Download Document

Aggregate Expenditure
and Aggregate Demand
CHAPTER
25
© 2003 South-Western/Thomson Learning
1
Aggregate Expenditure and Income
Here we build on the income-consumption
connection to uncover the tie between
income and total spending
Assumptions
No capital depreciation
No business saving
Each dollar spent on production translates
directly into a dollar of aggregate income 
GDP equals aggregate income
Investment, government purchases, and net
exports are autonomous  independent of the
level of income
2
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
3
Aggregate Expenditures
Aggregate 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, C
Planned investment, I
Government purchases, G
Net exports, X – M
Consumption is the only spending
component that varies with the level of real
GDP
4
Exhibit 1: Table for Real GDP With Net Taxes and
Government Purchases (trillions of dollars)
Saving
(S)
(5)
Planned
Investment
(I)
(6)
Government
Purchases
(G)
(7)
Net
Exports
(X-M)
(8)
Planned
Aggregate
Expenditur
e
(AE)
(9)
7.5
0.5
0.8
1.0
-0.1
9.5
-.02
8.5
7.9
0.6
0.8
1.0
-0.1
9.6
-0.1
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
Real
GDP
(Y)
(1)
Net
Taxes
(NT)
(2)
Disposable
Income
Consumption
(Y-NT)
(C)
(3)=(1)-2) (4)
9.0
1.0
8.0
9.5
1.0
10.0
Unintended
Inventory
Adjustment
(Y-AE)
(10)=(1)(9)
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
5
Saving, MPS assumed to be 1/5
Saving
(S)
(5)
Planned
Investment
(I)
(6)
Government
Purchases
(G)
(7)
Net
Exports
(X-M)
(8)
Planned
Aggregate
Expenditur
e
(AE)
(9)
7.5
0.5
0.8
1.0
-0.1
9.5
-.02
8.5
7.9
0.6
0.8
1.0
-0.1
9.6
-0.1
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
Real
GDP
(Y)
(1)
Net
Taxes
(NT)
(2)
Disposable
Income
Consumption
(Y-NT)
(C)
(3)=(1)-2) (4)
9.0
1.0
8.0
9.5
1.0
10.0
Unintended
Inventory
Adjustment
(Y-AE)
(10)=(1)(9)
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 balanced
The final column lists any unplanned inventory adjustment which equals real GDP minus
planned aggregate expenditures
When 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
6
Exhibit 1: Table for Real GDP With Net Taxes and
Government Purchases (trillions of dollars)
Real
GDP
(Y)
(1)
Net
Taxes
(NT)
(2)
Disposable
Income
Consumption
(Y-NT)
(C)
(3)=(1)-2) (4)
9.0
1.0
8.0
9.5
1.0
10.0
Planned
Aggregate
Expenditure
(AE)
(9)
Unintended
Inventory
Adjustment
(Y-AE)
(10)=(1)(9)
Saving
(S)
(5)
Planned
Investment
(I)
(6)
Government
Purchases
(G)
(7)
Net
Exports
(X-M)
(8)
7.5
0.5
0.8
1.0
-0.1
9.5
-.02
8.5
7.9
0.6
0.8
1.0
-0.1
9.6
-0.1
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
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
7
Exhibit 2: Deriving Aggregate Output
C + I + G + (X – M)
(trillions of dollars)
Aggregate expenditure
This graph is often called the income-expenditure model. The aggregate
expenditure line reflects the sum of consumption, investment, government
purchases, and net exports
e
10.0
45º
0
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
10.0
Real GDP
(trillions of dollars)
8
Exhibit 2: Deriving Aggregate Output
C + I + G + (X – M)
(trillions of dollars)
Aggregate expenditure
The special feature of the 45degree line is that it identifies all
points where planned expenditure
equals real GDP.
e
10.0
Aggregate output demanded at
any given price level occurs where
real GDP equals planned
aggregate expenditure, at point e
45º
0
10.0
Real GDP
(trillions of dollars)
9
Exhibit 2: Deriving Aggregate Output
(trillions of dollars)
Aggregate expenditure
C + I + G + (X – M)
e
10.0
b
9.2
9.0
a
45º
0
9.0
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 reductions
cannot continue indefinitely;
firms will increase employment
 increasing income 
increasing consumer spending.
