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Aggregate Expenditure and Aggregate Demand

CHAPTER

25

© 2003 South-Western/Thomson Learning

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Aggregate Expenditure and Income

Here we build on the income-consumption connection to uncover the tie between income and total spending

AssumptionsNo capital depreciationNo business savingEach dollar spent on production translates directly into a dollar of aggregate income GDP equals aggregate incomeInvestment, government purchases, and net exports are autonomous independent of the level of income

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Components of Aggregate Expenditure

To develop the aggregate demand curve, we begin by asking how much aggregate output would be demanded at a given price level

Our objective is to analyze the relationship between aggregate spending in the economy and aggregate income, or real GDP

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Aggregate ExpendituresAggregate 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, CPlanned investment, IGovernment purchases, GNet exports, X – MConsumption is the only spending component that varies with the level of real GDP

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Exhibit 1: Table for Real GDP With Net Taxes and Government Purchases (trillions of dollars)

Suppose the price level in the economy is 130 30% higher than in the base year

First column lists a range of possible levels of real GDP symbolized by Y

When we subtract net taxes, column (2), we get disposable income in column (3)

Households only have two possible uses for disposable income

Consumption, MPC assumed to be 4/5

Saving, MPS assumed to be 1/5

RealGDP(Y)(1)

NetTaxes(NT)(2)

DisposableIncome(Y-NT)(3)=(1)-2)

Consumption(C)(4)

Saving(S)(5)

PlannedInvestment(I)(6)

GovernmentPurchases(G)(7)

NetExports(X-M)(8)

PlannedAggregateExpenditure(AE)(9)

UnintendedInventoryAdjustment(Y-AE)(10)=(1)-(9)

9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02

9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1

10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0

10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1

11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2

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RealGDP(Y)(1)

NetTaxes(NT)(2)

DisposableIncome(Y-NT)(3)=(1)-2)

Consumption(C)(4)

Saving(S)(5)

PlannedInvestment(I)(6)

GovernmentPurchases(G)(7)

NetExports(X-M)(8)

PlannedAggregateExpenditure(AE)(9)

UnintendedInventoryAdjustment(Y-AE)(10)=(1)-(9)

9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02

9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1

10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0

10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1

11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2

Columns (6), (7), and (8) list the injections into the circular flow: planned investment, government purchases and net exports.Government purchases equals net taxes government’s budget is balancedThe final column lists any unplanned inventory adjustment which equals real GDP minus planned aggregate expendituresWhen the amount people plan to spend equals the amount produced, there are no unplanned inventory adjustments. In our example, this occurs where planned aggregate expenditures and real GDP equal 10.0

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If, however, real GDP is $9.0 trillion

Planned aggregate expenditure is $9.2 trillion firms must reduce inventories to make up the shortfall in output

When the amount produced exceeds planned spending, firms get stuck with unsold goods which become unplanned increases in inventories

For example, if real GDP is $11.0 trillion, planned aggregate expenditure is only $10.8 trillion $0.2 million in output remains unsold firms respond by reducing output and do so until they produce the amount that people want to buy

RealGDP(Y)(1)

NetTaxes(NT)(2)

DisposableIncome(Y-NT)(3)=(1)-2)

Consumption(C)(4)

Saving(S)(5)

PlannedInvestment(I)(6)

GovernmentPurchases(G)(7)

NetExports(X-M)(8)

PlannedAggregateExpenditure(AE)(9)

UnintendedInventoryAdjustment(Y-AE)(10)=(1)-(9)

9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02

9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1

10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0

10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1

11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2

Exhibit 1: Table for Real GDP With Net Taxes and Government Purchases (trillions of dollars)

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Exhibit 2: Deriving Aggregate Output

Real GDP(trillions of dollars)

0

C + I + G + (X – M)

e10.0

10.0

45º

Agg

rega

te e

xpen

dit

ure

(tri

llio

ns

of

do

llars

)This graph is often called the income-expenditure model. The aggregate expenditure line reflects the sum of consumption, investment, government purchases, and net exports

Planned aggregate expenditure is measured on the vertical

axis. Real GDP, measured on the horizontal axis, can be viewed in two ways: 1) the

value of aggregate output ,and 2) as the aggregate income

generated by that level of output for a given price level

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Exhibit 2: Deriving Aggregate Output

Real GDP(trillions of dollars)

0

C + I + G + (X – M)

e10.0

10.0

45º

Agg

rega

te e

xpen

dit

ure

(tri

llio

ns

of

do

llars

)The special feature of the 45-

degree line is that it identifies all points where planned expenditure

equals real GDP.

