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C H A P T E R C H E C K L I S T

- When you have completed your study of this

chapter, you will be able to

Distinguish between autonomous expenditure and

induced expenditure and explain how real GDP

influences expenditure plans.

Explain how real GDP adjusts to achieve

equilibrium expenditure.

Describe and explain the expenditure multiplier.

Derive the AD curve from equilibrium expenditure.

A QUICK REVIEW AND PREVIEW

- The Economy at Full Employment
- At full employment, real GDP equals potential GDP

and the unemployment rate equals the natural

unemployment. - Potential GDP and the natural unemployment rate

are determined by real factors and are

independent of the price level.

A QUICK REVIEW AND PREVIEW

- The quantity of money and money equilibrium

determine nominal GDP. - Nominal GDP and potential GDP determine the price

level. - So changes in the quantity of money change

nominal GDP and change the price level but have

no effect on potential GDP. - Since 1959, unit money supply (M2/Y) has risen by

3.7 per year while the price level (P) has risen

by 3.8 per year.

A QUICK REVIEW AND PREVIEW

- Departures from Full Employment
- Aggregate supply and aggregate demand determine

equilibrium real GDP and the price level. - Fluctuations in aggregate supply and aggregate

demand bring fluctuations around full employment.

A QUICK REVIEW AND PREVIEW

- Fixed Price Level
- In the aggregate expenditure model, the price

level is fixed. - Keynes wrote the model to explain an economy in a

deep recession, when firms could produce more

without raising prices. - It explains the forces that determine real GDP at

a given price level.

15.1 EXPENDITURE PLANS AND REAL GDP

- From the circular flow of expenditure and income,

aggregate expenditure is the sum of - Consumption expenditure, C
- Investment, I
- Government purchases of goods and services, G
- Net exports, NX X - M
- Aggregate expenditure C I G X - M.

15.1 EXPENDITURE PLANS AND REAL GDP

- Planned and Unplanned Expenditures
- Motorola decides to produce 11 million cell

phones, planning to sell 10 million phones and to

put 1 million into inventory. - People plan to and buy 9 million phones from

Motorola. - Planned expenditure is 10 million phones (9

million 1 million), which is less than

production of 11 million. - Motorolas inventories rise by 2 million phones,

1 million more than planned, so Motorola cuts

production.

15.1 EXPENDITURE PLANS AND REAL GDP

- Aggregate planned expenditure is planned

consumption expenditure plus planned investment

plus planned government expenditure plus planned

exports minus planned imports. - Notice that actual expenditure, which equals

planned expenditure plus the unplanned change in

firms inventories, always equals GDP and

aggregate income. - But aggregate planned expenditure might not equal

real GDP because firms might end up with up more

or less inventories than planned.

15.1 EXPENDITURE PLANS AND REAL GDP

- If aggregate planned expenditure (AE) equals real

GDP (Y), firms inventories are as planned this

is expenditure equilibrium. - If AE gt Y, firms inventories are smaller than

planned firms increase production. - If AE lt Y, firms inventories are larger than

planned firms reduce production.

15.1 EXPENDITURE PLANS AND REAL GDP

- Unplanned changes in firms inventories lead to

changes in production and incomes. - When firms have unwanted inventories, they

decrease production. Real GDP falls. - When inventories fall below planned levels, firms

increase production. Real GDP rises.

15.1 EXPENDITURE PLANS AND REAL GDP

- Induced Expenditure and Autonomous Expenditure
- Autonomous expenditure, A
- The components of aggregate expenditure that do

not change when real GDP changes. - A I G X C0 M0, where C0 and M0 are the

portions of consumption expenditure and imports

that are independent of real GDP.

15.1 EXPENDITURE PLANS AND REAL GDP

- Induced expenditure
- The components of aggregate expenditure that

change when real GDP changes. - Induced expenditure equals consumption

expenditure minus imports (excluding C0 M0).

