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A ggregate E xpenditure. AE = C + I + G + NX C = C onsumption expenditures Durable goods: T.V.’s, and cars. Does not include houses Non-durable goods: clothing, food, and fuel Services: health care, education I = I nvestment expenditures

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slide1

Aggregate Expenditure

AE = C + I + G + NX

C = Consumption expenditures

  • Durable goods: T.V.’s, and cars. Does not include houses
  • Non-durable goods: clothing, food, and fuel
  • Services: health care, education

I = Investment expenditures

  • Business fixed investment on structures (factories, warehouses) and equipment (vehicles, furniture, computers)
  • Residential investment on the construction of new homes

G = Government expenditures on goods and services

  • New aircraft carriers, Air Force I, Presidential limo, FBI vehicles, etc.
  • Does the government buy US products only?

NX = net exports = eXports – iMports

  • X is the amount spent by foreigners on goods built in the USA
  • M is the amount spent by Americans on goods from outside of the USA
slide2

Consumption expenditure

Simulated consumption

  • The Consumption function is the relationship between consumption and disposable income
  • Disposable income (DI) is aggregate income (GDP) minus net taxes (T).

DI = Y – T

where T = taxes paid to the government minus transfer payments received from the government.

  • The diagram to the right shows how C and DI evolve over time.
  • Download the data, use Excel to derive the C function

http://research.stlouisfed.org/fred2/graph/?g=o4I

slide3

Consumption expenditure

Simulated consumption

A =W + Ye – PL – r

C = A + mpc∙DI

C = [W + Ye – PL – r ]+ mpc∙DI

  • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = [W+ Ye– PL – r ] + mpc∙DI

slide4

Consumption expenditure

Simulated consumption

A =W + Ye – PL – r

C = A + mpc∙DI

C = [W + Ye – PL – r ]+ mpc∙DI

  • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = [5 + Ye– PL – r ] + mpc∙DI

slide5

Consumption expenditure

Simulated consumption

A =W + Ye – PL – r

C = A + mpc∙DI

C = [W + Ye – PL – r ]+ mpc∙DI

  • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = [5 + 7 – PL – r ] + mpc∙DI

slide6

Consumption expenditure

Simulated consumption

A =W + Ye – PL – r

C = A + mpc∙DI

C = [W + Ye – PL – r ]+ mpc∙DI

  • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = [5 + 7 – 8 – r ] + mpc∙DI

slide7

Consumption expenditure

Simulated consumption

A =W + Ye – PL – r

C = A + mpc∙DI

C = [W + Ye – PL – r ]+ mpc∙DI

  • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = [5 + 7 – 8 – 2] + mpc∙DI

slide8

Consumption expenditure

Simulated consumption

A =W + Ye – PL – r

C = A + mpc∙DI

C = [W + Ye – PL – r ]+ mpc∙DI

  • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = [5 + 7 – 8 – 2] + 0.75∙DI

slide9

Consumption expenditure

Simulated consumption

A =W + Ye – PL – r

C = A + mpc∙DI

C = [W + Ye – PL – r ]+ mpc∙DI

  • Example: Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = 2 + 0.75∙DI

slide10

Consumption expenditure

Simulated consumption

  • Example (continued):

C = 2 + 0.75DI

When DI = 0

C = 2 + 0.75(0)

C = 2

When DI = 8

C = 2 + 0.75(8)

C = 2 + 6

C = 8

C

8

2

0

8

DI

slide11

Consumption expenditure

Simulated consumption

  • Example (continued):

C = 2 + 0.75DI

When consumption lies on the 45° line, all disposable income is consumed and saving is zero.

Saving = DI – C

= 8 – 8

= 0

C

45o

8

2

0

8

DI

slide12

Consumption expenditure

Simulated consumption

  • Example (continued):

C = 2 + 0.75DI

When consumption lies below the 45° line, saving occurs.

When DI = 9

C = 2 + 0.75(9)

= 2 + 6.75

= 8.75

S = DI – C

= 9 – 8.75

= 0.25

C

45o

8.75

2

0

9

DI

slide13

Consumption expenditure

Simulated consumption

  • Example (continued):

C = 2 + 0.75DI

When consumption lies above the 45° line, dissaving occurs.

