CHAPTER 9
The Sticky-Price IncomeExpenditure Framework:
Consumption and the Multiplier
9-1
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What are “sticky” prices?
• What factors might make prices
sticky?
• When prices are sticky, what
determines the level of real GDP in
the short run?
9-2
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• When prices are sticky, what happens
to real GDP if some component of
planned total expenditure rises or
falls?
• When exports, investment, or
government purchases rise, in
general GDP rises by a multiplied
amount. What determines the size of
the spending multiplier?
9-3
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Real GDP in U.S. History
• The flexible-price model does not give
a complete picture of the
macroeconomy
– real GDP does not always grow by the
same rate as potential output
– the unemployment rate is not always at
the natural rate
– inflation is not always steady
9-4
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.1 - Real GDP per Worker and
Potential Output, 1960-2004
9-5
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Business Cycles
• Fluctuations in economic growth are
called business cycles
• A business cycle has two phases
– expansion or boom
• production, employment, and prices all grow
rapidly
– recession or depression
• production falls, unemployment rises, and
inflation decelerates
9-6
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Business Cycles
• To understand business cycles, we
need a model that does not always
guarantee full employment
• We will no longer assume that prices
are flexible
• Instead, prices will be assumed to be
“sticky”
– they will remain fixed at predetermined
levels as businesses expand or contract
production
9-7
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• Suppose that autonomous
consumption falls from $2,000 billion
to $1,800 billion per year
• In the flexible-price model, real GDP
would be unaffected
– the economy would remain at full
employment
– real GDP would equal potential output
9-8
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.2 – Flexible-Price Logic: Labor
Market Equilibrium
Real Wage
Labor supply = labor force
Market
equilibrium
real wage
Economywide
demand for
labor Ld
Equilibrium
employment
9-9
Employment
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the flexible-price model, a fall in
consumption means an increase in
savings
– the real interest rate falls
– the equilibrium level of investment and
net exports increases by $200 billion per
year
9-10
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.3 – Flexible-Price Logic: The Effect
on Savings of a Fall in Consumption Spending
Real Interest
Rate r
Total Saving
Investment Demand
Flow of Funds
through
Financial
Markets
9-11
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the flexible-price model, the
consequences of a fall in consumers’
desired baseline consumption are
– a drop in consumption
– an increase in household savings
– a decline in the real interest rate
– a rise in investment
– a rise in the exchange rate
– a rise in net exports; a fall in foreign
saving
9-12
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the sticky-price model, a drop in
consumption leads to a drop in
aggregate expenditure
• As businesses see spending on their
products falling, they cut back
production
– they will fire some of their workers
– incomes will fall
9-13
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the sticky-price model, a drop in
consumption does not lead to an
increase in savings
– the increase in savings (from the fall in
consumption) is exactly offset by a
decrease in savings (from the fall in
income)
• The real interest rate is unaffected
– no change in investment or net exports
9-14
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.4 – Sticky-Price Logic: The Effect on
Savings of a Fall in Consumption Spending
Real Interest
Rate r
Total Saving
No change
in the real
interest rate
Investment Demand
9-15
No change
in investment
spending
Flow of Funds
through
Financial
Markets
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
A Decrease in Autonomous
Consumption (C0)
• In the sticky-price model, the
consequences of a fall in consumers’
desired baseline consumption are
– a drop in consumption
– a decline in production
– a decline in employment
– a decrease in national income
– no change in the real interest rate,
investment, or the exchange rate
9-16
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Expectations
• Price stickiness causes problems only
in the short run
• If individuals had time to foresee and
gradually adjust their wages and
prices to changes in expenditure,
sticky prices would not be a problem
– both the stickiness of prices and the
failure to accurately foresee changes are
needed to create business cycles
9-17
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Short Run vs. Long Run
• In the short run, prices are sticky
– shifts in policy or in the economic
environment that affect the components
of planned total expenditure will affect
real GDP and employment
• In the long run, prices are flexible
– individuals have time to react and adjust
to changes in policy or the economic
environment
• real GDP and employment are unaffected
9-18
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• Menu costs are costs associated with
changing prices
– changing prices can be costly for a
variety of reasons
– managers and workers may prefer to
keep prices and wages stable as long as
the shocks that affect the economy are
relatively small
9-19
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• Imperfect information causes a
misperception of real and nominal
price changes
– managers and workers lack full
information about the state of the
economy and may confuse changes in
economy-wide spending with changes in
demand for their particular products
• cut production rather than cutting the price of
the product
9-20
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• The level of prices is often determined
by “what is fair”
• Work effort and work intensity depend
on whether or not workers feel that
they are treated fairly
– most managers are reluctant to cut
wages
– if wages are sticky, firms will adjust
employment when demand changes
9-21
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Prices Are Sticky
• Managers and workers may suffer
from money illusion
– confuse changes in nominal prices with
changes in real prices
• firms react to higher nominal prices by
believing that it is profitable to produce more
• workers react to higher nominal wages by
searching more intensively for jobs and
working more hours
9-22
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier Process
• If prices are sticky, higher planned
expenditure boosts production
• Incomes rise
• Higher incomes give a further boost to
production which increases planned
expenditure even more
9-23
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.5 - The Multiplier Process
An initial shock
to planned
expenditure
raises total
spending
Higher spending
raises production
Higher production
raises spending
Higher income
raises total
spending still
further
9-24
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Building Up Planned Total
Expenditure
• Planned total expenditure (PE) has
four components
– consumption (C)
– investment (I)
– government purchases (G)
– net exports (NX)
PE  C  I  G  NX
9-25
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Building Up Planned Total
Expenditure
• As long as prices are sticky, the level
of real GDP is determined by the level
of planned total expenditure
– not by the level of potential output (Y*)
Y = PE
9-26
