Download Chapter 30

Aggregate Expenditure
Multiplier
30
EYE Ons
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How big is the government
expenditure multiplier?
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30
Aggregate Expenditure
Multiplier
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain how real GDP influences expenditure plans.
2 Explain how real GDP adjusts to achieve equilibrium
expenditure.
3 Explain the expenditure multiplier.
4 Derive the AD curve from equilibrium expenditure.
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30.1 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 expenditure on goods and services, G
• Net exports, NX
Aggregate expenditure = C + I + G + NX.
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30.1 EXPENDITURE PLANS AND REAL GDP
Aggregate planned expenditure is the sum of the
spending plans of households, firms, and governments.
Aggregate planned expenditure is planned
consumption expenditure, plus planned investment,
plus planned government expenditure, plus planned
exports, minus planned imports.
We divide aggregate expenditure plans into
autonomous expenditure and induced expenditure.
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30.1 EXPENDITURE PLANS AND REAL GDP
Autonomous expenditure is the components of
aggregate expenditure that do not change when real GDP
changes.
Autonomous expenditure equals investment, plus
government expenditure, plus exports, plus the
components of consumption expenditure and imports that
are not influenced by real GDP.
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30.1 EXPENDITURE PLANS AND REAL GDP
Induced expenditure is the components of aggregate
expenditure that change when real GDP changes.
Induced expenditure equals consumption expenditure
minus imports (excluding the elements of consumption
expenditure and imports that are part of autonomous
expenditure).
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30.1 EXPENDITURE PLANS AND REAL GDP
The Consumption Function
Consumption function is the relationship between
consumption expenditure and disposable income, other
things remaining the same.
Disposable income is aggregate income (GDP) minus
net taxes.
Net taxes are taxes paid to the government minus
transfer payments received from the government.
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30.1 EXPENDITURE PLANS AND REAL GDP
Figure 30.1 shows the
consumption function.
Each dot corresponds to
a column of the table.
Point A shows that
autonomous consumption
is $2 trillion.
As disposable income
increases, consumption
expenditure increases—
induced consumption.
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30.1 EXPENDITURE PLANS AND REAL GDP
Along the 45° line,
consumption expenditure
equals disposable
income.
1. When the consumption
function is above the
45° line, saving is
negative (dissaving
occurs).
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30.1 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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30.1 EXPENDITURE PLANS AND REAL GDP
Marginal Propensity to Consume
Marginal propensity to consume (MPC) is the
fraction of a change in disposable income that is spent
on consumption.
Change in consumption expenditure
MPC =
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Change in disposable income
30.1 EXPENDITURE PLANS AND REAL GDP
Figure 30.2 shows how to
calculate the marginal
propensity to consume.
1. A $3 trillion change in
disposable income brings
2. A $2 trillion change in
consumption expenditure,
so...
3. The MPC is
$2 trillion ÷ $3 trillion =
2/3.
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30.1 EXPENDITURE PLANS AND REAL GDP
Other Influences on Consumption Expenditure
The factors that influence consumption plans are
• Real interest rate
• Wealth
• Expected future income
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30.1 EXPENDITURE PLANS AND REAL GDP
Real Interest Rate
When the real interest rate falls, consumption
expenditure increases and saving decreases.
When the real interest rate rises, consumption
expenditure decreases and saving increases
Wealth and Expected Future Income
When wealth or expected future income increases,
consumption expenditure increases.
When wealth or expected future income decreases,
consumption expenditure decreases.
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30.1 EXPENDITURE PLANS AND REAL GDP
Figure 30.3 shows shifts in
the consumption function.
1. Consumption expenditure
increases and the
consumption function shifts
upward if
• The real interest rate falls
• Wealth increases
• Expected future income
increases
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30.1 EXPENDITURE PLANS AND REAL GDP
2. Consumption expenditure
decreases and the
consumption function shifts
downward if
• The real interest rate rises
• Wealth decreases
• Expected future income
decreases
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30.1 EXPENDITURE PLANS AND REAL GDP
Imports and Real GDP
Consumption expenditure is one major component of
induced expenditure, imports are the other.
In the short run, the factor influencing imports is
U.S. real GDP.
Marginal propensity to import 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 that brought
it about.
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30.2 EQUILIBRIUM EXPENDITURE
Aggregate Planned Expenditure and Real
GDP
Consumption expenditure increases when disposable
income increases.
Disposable income equals aggregate income—real
GDP—minus net taxes, so disposable income and
consumption expenditure increase when real GDP
increases.
We use this link between consumption expenditure and
real GDP to determine equilibrium expenditure.
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30.2 EQUILIBRIUM EXPENDITURE
Figure 30.4 shows the AE curve.
Aggregate expenditure is the sum of
Investment (I),
Government expenditure (G),
Exports (X),
Consumption expenditure (C)
minus Imports (M).
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30.2 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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30.2 EQUILIBRIUM EXPENDITURE
Figure 30.5 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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30.2 EQUILIBRIUM EXPENDITURE
3. When aggregate planned
expenditure equals real GDP,
there are no unplanned
inventories and real GDP
remains at equilibrium
expenditure.