When DI = 7

C = 2 + 0.75(7)

= 2 + 5.25

= 7.25

S = DI – C

= 7 – 7.25

= –0.25

C

45o

7.25

2

0

7

DI

slide14

Consumption expenditure

Simulated consumption

  • Example (continued): With real GDP held constant at 11 trillion dollars, show what happens to the consumption model when
    • consumer wealth rises to 5.5 trillion dollars
    • expected future income decreases to 6.5 trillion dollars
    • price level increases to 8.5 thousand dollars
    • mpc increases to 0.8
    • real rate of interestincreases by 0.5 pct. points
    • tax revenue is cut by 0.5 trillion dollars
    • government expenditure is raised by 0.5 trillion dollars

What is monetary policy, and who conducts it?

What is fiscal policy, and who conducts it?

Compute the budget balance. Is there a budget deficit or surplus?

slide15

Consumption expenditure

Simulated consumer expenditure

  • Because AE, AD, SRAS, and LRAS are graphed with Y on the horizontal axis, C should be too:

C = [W + Ye – PL – r ] + mpc∙DI

DI = Y – T

C = [ W + Ye – PL – r ] + mpc∙(DI)

C = [ W + Ye – PL – r ] + mpc∙(Y – T)

C = [ W + Ye – PL – r ] + mpc∙Y – mpc∙T

C = [ W + Ye – PL – r – mpc∙T] + mpc∙Y

slide16

Consumption expenditure

Simulated consumer expenditure

  • Example (continued): With real GDP held constant at 11 trillion dollars, show what happens to the consumption model when
    • consumer wealth rises to 5.5 trillion dollars
    • expected future income decreases to 6.5 trillion dollars
    • price level increases to 8.5 thousand dollars
    • mpc increases to 0.8
    • real rate of interestincreases by 0.5 pct. points
    • tax revenue is cut by 0.5 trillion dollars
    • government expenditure is raised by 0.5 trillion dollars

What is monetary policy, and who conducts it?

What is fiscal policy, and who conducts it?

Compute the budget balance. Is there a budget deficit or surplus?

slide17

Net foreigner expenditure

Import function

  • Money is spent on domestic products (C ) & imported products (M ). M is the amount spent by Americans on goods from outside of the USA.
  • In the short run, the factor influencing imports is U.S. real GDP
  • If Y = 0, products cannot be imported (M = 0)
  • As Y rises, expenditures on imports increase.
  • Download the following data to generate an empirical iMport function
  • http://research.stlouisfed.org/fred2/graph/?g=o4M
  • Marginal Propensity to iMport is the fraction of a rise in Y spent on imports.
  • M = mpm∙Y
  • Simulated net foreigner expenditure
  • eXports are exogenous
  • NX = X – M
  • NX = X – mpm∙Y
  • Example: In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • NX = 0.5– 0.25∙Y
slide18

Aggregate Expenditure

Simulated AE

AE =[C]+ I + G + NX }

slide19

Aggregate Expenditure

Simulated AE

AE =[C]+ I + G + {NX}

NX = X – mpm∙ Y

C = W + Ye – PL – r – mpc∙ T + mpc∙ Y

AE =[W + Ye – PL – r – mpc∙ T + mpc∙ Y] + I + G + {X –mpm∙ Y}

AE =[W + Ye – PL – r – mpc∙ T + I + G + X]+mpc∙ Y – mpm∙ Y

AE =[W + Ye – PL – r – mpc∙ T + I + G + X]+{mpc– mpm}∙ Y

slide20

Aggregate Expenditure

Simulated AE

AE =[C]+ I + G + {NX}

M = mpm∙ Y

C = W + Ye – PL – r – mpc∙ T + mpc∙ Y

AE = [W + Ye – PL – r – mpc∙ T + mpc∙ Y]+ I + G + X – {mpm∙ Y }

AE = [W + Ye – PL – r – mpc∙ T + I + G + X]+ mpc∙ Y – mpm∙ Y

AE = [W + Ye – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y

slide21

Aggregate Expenditure

  • Example: In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.

