C H A P T E R C H E C K L I S T

2. 1 2 3 4 C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • Distinguish between autonomous expenditure and induced expenditure and explain how real GDP influences expenditure plans. Explain how real GDP adjusts to achieve equilibrium expenditure. • Describe and explain the expenditure multiplier. Derive the AD curve from equilibrium expenditure.

3. A QUICK REVIEW AND PREVIEW • The Economy at Full Employment • At full employment, real GDP equals potential GDP and the unemployment rate equals the natural unemployment. • Potential GDP and the natural unemployment rate are determined by realfactors and are independent of the price level.

4. A QUICK REVIEW AND PREVIEW • The quantity of money and money equilibrium determine nominal GDP. • Nominal GDP and potential GDP determine the price level. • So changes in the quantity of money change nominal GDP, • and change the price level, • but have no effect on potential GDP.

5. A QUICK REVIEW AND PREVIEW • Departures from Full Employment • Aggregate supply and aggregate demand determine equilibrium real GDP and the price level in the short run. • Fluctuations in aggregate supply and aggregate demand bring fluctuations around full employment – the business cycle. • In this chapter, we will develop a model based on Keynes’ ideas, the Aggregate Expenditure model, to explore how this can happen.

6. A QUICK REVIEW AND PREVIEW • Fixed Price Level • In the aggregate expenditure model, the price level is assumed to be fixed – not reality, but not a bad assumption for the short run. • The model helps explain: • What determines the quantity of real GDP demanded at a given price level • How the quantity of real GDP changes at a given price level.

7. 15.1 EXPENDITURE PLANS AND REAL GDP • From the circular flow of expenditure and income, aggregate expenditure is the sum of: • Consumption expenditure, C • Investment, I • Government purchases of goods and services, G • Net exports, (X – M) • Aggregate expenditure = C + I + G + (X – M).

8. 15.1 EXPENDITURE PLANS AND REAL GDP • Planned and Unplanned Expenditures – simple illustration: • Motorola decides to produce 11 million cell phones in 2001. • Motorola “plans” to sell 10 million phones and to put 1 million into inventory. • People and firms makes their expenditure plans and they decide to buy 9 million phones from Motorola. • Planned expenditure on phones is 10 million (9 million + 1 million), which is less than production of 11 million. • The other million get added to Motorola’s inventory.

9. 15.1 EXPENDITURE PLANS AND REAL GDP • Aggregate expenditure equals aggregate income and real GDP. • But aggregate planned expenditure might not equal real GDP because firms might end up with up more or less inventories than they planned. • Definition: Aggregate planned expenditure is planned consumption expenditure plus planned investment plus planned government expenditure plus planned exports minus planned imports.

10. 15.1 EXPENDITURE PLANS AND REAL GDP • Firms make their production plans, they pay incomes that equal the value of production, so aggregate income equals real GDP. • Households and governments make their planned purchases and net exports are as planned. • Firms make their planned purchases of new buildings, plant, and equipment, and their planned inventory changes.

11. 15.1 EXPENDITURE PLANS AND REAL GDP • If aggregate planned expenditure equals GDP, the change in firms’ inventories is the planned change. • If aggregate planned expenditure exceeds GDP, firms’ inventories are smaller than planned. • If aggregate planned expenditure is less than GDP, firms’ inventories are larger than planned. • Notice that actual expenditure, which equals planned expenditure plus the unplanned change in firms’ inventories, always equals GDP and aggregate income. Why? Because inventory change is part of investment – we count unplanned inventory change in investment.

12. 15.1 EXPENDITURE PLANS AND REAL GDP • Unplanned changes in firms’ inventories lead to changes in production and incomes. • If unwanted inventories have piled up, firms decrease production, which decreases real GDP. • If inventories have fallen below their target levels, firms increase production to rebuild their inventories to the desired level, which increases real GDP. This ‘inventory adjustment’ drives the model to ‘adjust’ and reach its new equilibrium.

13. 15.1 EXPENDITURE PLANS AND REAL GDP • Induced Expenditure and Autonomous Expenditure Definition: Autonomous expenditure The components of aggregate expenditure that do not change when real GDP changes are called ‘autonomous’ or ‘exogenous’ – determined outside the model. Jargon. Autonomous expenditure in this model equals planned investment plus government purchases plus exports plus the components of consumption expenditure and imports that are not influenced by real GDP.

14. 15.1 EXPENDITURE PLANS AND REAL GDP Definition: Induced expenditure The components of aggregate expenditure that change when real GDP changes are called ‘induced’ – GDP changes induce changes in these parts of expenditure. Induced expenditure in this model equals consumption expenditure minus imports (excluding the bits of consumption expenditure and imports that are part of autonomous expenditure).

15. 15.1 EXPENDITURE PLANS AND REAL GDP • The Consumption Function • Consumption function • The relationship between consumption expenditure and disposable income, other things remaining the same. • Disposable income is aggregate income (GDP) minus net taxes. • Net taxes are taxes paid to the government minus transfer payments received from the government.