Part (b) shows the unplanned
changes in inventories that
bring about equilibrium
expenditure.
© 2013 Pearson
30.2 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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30.2 EQUILIBRIUM EXPENDITURE
Convergence from Below Equilibrium
When aggregate planned expenditure is less than real
GDP, firms cut production. Real GDP decreases.
When 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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30.2 EQUILIBRIUM EXPENDITURE
Convergence from Above Equilibrium
When aggregate planned expenditure exceeds real
GDP, firms increase production. 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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30.3 EXPENDITURE MULTIPLIERS
When autonomous expenditure (e.g. 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 any
component of autonomous expenditure is magnified or
multiplied to determine the change that it generates in
equilibrium expenditure and real GDP.
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30.3 EXPENDITURE MULTIPLIERS
 The Basic Idea of the Multiplier
The initial increase in investment brings an even bigger
increase in aggregate expenditure because it induces
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.
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30.3 EXPENDITURE MULTIPLIERS
Figure 30.6 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
$13 trillion to $15 trillion.
3. The increase in equilibrium
expenditure is 4 times the
increase in investment, so the
multiplier is 4.
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30.3 EXPENDITURE MULTIPLIERS
The Size of the Multiplier
The multiplier is the amount by which a change in
autonomous expenditure is multiplied to determine the
change in equilibrium expenditure that it generates.
That is,
Multiplier =
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Change in equilibrium expenditure
Change in autonomous expenditure
30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
Now solve for Y as
(1 – MPC)  Y = I
Rearrange to get
Y =
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I
(1 – MPC)
30.3 EXPENDITURE MULTIPLIERS
I
Y =
(1 – MPC)
Now, divide both sides of the equation 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)
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= 4.
30.3 EXPENDITURE MULTIPLIERS
 The Multiplier, Imports, and Income Taxes
The size of the multiplier depends not only on
consumption decisions but also on imports and income
taxes.
Imports make the multiplier smaller than 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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30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
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
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1
=
(1 – Slope of AE curve)
30.3 EXPENDITURE MULTIPLIERS
Figure 30.7 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
investment increases real
GDP by $2 trillion. The
multiplier is 4.
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30.3 EXPENDITURE MULTIPLIERS
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
investment increases real
GDP by $1 trillion. The
multiplier is 2.
© 2013 Pearson
30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
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.
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30.3 EXPENDITURE MULTIPLIERS
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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30.3 EXPENDITURE MULTIPLIERS
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.
© 2013 Pearson
30.4 THE AD CURVE AND EQUILIBRIUM
EXPENDITURE
 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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30.4 THE AD CURVE AND EQUILIBRIUM
EXPENDITURE
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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30.4 THE AD CURVE AND EQUILIBRIUM
EXPENDITURE
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
net assets, 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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30.4 THE AD CURVE AND EQUILIBRIUM
EXPENDITURE
Figure 30.8 shows the connection
between the AE curve and the AD
curve.
1. When the price level is 110, the AE
curve is AE0.
Equilibrium expenditure is $14
trillion at point B.
The quantity of real GDP
demanded at the price level of
110 is $14 trillion—one point
on the AD curve.
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30.4 THE AD CURVE AND EQUILIBRIUM
EXPENDITURE
2. When the price level rises to 130,
the AE curve shifts downward
to AE1.
Equilibrium expenditure
decreases to $13 trillion at point A.
The quantity of real GDP
demanded at the price level of
130 is $13 trillion—a
movement along the AD curve
to point A.
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30.4 THE AD CURVE AND EQUILIBRIUM
EXPENDITURE
3. When the price level falls to 90,
the AE curve shifts upward
to AE2.
Equilibrium expenditure
increases to $15 trillion at
point C.
The quantity of real GDP
demanded at the price level
of 90 is $15 trillion—a
movement along the AD
curve to point C.
© 2013 Pearson
How Big Is the Government Expenditure Multiplier?
Christina Romer, Chair of the President’s Council of
Economic Advisers (CEA), has estimated the government
expenditure multiplier to be 1.6.
This number led administration economists to predict that
the stimulus plan that increased government expenditure
would prevent the unemployment rate from rising much
above 8 percent.
This prediction turned out to be optimistic.
One reason might be that the multiplier assumption was also
too optimistic.
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How Big Is the Government Expenditure Multiplier?
Robert Barro, a leading macroeconomist at Harvard
University, has studied the effects of very large increases in
government expenditure during wars.
Barro finds that the multiplier is only 0.8.
Barro’s multiplier means that real GDP increases by less
than the increase in government expenditure.
The reason is that some private expenditure, mainly
investment, gets “crowded out” and real GDP falls.
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How Big Is the Government Expenditure Multiplier?
John Taylor of Stanford University, another leading
macroeconomist, agrees with Barro that the government
expenditure multiplier is less than 1.
Taylor says that crowding out gets more severe as time
passes.
So Taylor says that the multiplier gets smaller after two years
and smaller still after three years.
The figure on the next slide shows the range on estimates of
the expenditure multiplier.
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How Big Is the Government Expenditure Multiplier?
A big multiplier can occur only if there is substantial slack
in the economy—when the recessionary gap is large.
© 2013 Pearson