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumption Function
• As incomes rise, consumption
spending rises
– less than dollar for dollar
• The share of an extra dollar of
disposable income that is added to
consumption spending is equal to the
marginal propensity to consume
(Cy)
C  C0  Cy (1 - t)Y
9-27
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumption Function
• The slope of the consumption function
is smaller than the marginal
propensity to consume (Cy)
– because of the tax system, a one-dollar
increase in national income means less
than a one-dollar increase in disposable
income
9-28
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.6 - The Consumption Function and
the Marginal Propensity to Consume
Consumption
Spending
slope = Cy(1-t)
National
Income
9-29
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.7 - Consumption as a Function of
After-Tax Disposable Income
9-30
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Consumption Function
• Example
– Cy = 0.75
– t = 0.40
– when Y = $8 trillion, C = $5.5 trillion
C  C0  Cy (1 - t)Y
C  C0  0.75(1 - 0.4)Y
C  C0  0.45Y
$5.5  C0  0.45($8)
$5.5  C0  $3.6
C0  $1.9
C  $1.9  0.45Y
9-31
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Other Components of Total
Expenditure
• Investment (I) is determined by the
real interest rate and assessments of
profitability made by firms’ managers
I  I0  Irr
• Government purchases (G) is set by
politics
9-32
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Other Components of Total
Expenditure
• Net exports (NX) are equal to gross
exports minus imports
– gross exports are a function of the real
exchange rate () and the level of foreign
real GDP (Yf )
– imports are a function of national income
(Y)
NX  GX - IM  (Xf Y  X  )- IMy Y
f
9-33
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.8 - Components of Total Expenditure
9-34
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Components of Expenditure
• The components of total expenditure
can be divided into two groups
– autonomous spending (A)
• components of total expenditure that do not
depend directly on national income
– the marginal propensity to expend
(MPE) times the level of national income
(Y)
9-35
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Components of Expenditure
PE  [C0  Cy (1-t)Y]  I  G  [GX-IMy Y]
PE  [C0  I  G  GX]  [Cy (1-t)-IMy ]Y
PE  A  MPE(Y)
• A = autonomous expenditure
[A=C0+I+G+GX]
• MPE=marginal propensity to expend
[MPE=Cy(1-t)-IMy]
9-36
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.9 - The Income-Expenditure Diagram
Planned
Expenditure
Planned-expenditure line
slope = MPE
Autonomous
spending
9-37
National
Income (Y)
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Income-Expenditure Diagram
• The y-intercept of the planned
expenditure line is the level of
autonomous spending (A)
– a change in the value of any component
of autonomous spending will shift the
planned expenditure line up or down
9-38
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.10 – An Increase in Autonomous
Spending
Planned
Expenditure
New planned-expenditure line
Old planned-expenditure line
Change in
autonomous
spending
Old
autonomous
spending
9-39
National
Income (Y)
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Income-Expenditure
Diagram
• The slope of the planned expenditure
line is the marginal propensity to
expend (MPE)
– changes in the marginal propensity to
consume (Cy), the tax rate (t), or in the
propensity to spend on imports (IMy) will
change the MPE and the slope of the
planned expenditure line
9-40
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.11 – An Increase in the Marginal
Propensity to Expend
Planned
Expenditure
New plannedexpenditure line
High MPE
Old planned-expenditure line
Low MPE
Autonomous
spending
9-41
National
Income (Y)
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Calculating the MPE
• Example
– Cy = 0.75
– t = 0.40
– IMy = 0.15
MPE  [C y (1 - t)- IMy ]
MPE  [0.75(1 - 0.40) - 0.15]
MPE  [0.45 - 0.15]  0.30
9-42
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Sticky-Price Equilibrium
• The economy will be in equilibrium
when planned expenditure equals real
GDP
– there will be no short-run forces pushing
for an immediate expansion or
contraction of national income, real GDP,
or total expenditure
9-43
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.12 – Equilibrium on the IncomeExpenditure Diagram
Planned
Expenditure
45-degree line
Planned-expenditure
Equilibrium
National
Income (Y)
9-44
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Sticky-Price Equilibrium
• Equilibrium occurs when planned
expenditure (PE) is equal to real GDP
(Y)
Y  PE  A  MPE(Y)
A
Y  PE 
1-MPE
• Example
– A = $5,600 billion Y  PE  $5,600  $8,000 billion
0.70
– MPE = 0.30
9-45
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Sticky-Price Equilibrium
• If the economy is not on the 45degree line, the economy is not in
equilibrium
– planned expenditure (PE) does not equal
real GDP (Y)
• If Y>PE
– there is excess supply of goods
• If Y<PE
– there is excess demand for goods
9-46
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Inventory Adjustment
• Excess supply
– production > planned expenditure
– inventories are rising rapidly
– firms will cut production
• Excess demand
– production < planned expenditure
– inventories are being depleted
– firms will expand production
9-47
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.13 - Inventory Adjustment and
Equilibrium: Goods Market Equilibrium and
the Income-Expenditure Diagram
Planned
Expenditure
Rising
inventories
45-degree line
Planned-expenditure
Equilibrium
Falling
inventories
National
Income (Y)
9-48
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Inventory Adjustment
• Suppose that businesses see their
inventories declining
– they will respond by boosting production
to equal last month’s planned
expenditure
• This will not bring the economy into
goods market equilibrium
9-49
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.14 – The Inventory Adjustment
Process: An Income-Expenditure Diagram
45-degree line
Planned
Expenditure
Planned-expenditure
New
expenditure
Initial
expenditure
National
Income (Y)
9-50
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Suppose that autonomous spending
increases
– the planned expenditure line will shift up
– planned expenditure > national income
• inventories would fall
• businesses would boost production
– how much production would expand
depends on the magnitude of the change
in autonomous spending and the value of
the spending multiplier
9-51
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 9.17 – The Multiplier Effect
Planned
Expenditure
change in
component
of planned
expenditure
change in
equilibrium
national income
National
Income (Y)
9-52
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• The value of the multiplier depends on
the slope of the planned expenditure
line
– the higher is the MPE, the steeper is the
planned expenditure line and the greater
is the multiplier
9-53
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Equilibrium means that
A
Y  PE 
1-MPE
 1 
Y  
 A
 1-MPE 
9-54
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• 1/[1-MPE] is the multiplier
– it multiplies the upward shift in the
planned expenditure line into a change in
the equilibrium level of real GDP, total
income, and aggregate demand
– because autonomous spending is
influenced by many factors, almost every
change in economic policy or the
economic environment will set the
multiplier process in motion
9-55
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Example
– A = $5.6 trillion
– MPE = 0.3
Y  PE  $8.0 trillion
– A = $0.1 trillion Y  PE  $8.143 trillion
Y 0.143
multiplier 

