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O’Sullivan, Sheffrin, Perez
Economics: Principles, Applications, and Tools
The Income-Expenditure
Model
By 2003, the Japanese
economy appeared to have
recovered from a recession
that began in the early 1990s.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
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CHAPTER 11
The IncomeExpenditure Model
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APPLYING THE CONCEPTS
1
How do changes in the value of homes affect
consumer spending?
Falling Home Prices, the Wealth Effect, and
Decreases in Consumer Spending
2
Why does real GDP typically increase after natural
disasters?
Increased Investment Spending Raises GDP after
Natural Disasters
3
How influential a figure was John Maynard Keynes?
John Maynard Keynes: A World Intellectual
4
How do countries benefit from growth in their
trading partners?
The Locomotive Effect: How Foreign
Demand Affects a Country’s Output
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CHAPTER 11
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11.1
A SIMPLE INCOME-EXPENDITURE MODEL
Equilibrium Output
 FIGURE 11.1
The 45° Line
At any point on the
45° line, the distance
to the horizontal axis
is the same as the
distance to the
vertical axis.
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CHAPTER 11
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11.1
A SIMPLE INCOME-EXPENDITURE MODEL
Equilibrium Output
• planned expenditures
Another term for total demand
for goods and services.
• equilibrium output
The level of GDP at which
planned expenditure equals
the amount that is produced.
equilibrium output = y* = C + I = planned expenditures
 FIGURE 11.2
Determining Equilibrium Output
At equilibrium output y*, total
demand y* equals output y*.
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CHAPTER 11
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11.1
A SIMPLE INCOME-EXPENDITURE MODEL
Adjusting to Equilibrium Output
 FIGURE 11.3
Equilibrium Output
Equilibrium output (y*) is
determined at a, where
demand intersects the
45° line.
If output were higher
(y1), it would exceed
demand and production
would fall.
If output were lower (y2),
it would fall short of
demand and production
would rise.
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11.2
THE CONSUMPTION FUNCTION
Consumer Spending and Income
• consumption function
The relationship between consumption
spending and the level of income.
C = Ca + by
• autonomous consumption
The part of consumption that does not
depend on income.
• marginal propensity to consume (MPC)
The fraction of additional income that
is spent.
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11.2
THE CONSUMPTION FUNCTION
Consumer Spending and Income
 FIGURE 11.4
Consumption Function
The consumption
function relates desired
consumer spending to
the level of income.
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11.2
THE CONSUMPTION FUNCTION
Changes in the Consumption Function
 FIGURE 11.5
Movements of the Consumption Function
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11.2
THE CONSUMPTION FUNCTION
Changes in the Consumption Function
Two factors that can cause autonomous
consumption to change:
• Increases in consumer wealth will cause an
increase in autonomous consumption.
• Increases in consumer confidence will increase
autonomous consumption.
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CHAPTER 11
The IncomeThe IncomeExpenditure
Expenditure Model
Model
APPLICATION
1
FALLING HOME PRICES, THE WEALTH EFFECT, AND
DECREASED CONSUMER SPENDING
APPLYING THE CONCEPTS #1: How do changes in the
value of homes affect 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. Changes in the value of
home equity—like other forms of wealth—affect consumer spending.
The period from 1997 to mid-2006 was paradise for consumers. Housing
prices rose nationally by approximately 90 percent and consumer wealth
grew by $6.5 trillion dollars over that period. The party ended in the summer
of 2006 as housing prices began to fall.
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, or ultimately
from $21 to $72 billion of spending. This decrease would subtract 0.1 to 0.5
percentage points from economic growth during 2007.
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11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION
 FIGURE 11.6
Equilibrium Output and
the Consumption Function
Equilibrium output is determined
where the C + I line intersects
the 45° line.
At that level of output, y*,
desired spending equals output.
(autonomous consumption + investment)
equilibrium output 
(1 
MPC )
( Ca )I
y*
1
(  b)
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11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION
Saving and Investment
• savings function
The relationship between the level of
saving and the level of income.
S=y−C
y=C+I
y−C=I
S=I
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11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION
Saving and Investment
 FIGURE 11.7
Savings, Investment, and
Equilibrium Output
Equilibrium output is
determined at the level of
output, y*, where savings
equals investment.
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11.3
EQUILIBRIUM OUTPUT AND
THE CONSUMPTION FUNCTION
Understanding the Multiplier
 FIGURE 11.8
The Multiplier
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).
1
multiplier 
(1 
MPC)
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APPLICATION
2
INCREASED INVESTMENT SPENDING RAISES GDP
AFTER NATURAL DISASTERS
APPLYING THE CONCEPTS #2: Why does real GDP
typically increase 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.
• Reason: natural disasters can often stimulate economic activity.
• Example: if a hurricane destroys a house, the owner of the house and
the insurance company suffer an important loss.
• The homeowner will typically want to rebuild the house.
• He or she must hire a builder and pay for cement, wood, paint,
windows, appliances, and furniture.
• 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.
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11.4
GOVERNMENT SPENDING
AND TAXATION
Fiscal Multipliers
planned expenditures including government = C + I + G
 FIGURE 11.9
Government Spending, Taxes, and GDP
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11.4
GOVERNMENT SPENDING
AND TAXATION
Fiscal Multipliers
1
multiplier for government spending 
(1 
MPC )
The consumption function with taxes is
C  C a  b( y T)
The formula for the tax multiplier is
MPC
tax multiplier 
1
( 
MPC)
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11.4
GOVERNMENT SPENDING
AND TAXATION
Using Fiscal Multipliers
Though it is very simple, our income-expenditure model 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.
