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C h a p t e r
10
EXPENDITURE
MULTIPLIERS
O u t l i n e
Economic Amplifier or Shock Absorber?
A. A voice can be a whisper or fill Central Park, depending
on the amplification.
B. A limousine with good shock absorbers can ride smoothly
over terrible potholes.
C. Investment and exports can fluctuate like the amplified
voice, or the terrible potholes; does the economy react
like a limousine, smoothing out the bumps, or like an
amplifier, magnifying the fluctuations? These are the
questions this chapter addresses.
I.
Fixed Prices and Expenditure Plans
A. The Aggregate Implications of Fixed Prices
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 must focus on
what causes aggregate demand to 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 25.1 (page 577/231) illustrates the consumption
function and the saving function.
D. Marginal Propensities to Consume and Save
1. The marginal propensity to consume (MPC) is the fraction of
a change in disposable income spent on consumption. 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.
4. Divide this equation by YD to obtain,
C/YD + S/YD = YD/YD, or.
MPC + MPS = 1.
E. Slopes and Marginal Propensities
1. Figure 25.2 (page 579/233) shows that the MPC is the
slope of the consumption function and the MPS is the
slope of the saving function.
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 25.3 (page 580/234) illustrates.
G. The U.S. Consumption Function
1. Data for the United States show that the consumption
function has shifted upward over time because economic
growth has created greater wealth and higher expected
future income.
2. Figure 25.4 (page 581/235) illustrates for 1961 to
2001; the assumed MPC in the figure is 0.9.
H. Consumption as a Function of Real GDP
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.
I. 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 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 expenditure
schedule, which lists the level of aggregate expenditure
planned at each level of real GDP, or by the aggregate
expenditure curve, which is a graph of the aggregate
expenditure schedule.
B. Aggregate Planned Expenditure and Real GDP
1. The table in Figure 25.5 (page 582/236) shows how the
aggregate 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 can
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 may 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.
2. Figure 25.6 (page 584/238) illustrates equilibrium
expenditure, which occurs at the point at which the
aggregate expenditure curve crosses the 45° line and
there are no unplanned changes in business
inventories.
E. Convergence to Equilibrium
1. Figure 25.6 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.
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 and the increase in real GDP
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 25.7 (page 587/241) 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
make 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/MPS.
1/(1 – MPC)or, alternatively,
3. Figure 25.8 (page 589/243) 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 25.9 (page 590/244) shows the relation 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. An increase in autonomous expenditure brings an
unplanned decrease in inventories, which triggers an
expansion.
3. A decrease in autonomous expenditure brings an
unplanned increase in inventories, which triggers a
recession.
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 two models are related.
B. Aggregate Expenditure and Aggregate Demand
1. The aggregate expenditure
between aggregate planned
with all other influences
expenditure remaining the
curve is the relationship
expenditure and real GDP,
on aggregate planned
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.
2. Figure 25.10 (page 592/246) illustrates the effects of
a change in the price level on the AE curve,
equilibrium expenditure, and the quantity of real GDP
demanded.
a) In Figure 25.10(a), a rise in price level from 110
to 130 shifts the AE curve from AE0 downward to
AE1and decreases the equilibrium level of real
output from $10 trillion to $9 trillion.
b) In Figure 25.10(b), the same rise in the price
level that lowers equilibrium expenditure, brings a
movement along the AD curve to point A.
c) A fall in price level from 110 to 90 shifts the AE
curve from AE0upward to AE2 and increases
equilibrium l real GDP from $10 trillion to $11
trillion.
d) The same fall in the price level that raises
equilibrium expenditure brings a movement along the
AD curve to point C.
e) 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.
3. Figure 25.11 (page 593/247) 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.
D. Equilibrium Real GDP and the Price Level
1. Figure 25.12 (page 594/248) 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 25.12(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 25.12(b) real
GDP increases from $10 trillion from $11.3 trillion,
instead of to $12 trillion as it does with a fixed
price level.
4. Figure 25.13 (page 595/249) illustrates the long-run
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.
In the short run, the price level rises.