Download Keynesian Cross and Multiplier

Fixed Prices and
Expenditure Plans
• In the very short term, firms’ prices are
fixed.
• The quantities they sell depend on demand,
not supply.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• The Aggregate Implications of Fixed Prices
1) Because each firm’s price is fixed, the
price level is fixed.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• The Aggregate Implications of Fixed Prices
2) Because demand determines the
quantities that each firm sells, aggregate
demand determines the aggregate
quantity of goods and services sold,
which equals GDP.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• The aggregate expenditure model explains
fluctuations in aggregate demand by
identifying the forces that determine
expenditure plans.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Expenditure Plans
• The components of aggregate expenditure are:
1) Consumption expenditure
2) Investment
3) Government purchases of goods and services
4) Net exports (exports minus imports)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Expenditure Plans
• Aggregate planned expenditure is equal to
planned consumption expenditure plus planned
investment plus planned government purchases
plus planned exports minus planned imports.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Expenditure Plans
• In the very short term all are fixed except
planned consumption expenditure and planned
imports.
• They depend on the level of GDP.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• A Two-Way Link Between Aggregate
Expenditure and GDP
1) An increase in real GDP increases
aggregate planned expenditure
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• A Two-Way Link Between Aggregate
Expenditure and GDP
1) An increase in real GDP increases aggregate planned expenditure
2) An increase in aggregate expenditure
increases real GDP
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Consumption Function and Saving Function
• We are going to focus on the relationship
between consumption and disposable income
when other factors are constant.
• The reason: Disposable income and
consumption are interrelated.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• The main factors that influence
consumption and saving are:
1) Real interest rate
2) Disposable income
3) Purchasing power of net assets
4) Expected future income
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Consumption Function and Saving Function
• The consumption function shows the
relationship between consumption expenditure
and disposable income.
• The saving function shows the relationship
between saving and disposable income.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Consumption Function and Saving Function
Planned
Disposable consumption
income
expenditure
Planned
saving
(trillions of 1992 dollars per year)
a
0
0.75
-0.75
b
1
1.50
-0.50
c
2
2.25
-0.25
d
3
3.00
0
e
4
3.75
0.25
f
5
4.5
0.50
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Consumption expenditure
(trillions of 1992 dollars/year.
Consumption Function and Saving Function
5
4
3
2
1
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Consumption expenditure
(trillions of 1992 dollars/year.
Consumption Function and Saving Function
5
4
3
2
1
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Consumption expenditure
(trillions of 1992 dollars/year.
Consumption Function and Saving Function
5
f
4
e
3
c
2
1
d
b
a
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Consumption expenditure
(trillions of 1992 dollars/year.
Consumption Function and Saving Function
5
f
Saving
4
e
Dissaving
3
c
2
1
d
Consumption
function
b
a
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Consumption Function
and Saving Function
• Consumption expenditure that occurs when
disposable income is zero is autonomous
consumption.
• Consumption in excess of this is called
induced consumption.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Consumption Function
and Saving Function
1
0
-1
Copyright © 1998 Addison Wesley Longman, Inc.
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year)
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Consumption Function
and Saving Function
1
0
-1 a
Copyright © 1998 Addison Wesley Longman, Inc.
d
1
3
b
c
e
4
f
Saving
function
5
Disposable income
(trillions of 1992 dollars per year)
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Consumption Function
and Saving Function
Saving
1
0
-1 a
Copyright © 1998 Addison Wesley Longman, Inc.
Dissaving
d
1
3
b
c
e
4
f
Saving
function
5
Disposable income
(trillions of 1992 dollars per year)
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Marginal Propensities to Consume and Save
• The marginal propensity to consume (MPC) is
the fraction of a change in disposable income
that is consumed.
C
MPC 
YD
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Marginal Propensities to Consume and Save
• The marginal propensity to save (MPS) is the
fraction of a change in disposable income that
is saved.
S
MPS 
YD
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
Marginal Propensities to Consume and Save
C  S  YD
Divide both sides of the equation by the change
in disposable income to obtain:
C
S

1
YD YD
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• These two values are the marginal
propensity to consume and the marginal
propensity to save, so:
MPC  MPS  1
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Slopes and Marginal Propensities
• The slopes of the consumption function and the
saving function are the marginal propensities to
consume and save.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Marginal Propensities to
Consume and Save45 line
Consumption expenditure
(trillions of 1992 dollars/year.
o
5
f
4
e
3
Consumption
function
2
1
c
d
b
a
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Marginal Propensities to
Consume and Save
o
Consumption expenditure
(trillions of 1992 dollars/year.
