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Chapter 6 Aggregate expenditures model and multipliers Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-1 Learning objectives • Describe the assumptions underlying the aggregate expenditures model • Explain the consumption–income and saving– income relationships upon which the aggregate expenditures model is based • Examine the determinants of the level of investment (firms’ purchases of capital equipment), and analyse the impact of changes in its level on equilibrium real GDP, income and employment Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-2 Learning objectives (cont.) • Discuss the rationale for the presence of the multiplier and the multiplier effect • Apply the aggregate expenditures model to a discussion of the paradox of thrift • Examine the difference that may exist between the equilibrium level of output and that corresponding to the full-employment level of output, allowing discussion of the nature of recessionary and inflationary gaps Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-3 Learning objectives (cont.) • Analyse the macroeconomic impacts of the government sector and foreign trade on equilibrium GDP • Apply the model to explain the concept of the balanced-budget multiplier Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-4 Aggregate expenditures model Assumptions 1. Two sectors i.e. closed economy with no government 2. All savings are treated as personal savings 3. Depreciation and net Australian income earned abroad are zero 4. Businesses make investment decisions 5. Real interest rates influence investment (I) 6. Fixed prices and wages or price–wage inflexibility Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-5 Aggregate expenditures (AE) • Sum of expenditures on consumption (C), investment (I), government spending (G) and net exports (NX) • Determines the level of output and employment in economy Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-6 Consumption and savings • Both consumption and savings level are determined by household disposable income (DI) • Households consume most of their DI • DI that is not consumed is called ‘savings’ Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-7 Consumption schedule • A schedule of the income–consumption relationship • Shows the various amounts households plan or intend to consume at various possible levels of disposable income Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-8 Saving schedule • A schedule of the income–saving relationship • Shows the various amounts households plan or intend to save at various levels of disposable income Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-9 Consumption & saving schedules Consumption C 425 410 405 400 Saving $5 billion Consumption schedule 375 Dissaving $5 billion Saving 0 45 o 370 390 410 430 450 Disposable income S Dissaving $5 billion 0 Saving $5 billion 370 390 410 430 450 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Saving schedule Disposable income 6-10 Average propensity to consume (APC) • The fraction of any total income that is spent on consumption • APC = Consumption Income Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-11 Average propensity to save (APS) • That fraction of total income that is saved • APS = Saving Income • APC + APS = 1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-12 Marginal propensity to consume • That fraction of each additional dollar of income that is consumed • MPC = Change in consumption Change in income • Represented as the slope of the consumption schedule Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-13 Marginal propensity to save • That fraction of each additional dollar of income that is saved • MPS = Change in saving Change in income • Represented as the slope of the saving schedule • MPC + MPS = 1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-14 Consumption & saving schedules Consumption SAVING C Consumption schedule MPC = Slope of C 0 45 o Saving Dissaving 0 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Disposable income Saving schedule MPS = Slope of S S Saving Disposable income 6-15 The marginal propensity to consume and the marginal propensity to save Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-16 Non-income determinants of consumption & savings • • • • • • Wealth Price level Expectations Consumer debt levels Taxation Changes in these determinants cause a shift (up or down) of the curves Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-17 Consumption Shifts in the consumption & saving schedules C1 C0 An increase in consumption... C C 45 0 o Saving Disposable income Means a decrease in saving S0 S1 0 Disposable income S S Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-18 Consumption Shifts in the consumption & saving schedules (cont.) C C1 A decrease in consumption... C 45 0 o Means an increase in saving Disposable income Saving S S 0 S S Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Disposable income 6-19 Determinants of investment Two determinants of investment • Expected rate of net profits that businesses hope to realise from investment spending • The real rate of interest Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-20 Expected rate of net profit • Businesses are motivated by profit • Businesses invest if they expect a net profit from this investment Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-21 Real rate of interest • The inflation-adjusted cost associated with borrowing money • Equals nominal interest rate minus the inflation rate • Investment projects will only be undertaken if net expected profit rate exceeds real interest rate Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-22 Investment demand curve • Shows graphically the investment–interest rate relationship • Shows cumulative levels of investment at possible levels of investment at some point in time Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-23 