a regional shopping center it plans to build in a few years. c. A K
-Mart store adds 1,000 T-shirts to its inventory. d. Crew buys computers for its office staff. e. Your family buys a house. 2. If saving dropped sharply in the economy, what would likely happen to investment? Why? 3. Suppose local governments throughout the United States increase their tax on business inventories. What would you expect to happen to U.S. investment? Why? 4. Suppose the government announces it will pay for half of any new investment undertaken by firms. How will this affect the investment demand curve? 5. White House officials often exude more confidence than they actually feel about future prospects for the economy. Why might this be a good strategy? Are there any dangers inherent in it? 6. Suppose everyone expects investment to rise sharply in three months. How would this expectation be likely to affect bond prices? 8. 7. Suppose that every increase of $1 in real GDP automatically stimulates $0.20 in additional investment spending. How would this affect the multiplier? If environmental resources were counted as part of the capital stock, how would a major forest fire affect net investment? In the Case in Point on reducing private capital in the Great Depression, we saw that net investment was negative during that period. Could gross investment ever be negative? Explain. 9. 10. The Case in Point on lowering the tax rate for one year for companies that repatriated profits suggests that investment did not increase, even though company representatives are quoted as saying that they were using the repatriated profits for investment. Explain this seeming contradiction. 11. Use the model of aggregate demand and aggregate supply to evaluate the argument that an increase in investment would raise the standard of living. 14.4 Review and Practice 598 Chapter 14 Investment and Economic Activity. Suppose a construction company is trying to decide whether to buy a new nail gun. The table below shows the hypothetical costs for the nail gun and the amount the gun will save the company each year. Assume the gun will last forever. In each case, determine the highest interest rate the company should pay for a loan that makes purchase of the nail gun possible. Cost Savings a. $1,000 $100 b. $1,000 $200 c. $1,000 $300 2. A car company currently has capital stock of $100 million and desires a capital stock of $110 million. a. b. c. If it experiences no depreciation, how much will it need to invest to get to its desired level of capital stock? If its annual depreciation is 5
%, how much will it need to invest to get to its desired level? If its annual depreciation is 10%, how much will it need to invest to get to its desired level? 3. Burger World is contemplating installing an automated ordering system. The ordering system will allow Burger World to permanently replace five employees for an annual (and permanent) cost savings of $100,000. a. b. c. If the automated system cost $1,000,000, what is the rate of return on the investment? If the system cost $2,000,000, what would be its rate of return? If the government were to introduce an investment tax credit that allows firms to deduct 10% of its investment from its tax liability, what would happen to the rate of return if the system costs $1,000,000? 14.4 Review and Practice 599 Chapter 14 Investment and Economic Activity d. If Burger World has to pay 8% to borrow the funds to purchase the system, what is the most it should pay for the system? Assume that there is no investment tax credit. 4. The table below shows a number of investment projects and their effective earned interest rates or returns. Given the market interest rates shown below, identify which projects will be undertaken and the total amount of investment spending that will ensue. Project Return on project Cost A B C D E F 30% $1,000 28 22 17 8 4 500 2,500 1,000 750 1,200 a. 20% b. 15% c. 10% d. 5% e. 3% f. Sketch out the investment demand curve implied by these data. 5. The table below describes the amounts of investment for different interest rates. Interest rate Amount of investment (billions) 25% 20 15 10 5 $5 $10 $15 $20 $25 14.4 Review and Practice 600 Chapter 14 Investment and Economic Activity a. Draw the investment demand curve for this economy. b. Show the effect you would expect a decrease in the cost of capital goods to have on this investment demand curve. c. Show the effect you would expect an investment tax credit to have on this investment demand curve. d. Show the effect you would expect a recession to have on this investment demand curve. 6. Suppose real GDP in an economy equals its potential output of $2,000 billion, the multiplier is 2.5, investment is raised by $200 billion, and the increased investment does not affect the economy’s potential. a. Show the short
