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11
The Income-Expenditure Model
Chapter Summary
The model we develop in this chapter is called the income-expenditure model, sometimes referred to as
the Keynesian cross. The model was developed by the economist John Maynard Keynes in the 1930s.
This chapter will primarily use graphical tools to explain the income-expenditure model. An appendix to
this chapter provides an algebraic treatment of the model and shows how some of the key formulas are
derived. Here are the main points of the chapter:
 In the income-expenditure model, the level of output in the economy will adjust to equal the level
of planned expenditures. This level of output is called equilibrium output.
 Consumption spending consists of two parts. One part is independent of income, but can be
influenced by changes in wealth or consumer sentiment. The other part depends on the level of
income.
 Increases in planned expenditures by households, the government, or the foreign sector lead to
increases in equilibrium output.
 Because of the multiplier, the final increase in equilibrium output is larger than the initial
increase.
 Policymakers can use multipliers to calculate the appropriate size of economic policies.
 Higher tax rates, by reducing the multiplier, can reduce fluctuations in GDP.
 Increases in exports lead to increases in equilibrium output; increases in imports lead to decreases
in equilibrium output.
 The income-expenditure model can be used to derive the aggregate demand curve.
Applying the Concepts
After reading this chapter, you should be able to answer these four key questions:
1. How do changes in the value of homes affect consumer spending?
2. Why does real GDP typically increase after natural disasters?
3. How influential a figure was John Maynard Keynes?
4. How do countries benefit from growth in their trading partners?
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163
11.1 A Simple Income-Expenditure Model
To determine equilibrium output, we need to understand the behavior of firms. Figure 11.1 illustrates the
behavior of firms with a 45° line from the origin. In the income-expenditure model, the 45° line
represents where planned expenditure equals actual output. Because firms are willing to supply whatever
is demanded without raising prices very much, demand is the key factor in determining the level of
output, or GDP.
As we consider demand, we will focus on consumption spending (C) and investment spending (I). Total
demand or planned expenditures in this model will be C + I. In the income-expenditure model, the level
of output in the economy will adjust to equal the level of planned expenditures. The level of output is
called the equilibrium output. The following equation shows this relationship:
 Key Equation
Equilibrium output = y* = C + I = planned expenditures
Figure 11.2 can help us understand how the level of equilibrium output, or GDP, in the economy is
determined. On the expenditure-output graph, we draw the line representing planned expenditures, C + I,
which is a horizontal line, because both C and I are fixed amounts. The intersection of the 45° line with
the planned expenditures line at point a determines equilibrium output, y*. Later we will add other
components of aggregate demand and demonstrate their effects on the income-expenditure model.
What if production is greater or lesser than equilibrium output? Figure 11.3 illustrates how adjustment
would occur:
 If there is excess production, the 45° line is greater than planned expenditures. Output that is not
purchased piles up as business inventories. Businesses see inventories rising and reduce
production in the next period to meet demand.
 If there is insufficient production, the 45° line is lower than planned expenditures. When people
purchase more output than firms are currently producing, inventories fall. Firms see inventories
falling and increase production in the next period.
 Study Tip
Table 11.1shows how adjustment to equilibrium output occurs with numerical data. Notice
that production here refers to output produced. The interaction between planned
expenditures, C + I, and output produced determines the equilibrium output amount.
 Caution!
Demand—not prices—drives the production of inputs and products in the short run.
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11.2 The Consumption Function
As we build the model toward total planned expenditures, we will start with household consumption.
Other components in later sections to be added later as we build toward total planned expenditures. You
will remember from Chapter 5, consumption expenditures were $10,046 billion or 70.8 percent of GDP.
(See Table 5.1 on page 104.) The following equations are key to understanding consumption behavior.
 Key Equations
Consumption Function: C = Ca + by, where Ca is autonomous consumption expenditures, b
is the marginal propensity to consume (MPC), and y is income.
MPC =
additional consumption
additional income
MPS =
additional saving
additional income
In Chapter 9 you learned that consumption expenditures can be broken into two pieces. Autonomous
consumption is consumption expenditures that don’t change when income changes. Autonomous
consumption is represented in the equation as (Ca). The other term, (by), in the consumption function
represents consumer spending dependent on changes in income. This term has two parts to it. The letter b
represents the marginal propensity to consume and the letter y represents income. The marginal
propensity to consume, or MPC, is the fraction of additional income spent on consumption goods. The
marginal propensity to save, or MPS, is the remaining fraction of additional income that must be saved.