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.
P R I N C I P L E O F O P P O RT U N I T Y C O S T
The opportunity cost of something is what you sacrifice to get it.
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APPLICATION
3
JOHN MAYNARD KEYNES: A WORLD
INTELLECTUAL
APPLYING THE CONCEPTS #3: How influential a
figure was John Maynard Keynes?
At King’s College in Cambridge, Keynes began a lifetime association with an
important group of writers and artists, the Bloomsbury group, which included
the well-regarded writer Virginia Woolf.
After World War I, he attended the Versailles Peace Conference and wrote a
book, The Economic Consequences of the Peace.
• It condemned the peace treaty and its negotiators.
• This book established Keynes as both a first-rate economic analyst and
a brilliant writer.
Between the wars, Keynes wrote his most famous work, The General
Theory of Employment, Interest, and Money, which challenged the
conventional wisdom that economies would automatically recover from
economic downturns.
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11.4
GOVERNMENT SPENDING
AND TAXATION
Understanding Automatic Stabilizers
 FIGURE 11.10
Growth Rates of U.S.
GDP, 1871–2007
After World War II,
fluctuations in GDP
growth became
considerably smaller.
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11.4
GOVERNMENT SPENDING
AND TAXATION
Understanding Automatic Stabilizers
C = Ca + b(1 − t)y
adjusted MPC = b(1 − t)
 FIGURE 11.11
Increase in Tax Rates
An increase in tax rates
decreases the slope of
the C + I + G line.
This lowers output and
reduces the multiplier.
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11.5
EXPORTS AND IMPORTS
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.
M = my
• marginal propensity to import
The fraction of additional income that
is spent on imports.
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11.5
EXPORTS AND IMPORTS
 FIGURE 11.12
U.S. Equilibrium Output
in an Open Economy
Output is determined
when the demand for
domestic goods equals
output.
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11.5
EXPORTS AND IMPORTS
 FIGURE 11.13
How Increases in Exports and Imports Affect U.S. GDP
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APPLICATION
4
THE LOCOMOTIVE EFFECT: HOW FOREIGN DEMAND
AFFECTS A COUNTRY’S OUTPUT
APPLYING THE CONCEPTS #4: How do countries
benefit from growth in their trading partners?
From the early 1990s until quite recently, the United
States was what economists term the “locomotive” for
global growth.
• Our demand for foreign products increased.
• U.S. imports increased along with output during this period.
• The increased demand fueled exports in foreign countries and
promoted their growth.
Studies have shown that the increase in demand for foreign goods
was actually more pronounced for developing countries than for
developed countries.
Conclusion: The United States was truly a locomotive, pulling the
developing countries along.
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11.6
THE INCOME-EXPENDITURE MODEL
AND THE AGGREGATE DEMAND CURVE
 FIGURE 11.14
Deriving the Aggregate
Demand Curve
As the price level falls
from P0 to P1, planned
expenditures increase,
which increases the
level of output from y0
to y1.
The aggregate demand
curve shows the
combination of prices
and equilibrium output.
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11.6
THE INCOME-EXPENDITURE MODEL
AND THE AGGREGATE DEMAND CURVE
 FIGURE 11.15
Shifts in Aggregate Demand
As government spending
increases from G0 to G1,
planned expenditures
increase, which raises output
from y0 to y1.
At the price level P0, this
shifts the aggregate demand
curve to the right, from AD0
to AD1.
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KEY TERMS
autonomous consumption
marginal propensity to consume (MPC)
consumption function
marginal propensity to import
equilibrium output
planned expenditures
savings function
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
Formula for Equilibrium Output
1
2
3
4
5
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
The Multiplier for Investment
For the original level of investment at I0, we have
For a new level of investment at I1, we have
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The Multiplier for Investment
Substituting for the levels of output, we have
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
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The Multiplier for Investment
Finally, because (I1 − I0) is the change in investment, ΔI, we can write
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
Another Way to Derive the Formula for the Multiplier
y  $1 ($1  b)($1
)($1
b 2 ...)
b3
or
The term in parentheses is an infinite series whose value is equal to
Substituting this value for the infinite series, we have the expression for the
multiplier:
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Government Spending and Taxes
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
Government Spending and Taxes
Using this formula and the method just outlined, we can find the multiplier for
changes in government spending and the multiplier for changes in taxes:
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CHAPTER 11
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Balanced-Budget Multiplier
1
b
balanced-budget multiplier 

(1  b)(1
)b
(1  b)

(1  b)
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
1
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APPENDIX
FORMULAS FOR EQUILIBRIUM INCOME AND
THE MULTIPLIER
Equilibrium Output with Government Spending, Taxes, and the
Foreign Sector
output  planned expenditures ( C  I  G  X  M)
C  C a  b( y T)
M  mY
y  Ca  b( y T)  I  G  X  mY
y ( b  m) y  C a  bT  I  G  X
y [1 ( b  ]m)  Ca  bT  I  G  X
( Ca  bT  I  G  X
y*
[1 ( b  ]m)
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