Aggregate Expenditure and Aggregate Demand

1. Aggregate Expenditure and Aggregate Demand CHAPTER 25 © 2003 South-Western/Thomson Learning

2. Aggregate Expenditure and Income • Here we build on the income-consumption connection to uncover the tie between income and total spending • Assumptions • No capital depreciation • No business saving • Each dollar spent on production translates directly into a dollar of aggregate income  GDP equals aggregate income • Investment, government purchases, and net exports are autonomous  independent of the level of income

3. Components of Aggregate Expenditure • To develop the aggregate demand curve, we begin by asking how much aggregate output would be demanded at a given price level • Our objective is to analyze the relationship between aggregate spending in the economy and aggregate income, or real GDP

4. Aggregate Expenditures • Aggregate expenditures equals the amount that households, firms, governments, and the rest of the world plan to spend on U.S. output at each level of real GDP • Consumption, C • Planned investment, I • Government purchases, G • Net exports, X – M • Consumption is the only spending component that varies with the level of real GDP

5. Simple Spending Multiplier • If we continue to assume that the price level remains unchanged, we can trace the effects of changes in planned spending on aggregate output demanded • The key point is that like a stone thrown into a still pond, the effect of any shift in planned spending ripples through the economy, generating changes in aggregate output that may far exceed the initial shift in planned spending

6. Simple Spending Multiplier • The cumulative spending resulting from an infinite series of rounds equals 1 / (1 – MPC) which in our example where the MPC was 0.8  1 / 0.2  5 • Thus, the initial increase in planned investment of $100 billion will eventually boost real GDP by 5 times this $100 billion, or $500 billion • Simple Spending Multiplier =1/(1–MPC)

7. Simple Spending Multiplier • The multiplier depends on the value of the MPC • Specifically, the larger the fraction of an increase in income that is spent each round, the larger the spending multiplier  the larger the MPC, the larger the simple multiplier • With an MPC of 0.8, the multiplier is 5 • With an MPC of 0.9, the multiplier is 10 • With an MPC of 0.75, the multiplier is 4

8. Simple Spending Multiplier • Recall from previous discussions that the MPC and the MPS must add up to 1 • Therefore, we can define the simple spending multiplier in terms of the MPS as follows: • Simple spending multiplier = 1 / MPS

9. Simple Spending Multiplier • In our example, the multiplier process started because of an increase in investment • The same impact would occur if any one of the components of aggregate expenditures changed • Finally, if the higher level of planned investment is not sustained in future years, real GDP would fall back and the multiplier process would work in reverse

10. Deriving the Aggregate Demand Curve • Thus far we have used the aggregate expenditure line to determine real GDP demanded for a given price level • What happens to the aggregate expenditure line if the price level changes • As will be seen, for each price level there is a specific aggregate expenditure line which yields a unique real GDP demanded  by altering the price level, we can derive the aggregate demand curve

11. A Higher Price Level • What is the effect of a higher price level on the economy’s aggregate expenditure line and, in turn, on real GDP demanded? • A higher price level • reduces consumption because it reduces the real value of dollar-denominated assets held by households • increases the market rate of interest which reduces investment • makes U.S. goods relatively more expensive abroad  imports rise and exports fall

12. Aggregate Demand and Expenditures • The aggregate expenditure line and the aggregate demand curve portray real output from different perspectives • The aggregate expenditure line shows, for a given price level, how planned spending relates to the level of real GDP in the economy • The aggregate demand curve shows, for various price levels, the quantities of real GDP demanded

13. Multiplier and Aggregate Demand • Suppose we return to the situation where the price level is assumed to be constant • What we want to do now is trace through the effects of a shift in any of the components of spending on aggregate demand, while assuming that the price level does not change, e.g., we want to look at the multiplier and shifts in aggregate demand

14. Limitations of the Multiplier • Our discussion of the simple spending multiplier exaggerates the actual effect we might expect from a given shift in the aggregate expenditure line • We have assumed that the price level remains constant. However, as we will see later, once we incorporate aggregate supply into the analysis, changes in the price level reduce the impact of the multiplier • Leakages such as higher income taxes and increased spending on imports all reduce the size of the multiplier • The spending multiplier takes time to work itself out  the process does not occur instantly