Look again at Figure 10.2 "The Monetary Transmission Mechanism". We have so far explored the links from the Fed’s decision on a target to spending on durable goods and net exports. Now we examine how changes in spending affect total output in the economy. The aggregate expenditure model allows us to see how changes in aggregate spending translate into changes in GDP, at a given price level. The idea underlying the aggregate expenditure model is that, by the rules of national income accounting, real GDP must equal both production and spending. If spending increases, then it must be the case that production increases as well. The key diagram of the aggregate expenditure model is shown in Figure 10.8 "Aggregate Spending Depends Positively on Income".
Variations in the real interest rate influence the level of aggregate spending through the level of autonomous spending (the intercept term). To see why, recall that total spending is the sum of consumption, investment, government purchases, and net exports. The intercept term of the expenditure relationship includes all the influences on spendingother than output. Thus any changes in consumption, investment, or net exports that arenotinduced by changes in output show up as changes in the intercept term. In particular, if an increase in interest rates causes firms to cut back on their investment spending, then the planned spending line shifts downward.
We saw in Figure 10.7 "The Relationship between the Real Interest Rate and Spending on Durable Goods" that, as the real interest rate increases, the level of spending on durables decreases. This leads to a decrease in spending, given the level of income, and thus a decrease in the intercept of the spending line, as shown in Figure 10.9 "Increases in Real Interest Rates Reduce Real GDP". The magnitude of the reduction in spending—that is, the shift downward in the spending line—will depend on the sensitivity of durable spending to real interest rates. The more sensitive durable spending is to changes in the real interest rate, the larger the shift in the spending line will be when the real interest rate changes.
The initial reduction in spending induced by the increased real interest rate is then magnified by the multiplier process. The reduction in durable spending leads to a contraction in output. The resulting decrease in income leads households to spend less, leading to further contractions in output and income. In the end, the overall reduction in output exceeds the initial reduction in spending. This is visible in Figure 10.9 "Increases in Real Interest Rates Reduce Real GDP" from the fact that the horizontal difference between the old and new equilibrium points is larger than the vertical shift in the spending line.
Toolkit: Section 16.19 "The Aggregate Expenditure Model"
You can review the aggregate expenditure model and the multiplier in the toolkit.
- 1041 reads