45 line
5
f
MPC= 0.75
4
e
3
Consumption
function
2
1
c
b
d
C  $ 0 .75 trillion
YD  $1 trillion
a
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Marginal Propensities to
Consume and Save
1
0
-1 a
Copyright © 1998 Addison Wesley Longman, Inc.
d
1
3
b
c
e
4
f
Saving
function
5
Disposable income
(trillions of 1992 dollars per year)
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Marginal Propensities to
Consume and Save
S  $0.25 trillion
MPS= 0.25
1
0
-1 a
Copyright © 1998 Addison Wesley Longman, Inc.
d
1
3
b
c
e
4
f
Saving
function
5
Disposable income
(trillions of 1992 dollars per year)
YD  $1 trillion
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• The other factors that change consumption
expenditure and saving are:
1) Real interest rates
2) The purchasing power of net assets
3) Expected future income
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Shifts in the Consumption
and Saving Function
o
Consumption expenditure
(trillions of 1992 dollars/year.
45 line
5
CF0
4
3
2
1
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Shifts in the Consumption
and Saving FunctionCF
o
Consumption expenditure
(trillions of 1992 dollars/year.
45 line
1
5
CF0
4
3
2
1
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Shifts in the Consumption
and Saving FunctionCF
o
Consumption expenditure
(trillions of 1992 dollars/year.
45 line
1
5
CF0
CF2
4
3
2
1
0
1
2
3
4
5
Disposable income
(trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Shifts in the Consumption
and Saving Function
1
0
-1
Copyright © 1998 Addison Wesley Longman, Inc.
SF0
1
2
3
4
5
SF1
Disposable income
(trillions of 1992 dollars per year)
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Shifts in the Consumption
and Saving Function
1
0
-1
Copyright © 1998 Addison Wesley Longman, Inc.
SF0
1
2
3
4
5
SF1
Disposable income
(trillions of 1992 dollars per year)
TM 11-‹#›
Saving (trillions of 1992 dollars per year)
Shifts in the Consumption
and Saving Function
SF2
SF0
1
0
-1
Copyright © 1998 Addison Wesley Longman, Inc.
1
2
3
4
5
SF1
Disposable income
(trillions of 1992 dollars per year)
TM 11-‹#›
The U.S. Consumption Function
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Fixed Prices and
Expenditure Plans
• Import Function
• The greater the U.S. real GDP, the larger is the
quantity of U.S. imports, other things remaining
the same.
• The marginal propensity to import is the
fraction of an increase in real GDP that is spent
on imports.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Real GDP with a
Fixed Price Level
• How does aggregate expenditure plans
interact to determine real GDP when the
price level is fixed?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Real GDP with a
Fixed Price Level
• First, we will study the relationship between
aggregate planned expenditure and real
GDP.
• Second, we’ll learn about the key
distinction between planned expenditure
and actual expenditure.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate Planned Expenditure
Darken lines
Planned expenditure
Consumption
Real GDP expenditure
(Y)
(C)
Investment
(I)
Government
purchases Exports
(G)
(X)
Aggregate
planned
Imports
expenditure
(M) (AE=C+I+G+X–M)
(trillions of 1992 dollars)
a
0
0.75
0.5
0.55
1.2
0.0
3
b
2
2.25
0.5
0.55
1.2
0.5
4
c
4
3.75
0.5
0.55
1.2
1.0
5
d
6
5.25
0.5
0.55
1.2
1.5
6
e
8
6.75
0.5
0.55
1.2
2.0
7
f
10
8.25
0.5
0.55
1.2
2.5
8
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate planned expenditure
(trillions of 1992 dollars/year.
Aggregate Planned Expenditure
10
8
6
4
2
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate planned expenditure
(trillions of 1992 dollars/year.
Aggregate Planned Expenditure
10
8
6
4
2
I
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate planned expenditure
(trillions of 1992 dollars/year.
Aggregate Planned Expenditure
10
8
6
4
2
I+G
I
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate planned expenditure
(trillions of 1992 dollars/year.
Aggregate Planned Expenditure
10
8
6
4
I+G+X
2
I+G
I
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate Planned Expenditure
Aggregate planned expenditure
(trillions of 1992 dollars/year.
I+G+X+C
10
8
6
Consumption
expenditure
4
I+G+X
2
I+G
I
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate Planned Expenditure
Aggregate planned expenditure
(trillions of 1992 dollars/year.
I+G+X+C
10
Imports
AE
8
f
e
6
d
Consumption
expenditure
c
4
a
b
I+G+X
2
I+G
I
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate Planned
Expenditure and Real GDP
• Equilibrium Expenditure
• Equilibrium expenditure is the level of
aggregate expenditure that occurs when
aggregate planned expenditure equals real GDP.
