Aggregate%20Expenditure

1
Aggregate Expenditure

• Outline
• Components of aggregate expenditure
• Planned and unplanned expenditure
• The consumption function
• Imports and GDP
• Equilibrium expenditure
• The expenditure multiplier

2
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

ThusAggregate expenditure C I G NX
3
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.
4
Aesops 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
5
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.

6
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.
7
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.

8
www.bea.gov
1991
9
450 line
Consumption (trillions of 1996 dollars)
Saving
F
Consumption function
E
D
6.0
Dissaving
C
Saving is zero
B
A
2.0
6.0
2.0
10.0
Disposable income (trillions of 1996 dollars)
(trillions of 1996 dollars)
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
10
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
11
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
Change in consumption expenditure
MPC
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
12
MPC gives the slope of the consumption function
Consumption function
E
7.5
D
rise
Consumption (trillions of 1996 dollars)
6.0
K
run
0
6.0
8.0
Disposable income (trillions of 1996 dollars)
13
Determinants of Consumption Expenditure
Disposable income

(Expected) real interest rate
RealConsumptionSpending
-

The buying power of net assets

Expected future disposable income
14
Shifts of the consumption function

• CF0 to CF1
• Decrease in the real interest rate.
• Buying power of net assets increases.
• Rise in expected future disposable income.

CF1
CF0
CF2
Consumption (trillions of 1996 dollars)
0
Disposable income (trillions of 1996 dollars)
15
Falling interest rates have stimulated consumer
spending recently
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18
Complete Exercise 1 on p. 394
19
Imports and GDP
Imports are a component of induced expenditure.
Imports depend partly on the health of the
domestic economy.
20
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
Change imports
MPI
Change in disposable income
Suppose that, ceteris paribus, when disposable
income increases from 2 trillion, imports
increase by 0.3 trillion. Thus we have
21
Aggregate Expenditure and Real GDP
        Planned Expenditures Planned Expenditures Planned Expenditures Planned Expenditures
Y C I G X M AE C I G X - M
    (trillions of 1996 dollars) (trillions of 1996 dollars) (trillions of 1996 dollars) (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
Note Y is real GDP
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I G C X
Agg. Exp. (billions of 1996 dollars)
imports
AE
D
Consumption expenditure
C
I G X
4.5
A
I G
3
I
0
9
GDP (Billions of 1996 dollars)
23
    Aggregate Unplanned
Real planned inventory
  GDP expenditure change
  (trillions of 1996 dollars) (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

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AE (trillions of 1996 dollars)
AE
J
12
F
D
9
B
6
K
450
0
3
9
15
GDP (trillions of 1996 dollars)
25
Case 1 GDP 3 trillion

• AE gt 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

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Case 2 GDP 15 trillion

• GDP gt 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

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Case 3 GDP 9 trillion

• 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.

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Says Law1

• 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.

Says law apparently rules out the possibility of
a widespread glut of goods.
1 J.B. Say. Treatise on Political Economy, 1903.
29
Says law implies that full-employment
equilibrium is the normal state of affairs
AE
C I G NX
AE touchesthe 450 line at potential GDP
Full employment GDP
GDP
30
General (Keynesian) Case Underemployment
Equilibrium
AE
A
C I G NX
H
Full employment GDP
Y
GDP
31
What happens when things change?

• 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?

32
How did a 0.5 trillion change in I bring about a
2 trillion change in GDP?
AE2
AE
?2
AE1
?1
5
?I
4.5
?GDP
450
0
11.0
9.0
GDP
33
Its a bird
Its a plane
No, its the multiplier effect!
34
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.
Change in equilibrium expenditure
Multiplier
Change in autonomous expenditure
Thus in our case the multiplier is given by
35
Chain of causation
When firms increase investment by 0.5 trillion,
sales revenues at investment goods manufacturers
(Boeing, Westinghouse, Cincinnati Milacron) will
increase by 0.5 trillion
1
The 0.5 trillion in revenue will be distributed
as factor payments to those supplying resources
necessary to produce capital goodshence the
change in spending generates 0.5 trillion in
income in the first round.
2
36
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
incomethat is ?C .75 ? 0.5 trillion
0.375 trillion Hence, households spend 375
billion and save 125billion
3
But the story does not end here, since
McDonaldss, 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.
4
37
Those who earned additional income in consumer
goods industries will now increase their
spending. By how much? ?C .75 ? 375
281.85.
5
This will result in additional production and
factor payments. Spending will then increase. And
so on. And so on.
6
38
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.
39
The Multiplier and the MPC
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
Now substitute 2 into 1 to obtain
1
40
Now solve for ?Y
4
Now rearrange 4
5
Divide both sides of 5 by ?I to obtain the
multiplier
The expenditure multiplier
41
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
42
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)
43
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
Change in tax payments
MTR
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
44
The real expenditure multiplier
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
45
In this case, MPC 0.75 MPI 0.15 MTR 0.1
Slope 0.5
AE2
AE
?2
AE1
?1
5
?I
4.5
?Y
450
0
10.0
9.0
GDP