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Aggregate Expenditure and Aggregate Demand

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Title: Aggregate Expenditure and Aggregate Demand


1
Aggregate Expenditure and Aggregate Demand
  • Chapter 10

2
Aggregate Expenditure and Income
  • Each dollar spent on production translates
    directly into a dollar of aggregate income
    RememberGDP equals aggregate income
  • Investment, government purchases, and net exports
    are autonomous, independent of the level of
    income (some of this will be relaxed in later
    chapters).

3
Aggregate Expenditures
  • Equals the amount that households, firms,
    governments, and the rest of the world plan to
    spend on U.S. output at each level of real GDP
  • Consumption, C
  • Planned investment, I
  • Government purchases, G
  • Net exports, X M
  • Consumption is the only spending component that
    varies with the level of real GDP

4
Aggregate Expenditures
  • Planned investment amount of investment that
    firms plan to undertake during a year
  • Actual investment amount of investment actually
    undertaken equals planned investment plus
    unplanned changes in inventories
  • Whats left over??? Its unplanned
    investmentthis is an increase or decrease in
    inventories that is not anticipatedSALE!!!

5
Exhibit 1 Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
Autonomous
  • Suppose the price level in the economy is 130,
    30 higher than in the base year.
  • Can we calculate the MPS and MPC from this table?
    (the answer is yes).
  • This table presents the information that is
    needed on the various components of aggregate
    demand and expenditure MPC is 4/5 and the MPS is
    1/5

6
Exhibit 1 Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
  • Government purchases equals net taxes
    governments budget is balanced
  • The final column lists any unplanned inventory
    adjustment equals real GDP minus planned
    aggregate expenditures
  • When the amount of planned spending equals the
    amount produced, there are no unplanned inventory
    adjustments. Here, this occurs where planned
    aggregate expenditures and real GDP equal 12.0
    trillion

7
Exhibit 1 Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
  • When real GDP is 11 trillion, planned aggregate
    expenditure is 11.2, which exceeds the amount
    produced by 0.2 trillion
  • Firms rely upon inventories to make up the
    shortfall (unplanned inventory investment of
    -0.2) and respond by increasing output

8
Exhibit 1 Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
  • If the amount produced exceeds planned spending,
    firms get stuck with unsold goods unplanned
    increases in inventories, however for now, they
    arent allowed to reduce prices to sell the
    excess inventorieswhat do they adjust???
    Production!
  • When real GDP is 13 trillion, planned aggregate
    expenditure is only 12.8, and 0.2 trillion in
    output remains unsold
  • Firms, under the assumption of a fixed price
    level, respond by cutting output

9
Real GDP Demanded
  • The aggregate expenditure line shows the
    relationship, for a given price level, of planned
    spending at each income, or real GDP.
  • The total of C, I, G, and (X - M) at each income
    level, or real GDP.
  • Each row in the table above represents a single
    point on the AE line.

10
Real GDP Demanded
  • From this we develop the Income-expenditure
    model a relationship between aggregate income
    and aggregate spending that determines, for a
    given price level, where spending (AE) is equal
    to the amount produced (GDP).

11
Exhibit 2 Deriving the Real GDP Demanded for a
Given Price Level
  • 45 degree line identifies all points where
    planned expenditure real GDP
  • Planned aggregate expenditure is measured on the
    vertical axis.
  • Aggregate output demanded at any given price
    level occurs where real GDP equals planned
    aggregate expenditures, at point e


12
Exhibit 2 Deriving the Real GDP Demanded for a
Given Price Level
C I G (X M)
  • Consider what happens when real GDP is initially
    less than 12 trillion, say 11 trillion.
    Planned aggregate expenditures of 11.2 trillion
    (point b) exceeds output by 0.2 trillion
  • Because we assume prices will remain constant,
    firms will reduce inventories
  • But unplanned inventory reductions cannot
    continue indefinitely firms will increase
    employment increasing income, increasing
    consumer spending. This process will continue
    until planned spending equals real GDP at point e.