Aggregate output demanded at any given price level occurs where

real GDP equals planned aggregate expenditure, at point e

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Real GDP(trillions of dollars)

0

C + I + G + (X – M)

e10.0

10.0

45º

9.0 a

9.0

9.2b

Agg

rega

te e

xpen

dit

ure

(tri

llio

ns

of

do

llars

)

Exhibit 2: Deriving Aggregate Output

Consider what happens when real GDP is initially less than $10.0

trillion, say $9.0 trillion. Planned aggregate expenditures of $9.2

trillion (point b) exceed real GDP: planned expenditures exceed the

amount that firms produce. Because we assume prices will

remain constant, firms will reduce inventories. But

unplanned inventory reductionscannot continue indefinitely;

firms will increase employment increasing income

increasing consumer spending. This process will continue until

planned spending equals real GDP at point e

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Exhibit 2: Deriving Aggregate Output

Real GDP(trillions of dollars)

0

C + I + G + (X – M)

e10.0

10.0

45º

d

11.0

10.8 11.0

c

Agg

rega

te e

xpen

dit

ure

(tri

llio

ns

of

do

llars

)

When aggregate expenditures exceed real

GDP - for example at $11.0 - planned spending

(point c on the AE line) falls short of production

(point d). Since real GDP exceeds the amount people

want to spend, unsold goods accumulate. Rather

than allow inventories to pile up indefinitely, firms reduce production, which reduces employment and

income.

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Simple Spending Multiplier

If we continue to assume that the price level remains unchanged, we can trace the effects of changes in planned spending on aggregate output demanded

The key point is that like a stone thrown into a still pond, the effect of any shift in planned spending ripples through the economy, generating changes in aggregate output that may far exceed the initial shift in planned spending

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Exhibit 3: Effect of an Increase In Autonomous Investment on Real GDP Demanded

Ag

gre

gat

e e

xp

en

dit

ure

(tr

illio

ns

of

do

llars

)

0

10.0

10.5

10.0

e

Real GDP (trillions of dollars)

10.5

45º

0.1

10.1 a

Assume that we begin at equilibrium at point e

and that firms become more optimistic about future prospects. As a

result they increase their planned investment,

from I to I'.

In our example, investment is assumed to

have increased by $0.1 trillion per year. What is important to note is that

real GDP increased by $0.5 trillion.

C+I´+G+(X-M)

C+I+G+(X-M)

e´

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Exhibit 3: Autonomous Increase In Investment

C + I + G + (X – M)

Ag

gre

gat

e e

xp

en

dit

ure

(tr

illio

ns

of

do

llars

)

0

10.0

10.5

10.0

e

Real GDP (trillions of dollars)

10.5

45º

gcd

e'

10.1

f

0.1

10.1 ab

Round 1: The upward shift of the AE line means that at the initial real GDP level of

$10.0 trillion, planned spending now exceeds output

by $0.1 trillion: e a Initially, inventories may be reduced, prompting firms to

expand production: a b

e b shows the first round in the multiplier process.

Those who receive this additional income spend

some of it and save the rest, laying the basis for round

two of spending and income.

C + I' + G + (X – M)

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Exhibit 3: Autonomous Increase In Investment

C + I + G + (X – M)

Ag

gre

gat

e e

xp

en

dit

ure

(tr

illio

ns

of

do

llars

)

0

10.0

10.5

10.0

e

Real GDP (trillions of dollars)

10.5

45º

gcd

e'

10.1

f

0.1

10.1 ab

C + I' + G + (X – M)

Round Two. Given a MPC of 0.8, those who receive the additional income of $100

billion as income will spend a total of $80 billion,shown by the move from point b c. Firms

respond by increasing their output by $80 billion: c d.