15.1 EXPENDITURE PLANS AND REAL GDP

- The Consumption Function
- Consumption function
- The relationship between consumption expenditure

and disposable income, other things remaining the

same. - Disposable income is aggregate income (GDP) minus

net taxes. YD Y - T - Net taxes are taxes paid to the government minus

transfer payments received from the government. - T Ta tY - Tr

15.1 EXPENDITURE PLANS AND REAL GDP

- Figure 15.1 shows the consumption as a function

of disposable income C a bYD

When YD 0, C a 1.5 trillion. This portion

of C is independent of YD, hence autonomous.

As disposable income increases, consumption

expenditure increasesinduced consumption.

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15.1 EXPENDITURE PLANS AND REAL GDP

- Along the 45 line, y x.
- At D, consumption expenditure equals disposable

income.

1. When the consumption function is above the 45

line, saving is negative (dissaving occurs).

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15.1 EXPENDITURE PLANS AND REAL GDP

2. When the consumption function is below the 45

line, saving is positive.

- 3. At the point where the consumption function

intersects the 45 line, all disposable income is

consumed and saving is zero.

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15.1 EXPENDITURE PLANS AND REAL GDP

- Marginal propensity to consume (MPC) is the

fraction of a change in disposable income that is

spent on consumption. It is the slope of C a

b YD. MPC b.

15.1 EXPENDITURE PLANS AND REAL GDP

- Figure 15.2 shows how to calculate the marginal

propensity to consume.

1. A 2 trillion change in disposable income

brings

2. A 1.5 trillion change in consumption

expenditure, so...

3. The MPC is 1.5 trillion 2.0 0.75.

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15.1 EXPENDITURE PLANS AND REAL GDP

- Other Influences on Consumption
- The factors that influence planned consumption

are - Disposable income
- Real interest rate
- The buying power of net assets (e.g., money)
- Expected future disposable income

15.1 EXPENDITURE PLANS AND REAL GDP

- A change in disposable income leads to a change

in consumption expenditure and a movement along

the consumption function. - A change in any other influence on planned

consumption shifts the consumption function, C. - For example, C shifts upward when
- The real interest rate decreases
- The buying power of net assets increases
- Expected future income increases

15.1 EXPENDITURE PLANS AND REAL GDP

- Similarly, C shifts downward when
- The real interest rate increases
- The buying power of net assets decreases
- Expected future income decreases

15.1 EXPENDITURE PLANS AND REAL GDP

- Figure 15.3 shows shifts in the consumption

function.

1. A fall in the real interest rate or an

increase in either the buying power of money or

expected future income increases consumption

expenditure and shifts the consumption function

upward from CF0 to CF1.

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15.1 EXPENDITURE PLANS AND REAL GDP

- 2. A rise in the real interest rate or a decrease

in either the buying power of money or expected

future income decreases consumption expenditure

and shifts the consumption function downward from

CF0 to CF2.

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15.1 EXPENDITURE PLANS AND REAL GDP

- Imports and GDP
- Short run changes in imports are directly related

to, or induced by, changes in real GDP. - Marginal propensity to import, m, is the fraction

of an increase in real GDP that is spent on

imports. - The marginal propensity to import equals the

change in imports divided by the change in real

GDP.

15.2 EQUILIBRIUM EXPENDITURE

- Writing consumption as a function of real GDP
- YD Y T definition of disposable income
- T Ta tY Tr definition of net taxes
- C a b YD consumption as a function of YD.

Substitute for YD - C a b (Y T) substitute for T
- C a b (Y (Ta tY Tr )) multiply through

by -1 - C a b (Y Ta tY Tr ) multiply through

by b - C a b Y bTa btY bTr rearrange to

group like terms - C (a bTa bTr ) b Y btY Let C0 a bTa

bTr - C C0 b Y btY factor out b and Y
- C C0 b (1 t) Y Result is C as a function

of Y.