 Study Tip
Output is also equal to the income that flows to the households. As firms produce output,
they pay households income in the form of wages, interest, profits, and rents. Recall the
discussion of value added in Chapter 5. Since total income equals total value added, we
know total income must also equal total output. We can therefore use y to represent both
output and income.
Figure 11.4 shows how the consumption function is graphed in the income-expenditure model.
Autonomous consumption (Ca) is graphed as the intercept term. The consumption function has a slope of
b, equal in value to the marginal propensity to consume (MPC).
Figure 11.5 shows how changes in autonomous consumption and the marginal propensity to consume
cause changes in the consumption function. Panel A shows that an increase in autonomous consumption
from C0a to C1a shifts the entire consumption function upward. Note that the slope of the consumption
function does not change. The consumption function shifts when:
 Consumer wealth changes
 Consumer confidence changes
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Panel B shows that an increase in the MPC from b to b′ increases the slope of the consumption function.
Increases in MPC pivot the consumption function counterclockwise; decreases in MPC pivot the
consumption function clockwise.
Let’s review an Application that answers one of the key questions we posed at the start of the chapter:
1. How do changes in the value of homes affect consumer spending?
APPLICATION 1: FALLING HOME PRICES, THE WEALTH EFFECT, AND
DECREASED CONSUMER SPENDING
The value of homes in excess of what people borrow with a mortgage is known as their
home equity. Home equity is the single largest component of net wealth for most families
in the United States. From 1997 to mid-2006, housing prices rose nationally by approximately 90
percent and consumer wealth grew by $6.5 trillion. In the summer of 2006, housing prices began
to fall, in some regions by as much as 30 percent, and many recent home purchasers owed more
than their homes were worth. In its review of the literature, the Congressional Budget Office
found most studies estimated a decrease of consumer wealth of $1 would lower consumption
spending by somewhere between $.02 and $.07. Based on forecasts for housing prices, the
Congressional Budget Office estimated the declines in housing prices would reduce consumer
wealth and ultimately consumer spending between $21 and $72 billion during 2007.
11.3 Equilibrium Output and the Consumption Function
Figure 11.6 shows how equilibrium output is determined with a consumption function.
following steps in graphing equilibrium output:
1. Draw the consumption function (C).
2. Draw the C + I line parallel to the C line but shifted upward by I units.
3. Draw the 45° line.
4. Where the C + I line crosses the 45° line determines equilibrium output, y*.
Take the
 Key Equation
y* 
Ca  I
1  MPC
In Chapter 8, we defined the relationship between saving and investment. We can also define equilibrium
output in terms of savings and investment as follows:
 Key Equations
y = C + S (Income) => S = y - C
y = C + I (Output) => I = y - C
S=I
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From these equations, we can derive a savings function that shows the level of savings given a level of
income. The savings function is derived as follows:
 Key Equations
S=y–C
S = y – (Ca + by)
S = y – Ca – by
S = -Ca + y – by
S = -Ca + (1 – b)y
Figure 11.8 illustrates the impact of the multiplier in the income-expenditure model. When investment
increases from I0 to I1, equilibrium output increases from y0 to y1. The change in output (Δy) is greater
than the change in investment (ΔI). The logic behind the multiplier is that spending generates income for
additional spending. As this process continues over time, total spending will continue to increase, but in
diminishing amounts.
 Key Equations
Multiplier =
1
1  MPC
1


y  I 

1

MPC


 Study Tip
Learn now to apply the multiplier formulas above. They will be similar to fiscal policy
applications in section 11.4 in this chapter. Try practice problems in this study guide until
you feel comfortable solving these problems.
Let’s review an Application that answers one of the key questions we posed at the start of the chapter:
2. Why does real GDP typically increase after natural disasters?
APPLICATION 2: INCREASED INVESTMENT SPENDING RAISES GDP AFTER
NATURAL DISASTERS
When Hurricane Katrina devastated the Gulf Coast and New Orleans in 2005, many economists
predicted that it would have only small and temporary effects on total U.S. GDP. The basic
reason for their prediction was that natural disasters can often stimulate economic activity
because people need to buy material to rebuild homes. The purchase of goods and services is
new investment spending for the economy, which stimulates GDP both through its direct effect
and through the multiplier. Ironically, although the hurricane destroys wealth (in terms of the
house), it stimulates new production.
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 Some economists call spending like this “regrettables” because most people would rather not spend
to rebuild a destroyed house.
