Download What is Economics? 1 Chapter 13 expenditure multipliers: The

C h a p t e r
I.
13
EXPENDITURE
MULTIPLIERS: THE
KEYNESIAN
MODEL**
Fixed Prices and Expenditure Plans
A. The Keynesian model of this chapter studies the economy in the very short run.
1.
In the very short run, prices are fixed and the aggregate amount that is sold depends only
on the aggregate demand for goods and services.
2.
Therefore in this very short run, we focus on what makes aggregate demand fluctuate.
B. Expenditure Plans
1.
The four components of aggregate expenditure—consumption expenditure, investment,
government purchases of goods and services, and net exports—sum to real GDP.
2.
Aggregate planned expenditure equals planned consumption expenditure plus
planned investment plus planned government purchases plus planned exports minus
planned imports.
3.
A two-way link exists between aggregate expenditure and real GDP:
a)
An increase in aggregate expenditure increases real GDP.
b) Planned consumption expenditure and planned imports depend on real GDP, so an
increase in real GDP increases aggregate planned expenditure.
C. Consumption Function and Saving Function
1.
Consumption and saving depend on the real interest rate, disposable income, wealth, and
expected future income.
a)
Disposable income is aggregate income minus taxes plus transfer payments.
b) To explore the two-way link between real GDP and planned consumption
expenditure, we focus on the relationship between consumption expenditure and
disposable income when the other factors are constant.
*
2.
The relationship between consumption expenditure and disposable income, other things
remaining the same, is the consumption function. And the relationship between
saving and disposable income, other things remaining the same, is the saving
function.
3.
Figure 13.1 illustrates the consumption function and the saving function.
* This is Chapter 29 in Economics.
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D. Marginal Propensities to Consume and Save
1.
The marginal propensity to consume (MPC) is the fraction of a change in
disposable income that is consumed. It is calculated as the change in consumption
expenditure, C, divided by the change in disposable income, YD, that brought it
about. That is:
MPC = C/YD.
2.
The marginal propensity to save (MPS) is the fraction of a change in disposable
income that is saved. It is calculated as the change in saving, S, divided by the change
in disposable income, YD, that brought it about. That is:
MPS = S/YD.
3.
The MPC plus the MPS equals one. To see why, note that,
C + S = YD.
Then divide this equation by YD to obtain,
C/YD + S/YD = YD/YD,
which means that
EXPENDITURE MULTIPLI ERS: THE KEYNESIAN MODEL
MPC + MPS = 1.
E. Slopes and Marginal Propensities
1.
Figure 13.2 shows that the MPC
is the slope of the consumption
function and the MPS is the slope
of the saving function.
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F. Other Influences on Consumption Expenditure and Saving
1.
When an influence other than
disposable income changes — the
real interest rate, wealth, or
expected future income—the
consumption function and saving
function shift.
2.
Figure 13.3 illustrates shifts in
the consumption function and the
saving function.
EXPENDITURE MULTIPLI ERS: THE KEYNESIAN MODEL
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G. The U.S. Consumption Function
1.
Data for the United States show that
the U.S. consumption function has
shifted upward over time because
economic growth has created greater
wealth and higher expected future
income.
2.
Figure 13.4 illustrates for 1961 to
2003; the assumed MPC in the
figure is 0.9.
H. Consumption as a Function of Real GDP
I.
1.
Disposable income changes when
either real GDP changes or when net
taxes change.
2.
If tax rates don’t change, real GDP
is the only influence on disposable
income, so consumption expenditure
is a function of real GDP.
3.
We use this relationship to determine equilibrium expenditure.
Import Function
1.
In the short run, imports are influenced primarily by U.S. real GDP.
2.
The marginal propensity to import is the fraction of an increase in real GDP that is
spent on imports. In recent years, NAFTA and increased integration in the global
economy have increased U.S. imports. Removing the effects of these influences, the U.S.
marginal propensity to import is probably about 0.2.
II. Real GDP with a Fixed Price Level
A. The relationship between aggregate planned expenditure and real GDP can be described by
an aggregate planned expenditure schedule, which lists the level of aggregate expenditure
planned at each level of real GDP, or by the aggregate planned expenditure curve, which is a
graph of the aggregate planned expenditure schedule.
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B. Aggregate Planned Expenditure and Real GDP
1.
The table in Figure 13.5 shows how the aggregate planned expenditure schedule is
constructed from the components of aggregate planned expenditure.
2.
Consumption expenditure minus imports, which varies with real GDP, is induced
expenditure.
3.
The sum of investment, government purchases, and exports, which does not vary with
GDP, is autonomous expenditure. (Consumption expenditure and imports also have
an autonomous component.)
C. Actual Expenditure, Planned Expenditure, and Real GDP
1.
Actual aggregate expenditure is always equal to real GDP.
2.
Aggregate planned expenditure can differ from actual aggregate expenditure because
firms can have unplanned changes in inventories.
D. Equilibrium Expenditure
1.
Equilibrium expenditure is the level of aggregate expenditure that occurs when
aggregate planned expenditure equals real GDP.
EXPENDITURE MULTIPLI ERS: THE KEYNESIAN MODEL
2.
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Figure 13.6 illustrates equilibrium expenditure, which occurs at the point at which the
aggregate planned expenditure curve, AE, crosses the 45° line so that there are no
unplanned changes in business inventories.
E. Convergence to Equilibrium
1.
Figure 13.6 also illustrates the process of convergence toward equilibrium expenditure.
If aggregate planned expenditure is greater than real GDP (the AE curve is above the 45°
line), an unplanned decrease in inventories induces firms to hire workers and increase
production, so real GDP increases.
2.
If aggregate planned expenditure is less than real GDP (the AE curve is below the 45°
line), an unplanned increase in inventories induces firms to fire workers and decrease
production, so real GDP decreases.
