This document provides an overview of macroeconomic theory for determining GDP in the short term. It discusses how GDP is determined by the components of aggregate demand (C, I, G, NX) and how consumption, investment, and aggregate spending functions relate GDP to disposable income. It also covers equilibrium GDP, the multiplier effect of changes in autonomous spending, and how to calculate GDP using a simple consumption function and investment amount.

1. Determination of GDP in the
Short Term
Lecture 3

2. Outline
• Macroeconomic theory explains the deviation of
actual from potential GDP (i.e. GDP gap)
• Determination of GDP in the short run depends
on the behaviour of key categories of (C, I, G, NX)
• Consumption spending depends on disposable
income and wealth
• Investment spending depends on real interest
rates and business confidence
• A necessary condition for GDP to be in
equilibrium is that desired domestic spending is
equal to actual output
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3. • The central problem for macroeconomic
policy-makers is to decide how to manage the
economy in such a way that inflation is kept
under control while unemployment is also
kept to a minimum
• Virtually all economies have some periods
when actual GDP is growing faster than
potential and other periods when it is growing
more slowly than potential, or even falling
• In other words, actual economies exhibit
cycles about the trend growth path
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4. • Periods of decline in actual GDP (or even
when growth in actual GDP is below potential)
are costly because they are associated with a
loss of output that is gone forever
• Economic downturns do not typically lead to
all citizens loosing some equal amount of
income – rather, they lead to some people
losing their jobs (or businesses) and thereby
suffering loss of income and well-being
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5. • Unemployment is undesirable, and is
commonly agreed that policy-makers should
aim to sustain unemployment a low level
• The outcome of an excessive growth in
demand relative to supply is inflation, which is
disruptive to the economy
5
SO
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6. Key Assumptions on Macro Theory
• Aggregation across industries
– In elementary macro economics, we assume the existence
of a single productive sector producing a homogeneous
output
• Time-scale
– Short run- the period during which the economy maintains
a deviation of actual from potential output, or a GDP gap.
This deviation is associated with the existence of excess
capacity and unemployment (recession), or with
unsustainable output and inflation (boom)
– Analysis of the short run in macroeconomics is concerned
with explaining why national output can deviate from its
potential level. It is about the GDP gap and how to keep
both positive and negative gaps as small as possible
– That is, how do we keep actual GDP as close as possible to
potential GDP?
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7. Key Assumptions on Macro Theory
• Long run- a period sufficient to allow time for
the automatic adjustment mechanisms to
return economic activity to equilibrium after
it has been disturbed by an exogenous shock
– This equilibrium is reached when the economy
returns to producing the level of potential (or full
employment) output
– We assume that the long run level of output is
constant and is associated with a fixed capital
stock and a fixed level of technical knowledge
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8. Temporary Assumptions
• The price level
– We assume that the price level (the money price of the
economy’s single output good) is fixed
– Hence all variables must necessarily be measured in real
terms
• Excess capacity
– We assume the economy has excess capacity so that is not
constrained from producing more output by shortages of
capital stock or labour
• Closed economy
– We ignore the possibility that the output of the economy
can be sold overseas and that domestic consumers can
buy foreign-produced goods
• No government
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9. Summarising Assumptions
• We have a closed economy with a single
industrial sector, producing a homogeneous
output, at a fixed price, with no government.
There is also excess capacity, so there are no
resource constraints preventing the expansion
of national output
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10. What Determines Aggregate
Spending
From actual to desired spending
• Desired (planned/intended) spending – refers to what
people want to spend out of the resources that are at their
command
– Desired private consumption, desired investment, desired
government consumption, and desired exports (total desired
spending on domestically produced goods and services, called
aggregate spending, or AE = C + I + G + (X – IM))
• The National Accounts measure actual spending in each of
the four categories: private consumption, investment,
government consumption, and net exports. The theory of
GDP determination deals with desired spending in each of
these four categories
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11. What Determines Aggregate
Spending II
Autonomous and Induced Spending
• Autonomous (exogenous) spending –
components of aggregate spending that do
not depend on current domestic incomes
– Autonomous spending can and does change, but
such changes do not occur systematically in
response to changes in income)
• Induced (or endogenous) spending –
components of aggregate spending that do
change in response to changes in income
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12. What Determines Aggregate
Spending III
Desired private consumption spending
• There are only two possible uses of disposable
income: consumption and saving. So when each
individual decides how much to put to one use,
she has automatically decided how much to put
to the other use
• What determines the division between the
amount that people decide to spend on goods
and services for consumption and the amount
that they decide to save?
– Consumption function and saving function
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13. • Consumption function relates the total desired consumer
spending of the personal sector to the variables that affect it
• Under the assumptions, there are no taxes
– Individuals receive all income that is generated
– Therefore, disposable income Yd is equal to national income, Y
• The term consumption function describes the relationship
between private consumption and the variables that
influence it. In the simplest theory, consumption spending is
determined by current disposable income
– When income is zero, a typical individual will still (via borrowing,
or drawing down savings) consume some minimal amount (i.e.
autonomous)
– The higher a person’s income, the more he or she will want to
consume (i.e. induced). Table
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14. The slope of the consumption function
• Properties of the short-term consumption
function as follows
– There is a break-even level of income at which
APC equals unity.
– Below this level APC is greater than unity; above
it APC is less than unity.
– Below the break-even level consumption exceeds
income, so consumers run down savings or
borrow.
