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When you have completed your study of this chapter, you will be able to

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Title: When you have completed your study of this chapter, you will be able to


1
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2
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.
3
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.

4
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.

5
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.

6
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.

7
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.

8
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.

9
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.

10
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.

11
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.

12
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.

13
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).

14
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
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.

22
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

25
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

26
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

27
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.

32
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.

33
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

34
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

35
15.2 EQUILIBRIUM EXPENDITURE
  • The Autonomous Expenditure Multiplier
  • equals the change in real GDP divided by the
    change in autonomous expenditure

36
15.2 EQUILIBRIUM EXPENDITURE
  • The Lump-sum Tax Multiplier
  • equals the change in real GDP divided by the
    change in lump-sum taxes.

37
15.2 EQUILIBRIUM EXPENDITURE
  • The Lump-sum Transfer Payments Multiplier
  • equals the change in real GDP divided by the
    change in lump-sum transfers.

38
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.

41
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.

46
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.

47
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.

48
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.

49
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.

50
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.

51
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,

54
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.

55
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

56
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

57
15.3 THE EXPENDITURE MULTIPLIER
  • Now solve for ?Y as
  • (1 MPC) ? ?Y ?I
  • Rearrange to get

58
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
59
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.

60
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.

61
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.

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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

63
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.

68
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.

69
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.

70
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.

71
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.

72
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.

73
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.

74
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.

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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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