Download 15.1 expenditure plans and real gdp

CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Distinguish between autonomous expenditure and
induced expenditure and explain how real GDP
influences expenditure plans.
2
Explain how real GDP adjusts to achieve equilibrium
expenditure.
3
Describe and explain the expenditure multiplier.
4
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.
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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.
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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.
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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.
Motorola’s inventories rise by 2 million phones, 1 million
more than planned, so Motorola cuts production.
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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.
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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 > Y, firms’ inventories are smaller than planned;
firms increase production.
If AE < Y, firms’ inventories are larger than planned;
firms reduce production.
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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.
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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.
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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).
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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
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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 increases—
induced 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.
Change in consumption expenditure
MPC =
Change in disposable income
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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
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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
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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.
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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.
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15.2 EQUILIBRIUM EXPENDITURE
Aggregate Planned Expenditure and GDP
M = M0 + mY, but let’s 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
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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
 1 
 A
Yeq  
1 g 
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15.2 EQUILIBRIUM EXPENDITURE
• The Autonomous
Expenditure Multiplier
… equals the change in real
GDP divided by the
change in autonomous
expenditure:
 1 
A
Y  
1 g 
Y  1 

 
A  1  g 
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15.2 EQUILIBRIUM EXPENDITURE
• The Lump-sum Tax
Multiplier
… equals the change in
real GDP divided by the
change in lump-sum
taxes.
A  bTa
 1 

Y  bTa 
1 g 
Y   b 

 
Ta  1  g 
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15.2 EQUILIBRIUM EXPENDITURE
• The Lump-sum Transfer
Payments Multiplier
… equals the change in real
GDP divided by the
change in lump-sum
transfers.
A  bTr
 1 

Y  bTr 
1 g 
Y  b 

 
Tr  1  g 
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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,
Multiplier =
Change in equilibrium expenditure
Change in autonomous expenditure
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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.
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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
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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
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15.3 THE EXPENDITURE MULTIPLIER
Now solve for Y as:
(1 – MPC)  Y = I
Rearrange to get
Y =
I
(1 – MPC)
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15.3 THE EXPENDITURE MULTIPLIER
I
Y =
(1 – MPC)
Now, divide both sides of the by the I to give:
Y
I
=
1
(1 – MPC)
When MPC is 0.75, so the multiplier is:
1
1
Y
=
=
0.25
I
(1 – 0.75)
= 4.
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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.
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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.
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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 taxes—the 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:
Y
I
1
=
(1 – Slope of AE curve)
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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
trillion—the 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
trillion—the 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 economy’s
new direction is the multiplier.
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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.
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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.
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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.
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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.
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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.
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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 trillion—one 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 trillion—a 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 trillion—a movement
along the AD curve to point A.