– Above the break-even level income exceeds
consumption, so there is positive saving
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15. The slope of the consumption function
• Properties of the short-term consumption
function as follows
– MPC is greater than zero, but less than unity, for
all levels of income.
– This means that for each additional GHȼ1 of
income, less than GHȼ1 is spent on consumption
and the rest saved.
– For a straight-line consumption function, the MPC
is constant at all levels of income
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16. The saving function
• Once we know the dependence of consumption on
disposable income, we also automatically know the
dependence of saving on disposable income
• We also have APS and MPS
• There is a simple relationship between the saving and
consumption propensities
• APC and APS must sum to unity (1), just like MPC and
MPS
• Because income is either spent or saved, it follows that
the fractions of incomes consumed and saved must
account for all income (APC + APS = 1)
• It also follows that the fractions of any increment to
income consumed and saved must account for all of
that increment (MPC + MPS = 1)
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17. • What happens when there is an unexpected rise in
wealth?
– Less of current disposable income needs to be saved for
the future
– Will tend to cause a larger fraction of disposable income to
be spent on consumption and a smaller fraction to be
saved
– This will shift the consumption function upward and saving
function downward
• A fall in wealth
– Increases the incentive to save in order to restore wealth
– This shifts the consumption function downward and saving
function upward
• What about interest rate and consumer spending?
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18. Desired investment Spending
• Investment spending is the most volatile
component of GDP and
• Changes in investment spending are strongly
associated with economic fluctuations
• What is the relationship between Investment and
the Real interest rate
• Other things being equal, the higher the real
interest rate, the higher is the cost of borrowing
money for investment purposes and the less is
the amount of desired investment spending
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19. • Inventory accumulation
– The higher the real rate of interest, the lower is the
desired inventory of goods and materials. Changes in
the rate of interest cause temporary bouts of
investments (or disinvestment) as inventories are
either increased or decreased
• Residential housing construction
– Spending for residential construction tends to vary
negatively with interest rates
• Business fixed capital formation
– Increase in real interest rates means that the
opportunity cost of investing in fixed capital had risen
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20. • Expectations and business confidence
– Business investments depends in part on firms’
forecasts of the future state of the economy
– When firms expect good times ahead they will
want to invest so as to reap future profits
– When they expect bad times they will not invest,
because, given their expectations, there will be no
payoff from doing so
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21. The Aggregate Spending Function
• The aggregate spending function relates the
level of desired real spending to the level of
real national income (real GDP)
• Generally, total desired spending on the
nation’s output is the sum of desired private
consumption, investment, government
consumption, and net export spending –
AE = C + I = AE = 350 + 0.8Y
• (Table)
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22. The propensity to spend out of national income
• Marginal propensity to spend (c) – the fraction
of any increment to national income (GDP) that
will be spent on purchasing domestic output
(∆AE/∆Y)
– The slope of the AE function
• Marginal propensity not to spend (1 – c) – the
fraction of an increment to national income that
does not add to desired aggregate spending
• Note – know the difference between the MPC
and MPS and MPnS and MPS
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23. Equilibrium GDP
• When something is in equilibrium there is no
tendency for it to change, forces are acting on it,
but they balance out, and the net result is no
change
– At any level of GDP at which aggregate desired
spending exceeds total output, there will be pressure
for GDP to rise caused by:
• Queues and unfulfilled order books
• Extra sales after reduction in inventories
– At any level of GDP for which aggregate desired
spending is less than total output, there will be
pressure for GDP to fall
– The equilibrium level of GDP occurs where aggregate
desired spending equals total output
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24. Changes in GDP
Suppose desired aggregate spending rises
• This may be as a response to a change in GDP
(incomes) – movement along the AE function,
or
• It may be the result of an increased desire to
spend at each level of GDP – shift in the AE
function
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25. Shifts in the Aggregate Spending Function
• Upward Shifts
– If individuals permanently increase their levels of
desired consumption spending at each level of
disposable income
– A major company desires to invest in more fixed
capital
• Two types of upward shift
– If the same addition to spending occurs at all levels of
income the AE line shifts parallel to itself
– If there is a change in the propensity to spend out of
national income, the slope of the AE line changes
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26. • Downward shifts
– Decrease in the amount of consumption at each level of
income
– Decrease in the amount of investment spending at each
level of income
• 2 General Propositions of the theory of GDP
determination
– A rise in the amount of desired aggregate spending that
is associated with each level of national income will
increase equilibrium national output (GDP)
– A fall in the amount of desired aggregate spending that
is associated with each level of national income will
lower equilibrium national output (GDP)
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27. The Multiplier
• We know how to predict the direction of changes in
GDP that will occur in response to various shifts in the
aggregate spending function
• How can we predict the magnitude of these changes?
• The multiplier is the measure of the magnitude of
changes in GDP induced by a given change in
autonomous expenditure
• The ratio of the change in GDP to the change in
autonomous spending
• The simple multiplier measures the change in
equilibrium GDP that occurs in response to a change in
autonomous spending at a constant price level
• Why is the multiplier greater than 1
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28. The size of the Multiplier
• The larger the marginal propensity to spend,
the steeper is the aggregate spending function
and the larger is the multiplier
K = ∆Y/∆A = 1/1 – c
• The simple multiplier equals the reciprocal of
the marginal propensity not to spend
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29. Assignment
• Calculate GDP using the following information
(where there is no government and no foreign
trade): C = 100 + 0.8Y; I = 1,000.
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