15.2 EQUILIBRIUM EXPENDITURE

- Aggregate Planned Expenditure and GDP
- M M0 mY, but lets assume M0 0, so M mY
- AE C I G X M substitute for C and M.
- AE C0 b (1 t) Y I G X mY

rearrange - AE C0 I G X b (1 t) Y mY Let A

C0 I G X factor out Y - AE A (b (1 t) m)Y Let g b (1 t) m
- AE A gY

15.2 EQUILIBRIUM EXPENDITURE

- In equilibrium, Y AE. To find equilibrium

expenditure, substitute for AE and solve for Y - Y A gY subtract gY from both sides
- Y gY A factor out Y
- Y(1 g) A divide both sides by 1 g

15.2 EQUILIBRIUM EXPENDITURE

- The Autonomous Expenditure Multiplier
- equals the change in real GDP divided by the

change in autonomous expenditure

15.2 EQUILIBRIUM EXPENDITURE

- The Lump-sum Tax Multiplier
- equals the change in real GDP divided by the

change in lump-sum taxes.

15.2 EQUILIBRIUM EXPENDITURE

- The Lump-sum Transfer Payments Multiplier
- equals the change in real GDP divided by the

change in lump-sum transfers.

15.2 EQUILIBRIUM EXPENDITURE

- Figure 15.4 shows the AE curve.

Aggregate expenditure (AE) is the sum of

investment (I), government purchases (G), exports

(X), consumption expenditure (C) minus imports

(M).

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15.2 EQUILIBRIUM EXPENDITURE

- Equilibrium Expenditure
- Equilibrium expenditure is the level of aggregate

expenditure when aggregate planned expenditure

equals real GDP. - Equilibrium expenditure equals the real GDP at

which the AE curve intersects the 45 line.

15.2 EQUILIBRIUM EXPENDITURE

- Figure 15.5 shows equilibrium expenditure.

1. When aggregate planned expenditure exceeds

real GDP, an unplanned decrease in inventories

occurs.

2. When aggregate planned expenditure is less

than real GDP, an unplanned increase in

inventories occurs.

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15.2 EQUILIBRIUM EXPENDITURE

- Figure 15.5 shows equilibrium expenditure.

3. When aggregate planned expenditure equals real

GDP, there are no unplanned changes in

inventories and real GDP remains at equilibrium

expenditure.

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15.2 EQUILIBRIUM EXPENDITURE

- Convergence to Equilibrium
- At equilibrium expenditure, production plans and

spending plans agree, and there is no reason to

change production or spending. - But when aggregate planned expenditure and actual

aggregate expenditure are unequal, production

plans and spending plans are misaligned, and a

process of convergence toward equilibrium

expenditure occurs. - Throughout this convergence process, real GDP

adjusts.

15.2 EQUILIBRIUM EXPENDITURE

- Back at Motorola
- Recall that Motorola has unwanted inventories.
- So, Motorola cuts production.
- Where does the process end?
- The process ends when expenditure equilibrium is

reached. - Equilibrium expenditure is reached because when

real GDP changes by 1 aggregate planned

expenditure changes by less than 1.

15.2 EQUILIBRIUM EXPENDITURE

- When aggregate planned expenditure is less than

real GDP, firms cut production and real GDP

decreases. - Aggregate planned expenditure decreases, but real

GDP decreases by more than planned expenditure,

so eventually the gap between planned expenditure

and actual expenditure closes.

15.2 EQUILIBRIUM EXPENDITURE

- Similarly, when aggregate planned expenditure

exceeds real GDP, firms increase production and

real GDP increases. - But real GDP increases by more than the increase

in planned expenditure. - Eventually, the gap between planned expenditure

and actual expenditure is closed.

15.3 THE EXPENDITURE MULTIPLIER

- When investment increases, aggregate expenditure

and real GDP also increase. - But the increase in real GDP is larger than the

increase in investment. - The multiplier is the amount by which a change in

investment is multiplied to determine the change

that it generates in equilibrium expenditure and

real GDP.