- and long-run effects of the change upon real GDP and the price level, using the graphical framework for the model of aggregate demand and aggregate supply. b. Would real GDP rise by the multiplier times the change in investment in the short run? In the long run? Explain. 7. Use the information below to compute the levels of gross and net private domestic investment. Data are in billions of dollars. Change in business inventories $ 59.3 Residential construction 369.6 Producers’ durable equipment 691.3 Nonresidential structures 246.9 Depreciation 713.9 8. Complete the table, which shows investment in the United States in billions of 2000 chained dollars. Year Gross private domestic investment Depreciation Net private domestic investment a. 2005 1,873.5 1,266.6 14.4 Review and Practice 601 Chapter 14 Investment and Economic Activity Gross private domestic investment Year b. 2006 c. 2007 1,809.7 Depreciation 1,216.1 Net private domestic investment 696.4 546.7 14.4 Review and Practice 602 Chapter 15 Net Exports and International Finance Start Up: Currency Crises Shake the World It became known as the “Asian Contagion,” and it swept the world as the 20th century came to a close. Japan, crippled by the threat of collapse of many of its banks, seemed stuck in a recessionary gap for most of the decade. Because Japan was a major market for the exports of economies throughout East Asia, the slump in Japan translated into falling exports in neighboring economies. Slowed growth in a host of economies that had grown accustomed to phenomenal growth set the stage for trouble throughout the world. The first crack appeared in Thailand, whose central bank had successfully maintained a stable exchange rate between the baht, Thailand’s currency, and the U.S. dollar. But weakened demand for Thai exports, along with concerns about the stability of Thai banks, put downward pressure on the baht. Thailand’s effort to shore up its currency ultimately failed, and the country’s central bank gave up the effort in July of 1997. The baht’s value dropped nearly 20% in a single day. Holders of other currencies became worried about their stability and began selling. Central banks that, like Thailand’s, had held their currencies stable relative to the dollar, gave up their efforts as well. Malaysia quit propping up the ringgit less than two weeks after the bah
t’s fall. Indonesia’s central bank gave up trying to hold the rupiah’s dollar value a month later. South Korea let the won fall in November. Currency crises continued to spread in 1998, capped by a spectacular plunge in the Russian ruble. As speculators sold other currencies, they bought dollars, driving the U.S. exchange rate steadily upward. What was behind the currency crises that shook the world? How do changes in a country’s exchange rate affect its economy? How can events such as the fall of the baht and the ringgit spread to other countries? 603 Chapter 15 Net Exports and International Finance We will explore the answers to these questions by looking again at how changes in a country’s exchange rate can affect its economy—and how changes in one economy can spread to others. We will be engaged in a study of international finance1, the field that examines the macroeconomic consequences of the financial flows associated with international trade. We will begin by reviewing the reasons nations trade. International trade has the potential to increase the availability of goods and services to everyone. We will look at the effects of trade on the welfare of people and then turn to the macroeconomic implications of financing trade. 1. The field that examines the macroeconomic consequences of the financial flows associated with international trade. 604 Chapter 15 Net Exports and International Finance 15.1 The International Sector: An Introduction. Discuss the main arguments economists make in support of free trade. 2. Explain the determinants of net exports and tell how each affects aggregate demand. How important is international trade? Take a look at the labels on some of your clothing. You are likely to find that the clothes in your closet came from all over the globe. Look around any parking lot. You may find cars from Japan, Korea, Sweden, Britain, Germany, France, and Italy—and even the United States! Do you use a computer? Even if it is an American computer, its components are likely to have been assembled in Indonesia or in some other country. Visit the grocery store. Much of the produce may come from Latin America and Asia. The international market is important not just in terms of the goods and services it provides to a country but also as a market for that country’s goods and services. Because foreign demand for U.S. exports is almost as large as investment and government purchases as a component of aggregate demand, it can be very important in terms of growth. The increase in
exports in 2011, for example, accounted for about half of the gain in U.S. real GDP in that year. The Case for Trade International trade increases the quantity of goods and services available to the world’s consumers. By allocating resources according to the principle of comparative advantage, trade allows nations to consume combinations of goods and services they would be unable to produce on their own, combinations that lie outside each country’s production possibilities curve. A country has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost than can other countries. If each country specializes in the production of goods in which it has a comparative advantage and trades those goods for things in which other countries have a comparative 605 Chapter 15 Net Exports and International Finance advantage, global production of all goods and services will be increased. The result can be higher levels of consumption for all. If international trade allows expanded world production of goods and services, it follows that restrictions on trade will reduce world