11.4 Government Spending and Taxation
Using taxes and spending to influence the level of GDP in the short run is known as Keynesian fiscal
policy. As with investment spending in the previous section, government spending and taxes have
multiplier effects. In this section, we will expand planned expenditures to include government spending:
 Key Equation
equilibrium output = y* = C + I + G = planned expenditures
Panel A of Figure 11.9 shows how increases in government spending affect GDP. The increase in
government spending from G0 to G1 shifts the C + I + G line upward and increases the level of GDP from
y0 to y1.
 Study Tip
The multiplier for changes in autonomous variables such as autonomous consumption,
investment, and government expenditures are all the same as the one shown below.
 Key Equation
Multiplier =
1
1 - MPC
Panel B of Figure 11.9 shows how an increase in taxes will decrease the level of GDP. As the level of
taxes increases, the demand line will shift downward by b (the increase in taxes). Equilibrium income will
fall from y0 to y1. The multiplier for taxes is slightly different than the multiplier for government
spending.
 Key Equation
Tax Multiplier =
MPC
1  MPC
The tax multiplier is negative because increases in taxes decrease disposable personal income and lead to
a reduction in consumption spending. Any change in taxes does not directly affect spending. Instead it
affects disposable income. A tax cut causes disposable income to increase. Spending increases by the
MPC times the increase in disposable income. That’s why the MPC is in the numerator of the tax
multiplier equation.
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 Caution!
Be sure and use negative signs to show tax and spending decreases in your calculations.
The multipliers are built to take into account increases and decreases.
Although our income-expenditure model with government is very simple and leaves out many factors,
like all models, it illustrates some important lessons:
 An increase in government spending will increase total planned expenditures for goods and
services.
 Cutting taxes will increase the after-tax income of consumers and will also lead to an increase in
planned expenditures for goods and services.
 Policymakers need to take into account the multipliers for government spending and taxes as they
develop policies.
Keynes was a strong advocate for activist fiscal policy. One of Keynes’s controversial ideas was that
governments could stimulate the economy even if they spent money on wasteful projects. In the General
Theory, he even remarked (tongue-in-cheek) how lucky the Egyptians were, because the death of the
pharaohs would lead to new pyramids being built. Pyramids do not add to the stock of capital to produce
regular goods and services. But Keynes’s point was that building pyramids does add to planned
expenditures and stimulates GDP in the short run.
In the long run, of course, we are better off if government spends the money wisely, such as on needed
infrastructure such as roads and bridges. This is an example of the principle of opportunity cost.
Principle of Opportunity Cost
The opportunity cost of something is what you sacrifice to get it.
Let’s review an Application that answers one of the key questions we posed at the start of the chapter:
3. How influential a figure was John Maynard Keynes?
APPLICATION 3: JOHN MAYNARD KEYNES: A WORLD INTELLECTUAL
This Application summarizes the life and accomplishments of John Maynard Keynes. Many have
called Keynes the most influential economist of the 20th century. Keynes was a prolific writer and
economist following in the footsteps of his father John Neville Keynes. The younger John
Maynard Keynes attended Cambridge and King’s College. His best known work is The General
Theory of Employment, Interest, and Money.
Figure 11.10 plots the rate of growth of U.S. real GDP from 1871 to 2007. It is apparent from the graph
that the U.S. economy has been much more stable after World War II than before. One reason for this
increased stability is automatic stabilizers. To see how automatic stabilizers work in our model, we must
take into account that the government levies income taxes by applying a tax rate to the level of income.
We will look to after-tax income or personal disposable income. The consumption function changes to
account for taxes.
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 Key Equation
C = Ca + b(1 – t)y where the adjusted MPC = b(1 – t)
Changes to the MPC cause the slope of the consumption function to change. Figure 11.11 shows how an
increase in the tax rate would affect the income-expenditure model. Raising the tax rate lowers the
adjusted MPC and reduces the slope of this line. The C + I + G line with taxes intersects the 45° line at a
lower level of income.
Automatic stabilizers help stabilize economic fluctuations. Permanent income and expectations that the
government will take action to stabilize the economy also contribute to economic stability.
11.5 Exports and Imports
An increase in exports means that there’s an increase in the demand for goods produced in the United
States. An increase in imports means that there is an increase in foreign-produced goods purchased by
U.S. residents. Importing goods rather than purchasing them from our domestic producers reduces the
demand for U.S. goods.