 1.43
A
0.1
1
1
multiplier 

 1.43
1 - MPE 0.7
9-56
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• One factor that tends to minimize the
multiplier is the tax system
– taxes are proportional rather than lumpsum
• when GDP is high, the government collects
more in tax revenue than it would with a
lump-sum tax
• when GDP is low, the government collects
less in tax revenue than it would with a lumpsum tax
9-57
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Thus, under a proportional tax
system, the multiplier is
Y
1
1


A 1-MPE 1-[Cy (1-t)-IMy ]
• Under a lump-sum tax system, the
multiplier would be
Y
1
1


A 1-MPE 1-[Cy -IMy ]
9-58
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• An economy that is more open to
world trade will have a smaller
multiplier than a less open economy
– the more open the economy, the greater
is the marginal propensity to expend on
imports
9-59
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• The multiplier for a closed economy
would be
Y
1
1


A 1-MPE 1-[Cy (1-t)]
9-60
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Business-cycle fluctuations can push
real GDP away from potential output
and unemployment far away from its
average rate
• If prices were perfectly and
instantaneously flexible, there would
be no such thing as business cycle
fluctuations
– models in which prices are sticky must
play a large role in macroeconomics
9-61
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• There are a number of reasons that
prices might be sticky
– menu costs, imperfect information,
concerns of fairness, or money illusion
– there is no overwhelming evidence as to
which is most important
• In the short run, while prices are
sticky, the level of real GDP is
determined by the level of planned
total expenditure
9-62
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The short-run equilibrium level of real
GDP is that level at which planned
total expenditure (as a function of
national income) is equal to the level
of national income (real GDP)
• Two quantities summarize planned
total expenditure as a function of total
income
– the level of autonomous spending and
the marginal propensity to expend (MPE)
9-63
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The level of autonomous spending is
the intercept of the planned
expenditure function on the incomeexpenditure diagram
– it tells us what the level of planned
expenditure would be if national income
was zero
9-64
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The MPE is the slope of the planned
expenditure function on the incomeexpenditure diagram
– it tells us how much planned expenditure
increases for each $1 increase in national
income
9-65
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• The value of the MPE depends on the
tax rate (t), the marginal propensity
to consume (Cy), and the share of
spending on imports (IMy)
MPE  C y (1 - t)- IMy
9-66
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• In the simple macro models, an
increase in any component of
autonomous spending causes a more
than proportional increase in real GDP
– this is the multiplier process
• The size of the multiplier depends on
the MPE
Y
1

A 1 - MPE
9-67
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.