production. That, in a nutshell, is the economic case for free trade. It suggests that restrictions on trade, such as a tariff2, a tax imposed on imported goods and services, or a quota3, a ceiling on the quantity of specific goods and services that can be imported, reduce world living standards. The conceptual argument for free trade is a compelling one; virtually all economists support policies that reduce barriers to trade. Economists were among the most outspoken advocates for the 1993 ratification of the North American Free Trade Agreement (NAFTA), which virtually eliminated trade restrictions between Mexico, the United States, and Canada, and the 2004 Central American Free Trade Agreement (CAFTA), which did the same for trade between the United States, Central America, and the Dominican Republic. They supported the 2007 free trade agreement with Peru and the 2011 agreements with Colombia, Panama, and South Korea. Most economists have also been strong supporters of worldwide reductions in trade barriers, including the 1994 ratification of the General Agreement on Tariffs and Trade (GATT), a pact slashing tariffs and easing quotas among 117 nations, including the United States, and the Doha round of World Trade Organization negotiations, named after the site of the first meeting in Doha, Qatar, in 2001 and still continuing. In Europe, member nations of the European Union (EU) have virtually eliminated trade barriers among themselves, and 17 EU nations now have a common currency, the euro, and a single central bank, the European Central Bank, established in 1999. Trade barriers have
also been slashed among the economies of Latin America and of Southeast Asia. A treaty has been signed that calls for elimination of trade barriers among the developed nations of the Pacific Rim (including the United States and Japan) by 2010 (although this deadline was missed) and among all Pacific rim nations by 2020. The global embrace of the idea of free trade demonstrates the triumph of economic ideas over powerful forces that oppose free trade. One source of opposition to free trade comes from the owners of factors of production used in industries in which a nation lacks a comparative advantage. 2. A tax imposed on imported goods and services. 3. A ceiling on the quantity of specific goods and services that can be imported, which reduces world living standards. A related argument against free trade is that it not only reduces employment in some sectors but also reduces employment in the economy as a whole. In the long run, this argument is clearly wrong. The economy’s natural level of employment is determined by forces unrelated to trade policy, and employment moves to its natural level in the long run. 15.1 The International Sector: An Introduction 606 Chapter 15 Net Exports and International Finance Further, trade has no effect on real wage levels for the economy as a whole. The equilibrium real wage depends on the economy’s demand for and supply curve of labor. Trade affects neither. In the short run, trade does affect aggregate demand. Net exports are one component of aggregate demand; a change in net exports shifts the aggregate demand curve and affects real GDP in the short run. All other things unchanged, a reduction in net exports reduces aggregate demand, and an increase in net exports increases it. Protectionist sentiment always rises during recessions. Unlike what happened during the Great Depression of the 1930s, there was a lot of talk during the Great Recession about more protection, but most countries avoided imposing substantially increased trade restrictions. The Rising Importance of International Trade International trade is important, and its importance is increasing. For example, from 1990 to 2010, world output growth was about 3% per year on average, while world export growth averaged about 6% per year. While international trade was rising around the world, it was playing a more significant role in the United States as well. In 1960, exports represented just 3.5% of real GDP; by 2011, exports accounted for more than 13% of real GDP. Figure 15.1 "U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2011" shows the growth in exports and
imports as a percentage of real GDP in the United States from 1960 to 2011. Why has world trade risen so spectacularly? Two factors have been important. First, advances in transportation and communication have dramatically reduced the costs of moving goods around the globe. The development of shipping containerization that allows cargo to be moved seamlessly from trucks or trains to ships, which began in 1956, drastically reduced the cost of moving goods around the world, by as much as 90%. As a result, the numbers of container ships and their capacities have markedly increased.For an interesting history of this remarkable development, see Marc Levinson, The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger (Princeton: Princeton University Press, 2006). Second, we have already seen that trade barriers between countries have fallen and are likely to continue to fall. 15.1 The International Sector: An Introduction 607 Chapter 15 Net Exports and International Finance Figure 15.1 U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2011 The chart shows exports and imports as a percentage of real GDP from 1960 through 2011. Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012). Net Exports and the Economy As trade has become more important worldwide, exports and imports have assumed increased importance in nearly every country on the planet. We have already discussed the increased shares of U.S. real GDP represented by exports and by imports. We will find in this section that the economy both influences, and is influenced by, net exports. First, we will examine the determinants of net exports and then discuss the ways in which net exports affect aggregate demand. Determinants of Net Exports Net exports equal exports minus imports. Many of the same forces affect both exports and imports, albeit in different ways. 15.1 The International Sector: An Introduction 608 Chapter 15 Net Exports and International Finance Income As incomes in other nations rise, the people of those nations will be able to buy more goods and services—including foreign goods and services. Any one country’s exports thus will increase as incomes rise in other countries and will fall as incomes drop in other countries. A nation’s own level of income affects its imports the same way it affects consumption. As consumers have more income, they will buy more goods and services. Because some of those goods and services are produced in other nations, imports will rise. An increase in real GDP thus boosts imports
; a reduction in real GDP reduces imports. Figure 15.2 "U.S. Real GDP and Imports, 1960–2011" shows the relationship between real GDP and the real level of import spending in the United States from 1960 through 2011. Notice that the observations lie close to a straight line one could draw through them and resemble a consumption function. Figure 15.2 U.S. Real GDP and Imports, 1960–2011 The chart shows annual values of U.S. real imports and real GDP from 1960 through 2011. The observations lie quite close to a straight line. Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012). 15.1 The International Sector: An Introduction 609 Chapter 15 Net Exports and International Finance Relative Prices A change in the price level within a nation simultaneously affects exports and imports. A higher price level in the United States, for example, makes U.S. exports more expensive for foreigners and thus tends to reduce exports. At the same time, a higher price level in the United States makes foreign goods and services relatively more attractive to U.S. buyers and thus increases imports. A higher price level therefore reduces net exports. A lower price level encourages exports and reduces imports, increasing net exports. As we saw in the chapter that introduced the aggregate demand and supply model, the negative relationship between net exports and the price level is called the international trade effect and is one reason for the negative slope of the aggregate demand curve. The Exchange Rate The purchase of U.S. goods and services by foreign buyers generally requires the purchase of dollars, because U.S. suppliers want to be paid in their own currency. Similarly, purchases of foreign goods and services by U.S. buyers generally require the purchase of foreign currencies, because foreign suppliers want to be paid in their own currencies. An increase in the exchange rate means foreigners must pay more for dollars, and must thus pay more for U.S. goods and services. It therefore reduces U.S. exports. At the same time, a higher exchange rate means that a dollar buys more foreign currency. That makes foreign goods and services cheaper for U.S. buyers, so imports are likely to rise. An increase in the exchange rate should thus tend to reduce net exports. A reduction in the exchange rate should increase net exports. Trade Policies A country’s exports depend on its own trade policies as well as the trade policies of other countries. A country may be able to increase
its exports by providing some form of government assistance (such as special tax considerations for companies that export goods and services, government promotional efforts, assistance with research, or subsidies). A country’s exports are also affected by the degree to which other countries restrict or encourage imports. The United States, for example, has sought changes in Japanese policies toward products such as U.S.-grown rice. Japan banned rice imports in the past, arguing it needed to protect its own producers. That has been a costly strategy; consumers in Japan typically pay as much as 10 times the price consumers in the United States pay for rice. Japan has given in to pressure from the United States and other nations to end its ban on foreign rice as part of the GATT accord. That will increase U.S. exports and lower rice prices in Japan. 