15.3 THE EXPENDITURE MULTIPLIER

- The Basic Idea of the Multiplier
- The initial increase in investment brought an

even bigger increase in aggregate expenditure

because it induced an increase in consumption

expenditure. - The multiplier determines the magnitude of the

increase in aggregate expenditure that results

from an increase in investment or another

component of autonomous expenditure. - The leakages, savings, imports, and income taxes,

open a gap between expenditure decisions and real

GDP. Each reduces the size of the multiplier.

15.3 THE EXPENDITURE MULTIPLIER

- Figure 15.6 illustrates the multiplier.

1. A 0.5 trillion increase in investment shifts

the AE curve upward by 0.5 trillion from AE0 to

AE1.

2. Equilibrium expenditure increases by 2

trillion from 9 trillion to 11 trillion.

3. The increase in equilibrium expenditure is 4

times the increase in autonomous expenditure, so

the multiplier is 4

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15.3 THE EXPENDITURE MULTIPLIER

- The Size of the Multiplier
- The multiplier
- The amount by which a change in autonomous

expenditure is multiplied to determine the change

in equilibrium expenditure that it generates. - That is,

15.3 THE EXPENDITURE MULTIPLIER

- Why Is the Multiplier Greater Than 1?
- The multiplier is greater than 1 because an

increase in autonomous expenditure induces an

increase in aggregate expenditure in addition to

the increase in autonomous expenditure.

15.3 THE EXPENDITURE MULTIPLIER

- The Multiplier and the MPC
- The greater the marginal propensity to consume,

the larger is the multiplier. - Ignoring imports and income taxes, the change in

real GDP (?Y) equals the change in consumption

expenditure (?C) plus the change in investment

(?I). - That is,
- ?Y ?C ?I

15.3 THE EXPENDITURE MULTIPLIER

- ?Y ?C ?I
- But the change in consumption expenditure is

determined by the change in real GDP and the

marginal propensity to consume. - It is
- ?C MPC ? ?Y
- Now substitute MPC ? ?Y for ?C in the equation at

the top of the screen - ?Y MPC ? ?Y ?I

15.3 THE EXPENDITURE MULTIPLIER

- Now solve for ?Y as
- (1 MPC) ? ?Y ?I
- Rearrange to get

15.3 THE EXPENDITURE MULTIPLIER

- Now, divide both sides of the by the ?I to give

When MPC is 0.75, so the multiplier is

15.3 THE EXPENDITURE MULTIPLIER

- Imports and Income Taxes
- The multiplier depends, in general, not only on

consumption decisions but also on imports and

income taxes. - Imports make the multiplier smaller that it

otherwise would be because only expenditure on

U.S.-made goods and services increases U.S. real

GDP. - The larger the marginal propensity to import, the

smaller is the change in U.S. real GDP that

results from a change in autonomous expenditure.

15.3 THE EXPENDITURE MULTIPLIER

- Income taxes make the multiplier smaller than it

would otherwise be. - With increased incomes, income tax payments

increase and disposable income increases by less

than the increase in real GDP. - Because disposable income influences consumption

expenditure, the increase in consumption

expenditure is less than it would if income tax

payments had not changed.

15.3 THE EXPENDITURE MULTIPLIER

- The marginal tax rate determines the extent to

which income tax payments change when real GDP

changes. - The marginal tax rate is the fraction of a change

in real GDP that is paid in income taxesthe

change in tax payments divided by the change in

real GDP. - The larger the marginal tax rate, the smaller is

the change in disposable income and real GDP that

results from a given change in autonomous

expenditure.

15.3 THE EXPENDITURE MULTIPLIER

- The marginal propensity to import and the

marginal tax rate together with the marginal

propensity to consume determine the multiplier. - Their combined influence determines the slope of

the AE curve. - The general formula for the multiplier is

15.3 THE EXPENDITURE MULTIPLIER

- Figure 15.7 shows the multiplier and the slope of

the AE curve.