• When aggregate planned expenditure and actual
aggregate expenditure are unequal, a process of
convergence toward equilibrium expenditure
occurs.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate Planned
Expenditure and Real GDP
• Convergence to Equilibrium
• When actual and planned expenditure are
unequal, unplanned changes in business
inventories (investment) occur.
• GDP either increases or decreases until actual
expenditures equal planned expenditures.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Equilibrium Expenditure
o
Aggregate planned expenditure
(trillions of 1992 dollars/year.
45 line
10.0
8.0
6.0
4.0
2.0
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Equilibrium Expenditure
o
Aggregate planned expenditure
(trillions of 1992 dollars/year.
45 line
10.0
8.0
f
e
d
6.0
b
4.0
c
a
2.0
0
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Equilibrium Expenditure
Aggregate planned expenditure
(trillions of 1992 dollars/year.
o
45 line
Real GDP exceeds
planned expenditure
10.0
8.0
f
e
d
6.0
b
4.0
c
a
Planned
expenditure
exceeds
real GDP
2.0
0
Equilibrium
expenditure
2
4
6
8
10
Real GDP (trillions of 1992 dollars per year
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The multiplier is the amount by which a
change in autonomous expenditure is
magnified or multiplied to determine the
change in equilibrium expenditure and real
GDP.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The Basic Idea of the Multiplier
• Suppose that investment increases
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The Basic Idea of the Multiplier
• Suppose that investment increases
• This means that aggregate expenditure and real
GDP increases.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The Basic Idea of the Multiplier
• Suppose that investment increases
• This means that aggregate expenditure and real GDP increases.
• Disposable income increases
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The Basic Idea of the Multiplier
• Suppose that investment increases
• This means that aggregate expenditure and real GDP increases.
• Disposable income increases
• Consumption expenditures increase
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The Basic Idea of the Multiplier
• Suppose that investment increases
• This means that aggregate expenditure and real GDP increases.
• Disposable income increases
• Consumption expenditures increase
• Aggregate expenditure increases again
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The Basic Idea of the Multiplier
• Suppose that investment increases
• This means that aggregate expenditure and real GDP increases.
• Disposable income increases
• Consumption expenditures increase
• Aggregate expenditure increases again
• Real GDP, disposable income, and consumption
expenditure increase more.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The Basic Idea of the Multiplier
• Suppose that investment increases
• This means that aggregate expenditure and real GDP increases.
• Disposable income increases
• Consumption expenditures increase
• Aggregate expenditure increases again
• Real GDP, disposable income, and consumption expenditure increase
more.
• The initial increase in investment brings an
even bigger increase in aggregate expenditure
because it induces an increase in consumption
expenditure.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate expenditure
(trillions of 1992 dollars)
The Multiplier
o
45 line
9
AE0
e
8
d
7
c
6
5
b
a
5
6
7
8
9
Real GDP (trillions of 1992 dollars)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate expenditure
(trillions of 1992 dollars)
The Multiplier
o
45 line
AE1
9
e' AE0
d'
8
e
c'
7
6
5
b'
a'
d
c
b
a
5
6
7
8
9
Real GDP (trillions of 1992 dollars)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
Aggregate expenditure
(trillions of 1992 dollars)
The Multiplier
o
45 line
AE1
9
d'
8
7
e' AE0
A $0,5 trillion
increase in
investment...
6
5
c'
b'
a'
6
d
c
b
a
5
e
…increases
real GDP by
$2 trillion
7
8
9
Real GDP (trillions of 1992 dollars)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• 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.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• The multiplier is (from the table shown
earlier):
Change in equilibrium expenditure
Multiplier =
Change in autonomous expenditure
=
Copyright © 1998 Addison Wesley Longman, Inc.
$2 trillion
=4
$0.5 trillion
TM 11-‹#›
The Multiplier
• The Multiplier and the Marginal Propensity
to Consume and Save
• The larger the marginal propensity to consume,
the larger the multiplier.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• A change in real GDP equals the change in
consumption expenditure plus the change in
investment:
Y  C  I
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• But the change in consumption expenditure
is determined by the change in real GDP
and the marginal propensity to consume:
C  MPCx Y
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• Substituting MPC  Y in the previous
equation we get:
Y  ( MPCY )  I
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• Solving for Y we get:
I
Y 
1  MPC
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• Dividing both sides of this equation by I
we get:
Y
1
Multiplier 

I 1  MPC
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier
• Using this formula, with MPC = 0.75, the
multiplier is:
1
1
Multiplier 

4
(1  0.75) 0.25
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›
The Multiplier Process
2.0
1.5
1.0
0.5
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Expenditure round
Increase in current round
Cumulative increase from previous rounds
Copyright © 1998 Addison Wesley Longman, Inc.
TM 11-‹#›