To modify our model to include the effects of world spending on exports and U.S. spending on imports,
we need to take two steps:
1. Add exports X, as another source of demand for U.S. goods and services.
2. Subtract imports, M, from total spending by U.S. residents. We will assume that imports, like
consumption, increase with the level of income.
 Key Equations
M = my where m is the marginal propensity to import.
b – m = marginal propensity to consume adjusted for imports.
Figure 11.12 shows how equilibrium output is determined including the international sector. Figure 11.13
shows the impacts on equilibrium output with changes in exports and changes in the marginal propensity
to import. Panel A shows that an increase in exports will increase the level of GDP. Panel B shows that
an increase in the marginal propensity to import will decrease the level of GDP.
Let’s review an Application that answers one of the key questions we posed at the start of the chapter:
4. How do countries benefit from growth in their trading partners?
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APPLICATION 4: THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND
AFFECTS A COUNTRY’S OUTPUT
From the early 1990s until quite recently, the United States was what economists term the
“locomotive” for global growth. As the U.S. economy grew, our demand for foreign products
increased. Imports increase as an economy grows, and U.S. imports also increased along with
output during this period. Because the U.S. economy is such an important part of the world
economy, its demands for foreign goods—U.S. imports—fueled exports in foreign countries and
promoted their growth.
 Study Tip
A basic fact of international trade is that one country’s imports must be the exports of other
countries in the world. If U.S. imports increase, then exports from some of the other
countries must also increase.
11.6 The Income-Expenditure Model and the Aggregate Demand Curve
In Figure 11.14, we see how the income-expenditure model provides the foundation for the aggregate
demand curve, which will enable us to analyze both changes in output and prices. As the price level falls
from P0 to P1, planned expenditures increase. Output increases from y0 to y1. The aggregate demand
curve shows the combination of prices and equilibrium output.
 Caution!
Anything affecting C, I, G, or NX other than the price level itself will cause shifts of the
aggregate demand curve. Price level changes will cause movement along the aggregate
demand curve.
Figure 11.15 shows what happens when a variable other than the price level changes. For example, the
increase in government expenditure will raise the equilibrium output, from y0 to y1. Because the price
level has not changed, we have a higher level of output at the same level of price. This means that the
aggregate demand curve would shift to the right, from AD0 to AD1.
 Study Tip
If you want to know how the equations are derived mathematically, refer to the appendix of
this chapter for detailed analysis.
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Activity
Suppose you have a consumption function of C = 500 + 0.9(y) and investment I = 400.
a. Calculate the equilibrium output y*.
b. Determine the savings function.
c. At y*, what is the savings amount?
Answers
a. Use the following key equation; y* 
Ca  I
1  MPC
y*= (500 + 400) / (1 – 0.9) = 9,000
b. S = y – C
S = y – (500 + 0.9y)
S = y – 500 – 0.9y
S = –500 + 0.1y
c. S = –500 + 0.1(9,000)
S = 400
Another way to solve for this answer is to use the S = I identity and know that investment was 400. In
these simple models, S will always be equal to I regardless of the level of equilibrium income.
Key Terms
Autonomous consumption: The part of consumption that does not depend on income.
Consumption function: The relationship between consumption spending and the level of income.
Equilibrium output:
produced.
The level of GDP at which planned expenditure equals the amount that is
Marginal propensity to consume (MPC): The fraction of additional income that is spent.
Marginal propensity to import: The fraction of additional income that is spent on imports.
Planned expenditures: Another term for total demand for goods and services.
Savings function: The relationship between the level of saving and the level of income.
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Practice Quiz
(Answers are provided at the end of the Practice Quiz.)
1. The income-expenditure model was originally developed by the economist ___________________
and later extended and refined by many economists.
a. Adam Smith
b. John Maynard Keynes
c. Milton Friedman
d. Joseph Schumpeter
2. Refer to the figure below. In the income-expenditure model, what happens at y*?
a.
b.
c.
d.
Output equals the change in inventories.
Output equals planned expenditures.
The amount of output demanded equals the amount of output in inventories.
all of the above
3. Refer to the figure below. When is production expected to rise?
The Income-Expenditure Model
a.
b.
c.
d.
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at y*
at y1
at y2
There isn’t sufficient information to answer the question.
4. Consider the consumption function C = Ca + bY. Which part of this function represents consumption
that does not depend on income?
a. Ca
b. b
c. bY
d. The entire consumption function, Ca + bY, represents consumption that does not depend on
income..