15.1 The International Sector: An Introduction 610 Chapter 15 Net Exports and International Finance Similarly, a country’s imports are affected by its trade policies and by the policies of its trading partners. A country can limit its imports of some goods and services by imposing tariffs or quotas on them—it may even ban the importation of some items. If foreign governments subsidize the manufacture of a particular good, then domestic imports of the good might increase. For example, if the governments of countries trading with the United States were to subsidize the production of steel, then U.S. companies would find it cheaper to purchase steel from abroad than at home, increasing U.S. imports of steel. Preferences and Technology Consumer preferences are one determinant of the consumption of any good or service; a shift in preferences for a foreign-produced good will affect the level of imports of that good. The preference among the French for movies and music produced in the United States has boosted French imports of these services. Indeed, the shift in French preferences has been so strong that the government of France, claiming a threat to its cultural heritage, has restricted the showing of films produced in the United States. French radio stations are fined if more than 40% of the music they play is from “foreign” (in most cases, U.S.) rock groups. Changes in technology can affect the kinds of capital firms import. Technological changes have changed production worldwide toward the application of computers to manufacturing processes, for example. This has led to increased demand for high-tech capital equipment, a sector in which the United States has a comparative advantage and tends to dominate world production. This has boosted net exports in the United States
. Net Exports and Aggregate Demand Net exports affect both the slope and the position of the aggregate demand curve. A change in the price level causes a change in net exports that moves the economy along its aggregate demand curve. This is the international trade effect. A change in net exports produced by one of the other determinants of net exports listed above (incomes and price levels in other nations, the exchange rate, trade policies, and preferences and technology) will shift the aggregate demand curve. The magnitude of this shift equals the change in net exports times the multiplier, as shown in Figure 15.3 "Changes in Net Exports and Aggregate Demand". Panel (a) shows an increase in net exports; Panel (b) shows a reduction. In both cases, the aggregate demand curve shifts by the multiplier times the initial change in net exports, provided there is no other change in the other components of aggregate demand. 15.1 The International Sector: An Introduction 611 Chapter 15 Net Exports and International Finance Figure 15.3 Changes in Net Exports and Aggregate Demand In Panel (a), an increase in net exports shifts the aggregate demand curve to the right by an amount equal to the multiplier times the initial change in net exports. In Panel (b), an equal reduction in net exports shifts the aggregate demand curve to the left by the same amount. Changes in net exports that shift the aggregate demand curve can have a significant impact on the economy. The United States, for example, experienced a slowdown in the rate of increase in real GDP in the second and third quarters of 1998—virtually all of this slowing was the result of a reduction in net exports caused by recessions that staggered economies throughout Asia. The Asian slide reduced incomes there and thus reduced Asian demand for U.S. goods and services. We will see in the next section another mechanism through which difficulties in other nations can cause changes in a nation’s net exports and its level of real GDP in the short run. 15.1 The International Sector: An Introduction 612 Chapter 15 Net Exports and International Finance • International trade allows the world’s resources to be allocated on the basis of comparative advantage and thus allows the production of a larger quantity of goods and services than would be available without trade. • Trade affects neither the economy’s natural level of employment nor its real wage in the long run; those are determined by the demand for and the supply curve of labor. • Growth in international trade has outpaced growth in world output over the past
five decades. • The chief determinants of net exports are domestic and foreign incomes, relative price levels, exchange rates, domestic and foreign trade policies, and preferences and technology. • A change in the price level causes a change in net exports that moves the economy along its aggregate demand curve. This is the international trade effect. A change in net exports produced by one of the other determinants of net exports will shift the aggregate demand curve by an amount equal to the initial change in net exports times the multiplier. T R Y I T! Draw graphs showing the aggregate demand and short-run aggregate supply curves in each of four countries: Mexico, Japan, Germany, and the United States. Assume that each country is initially in equilibrium with a real GDP of Y1 and a price level of P1. Now show how each of the following four events would affect aggregate demand, the price level, and real GDP in the country indicated. 1. The United States is the largest foreign purchaser of goods and services from Mexico. How does an expansion in the United States affect real GDP and the price level in Mexico? Japan’s exchange rate falls sharply. How does this affect the price level and real GDP in Japan? 2. 3. A wave of pro-German sentiment sweeps France, and the French sharply increase their purchases of German goods and services. How does this affect real GDP and the price level in Germany? 4. Canada, the largest importer of U.S. goods and services, slips into a recession. How does this affect the price level and real GDP in the United States? 15.1 The International Sector: An Introduction 613 Chapter 15 Net Exports and International Finance Case in Point: Canadian Net Exports Survive the Loonie’s Rise Throughout 2003 and the first half of 2004, the Canadian dollar, nicknamed the loonie after the Canadian bird that is featured on its one-dollar coin, rose sharply in value against the U.S. dollar. Because the United States and Canada are major trading partners, the changing exchange rate suggested that, other things equal, Canadian exports to the United States would fall and imports rise. The resulting fall in net exports, other things equal, could slow the rate of growth in Canadian GDP. Fortunately for Canada, “all other things” were not equal. In particular, strong income growth in the United States and China increased the demand for Canadian exports. In addition, the loonie’s appreciation against other currencies was less dramatic, and so