Aggregate expenditure (trillions of dollars)

AE(b)gtGDP(a)
45º
0
Real GDP (trillions of dollars)
13
Exhibit 2 Deriving Aggregate Output
  • When aggregate expenditures exceed real GDP, for
    example at 13.0, planned spending (point c)
    falls short of production (point d).
  • Since real GDP exceeds the amount people want to
    spend, unsold goods accumulate by 0.2 trillion
    more than firms planned
  • Rather than allow inventories to pile up
    indefinitely, firms reduce production, which
    reduces employment and income.

AE(c)ltGDP(d)
d
13.0
12.8

c
C I G (X M)

Aggregate expenditure (trillions of dollars)

45º
13.0
0
Real GDP (trillions of dollars)
14
Exhibit 2 The Real GDP Demanded for a Given
Price Level
  • At a given price level, any movement away from e
    will result in adjustments in inventories,
    employment, income and finally consumption to
    bring the economy back to point e, where
    expenditures output.


15
Exhibit 3 Shifting the AE Line(The Effect of an
Increase in Investment)
  • Investment increases by 0.1 trillion
  • Upward shift of the AE line means that at initial
    real GDP level of 12 trillion, planned spending
    exceeds output by 0.1 trillion (the distance
    between points e and f)
  • Reduced inventories prompt firms to expand
    production by 100 billion (movement from f to g )
  • Those who receive the additional 100 billion
    spend 80 on goods (movement from g to h)
  • Firms respond by increasing output again
    (movement from h to i)
  • This 80 billion will stimulate new spending of
    64 billion (moving from i to j), which causes
    firms to increase output, yet again (from j to k,
    etc.)
  • The initial infusion of 0.1 trillion (or 100
    billion) increases output by 0.5 trillion (or
    500 million)!!!

)
C I G (X M)
s
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a
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o
12.5
d

f
C I' G (X M)
o

s
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o
i
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i
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f
e
r
12.1
u
g
t
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12.0
e
n
e
p
x
e

e
0.1
t
a
g
e
r
g
45º
g
A
0
12.0
12.5
Real GDP
(trillions of dollars)
16
Exhibit 4Tracking the Rounds of Spending
Following a 100Billion Increase in investment
(billions of dollars)
8
?
  • Exhibit 4 summarizes the multiplier process,
    showing the first three rounds, round ten, and
    the cumulative effect of all rounds
  • The new spending generated in each round is shown
    in the second column and the accumulation of new
    spending appears in the third column
  • Total new spending after 10 rounds sums to 446.3
    billion
  • But calculating the exact total would require us
    to work through an infinite series of
    roundsthere is a shortcut.

17
Simple Spending Multiplier
  • Refers to the factor by which real GDP demanded
    changes for a given initial change in spending
  • Simple Spending Multiplier 1/(1MPC)
  • In our example, the MPC 0.8 ? a multiplier of 5
  • Initial increase in investment spending of 100
    billion will eventually boost real GDP demanded
    by 5 times this amount, or 500 billion

18
Simple Spending Multiplier
  • The multiplier depends on the value of the MPC
  • Specifically, the larger the fraction of an
    increase in income that is spent each round, the
    larger the spending multiplier ? the larger the
    MPC, the larger the simple multiplier
  • With an MPC of 0.8, the multiplier is 5
  • With an MPC of 0.9, the multiplier is 10
  • With an MPC of 0.75, the multiplier is 4

19
Simple Spending Multiplier
  • Simple spending multiplier 1 / MPS
  • In our example, the multiplier process started
    because of an increase in investment, but the
    same impact would occur if any one of the
    components of aggregate expenditures changed, (C,
    I, G, or X-M)
  • If the higher level of planned investment is not
    sustained in future years, real GDP would fall
    back and the multiplier process would work in
    reverse, reducing GDP by a multiple effect.

20
Spending Multiplier Whats its importance
  • Its used in all types of economic development
    work. The reason we provide incentives for
    industry to locate in GA is that investment
    dollars are multiplied in our economy.
  • We use a similar multiplier to estimate the
    effect of new industries locating in our area.