5. Refer to the figure below. Which graph correctly depicts an increase in the marginal propensity to
consume?
a.
b.
c.
d.
the graph on the left
the graph on the right
both graphs
neither graph
6. This question tests your understanding of Application 1 in this chapter: Falling home prices, the
wealth effect, and decreased consumer spending. How do changes in the value of homes affect
consumer spending?
Following significant increases from 1997 until mid-2006, home prices began to fall in the summer of
2006. The Congressional Budget Office estimated the ultimate decrease in consumer spending in
2007, based on the decrease in consumer wealth resulting from the decline in housing prices, would
be between $21 billion and $72 billion.
According to most of the studies reviewed by the Congressional Budget Office,
a. for every $1 decrease in consumer wealth, consumption spending decreases between $.02 and
$.07.
b. for every $1 decrease in consumption spending, consumer wealth decreases by $2 to $7.
c. a decrease in consumer wealth results in an equal-valued decrease in consumer spending.
d. changes in consumption spending are inversely related to changes in consumer wealth.
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7. Refer to the figure below. Which point best represents (Ca + I)?
a.
b.
c.
d.
point 1
point 2
point 3
point 4
8. The relationship between the level of income and the level of savings is called
a. the savings function.
b. the marginal propensity to save.
c. the savings multiplier.
d. the demand for savings.
9. Which of the following affects the level of GDP in the short run through its influence on the demand
for goods and services?
a. the level of government spending
b. the level of taxation
c. both the level of spending and the level of taxation
d. neither the level of spending nor the level of taxation
10. This question tests your understanding of Application 3 in this chapter: John Maynard Keynes: A
world intellectual. How influential a figure was John Maynard Keynes?
Which of the following were among Keynes’s ideas that challenged the conventional wisdom of his time?
a. Keynes argued that economies could automatically recover from economic downturns.
b. Keynes believed that economies could recover from downturns by themselves, without the help
of the government or anyone else.
c. Keynes believed that monetary policies could be very effective during deep recessions.
d. Keynes argued that governments needed to adopt active policies, such as increased public works,
in order to stimulate the economy.
11. Which of the following is the formula for the tax multiplier?
a. 1/MPC
b. 1/(1 – MPC)
c. – MPC/(1 – MPC)
d. change in y / change in G
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12. The U.S. economy has been much more stable after World War II than before. The reason is that
a. government taxes and transfer payments, which increase fluctuations in real GDP, grew slowly
after the war.
b. government taxes and transfer payments, which help to reduce fluctuations in real GDP, grew
sharply after the war.
c. government taxes have roughly equaled transfer payments, thereby reducing fluctuations in GDP
after the war.
d. government taxes and transfer payments, which increase fluctuations in real GDP, have remained
stable after the war.
13. Refer to the figure below. The shift in the function could have been caused by
a.
b.
c.
d.
an increase in government spending.
a decrease in government spending.
an increase in tax rates.
a decrease in tax rates.
14. To modify our model to include the effects of exports and imports, we need to
a. add exports and imports to total spending.
b. subtract exports and imports from total spending by U.S. residents.
c. add exports to total spending and subtract imports from total spending.
d. subtract exports from total spending and add imports to total spending.
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15. Refer to the figure below. The slope of this function equals
a.
b.
c.
d.
1/(1 – b)
1/(1 – b + m)
b–m
1–b+m
16. Refer to the figure below. Which graph best depicts the impact of an increase in exports?
a.
b.
c.
d.
the graph on the left
the graph on the right
both graphs
neither graph
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17. Refer to the figure below. Which move illustrates an increase in the price level in this graph?
a.
b.
c.
d.
a move from A to B
a move from A to C
a move from B to A
a move from C to A
18. The consumption function is 2,000 + 0.8Y. Find the level of consumption resulting from national
income if GDP is currently $10,000 billion.
a. $2,000 billion
b. $6,000 billion
c. $8,000 billion
d. $10,000 billion
19. Describe in words the meaning of the multiplier of autonomous planned investment spending.
20. Refer to the table. Use the numbers in the table to determine the value of autonomous consumption,
the marginal propensity to consume (MPC), the marginal propensity to save (MPS), construct the
consumption function, and construct the saving function.
21. When the expectations and spending decisions of buyers and sellers do not coincide with each other,
production may be too low for full employment. Explain what this Keynesian argument means.