Canadian exports remained competitive in those markets. While imports did increase, as expected due to the exchange rate change, exports grew at a faster rate, and hence net exports increased over the period. In sum, Canadian net exports grew, although not by as much as they would have had the loonie not appreciated. As Beata Caranci, an economist for Toronto Dominion Bank put it, “We might have some bumpy months ahead but it definitely looks like the worst is over. … While Canadian exports appear to have survived the loonie’s run-up, their fortunes would be much brighter if the exchange rate were still at 65 cents.” 15.1 The International Sector: An Introduction 614 Chapter 15 Net Exports and International Finance Source: Steven Theobald, “Exports Surviving Loonie’s Rise: Study,” Toronto Star, July 13, 2004, p. D1. Mexico’s exports increase, shifting its aggregate demand curve to the right. Mexico’s real GDP and price level rise, as shown in Panel (a). Japan’s net exports rise. This event shifts Japan’s aggregate demand curve to the right, increasing its real GDP and price level, as shown in Panel (b). 2. 3. Germany’s net exports increase, shifting Germany’s aggregate demand curve to the right, increasing its price level and real GDP, as shown in Panel (c). 4. U.S. exports fall, shifting the U.S. aggregate demand curve to the left, which will reduce the price level and real GDP, as shown in Panel (d). 15.1 The International Sector: An Introduction 615 Chapter 15 Net Exports and International Finance 15.2 International Finance. Define a country’s balance of payments, and explain what is included on the current and capital accounts. 2. Assuming that the market for a country’s currency is in equilibrium, explain why the current account balance will always be the negative of the capital account balance. 3. Summarize the economic arguments per se against public opposition to a current account deficit and a capital account surplus. There is an important difference between trade that flows, say, from one city to another and trade that flows from one nation to another. Unless they share a common currency, as some of the nations of the European Union do, trade among nations requires that currencies be exchanged as well as goods and services. Suppose,
for example, that buyers in Mexico purchase silk produced in China. The Mexican buyers will pay in Mexico’s currency, the peso; the manufacturers of the silk must be paid in China’s currency, the yuan. The flow of trade between Mexico and China thus requires an exchange of pesos for yuan. This section examines the relationship between spending that flows into a country and spending that flows out of it. These spending flows include not only spending for a nation’s exports and imports, but payments to owners of assets in other countries, international transfer payments, and purchases of foreign assets. The balance between spending flowing into a country and spending flowing out of it is called its balance of payments4. We will simplify our analysis by ignoring international transfer payments, which occur when an individual, firm, or government makes a gift to an individual, firm, or government in another country. Foreign aid is an example of an international transfer payment. International transfer payments play a relatively minor role in the international financial transactions of most countries; ignoring them will not change our basic conclusions. 4. The balance between spending flowing into a country and spending flowing out. A second simplification will be to treat payments to foreign owners of factors of production used in a country as imports and payments received by owners of factors of production used in other countries as exports. This is the approach when we use GNP rather than GDP as the measure of a country’s output. 616 Chapter 15 Net Exports and International Finance These two simplifications leave two reasons for demanding a country’s currency: for foreigners to purchase a country’s goods and services (that is, its exports) and to purchase assets in the country. A country’s currency is supplied in order to purchase foreign currencies. A country’s currency is thus supplied for two reasons: to purchase goods and services from other countries (that is, its imports) and to purchase assets in other countries. We studied the determination of exchange rates in the chapter on how financial markets work. We saw that, in general, exchange rates are determined by demand and supply and that the markets for the currencies of most nations can be regarded as being in equilibrium. Exchange rates adjust quickly, so that the quantity of a currency demanded equals the quantity of the currency supplied. Our analysis will deal with flows of spending between the domestic economy and the rest of the world. Suppose, for example, that we are analyzing Japan’s economy and its transactions with the rest of the world. The
