Post on 19-Dec-2015
Aggregate Expenditure
Outline
•Components of aggregate expenditure
•Planned and unplanned expenditure
•The consumption function
•Imports and GDP
•Equilibrium expenditure
•The expenditure multiplier
Components of Aggregate Expenditure
Recall from Chapter 5 that aggregate expenditure for final goods and services equals the sum of
•Consumption expenditure, C
•Investment, I
•Government purchases of goods and services, G
•Net exports, NX
Thus:
Aggregate expenditure = C + I + G + NX
Planned and Unplanned Expenditures
Aggregate expenditure aggregate income and real GDP. But
aggregate planned expenditure might not equal real GDP
because firms can end up with larger or smaller inventories than
they had intended.
Aesop’s Bottles B.C. 400 Investment Plans
Planned spending on buildings, equipment, and tools
20,000 drachmas
Planned inventory investment 0 drachmas
Value of inventories on Dec. 31, 401 B. C. 11,000 drachmas
Value of inventories on Dec. 31, 400 B.C. 13,500 drachmas
Unplanned inventory investment in 400 B.C. 2,500 drachmas
Actual investment in 400 B.C. 22,500 drachmas
Autonomous versus induced Expenditure
•Autonomous expenditure: The components of aggregate expenditure that do not change when real GDP changes.
•Induced expenditure: The components of aggregate expenditure that change when real GDP changes.
The Consumption Function
The consumption function shows the relationship between consumption
expenditure and disposable income, holding all other
influences on influences on household spending behavior constant.
What is disposable income?
•Disposable income is aggregate income (GDP) minus net taxes
•Net taxes are taxes paid to government minus transfer payments received from government.
Disposable Income and Consumption in the U.S., 1959-99
Disposable Income (billions of 1996 dollars)
7000600050004000300020001000
Consu
mpti
on (
billions
of
1996 d
ollars
)7000
6000
5000
4000
3000
2000
1000
www.bea.gov
1991
Dissaving
Disposable income 0 2.0 4.0 6.0 8.0 10.0
Planned Consumption Expenditure
1.5 3.0 4.5 6.0 7.5 9.0
A B C D E F
(trillions of 1996 dollars)Disposable income (trillions of 1996 dollars)
Consumption (trillions of 1996 dollars)
A
F
E
6.0
D
Saving is zeroB
C
Saving
Consumption function
450 line
6.0
2.0
2.0 10.0
Notice that autonomous consumption is given by point A. This is planned
consumption expenditure when disposable income is
zero ($1.5 trillion). This spending must be financed
by past saving or by borrowing
Marginal Propensity to Consume (MPC)
The marginal propensity to consume (MPC) is the fraction of the change in disposable income that is spent on consumption. That is:
MPC = Change in consumption expenditure
Change in disposable income
Notice that when disposable income increases from $6 to $8 trillion, consumption expenditure changes from $6.0 to $7.5 trillion. Thus we have:
75.00.2$
5.1$
trillion
trillionMPC
MPC gives the slope of the consumption function
0 6.0
6.0
8.0
7.5
Co
nsu
mp
tio
n (
tril
lio
ns
of
1996
do
llar
s)
Disposable income (trillions of 1996 dollars)
D
E
Consumption function
K
rise
run
75.00.2$
5.1$
trillion
trillion
KD
EK
run
riseMPCSlope
RealConsumption
Spending
Disposable income
(Expected) real interest rate
The buying power of net assets
Expected future disposable income
+
+
+
-
Shifts of the consumption function
0
Co
nsu
mp
tio
n (
tril
lio
ns
of
1996
do
llar
s)
Disposable income (trillions of 1996 dollars)
CF0
CF2
CF1
CF0 to CF1
•Decrease in the real interest rate.
•Buying power of net assets increases.
•Rise in expected future disposable income.
Falling interest rates have stimulated consumer spending recently
Complete Exercise #1 on p. 394
Imports and GDP
Imports are a component of induced expenditure.
Imports depend partly on the health of the
domestic economy.
Marginal Propensity to import (MPI)
The marginal propensity to import (MPI) is the fraction of the change in disposable income that is spent on imports . That is:
MPI = Change imports
Change in disposable income
Suppose that, ceteris paribus, when disposable income increases from $2 trillion, imports increase by $0.3 trillion. Thus we have:
15.00.2$
3.0$
trillion
trillionMPI
Planned Expenditures
[Y] [C] [I] [G] [X] [M] [AE = C + I + G +X - M]
(trillions of 1996 dollars)
A 0.00 0.00 2.00 1.00 1.50 0.00 4.50
B 3.00 2.25 2.00 1.00 1.50 0.75 6.00
C 6.00 4.50 2.00 1.00 1.50 1.50 7.50
D 9.00 6.75 2.00 1.00 1.50 2.25 9.00
E 12.00 9.00 2.00 1.00 1.50 3.00 10.50
F 15.00 11.25 2.00 1.00 1.50 3.75 12.00
Aggregate Expenditure and Real GDP
Note: Y is real GDP
II + G3
I + G + C + X
I + G + XA
C
D
9
Agg. Exp. (billions of 1996 dollars)
GDP (Billions of 1996 dollars)0
4.5
Consumption expenditure
imports
AE
Aggregate Unplanned
Real planned inventory
GDP expenditure change
(trillions of 1996 dollars)
A 0.0 0.0 -4.5
B 3.0 3.0 -3.0
C 6.0 6.0 -1.5
D 9.0 9.0 0.0
E 12.0 12.0 1.5
F 15.0 15.0 3.0
3 9
9
6
12
K
B
D
F
J
0
450
AE (trillions of 1996 dollars)
GDP (trillions of 1996 dollars)
AE
15
•AE > GDP by vertical distance B-K
•Plans of producing and spending units do not coincide
•Unplanned inventory investment = - $3 trillion
•Tendency for firms (on average) to step up the pace of production and offer more employment
• GDP > AE by vertical distance J-F
•Plans of producing and spending units do not coincide
•Unplanned inventory investment =$3 trillion
•Tendency for firms (on average) to scale back the on production and offer less employment
•AE = GDP
•Plans of producing and spending units coincide.