22. Explain the impact of the foreign sector on the income-expenditure model.
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Answers to the Practice Quiz
1. b. The income-expenditure model was originally developed by the economist John Maynard Keynes
in the 1930s and later extended and refined by many economists.
2. b. At equilibrium output y*, output equals planned expenditures, C + I, and inventories are not
changing.
3. c. If output were lower than equilibrium (y2), it would be less than demand and production would rise.
4. a. Consumption that does not depend on income is autonomous consumption.
5. b. An increase in the MPC increases the slope of the consumption function, pivoting the consumption
function counterclockwise.
6. a. Most studies reviewed by the Congressional Budget Office estimated a decrease of consumer
wealth of $1 would lower consumption spending by somewhere between $.02 and $.07.
7. d. Point 4 is the value of (Ca + I), or autonomous expenditures.
8. a. The level of savings in the economy is not fixed, and how it changes depends on the real GDP. The
savings function is the relationship between the level of income and the level of savings. The fraction
that the consumer saves is determined by his or her marginal propensity to save (MPS).
9. c. Both the level of government spending and the level of taxation, through their influence on the
demand for goods and services, affect the level of GDP in the short run.
10. d. Keynes provided the rationale for activist fiscal policy today.
11. c. This is the number by which a change in taxes will change equilibrium income.
12. b. Government taxes and transfer payments, which help to reduce fluctuations in real GDP, grew
sharply after the war.
13. c. An increase in tax rates decreases the slope of the C + I + G line. This lowers output and reduces
the multiplier.
14. c. To modify our model to include the effects of exports and imports, we need to take two steps: Add
exports, X, to other sources of spending as another source of demand for U.S. products. Subtract
imports, M, from total spending by U.S. residents. Consumers will import more goods as income
rises.
15. c. The fraction m is known as the marginal propensity to import. We subtract this fraction from b, the
overall marginal propensity to consume, to obtain the MPC for spending on domestic goods, b – m.
16. a. An increase in exports (X) affects the intercept of the expenditure function.
17. a. In this graph, a decrease in the price level causes a move along the aggregate demand curve, from
point A to point B.
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18. d. If GDP is $10,000, consumption spending will be $2,000 (autonomous consumption spending) plus
0.8 times $10,000, which is $2,000 plus $8,000 = $10,000..
19. The multiplier of autonomous planned investment shows the change in equilibrium income resulting
from a change in autonomous planned investment spending. Each dollar of additional investment yields
more than one dollar of additional income. In a closed economy without taxation, this multiplier equals
1/ (1 – MPC). If the MPC equals 0.8, for example, then the multiplier equals 5. In other words, for each
additional dollar of investment spending, equilibrium income will rise by five dollars.
20. The value of autonomous consumption equals 50, or the value of consumption when income equals
zero. The marginal propensity to consume (MPC) is the slope of the consumption function. Using any
two pairs of income and consumption values, the MPC = 0.75. Using any two pairs of income and
saving values, the MPS = 0.25, or 1 – MPS. The consumption function equals C = 50 + 0.75Y, and
the saving function equals S = – 50 + 0.25Y.
21. Since households and firms are two different groups of people, the spending and saving decisions of
households are divorced from the investment and production decisions of business firms. For
example, suppose that business expectations became pessimistic. Business firms would reduce
planned investment, regardless of how low interest rates dipped. If firms were unwilling to use
household saving to invest, then saving would be too high. If saving is too high, consumption is too
low, and some of the goods produced by the firm remain unsold. This, in turn, would prompt business
firms to reduce output and employment in future periods. This was the Keynesian argument, which,
combined with the existence of sticky wages, helped to explain the persistence of unemployment. If a
reduction in output and employment fails to put downward pressure on prices and wages, then the
economy could remain stuck at a level of output below the potential output for an extended period.
22. Exports are an autonomous component of expenditure. Exports depend on the income of foreigners,
not domestic income. Regardless of the level of domestic income, exports remain the same. Imports
depend on the level of domestic income. As domestic income rises, imports rise by an amount called
the marginal propensity to import (MPI). For example, for each additional dollar of income, domestic
consumers may spend 20 cents on foreign goods, making the marginal propensity to import 0.2. The
marginal propensity to import ends up in the denominator of the multiplier for the economy. As the
marginal propensity to import increases, the multiplier becomes smaller, rotating the aggregate
expenditure function clockwise, and decreasing the level of output and income. While exports
contribute to higher GDP, imports cause the contrary. The effect of net exports on equilibrium output
and income is positive as long as exports exceed imports.