Aggregate Expenditure

Outline

•Components of aggregate expenditure

•Planned and unplanned expenditure

•The consumption function

•Imports and GDP

•Equilibrium expenditure

•The expenditure multiplier

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

Thus:

Aggregate expenditure = C + I + G + NX

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.

Aesop’s 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

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.

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.

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.

Disposable Income and Consumption in the U.S., 1959-99

Disposable Income (billions of 1996 dollars)

7000600050004000300020001000

Consu

mpti

on (

billions

of

1996 d

ollars

)7000

6000

5000

4000

3000

2000

1000

www.bea.gov

1991

Dissaving

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

(trillions of 1996 dollars)Disposable income (trillions of 1996 dollars)

Consumption (trillions of 1996 dollars)

A

F

E

6.0

D

Saving is zeroB

C

Saving

Consumption function

450 line

6.0

2.0

2.0 10.0

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

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:

MPC = Change in consumption expenditure

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:

75.00.2$

5.1$

trillion

trillionMPC

MPC gives the slope of the consumption function

0 6.0

6.0

8.0

7.5

Co

nsu

mp

tio

n (

tril

lio

ns

of

1996

do

llar

s)

Disposable income (trillions of 1996 dollars)

D

E

Consumption function

K

rise

run

75.00.2$

5.1$

trillion

trillion

KD

EK

run

riseMPCSlope

RealConsumption

Spending

Disposable income

(Expected) real interest rate

The buying power of net assets

Expected future disposable income

+

+

+

-

Shifts of the consumption function

0

Co

nsu

mp

tio

n (

tril

lio

ns

of

1996

do

llar

s)

Disposable income (trillions of 1996 dollars)

CF0

CF2

CF1

CF0 to CF1

•Decrease in the real interest rate.

•Buying power of net assets increases.

•Rise in expected future disposable income.

Falling interest rates have stimulated consumer spending recently

Complete Exercise #1 on p. 394

Imports and GDP

Imports are a component of induced expenditure.

Imports depend partly on the health of the

domestic economy.

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:

MPI = Change imports

Change in disposable income

Suppose that, ceteris paribus, when disposable income increases from $2 trillion, imports increase by $0.3 trillion. Thus we have:

15.00.2$

3.0$

trillion

trillionMPI

        Planned Expenditures

[Y] [C] [I] [G] [X] [M] [AE = C + I + G +X - M]

    (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

Aggregate Expenditure and Real GDP

Note: Y is real GDP

II + G3

I + G + C + X

I + G + XA

C

D

9

Agg. Exp. (billions of 1996 dollars)

GDP (Billions of 1996 dollars)0

4.5

Consumption expenditure

imports

AE

    Aggregate Unplanned

Real planned inventory

  GDP expenditure change

  (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

3 9

9

6

12

K

B

D

F

J

0

450

AE (trillions of 1996 dollars)

GDP (trillions of 1996 dollars)

AE

15

•AE > 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

• GDP > 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

•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.

•“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.

Say’s Law1

Say’s law apparently rules out the

possibility of a widespread glut of

goods.

1 J.B. Say. Treatise on Political Economy, 1903.

Say’s law implies that full-employment equilibrium is the normal state of affairs

Full employment GDP

AE

GDP

C + I + G + NX

AE touchesthe 450 line at potential

GDP

General (Keynesian) Case: Underemployment Equilibrium

Full employment GDP

AE

GDP

C + I + G + NX

Y*

A

H

•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?

11.0

AE

GDP

AE1

9.0

1

2

AE2

450

4.5

5 I

GDP

How did a $0.5 trillion change in I

bring about a $2 trillion change in

GDP?

0

It’s a bird

It’s a plane

No, it’s the multiplier effect!

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.

Multiplier = Change in autonomous expenditure

Change in equilibrium expenditure

Thus in our case the multiplier is given by:

45.0$

2$

trillion

trillion

I

YMultiplier

When firms increase investment by $0.5 trillion, sales revenues at investment goods manufacturers (Boeing, Westinghouse, Cincinnati Milacron) will increase by $0.5 trillion

Chain of causation

The $0.5 trillion in revenue will be distributed as factor payments to those supplying resources necessary to produce capital goods—hence the change in spending generates $0.5 trillion in income in the first round.

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 income—that is: C = .75 $0.5 trillion = $0.375 trillion Hence, households spend $375 billion and save $125billion

But the story does not end here, since McDonalds’s, 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.

Those who earned additional income in consumer goods industries will now increase their spending. By how much? C = .75 $375 = $281.85.

This will result in additional production and factor payments. Spending will then increase. And so on. And so on.

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.

The Multiplier and the MPC

YCY

YMPCC

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]

[1]

Now substitute [2] into [1] to obtain:

ICMPCY

Now solve for Y

IYMPC )1( [4]

Now rearrange [4]

IMPC

Y

)1(

1[5]

Divide both sides of [5] by I to obtain the multiplier

425.0

1

)75.01(

1

)1(

1

MPCI

YMultiplier

The expenditure multiplier

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

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)

1.05.0$

05.0$

trillion

trillionMTR

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:

MTR = Change in tax payments

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:

The “real” expenditure multiplier

) 1(

1

curveAEofSlopeI

YMultiplier

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:

MTRMPIMPCI

YMultiplier

1

1

10.0

AE

GDP

AE1

9.0

1

2

AE2

450

4.5

5 I

Y

0

Slope = 0.5

In this case, MPC = 0.75; MPI = 0.15; MTR = 0.1

2 trillion$0.5

trillion0.1$

I

Y

Multiplier