3.
If aggregate planned expenditure equals real GDP (the AE curve intersects the 45° line),
no unplanned changes in inventories occur, so firms maintain their current production
and real GDP remains constant.
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III. The Multiplier
A. 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.
B. The Basic Idea of the Multiplier
1.
An increase in investment (or any other component of autonomous expenditure)
increases aggregate expenditure and real GDP. The increase in real GDP then leads to an
increase in induced expenditure.
2.
The increase in induced expenditure leads to a further increase in aggregate expenditure
and real GDP. So, real GDP increases by more than the initial increase in autonomous
expenditure.
3.
Figure 13.7 illustrates the
multiplier.
C. The Multiplier Effect
1.
The amplified change in real GDP
that follows an increase in
autonomous expenditure is the
multiplier effect.
2.
When autonomous expenditure
increases, inventories have an
unplanned decrease, so firms
increase production and real GDP
increases to a new equilibrium.
D. Why Is the Multiplier Greater than 1?
The multiplier is greater than 1 because
an increase in autonomous expenditure
induces further increases in
expenditure.
E. The Size of the Multiplier
The size of the multiplier is the change
in equilibrium expenditure divided by
the change in autonomous expenditure.
F. The Multiplier and the Marginal
Propensities to Consume and Save
1.
Ignoring imports and income taxes,
the marginal propensity to
consume determines the magnitude
of the multiplier.
2.
The multiplier equals 1/(1 – MPC)or, alternatively, 1/MPS.
EXPENDITURE MULTIPLI ERS: THE KEYNESIAN MODEL
3.
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Figure 13.8 illustrates the
multiplier process and shows how
the MPC determines the magnitude
of the amount of induced
expenditure at each round as
aggregate expenditure moves
toward equilibrium expenditure.
G. Imports and Income Taxes
Income taxes and imports both reduce the size of the multiplier. Including income taxes and
imports, the multiplier equals 1/(1 – slope of the AE curve). Figure 13.9 shows the
relationship between the multiplier and the slope of the AE curve.
H. Business Cycle Turning Points
1.
Turning points in the business cycle—peaks and troughs—occur when autonomous
expenditure changes.
2.
A decrease in autonomous expenditure brings an unplanned increase in inventories,
which triggers a recession.
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CHAPTER 13
3.
An increase in autonomous expenditure brings an unplanned decrease in inventories,
which triggers an expansion.
IV. The Multiplier and the Price Level
A. In the equilibrium expenditure model, the price level remains constant. But real firms don’t
hold their prices constant for long. When they have an unplanned change in inventories, they
change production and prices. And the price level changes when firms change prices. The
aggregate supply-aggregate demand model explains the simultaneous determination of real
GDP and the price level. The equilibrium expenditure and aggregate supply-aggregate
demand models are related.
B. Aggregate Expenditure and Aggregate Demand
1.
The aggregate expenditure curve is the relationship between aggregate planned
expenditure and real GDP, with all other influences on aggregate planned expenditure
remaining the same.
2.
The aggregate demand curve is the relationship between the quantity of real GDP
demanded and the price level, with all other influences on aggregate demand remaining
the same.
C. Aggregate Expenditure and the Price
Level
1.
When the price level changes, a
wealth effect and substitution effect
change aggregate planned
expenditure and change the quantity
of real GDP demanded.
a)
An increase in the price level
decreases aggregate planned
expenditure.
b) A decrease in the price level
increases aggregate planned
expenditure.
2.
Figure 13.10 illustrates the effects
of a change in the price level on the
AE curve, equilibrium expenditure,
and the quantity of real GDP
demanded.
a)
Points A, B, and C on the AD
curve correspond to the
equilibrium expenditure points
A, B, and C at the intersection
of the AE curve and the 45°
line.
b) In Figure 29.10(a), a rise in
price level from 105 to 125
shifts the AE curve from AE0
downward to AE1and decreases
the equilibrium level of real
output from $10 trillion to $9
EXPENDITURE MULTIPLI ERS: THE KEYNESIAN MODEL
c)
3.
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trillion. In Figure 13.10(b), the same rise in the price level that lowers equilibrium
expenditure, brings a movement along the AD curve from point B to point A.
A fall in price level from 105 to 85 shifts the AE curve from AE0 upward to AE2 and
increases equilibrium l real GDP from $10 trillion to $11 trillion. The same fall in
the price level that raises equilibrium expenditure brings a movement along the AD
curve from point B to point C.
Figure 13.11 illustrates the effects
of an increase in autonomous
expenditure. An increase in
autonomous expenditure shifts the
aggregate expenditure curve
upward and shifts the aggregate
demand curve rightward by the
multiplied increase in equilibrium
expenditure.
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D. Equilibrium Real GDP and the Price Level
1.
Figure 13.12 shows the effect of
an increase in investment in the
short run when the prices level
changes and the economy moves
along its SAS curve.
2.
The rise in the price level
decreases aggregate planned
expenditure and lowers the
multiplier effect on real GDP.
3.
In Figure 13.12(b), the AD curve
shifts rightward by the amount of
the multiplier effect but
equilibrium real GDP increases by
less than this amount because of
the rise in the price level. In
Figure 13.12(b) real GDP
increases from $10 trillion from
$11.3 trillion, instead of to $12
trillion as it would with a fixed
price level.
EXPENDITURE MULTIPLI ERS: THE KEYNESIAN MODEL
4.
Figure 13.13 illustrates the longrun effects of an increase in
autonomous expenditure at full
employment. If the increase in
autonomous expenditure takes
real GDP above potential GDP,
the money wage rate rises, the
SAS curve shifts leftward, and
real GDP decreases until it is
back at potential real GDP. The
long-run multiplier is zero.
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