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Chapter 10

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Title: Chapter 10


1
Chapter 10Aggregate Expenditures
ECONOMICS EXPLORE APPLYby Ayers and Collinge
2
Learning Objectives
  1. Summarize the perspective of Keynesian and
    Keynesian economics.
  2. Illustrate the income-expenditure.
  3. Explain the adjustment process to an expenditure
    equilibrium.
  4. Describe how new spending can have a ripple
    effect throughout the economy.

3
Learning Objectives
  1. Distinguish the types of multipliers in the
    Keynesian model.
  2. Graph the relationship of the income-expenditure
    model to aggregate demand.
  3. (EA) Compare economic analyses of the Great
    Depression.

4
10.1IN THE LONG RUN, WE ARE ALL DEAD
  • Keynes chose to ignore long-run tendencies toward
    full employment.
  • In his view the problems of unemployment could be
    solved only if people and government would buy
    more goods and services.
  • Consumption spending is 70 of GDP, and it
    motivates investment spending.
  • The Keynesian model is based around understanding
    how much spending is likely to occur at different
    levels of spending, and how government can
    influence that spending to ensure full employment.

5
10.2THE INCOME-EXPENDITURE MODEL
One persons spending is another persons
income.
6
The Income Expenditure Model
  • The aggregate expenditures function tells what
    the economys planned spending will be at each
    level of real GDP.
  • There will be only one GDP that does match up
    planned spending and actual spending.
  • That GDP occurs at the expenditure equilibrium,
    where the AE function and the 45-degree line
    intersect.

7
The Income Expenditure Model
45o Spendingproduction
Aggregate Expenditure Function
Expenditures
10 trillion
5 trillion
Real GDP (income)
10 trillion
8
Components of Aggregate Expenditures
  • Spending can be divided into two types
  • Autonomous spending spending that would occur
    even if people had no income.
  • Induced spending spending that depends upon
    income.

9
Components of Aggregate Expenditures
  • Autonomous spending includes both investments and
    goods.
  • Draw upon previous wealth and savings.
  • College students with no earnings drawing down
    their parents bank accounts to pay for room and
    board at school.
  • Graphically, autonomous spending is a positive
    amount that shows up as a horizontal line.

10
Components of Aggregate Expenditures
  • Since induced spending is entirely dependent upon
    income, graphically it starts at zero starts at
    zero and GDP rises from there.
  • When autonomous spending and induced spending are
    added together, the result is an aggregate
    expenditure function that has both a positive
    vertical intercept, and a positive slope.

11
Aggregate Expenditures
Expenditures
10 trillion
5 trillion
0
Real GDP (income)
10 trillion
12
Components of Aggregate Expenditures
  • The components of aggregate expenditures are
    merely the components of GDP.
  • GDP C I G (X-M)
  • The consumption function because of autonomous
    spending has a positive vertical intercept.
  • From there, it slopes upward because of the
    marginal propensity to consume (mpc).

13
MPC and MPS
  • The marginal propensity to consume (MPC) is the
    fraction of additional income that people spend.
  • The marginal propensity to save (MPS) is the
    fraction of additional income that people save.

MPC MPS 1
14
The Aggregate Expenditures Function
  • Investment and government purchases are of
    roughly comparable size.
  • If planned government purchases and investment
    spending are assumed to be completely autonomous,
    they will be constant as GDP changes.
  • For this reason, the slope of the AE function and
    the consumption function are the same.

15
Modeling the Expenditure Equilibrium
  • When the economy is not at equilibrium, actual
    GDP and planned spending differ.
  • Unintended inventory changes show up as the
    difference between planned and actual investment.

16
Modeling the Expenditure Equilibrium
Expenditure equilibrium aggregate expenditures
actual GDP
where
Aggregate expenditures consumption planned
investment government net exports
and
GDP consumption actual investment
government net exports
Expenditure equilibrium planned investment
actual investment
which implies
17
Modeling the Expenditure Equilibrium
45o Spendingproduction
1 if the economy starts here
2 A progression of inventory buildups less
production leads to the expenditures
equilibrium here.
Expenditures
Aggregate Expenditure Function
Real GDP (income)
18
10.3CHANGING THE EXPENDITURE EQUILIBRIUM
  • When there are changes in autonomous spending,
    the changes are magnified by the multiplier
    effect.
  • Adding autonomous spending causes a higher GDP,
    which causes more induced spending.
  • Thats because money that one person spends
    autonomously adds to income of others, which in
    turn induces them to buy more output.
  • At each stage in this cycle, however, some income
    is saved, thus eventually bringing the cycle to a
    halt.

19
The Multiplier Effect
Aggregate expenditure function
Expenditures
The multiplier effect causes a small increase in
autonomous expenditures to have a much larger
effect on GDP.
Real GDP (income)
20
The Multiplier Effect
  • The strength of the multiplier effect depends
    upon the proportion of income that is devoted to
    consumption.
  • To the extent that people save their incomes,
    savings represents a leakage out of the
    multiplier process.
  • A negative value for savings means that there is
    dissaving spending out of existing savings.