purchase by a buyer in, say, Germany of bonds issued by a Japanese corporation would be part of the rest-ofworld demand for yen to buy Japanese assets. Adding export demand to asset demand by people, firms, and governments outside a country, we get the total demand for a country’s currency. A domestic economy’s currency is supplied to purchase currencies in the rest of the world. In an analysis of the market for Japanese yen, for example, yen are supplied when people, firms, and government agencies in Japan purchase goods and services from the rest of the world. This part of the supply of yen equals Japanese imports. Yen are also supplied so that holders of yen can acquire assets from other countries. Equilibrium in the market for a country’s currency implies that the quantity of a particular country’s currency demanded equals the quantity supplied. Equilibrium thus implies that Equation 15.1 Quantity of currency demanded = quantity of currency supplied In turn, the quantity of a currency demanded is from two sources: 1. Exports 2. Rest-of-world purchases of domestic assets 15.2 International Finance 617 Chapter 15 Net Exports and International Finance The quantity supplied of a currency is from two sources: Imports 1. 2. Domestic purchases of rest-of-world assets Therefore, we can rewrite Equation 15.1 as Equation 15.2 Exports + (rest-of-world purchases of domestic assets) = imports + (domestic purchases of rest-of-world assets) Accounting for International Payments In this section, we will build a set of accounts to track international payments. To do this, we will use the equilibrium condition for foreign exchange markets given in Equation 15.2. We will see that the balance between a country’s purchases of foreign assets and foreign purchases of the country’s assets will have important effects on net exports, and thus on aggregate demand. We can rearrange the terms in Equation 15.2 to write the following: Equation 15.3 Exports − imports = − [(rest-of-world purchases of domestic assets) − (domestic purchases of rest-of-world assets)] Equation 15.3 represents an extremely important relationship. Let us examine it carefully. The left side of the equation is net exports. It is the balance between spending flowing from foreign countries into a particular country for the purchase of its goods and services and spending flowing out of the country for the purchase of goods and services produced in other countries
. The current account5 is an accounting statement that includes all spending flows across a nation’s border except those that represent purchases of assets. The balance on current account6 equals spending flowing into an economy from the rest of the world on current account less spending flowing from the nation to the rest of the world on current account. Given our two simplifying assumptions—that there are no international transfer payments and that we can treat rest-of-world purchases of domestic factor services as exports and domestic purchases of rest-of-world factor services as imports—the balance on current account equals net exports. When the balance on current account is positive, spending flowing in for the purchase of goods and 5. An accounting statement that includes all spending flows across a nation’s border except those that represent purchases of assets. 6. Spending flowing into an economy from the rest of the world on current account less spending flowing from the nation to the rest of the world on current account. 15.2 International Finance 618 Chapter 15 Net Exports and International Finance services exceeds spending that flows out, and the economy has a current account surplus7 (i.e., net exports are positive in our simplified analysis). When the balance on current account is negative, spending for goods and services that flows out of the country exceeds spending that flows in, and the economy has a current account deficit8 (i.e., net exports are negative in our simplified analysis). A country’s capital account9 is an accounting statement of spending flows into and out of the country during a particular period for purchases of assets. The term within the parentheses on the right side of the equation gives the balance between rest-of-world purchases of domestic assets and domestic purchases of rest-of-world assets; this balance is a country’s balance on capital account10. A positive balance on capital account is a capital account surplus11. A capital account surplus means that buyers in the rest of the world are purchasing more of a country’s assets than buyers in the domestic economy are spending on rest-of-world assets. A negative balance on capital account is a capital account deficit12. It implies that buyers in the domestic economy are purchasing a greater volume of assets in other countries than buyers in other countries are spending on the domestic economy’s assets. Remember that the balance on capital account is the term inside the parentheses on the right-hand side of Equation 15.3 and that there is a minus sign outside the parentheses. Equation 15.3 tells us

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