With no imports and income taxes, the slope of

the AE curve equals the marginal propensity to

consume, which in this example is 0.75.

A 0.5 trillion increase in autonomous

expenditure increases real GDP by 2 trillionthe

multiplier is 4.

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15.3 THE EXPENDITURE MULTIPLIER

- With imports and income taxes, the slope of the

AE curve is less than the marginal propensity to

consume.

In this example, the slope of the AE curve is 0.5.

A 0.5 trillion increase in autonomous

expenditure increases real GDP by 1 trillionthe

multiplier is 2.

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15.3 THE EXPENDITURE MULTIPLIER

- Business-Cycle Turning Points
- The forces that bring business-cycle turning

points are the swings in autonomous expenditure

such as investment and exports. - The mechanism that gives momentum to the

economys new direction is the multiplier.

15.3 THE EXPENDITURE MULTIPLIER

- An expansion is triggered by an increase in

autonomous expenditure that increases aggregate

planned expenditure. - At the moment the economy turns the corner into

expansion, aggregate planned expenditure exceeds

real GDP. - In this situation, firms see their inventories

taking an unplanned dive.

15.3 THE EXPENDITURE MULTIPLIER

- The expansion now begins.
- To meet their inventory targets, firms increase

production, and real GDP begins to increase. - This initial increase in real GDP brings higher

incomes, which stimulate consumption expenditure.

- The multiplier process kicks in, and the

expansion picks up speed.

15.3 THE EXPENDITURE MULTIPLIER

- The process works in reverse at a business cycle

peak. - A recession is triggered by a decrease in

autonomous expenditure that decreases aggregate

planned expenditure. - At the moment the economy turns the corner into

recession, real GDP exceeds aggregate planned

expenditure.

15.3 THE EXPENDITURE MULTIPLIER

- In this situation, firms see unplanned

inventories piling up. - The recession now begins.
- To reduce their inventories, firms cut

production, and real GDP begins to decrease. - This initial decrease in real GDP brings lower

incomes, which cut consumption expenditure. - The multiplier process reinforces the initial cut

in autonomous expenditure, and the recession

takes hold.

15.4 THE AD CURVE AND EQUILIBRIUM

- Deriving the AD Curve from Equilibrium

Expenditure - The AE curve is the relationship between

aggregate planned expenditure and real GDP when

all other influences on expenditure plans remain

the same. - A movement along the AE curve arises from a

change in real GDP.

15.4 THE AD CURVE AND EQUILIBRIUM

- The AD curve is the relationship between the

quantity of real GDP demanded and the price level

when all other influences on expenditure plans

remain the same. - A movement along the AD curve arises from a

change in the price level.

15.4 THE AD CURVE AND EQUILIBRIUM

- Equilibrium expenditure depends on the price

level. - When the price level changes, other things

remaining the same, aggregate planned expenditure

changes and equilibrium expenditure changes. - Aggregate planned expenditure changes because a

change in the price level changes the buying

power of money, the real interest rate, and the

real prices of exports and imports. - So when the price level changes, the AE curve

shifts.

15.4 THE AD CURVE AND EQUILIBRIUM

When the price level is 110, the AE curve is AE0.

Equilibrium expenditure is 10 trillion at point

B.

The quantity of real GDP demanded at the price

level of 110 is 10 trillionone point on the AD

curve.

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15.4 THE AD CURVE AND EQUILIBRIUM

When the price level falls to 90, the AE curve is

AE1.

Equilibrium expenditure increases to 11 trillion

at point C.

The quantity of real GDP demanded at the price

level of 90 is 11 trilliona movement along the

AD curve to point C.

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15.4 THE AD CURVE AND EQUILIBRIUM

When the price level rises to 130, the AE curve

is AE2.

Equilibrium expenditure decreases to 9 trillion

at point A.

The quantity of real GDP demanded at the price

level of 130 is 9 trilliona movement along the

AD curve to point A.

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