21
Spending Depends upon the Marginal Propensity to
Consume (mpc)
22
The Expenditure Multiplier
Expenditure multiplier 1/mps or 1/(1-MPC)
? Autonomous spending x 1/mps

? Expenditure equilibrium
23
The Multiplier Effect
  • The multiplier is multiplied by a change in
    autonomous spending to reveal the change in
    equilibrium GDP.
  • There must be some idle resources for the
    multiplier effect to occur.
  • Keynesian multiplier analysis assumes a constant
    price level.

24
Recession and Inflation within the
Income-Expenditure Model
  • If the expenditure equilibrium lies below
    full-employment GDP, it is called an unemployment
    equilibrium.
  • Along with the unemployment equilibrium comes an
    output gap, in which actual GDP falls below
    full-employment GDP.
  • At an unemployment equilibrium, there is to
    little spending for the economy to achieve full
    employment GDP.

25
Recession and Inflation within the
Income-Expenditure Model
The shortfall in spending is called a
recessionary gap.
  • If the expenditure equilibrium lies below
    full-employment GDP, it is called an unemployment
    equilibrium.
  • Along with the unemployment equilibrium comes an
    output gap, in which actual GDP falls below
    full-employment GDP.
  • At an unemployment equilibrium, there is to
    little spending for the economy to achieve full
    employment GDP.

26
Recession and Inflation within the
Income-Expenditure Model
  • If the expenditure equilibrium occurs past the
    full-employment GDP, multiplier analysis does not
    apply, because inflation will not allow it to
    stay there.
  • This possibility is referred to as an
    inflationary gap, which is the excess of the
    aggregate expenditure function above that
    consistent with a full employment equilibrium.

27
Making Policy with Multipliers
  • Keynesian analysis suggest that govern can use
    taxes to stimulate the economy.
  • However people might save some of their higher
    after tax income rather than spend it. The tax
    multiplier, which is the expansionary, or
    contractionary effect of a tax cut, or increase
    would be less than the multiplier by the amount
    of the initial round of spending.

28
Making Policy with Multipliers
Tax Multiplier -mpc/(1-mpc)
29
Balanced Budget Multiplier
  • Keynesians view extra government spending as the
    most effective policy to cure a recession.
  • The balanced-budget multiplier combines the
    expenditure multiplier for an increase in
    government spending and the tax multiplier
    because taxes would increase to finance that
    spending.

30
Making Policy with Multipliers
Balanced Budget Multiplier 1/(1-mpc)
mpc/(1-mpc) (1-mpc)/(1-mpc)1
31
10.4 AGGREGATE DEMAND
45o Spendingproduction
Expenditures
Actual Real GDP (income)
Price Level
Real GDP
32
10.5 EXPLORE APPLYThe Great Depression
  • The 1920s era of prosperity peaked in early
    1929.
  • A few months later the stock market crashed.
  • The Great Depression began and did not end for
    over a decade.
  • Keynesian aggregate expenditure analysis can be
    used to describe the depression and the policy
    action to correct it.

33
Terms Along the Way
  • income-expenditures model
  • aggregate expenditures
  • aggregate expenditures function
  • expenditure equilibrium
  • autonomous spending
  • induced spending
  • consumption function
  • marginal propensity to consume
  • marginal propensity to save

34
Terms Along the Way
  • multiplier effect
  • expenditure multiplier
  • unemployment equilibrium
  • output gap
  • recessionary gap
  • inflationary gap
  • tax multiplier
  • balanced budget multiplier

35
Test Yourself
  • John Maynard Keynes offered a long-run
    perspective on the macro-economy in the general
    theory.
  • If you had no income you could still engage in
    induced spending.
  • The marginal propensity to consume must be 1 or
    less.
  • An expenditure equilibrium occurs where the
    aggregate expenditure function intersects the
    vertical axis.
  • An injection of new autonomous spending will
    leave equilibrium real GDP unchanged when the
    marginal propensity to save equals 0.5.

36
Test Yourself
  • 2. Suppose actual spending equals planned
    spending. Then we can say
  • the economy is at an expenditure equilibrium.
  • real GDP is the most it can possibly be.
  • autonomous spending equals zero.
  • aggregate demand has shifted to the left.

37
Test Yourself
  • 3. In the income expenditures model the 45-degree
    line shows
  • the amount of autonomous spending.
  • the amount of induced spending.
  • the expenditure multiplier.
  • that the economys expenditures are actually the
    same as its output. .

38
Test Yourself
  • 4. Aggregate expenditures include all of the
    following except
  • consumption.
  • planned investment.
  • net exports.
  • unintended changes in business inventories.

39
Test Yourself
  • 5. The marginal propensity to consume equals
  • the fraction of their total income that people
    consume.
  • the fraction of additional income that people
    consume.
  • the fraction of their savings that people plan to
    spend within the next year.
  • one in most cases..

40
Test Yourself
  • 6. The paradox of thrift, if true suggest that
    people should
  • save more.
  • spend more.
  • vote more often.
  • spend the same amount of money, but spend it more
    wisely.

41
The End! Next Chapter 11 Fiscal Policy in Action"
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