This process will continue until
planned spending equals real
GDP at point e
10.0
Real GDP
(trillions of dollars)
10
(trillions of dollars)
Aggregate expenditure
Exhibit 2: Deriving Aggregate Output
d
11.0
10.8
C + I + G + (X – M)
c
e
10.0
45º
0
10.0
Real GDP
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.
11.0
(trillions of dollars)
11
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
12
Aggregate expenditure (trillions of dollars)
Exhibit 3: Effect of an Increase In Autonomous
Investment on Real GDP Demanded
e´
10.5
C+I´+G+(X-M)
a
10.1
10.0
e
C+I+G+(X-M)
0.1
45º
0
10.0
Real GDP
(trillions of dollars)
10.5
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.
13
Aggregate expenditure (trillions of dollars)
Exhibit 3: Autonomous Increase In Investment
C + I + G + (X – M)
e'
10.5
C + I' + G + (X – M)
f
c
g
d
a
10.1
b
10.0
e
0.1
45º
0
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
10.0 10.1
Real GDP
(trillions of dollars)
10.5
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.
14
Aggregate expenditure (trillions of dollars)
Exhibit 3: Autonomous Increase In Investment
C + I + G + (X – M)
e'
10.5
C + I' + G + (X – M)
f
c
g
d
a
10.1
b
10.0
e
0.1
45º
0
10.0 10.1
Real GDP
(trillions of dollars)
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.
10.5
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
15
Exhibit 4: Summary of the Multiplier Effect
8
New Spending Cumulative
New Saving
Round
This Round New Spending This Round
1
100
100
2
80
180
20
3
64
244
16
10
13.4
446.3
3.35
0
500
0

Cumulative
New Saving
20
36
86.6
100
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
16
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)
17
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 5
With an MPC of 0.9, the multiplier is 10
With an MPC of 0.75, the multiplier is 4
18
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
19
Simple Spending Multiplier
In 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
20
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
21
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 level
reduces consumption because it reduces the
real value of dollar-denominated assets held by
households
increases the market rate of interest which
reduces investment
makes U.S. goods relatively more expensive
abroad  imports rise and exports fall
22
In panel (a), the AE function
intersects the 45 degree line
at point e to yield $10.0
trillion in real GDP
demanded.
Aggregate expenditure
(trillions of dollars)
Exhibit 5: Income-Expenditure and Aggregate Demand
AE (P = 130)
e
(a) Income-expenditure model
45°
0
Real GDP (trillions of dollars)
140
Price level
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.
10.0
130
e
(b) Aggregate demand curve
0
10.0
Real GDP (trillions of dollars)
23
If the price level increases to 140?
It reduces consumption,
investment, and net exports, as
reflected in panel (a) by the
downward shift from AE to AE'
As a result of the decrease in
planned spending, real GDP
demanded declines from e  e'
Aggregate expenditure
(trillions of dollars)
Exhibit 5: Income-Expenditure and Aggregate Demand
AE" (P = 120)
e"
AE (P = 130)
AE' (P = 140)
e
e'
(a) Incomeexpenditure
model
45°
0
9.5
10.0
10.5
Real GDP (trillions of dollars)
If the price level declines to120?
e'
It increases consumption,
planned investment, and net
exports, as reflected panel (a) by
the upward shift in the spending
line from AE to AE"
Price level
140
The increase in planned spending at
each income level increases real GDP
demanded increases from e  e"
e
130
(b) Aggregate
demand curve
e"
120
AD
0
9.5
10.0
10.5
Real GDP (trillions of dollars)
24
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
25
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
26
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.
C + I' + G + (X – M)
C + I + G + (X – M)
e'
0.1
(a) Incomeexpenditure
model
e
45º
0
130
10.0
e
10.5
0
Real GDP (trillions of dollars)
e´
Price level
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)
Aggregate expenditure (trillions of dollars)
Exhibit 6: Shifts
(b) Aggregate
demand curve
AD'
AD
10.0
10.5
27
Real GDP (trillions of dollars)
Limitations of the Multiplier
Our 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 multiplier
Leakages such as higher income taxes and
increased spending on imports all reduce the
size of the multiplier
The spending multiplier takes time to work itself
out  the process does not occur instantly
28