Simulated AE

slide22

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [W + Ye – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y

Simulated AE

slide23

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + Ye – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y

Simulated AE

slide24

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y

Simulated AE

slide25

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y

Simulated AE

slide26

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – 2 – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y

Simulated AE

slide27

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – 2 – 0.75∙ T + I + G + X]+ {0.75– mpm}∙ Y

Simulated AE

slide28

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 + I + G + X]+ {0.75– mpm}∙ Y

Simulated AE

slide29

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + G + X]+ {0.75– mpm}∙ Y

Simulated AE

slide30

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + 3.5 + X]+ {0.75– mpm}∙ Y

Simulated AE

slide31

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + 3.5 + 0.5]+ {0.75– mpm}∙ Y

Simulated AE

slide32

Aggregate Expenditure

  • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation.
  • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + 3.5 + 0.5]+ {0.75– 0.25}∙ Y
  • AE = 4.75 + 0.5Y

When Y = 0

AE = 4.75 + 0.5(0) = 4.75

When Y = 9.5

AE = 4.75 + 0.5(9.5) = 9.5

Simulated AE

slide33

Aggregate Expenditure

Simulated AE

  • Example:

Point 1

Y = 0

AE = 4.75

Point 2

Y = 9.5

AE = 9.5

  • Since aggregate planned expenditure equals GDP, the change in firms’ inventories equals the planned change.
  • The AE model has reached an equilibrium

AE

45o

9.5

4.75

0

9.5

Y

slide34

Aggregate Expenditure

Simulated AE

  • Example: Suppose real GDP is $12 trillion.

AE = 4.75+ 0.5(12)

= 4.75 + 6

= 10.75

AE < Y

  • When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs.

AE

45o

10.75

0

12

Y

slide35

Aggregate Expenditure

Simulated AE

  • Example: Suppose real GDP is $12 trillion.

AE = 4.75+ 0.5(12)

= 4.75 + 6

= 10.75

AE < Y

  • When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs.
  • firms cut production. Real GDP decreases until it reaches equilibrium.

AE

45o

10.75

9.5

AE = Y

0

9.5

12

Y

slide36

Aggregate Expenditure

Simulated AE

  • Example: Suppose real GDP is $8 trillion.

AE = 4.75+ 0.5(8)

= 4.75 + 4

= 8.75

AE > Y

  • When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs.

AE

45o

8.75

0

8

Y

slide37

Aggregate Expenditure

Simulated AE

  • firms raise production. Real GDP increases until it reaches equilibrium.
  • Example: Suppose real GDP is $8 trillion.

AE = 4.75+ 0.5(8)

= 4.75 + 4

= 8.75

AE > Y

  • When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs.

AE

45o

9.5

8.75

AE = Y

0

8

9.5

Y

slide38

Aggregate Expenditure

Simulated AE

  • Example: (continued): With real GDP equal to 9.5 trillion dollars, show what happens if
  • consumer wealth rises to 5.5 trillion dollars
  • expected future income decreases to 6.5 trillion dollars
  • The price level increases to 8.5 thousand dollars
  • investment expenditure falls to 0.5 trillion dollars
  • exports rise to 1 trillion dollars
  • real rate of interestincreases by 0.5 pct. points
  • tax revenue is cut by 0.5 trillion dollars. Compute the tax cut multiplier. Compute the budget balance.
  • government expenditure is raised by 0.5 trillion dollars. Compute the government expenditure multiplier. Compute the budget balance.

What is monetary policy, and who conducts it?

What is fiscal policy, and who conducts it?

slide39

5.25

Aggregate Expenditure

Simulated AD

  • Example: (continued)

What happens if the price level falls by $0.5 thousand?

AE = [5 + 7 – 8 – 2 – 0.75∙3 + 1 + 3.5 + 0.5]+ {0.75– 0.25}∙Y

AE = 5.25+ 0.5Y

7.5

AE

PL

45o

AE > Y

Unplanned decrease in inventories

Real GDP rises

8

7.5

AE = 5.25 + 0.5 Y

Y = 5.25 + 0.5 Y

4.75

AD

0.5Y= 5.25

Y= 10.5

0

0

9.5

10.5

10.5

9.5

Y

Y