Round Three and Beyond. This increase of $80 becomes income to

resource suppliers. Based on the MPC, we know that four-fifths

($64 billion) will be spent: f g. So long as planned spending

exceeds output, production will increase, thereby creating more

income, which will generate still more spending

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Exhibit 4: Summary of the Multiplier Effect

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 rounds

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New Spending Cumulative New Saving CumulativeRound This Round New Spending This Round New Saving

1 100 100 - -2 80 180 20 203 64 244 16 36

10 13.4 446.3 3.35 86.60 500 0 100

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Simple Spending Multiplier

The cumulative spending resulting from an infinite series of rounds equals

1 / (1 – MPC) which in our example where the MPC was 0.8 1 / 0.2 5

Thus, the initial increase in planned investment of $100 billion will eventually boost real GDP by 5 times this $100 billion, or $500 billion

Simple Spending Multiplier =1/(1–MPC)

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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 5With an MPC of 0.9, the multiplier is 10With an MPC of 0.75, the multiplier is 4

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Simple Spending Multiplier

Recall from previous discussions that the MPC and the MPS must add up to 1

Therefore, we can define the simple spending multiplier in terms of the MPS as follows:

Simple spending multiplier = 1 / MPS

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Simple Spending MultiplierIn our example, the multiplier process started because of an increase in investment

The same impact would occur if any one of the components of aggregate expenditures changed

Finally, 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

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Deriving the Aggregate Demand Curve

Thus far we have used the aggregate expenditure line to determine real GDP demanded for a given price level

What happens to the aggregate expenditure line if the price level changes

As will be seen, for each price level there is a specific aggregate expenditure line which yields a unique real GDP demanded by altering the price level, we can derive the aggregate demand curve

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A Higher Price Level

What is the effect of a higher price level on the economy’s aggregate expenditure line and, in turn, on real GDP demanded?

A higher price levelreduces consumption because it reduces the real value of dollar-denominated assets held by householdsincreases the market rate of interest which reduces investmentmakes U.S. goods relatively more expensive abroad imports rise and exports fall

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Exhibit 5: Income-Expenditure and Aggregate Demand

0 Real GDP (trillions of dollars)

0

140

Ag

gre

gat

e e

xpen

dit

ure

(t

rill

ion

s o

f d

oll

ars)

e

AE (P = 130)

e

130

10.0

10.0 Real GDP (trillions of dollars)

45°

(a) Income-expenditure model

(b) Aggregate demand curve

In panel (a), the AE function intersects the 45 degree line at point e to yield $10.0 trillion in real GDP demanded.

Panel (b) shows more directly the link between real GDP demanded and the price level. When the price level is 130, real GDP demanded is $10.0 trillion. This combination of price level and real GDP is identified by point e on the aggregate demand curve.

Pri

ce

le

ve

l

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0 Real GDP (trillions of dollars)

0

140

AD

Ag

gre

gat

e e

xpen

dit

ure

(t

rill

ion

s o

f d

oll

ars)

AE' (P = 140)

e'

e'

9.5

9.5

e

AE (P = 130)

e

130

10.0

10.0 Real GDP (trillions of dollars)

120

AE" (P = 120)

e"

e"

10.5

10.5

45°

If the price level increases to 140?

As a result of the decrease in planned spending, real GDP demanded declines from e e'

Exhibit 5: Income-Expenditure and Aggregate Demand

It increases consumption, planned investment, and net exports, as reflected panel (a) by the upward shift in the spending line from AE to AE"

The increase in planned spending at each income level increases real GDP demanded increases from e e"

(a) Income-expenditure model

Pri

ce

le

ve

l

(b) Aggregate demand curve

It reduces consumption, investment, and net exports, as reflected in panel (a) by the downward shift from AE to AE'

If the price level declines to120?

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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

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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

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Exhibit 6: Shifts

Ag

gre

gat

e ex

pen

dit

ure

(tr

illi

on

s o

f d

oll

ars)

0 10.0 Real GDP (trillions of dollars)

C + I + G + (X – M)

45º

e

0 10.0 Real GDP (trillions of dollars)

AD

130

Pri

ce l

evel

10.5

e'

C + I' + G + (X – M)

0.1

10.5

AD'

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, the AE function shifts upward. Because the price level is assumed constant, the aggregate demand curve shifts from AD to AD' and the new point of equilibrium is shown as e' in both panels.

e e´

(a) Income-expenditure model

(b) Aggregate demand curve

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Limitations of the MultiplierOur discussion of the simple spending multiplier exaggerates the actual effect we might expect from a given shift in the aggregate expenditure line

We have assumed that the price level remains constant. However, as we will see later, once we incorporate aggregate supply into the analysis, changes in the price level reduce the impact of the multiplierLeakages such as higher income taxes and increased spending on imports all reduce the size of the multiplierThe spending multiplier takes time to work itself out the process does not occur instantly