21
Spending Multiplier Air Travel after 9/11
  • Lets think of a specific example of how the
    multiplier works after a specific event.
  • After 9/11 very few people were flying.
  • Immediate layoffs
  • Investment in aircraft falls
  • Income falls in airline jobs and any industry
    supporting airlines
  • Airline workers spend less on groceries
  • Businesses throughout the economy see sales fall
  • More jobs are lost in unrelated industries
  • and, so on

22
Another way of Deriving the Aggregate Demand Curve
  • What happens to the aggregate expenditure line if
    the price level changes
  • For each price level there is a specific
    aggregate expenditure line which yields a unique
    real GDP demanded, so a change in price level
    shifts the AE line.
  • By altering the price level, we can derive the
    aggregate demand curve in a different way than we
    learned previously.

23
A Higher Price Level
  • What is the effect of a higher price level on the
    economys aggregate expenditure line and, in
    turn, on real GDP demanded?
  • A higher price level
  • reduces consumption because it reduces the real
    value of dollar-denominated assets (i.e., cash
    holdings) held by householdspeople feel poorer.
  • An increasing price level increases the market
    rate of interest, which reduces investment
  • An increasing price level makes U.S. goods
    relatively more expensive abroad imports rise
    and exports fall
  • All of these results in an inward shift in AE.

24
Exhibit 5 Income-Expenditure and Aggregate Demand
(a) Income-expenditure model

Aggregate expenditure (trillions of dollars)
  • In panel (a), the AE function intersects the 45
    degree line at point e to yield 12 trillion in
    real GDP demanded
  • Panel b shows that when the price level is 130,
    real GDP demanded is 12 trillion and we have one
    point on the aggregate demand curve, e

45

0
Real GDP (trillions of dollars)
(b) Aggregate demand curve
140
Price level

0
Real GDP (trillions of dollars)
25
Exhibit 5 Income-Expenditure and Aggregate Demand
  • If the price level increases to 140, the increase
    in the price level reduces consumption, planned
    investment, and net exports as shown by the
    downward shift of the aggregate expenditure line
    from AE to AE' and real GDP demanded declines
    from 12 trillion to 11.5 trillion
  • If the price level falls, the opposite occurs
    consumption, investment, and net exports increase
    at each real GDP
  • The AE function shifts to AE' real GDP increases
    to 12.5 trillion
  • Connecting these three equilibrium points yields
    the AD curve

AE" (P 120)
e"
AE (P 130)
AE' (P 140)

Aggregate expenditure (trillions of dollars)
e
(a) Income-expenditure model
e'
45
12.5

0
Real GDP (trillions of dollars)
11.5
12.0
26
Aggregate Demand and Expenditures
  • The aggregate expenditure line and the aggregate
    demand curve portray real output from different
    perspectives
  • The aggregate expenditure line shows, for a given
    price level, how planned spending relates to the
    level of real GDP in the economy
  • The aggregate demand curve shows, for various
    price levels, the quantities of real GDP demanded

27
Multiplier and Aggregate Demand
  • Suppose we return to the situation where the
    price level is assumed to be constant
  • What we want to do now is trace through the
    effects of a shift in any of the components of
    spending on aggregate demand, while assuming that
    the price level does not change, e.g., we want to
    look at the multiplier and shifts in aggregate
    demand

28
Exhibit 6 Shifts in Aggregate Expenditures and
Aggregate Demand
C I G (X M)
  • At a price level of 130, the aggregate
    expenditure line intersects the 45 degree line at
    point e in panel (a), and yields point e on the
    aggregate demand curve in panel (b)
  • When one component of aggregate expenditure
    increases and the price level remains constant,
    the aggregate demand curve shifts from AD to AD'
    and the new point of equilibrium is shown as e
    in both panels

(a) Income-expenditure model
Aggregate expenditure (trillions of dollars)
e
45º
0
12.0
Real GDP (trillions of dollars)
(b) Aggregate demand curve
e'
e
130
Price level

AD
0
12.0
Real GDP (trillions of dollars)
29
Limitations of the Multiplier
  • Once aggregate supply is incorporated into the
    analysis, changes in the price level reduce the
    impact of the multiplier
  • Leakages such as higher income taxes and
    increased spending on imports all reduce the size
    of the multiplier
  • The spending multiplier takes time to work itself
    out, the process does not occur instantly
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