Investment demand curve and interest rate (per cent) Expected rate of net profits 16 14 12 10 8 6 4 2 0 5 10 15 20 25 30 35 40 Investment (billions of dollars) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-24 Shifts in investment demand Other determinants of investment: • Acquisition, operation and maintenance costs • Business taxes • Technological change • Business expectations • Stock of capital goods on hand • Expectations Changes in these factors shift the investment demand curve Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-25 Investment and income • Autonomous investment – Desired level of investment based upon long-term profit expectations • Induced investment – Level of investment induced by the current level of income Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-26 Investment (billions of dollars) The investment schedule: two possibilities 60 40 Autonomous Induced Investment Schedule Investment Schedule I′ I 20 0 370 390 410 450 430 450 490 510 Real domestic product, GDP (billions of dollars) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-27 Instability of investment • Consumption (especially non-durables) is relatively stable but • Investment is unstable. Why? – – – – Durable and therefore postponable purchases Irregularity of innovation Profit variability Variable expectations (consider the new global competitive environment!) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-28 The volatility of investment Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-29 Equilibrium income/GDP Two approaches to determine the equilibrium levels of output and income: • Expenditures–output approach • Leakages–injections approach Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-30 Expenditures–output approach • Utilises relationship between AE and income • In a two-sector economy, AE = C + I • Equilibrium occurs where the total output (measured by GDP) and aggregate expenditures (C + I ) for a two sector economy are equal Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-31 Equilibrium GDP: expenditures–output approach Private spending (billions of dollars) (C + I = GDP) Equilibrium C+I C+I C C+I C 45 0 o GDP (billions of dollars) 370 390 410 430 450 470 490 510 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-32 Leakages–injections approach • Utilises the relationship between leakages and injections back to the expenditure flow • Two sectors: S = I at all levels I = total investment • At equilibrium: S = planned investment Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-33 Saving and Investment (billions of dollars) Equilibrium GDP: leakages–injections approach S=I 60 40 20 Unplanned inventory decrease I At this level of GDP S I { 0 –5 S (S = I = $20) Equilibrium 370 390 410 430 450 470 490 510 530 550 Real domestic product, GDP (billions of dollars) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-34 Saving and investment (billions of dollars) Equilibrium GDP: leakages–injections approach S=I 60 At this level of GDP 40 20 (S = I = $20) Equilibrium I S { } Unplanned inventory increase S 0 -5 S I 370 390 410 430 450 470 490 510 530 550 Real domestic product, GDP (billions of dollars) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-35 Planned vs unplanned investment • Investment has two components – Ip = planned investment as determined by investment demand schedule – Iu = unplanned investment is unintended changes in the level of inventories – Actual investment = sum of planned and unplanned investment • At equilibrium: Iu = zero Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-36 Achieving equilibrium • Difference in savings and planned investment causes • Mismatching of production and spending causes • Revision of production plans by firms until equilibrium is once again re-established • The level of GDP would be stable only where savings and planned investment are equal Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-37 Changes in equilibrium GDP • GDP is seldom stable. It is characterised by cyclical fluctuations • Changes in investment schedule or the savingsconsumption schedule will lead to changes in equilibrium GDP • Investment expenditures are generally less stable due to changes in the expected rate of net profit Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-38 Autonomous expenditure changes • Shifts in the AE curve due to changes in autonomous expenditure – Result in new equilibrium levels of output (GDP) – How much output changes by depends on the size of the expenditure multiplier Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-39 Expenditure multiplier • A change in autonomous expenditure results in a change in equilibrium income that is a multiple of the initial change • The multiplier is defined as the ratio of the change in GDP arising from a change in autonomous spending Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-40 Changes in equilibrium GDP and the multiplier (C + I ) 1 (C + I ) 0 Private spending (billions of dollars) 510 490 Equilibrium GDP at I1 level of investment 470 450 Saving and investment (billions of dollars) 430 0 45 o Real GDP 390 450 470 490 If I S I1 increases... I0 Real GDP 20 0 510 390 450 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 470 490 510 6-41 Saving and investment (billions of dollars) Private spending (billions of dollars) Changes in equilibrium GDP and the multiplier (C + I ) 0 510 (C + I ) 2 490 Equilibrium GDP at I2 level of investment 470 450 430 0 45 o 430 450 470 490 510 Real GDP S 20 I0 I2 0 430 450 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 470 490 If I decreases... Real GDP 510 6-42 The multiplier effect • A change in autonomous spending gives rise to a larger change in GDP • The multiplier effect arises because initial increase in aggregate expenditure will induce successive rounds of increased expenditure • The multiplier = changes in real GDP/changes in I Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-43 Multiplier and marginal propensities • A relationship exists between the MPS (the amount of leakage) and the multiplier • Multiplier = 1/MPS = 1/(1 – MPC) • The simple multiplier is defined as 1/MPS, when the leakage in the economy is only saving Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-44 S, I & the paradox of thrift • Paradox of thrift – If society attempts to save more, it may end up actually saving the same amount or even less, as a result of the multiple decline in equilibrium GDP caused by the withdrawal of aggregate expenditure • For savings to be beneficial it must be matched by injection, especially I Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-45 Saving and investment (billions of dollars) The paradox of thrift 60 S2 40 S1 20 I S2 0 –5 I S1 S 370 390 410 430 450 470 490 510 Real domestic product, GDP (billions of dollars) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-46 Recessionary gap • The amount by which aggregate expenditures are deficient to that required to generate the full-employment level of GDP • Produces a concretionary impact upon the economy Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-47 Private spending (billions of dollars) Recessionary gap (cont.) (C + I )0 (C + I )1 } Recessionary gap Full employment 0 45 o 470 490 510 Real GDP (billions of dollars) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-48 Inflationary gap • The amount by which aggregate spending exceeds that required to achieve full employment • Produces an inflationary effect on the economy Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-49 Inflationary gap (cont.) (C + I )1 Private spending (billions of dollars) Inflationary Gap (C + I )0 { Full employment 0 45 o 470 490 510 Real GDP (billions of dollars) Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-50 Discretionary fiscal policy • Deliberate manipulation of taxes (T) and spending (G) by government for the purpose of altering real GDP and employment, controlling inflation and stimulating economic growth Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-51 Government purchases (G) • Added to AE • Changes to autonomous government expenditure impact equilibrium real GDP through the multiplier Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-52 Three-sector economy equilibrium • Aggregate expenditure = C + I + G = real GDP and • S=I+G where • C is after-tax consumption • S is after-tax saving Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-53 Government expenditure and equilibrium GDP C+I +G S, I + G (billions of dollars) C +I +G (billions of dollars) Government spending $20 billion 0 45 C+I C o 470 510 550 Real GDP (billions of dollars) S 40 I +G 20 I 0 470 510 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 550 Real GDP (billions of dollars) 6-54 Taxes and equilibrium GDP • Taxes are assumed to be lump-sum – A tax that collects the same amount at each level of GDP • Reduces levels of both saving and consumption • How much S and C are affected depends on the MPC and MPS Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-55 Taxes and equilibrium GDP C+I +G C+I+G (billions of dollars) $15 billion decrease in consumption S + T, I + G (billions of dollars) 0 45 Ca + I + G o 490 550 Sa + T 40 S Sa I +G I 20 0 Real GDP ($ billions) $20 billion increase in taxes 490 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal $5 billion decrease in saving 550 Real GDP ( $billions ) 6-56 Fiscal policy over the business cycle Expansionary fiscal policy • Increased G • Decreased T • Or both • Moves budget towards a deficit in recessionary times Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-57 Fiscal policy over the business cycle (cont.) Contractionary fiscal policy • Decreased G • Increased T • Or both • Moves budget towards a surplus in inflationary times Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-58 The multiplier and fiscal policy If the tax function is of the form T = TLS + MPT(Y ) where MPT = marginal propensity to tax, Multiplier = 1 [MPT + MPS (1 – MPT)] Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-59 Balanced-budget multiplier • The effect of an equal increase (or decrease) of both the level of government expenditure and taxation • Increases (decreases) the level of equilibrium GDP by exactly the amount of the increase (or decrease) in G and T • Thus, equal increases in G and T are expansionary Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-60 Foreign trade and equilibrium GDP • Exports (X ) and imports (M ) are introduced into the model • Net exports (NX) = X – M • AE = C + I + G + NX Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-61 Exports (X) • Level of X depends on foreign countries’ income, not on domestic income • Therefore X is an autonomous variable in the model Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-62 Imports (M) • Level of M is dependent on domestic income or GDP • Given autonomous exports, a rise in imports due to a rise in income results in a fall in NX Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-63 Equilibrium GDP with a rise in NX Spending (billions of dollars) (C + I + G + NX)2 (C + I + G) (C + I + G + NX)0 (C + I + G + NX)1 510 490 470 450 45 0 o 450 470 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 490 510 Real GDP ($ billions) 530 6-64 Open-economy multiplier • The introduction of foreign trade reduces – The expenditure multiplier – The slope of the AE curve • The open-economy multiplier = 1/[MPS + MPM], If taxes are lump sum with No marginal propensity to tax MPM is the marginal propensity to import Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-65 The complex multiplier for an open economy • The multiplier that arises when all leakages — savings, taxes, and imports — are taken into account: 1 k= [MPT + MPS (1 – MPT) + MPM] Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 6-66