•Unplanned inventory investment = 0
• No tendency for firms (on average) to step up the pace of production and offer more employment. Nor is there a tendency for firms to scale back on production and offer less employment.
•“Supply creates its own demand.”
•By producing goods and services, firms create a total demand for goods and services equal to what they have produced.
Say’s Law1
Say’s law apparently rules out the
possibility of a widespread glut of
goods.
1 J.B. Say. Treatise on Political Economy, 1903.
Say’s law implies that full-employment equilibrium is the normal state of affairs
Full employment GDP
AE
GDP
C + I + G + NX
AE touchesthe 450 line at potential
GDP
General (Keynesian) Case: Underemployment Equilibrium
Full employment GDP
AE
GDP
C + I + G + NX
Y*
A
H
•Assume the economy is in equilibrium when real GDP = $3 trillon.
•What would happen if, other things being equal, planned investment (I) increased by $0.5 trillion?
11.0
AE
GDP
AE1
9.0
1
2
AE2
450
4.5
5 I
GDP
How did a $0.5 trillion change in I
bring about a $2 trillion change in
GDP?
0
It’s a bird
It’s a plane
No, it’s the multiplier effect!
The expenditure multiplier The multiplier is amount by which a change in any component of autonomous expenditure is magnified or multiplied to determine the change that it generates in equilibrium expenditure and real GDP.
Multiplier = Change in autonomous expenditure
Change in equilibrium expenditure
Thus in our case the multiplier is given by:
45.0$
2$
trillion
trillion
I
YMultiplier
When firms increase investment by $0.5 trillion, sales revenues at investment goods manufacturers (Boeing, Westinghouse, Cincinnati Milacron) will increase by $0.5 trillion
Chain of causation
The $0.5 trillion in revenue will be distributed as factor payments to those supplying resources necessary to produce capital goods—hence the change in spending generates $0.5 trillion in income in the first round.
Now households have $1,000 in additional income. What do they do with it? Their spending will increase by the MPC times the change in income—that is: C = .75 $0.5 trillion = $0.375 trillion Hence, households spend $375 billion and save $125billion
But the story does not end here, since McDonalds’s, Disney, Kraft, American Airlines, and Amheiser Busch, etc. will see their sales increase by $375 billion, and will distribute $375 billion in wages, salaries, rental income, and profits to those who supplied resources necessary to produce the additional consumer goods.
Those who earned additional income in consumer goods industries will now increase their spending. By how much? C = .75 $375 = $281.85.
This will result in additional production and factor payments. Spending will then increase. And so on. And so on.
Why is the multiplier greater than 1?
As we see from the preceding illustration, a change in autonomous
expenditure (in this case, I) induces a
change in consumption expenditure.
The Multiplier and the MPC
YCY
YMPCC
We will now illustrate why the magnitude of the multiplier depends on the MPC. For the moment, assume no imports, exports, or taxes. Thus:
[1]
Where:
[2]
[1]
Now substitute [2] into [1] to obtain:
ICMPCY
Now solve for Y
IYMPC )1( [4]
Now rearrange [4]
IMPC
Y
)1(
1[5]
Divide both sides of [5] by I to obtain the multiplier
425.0
1
)75.01(
1
)1(
1
MPCI
YMultiplier
The expenditure multiplier
You can see from the math that the size of the
multiplier is positively linked to the MPC. The
higher the MPC, the greater the “induced”
expenditure resulting from a change in autonomous
expenditure
Taxes, Imports, and the Multiplier
Once we allow for imports and taxes, the multiplier depends not only on the
MPC, but also on the marginal propensity to import (MPI) and the
marginal tax rate (MTR)
1.05.0$
05.0$
trillion
trillionMTR
Marginal Tax Rate (MTR)
The marginal tax rate (MTR) is the fraction of the change in real GDP that is paid income taxes. That is:
MTR = Change in tax payments
Change in real GDP
Suppose that, ceteris paribus, when real GDP increases by $0.5 trillion, tax payments increase by $0.05 trillion. Thus we have:
The “real” expenditure multiplier
) 1(
1
curveAEofSlopeI
YMultiplier
The multiplier is given by
The slope of the AE curve is given by:
Slope of AE curve = MPC – (MPI + MTR)
Thus the multiplier can be written as:
MTRMPIMPCI
YMultiplier
1
1
10.0
AE
GDP
AE1
9.0
1
2
AE2
450
4.5
5 I
Y
0
Slope = 0.5
In this case, MPC = 0.75; MPI = 0.15; MTR = 0.1
2 trillion$0.5
trillion0.1$
I
Y
Multiplier