16. 15.1 EXPENDITURE PLANS AND REAL GDP Figure 15.1 shows a consumption function. Each dot corresponds to a column in the table. Point A implies autonomous consumption is $1.5 trillion. As disposable income increases, consumption expenditure increases—induced consumption.

17. 15.1 EXPENDITURE PLANS AND REAL GDP Along the 45° line, consumption expenditure equals disposable income. 1.When the consumption function is above the 45° line, saving is negative (dissaving occurs). Note: We can only really talk with confidence about parts of the graph near where we are – extending it back to the origin is silly, things would change.

18. 15.1 EXPENDITURE PLANS AND REAL GDP 3.At the point where the consumption function intersects the 45° line, all disposable income is consumed and saving is zero. 2.When the consumption function is below the 45° line, saving is positive.

19. Change in consumption expenditure MPC = Change in disposable income 15.1 EXPENDITURE PLANS AND REAL GDP • Marginal Propensity to Consume • Definition: Marginal propensity to consume (MPC) is the fraction of a change in disposable income that is spent on consumption. The MPC is how many cents of an extra dollar in the public’s hands that gets spent rather than saved.

20. 15.1 EXPENDITURE PLANS AND REAL GDP Figure 15.2 shows how to calculate the marginal propensity to consume. 1. A $2 trillion change in disposable income brings 2.A $1.5 trillion change in consumption expenditure, so... 3. The MPC is $1.5 trillion ÷ $2.0 = 0.75.

21. 15.1 EXPENDITURE PLANS AND REAL GDP • Other Influences on Consumption • Other factors that influence planned consumption include: • The real interest rate • The buying power of money, i.e. the output price level • Expected future disposable income • A change in disposable income leads to a change in consumption expenditure and a movement along the consumption function – which graphs consumption expenditure as a function of disposable income.

22. 15.1 EXPENDITURE PLANS AND REAL GDP • A change in any other influence on planned consumption shifts the consumption function. • When the real interest rate decreases, or the buying power of money increases, or expected future income increases, consumption expenditure increases – meaning the function shifts up (to the left). • When the real interest rate increases, or the buying power of money decreases, or expected future income decreases, consumption expenditure decreases – meaning the curve shifts down (to the right).

23. 15.1 EXPENDITURE PLANS AND REAL GDP Figure 15.3 shows shifts in the consumption function. 1.A fall in the real interest rate or an increase in either the buying power of money or expected future income increases consumption expenditure and shifts the consumption function up from CF0 to CF1.

24. 15.1 EXPENDITURE PLANS AND REAL GDP 2.A rise in the real interest rate or a decrease in either the buying power of money or expected future income decreases consumption expenditure and shifts the consumption function down from CF0 to CF2.

25. 15.1 EXPENDITURE PLANS AND REAL GDP • Imports and GDP • Consumption expenditure is one major component of induced expenditure, imports are another. • In the short run, with prices fixed, the factor that most influences the quantity of imports is U.S. real GDP; in the short run, relatively fixed fractions of real GDP are imported [as intermediate goods by retailers and manufacturers]. • Definition: Marginal propensity to import is the fraction of an increase in real GDP that is spent on imports. • The marginal propensity to import equals the change in imports divided by the change in real GDP that brought it about.

26. 15.2 EQUILIBRIUM EXPENDITURE • Aggregate Planned Expenditure and GDP • Consumption expenditure increases when disposable income increases. • Disposable income equals aggregate income — GDP — minus net taxes, so disposable income and consumption expenditure increase when GDP increases. • We use this link between consumption expenditure and GDP to determine equilibrium expenditure.

27. 15.2 EQUILIBRIUM EXPENDITURE Aggregate expenditure (AE) is the sum of investment (I), government purchases (G), exports (X), consumption expenditure (C) minus imports (M). Figure 15.4 shows the AE curve.

28. 15.2 EQUILIBRIUM EXPENDITURE • Equilibrium Expenditure • Definition: Equilibrium expenditure is the level of aggregate expenditure when aggregate planned expenditure equals real GDP. • Equilibrium expenditure equals the real GDP at which the AE curve intersects the 45° line.

29. 15.2 EQUILIBRIUM EXPENDITURE Figure 15.5 shows equilibrium expenditure. 1. When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs. 2. When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs.

30. 15.2 EQUILIBRIUM EXPENDITURE Figure 15.5 shows equilibrium expenditure. 3. When aggregate planned expenditure equals real GDP, there are no unplanned inventory changes and real GDP remains at equilibrium expenditure.

31. 15.2 EQUILIBRIUM EXPENDITURE • Convergence to Equilibrium • At equilibrium expenditure, production plans and spending plans agree, and there is no reason to change production or spending. • But when aggregate planned expenditure and actual aggregate expenditure are unequal, production plans and spending plans are misaligned, and a process of convergence toward equilibrium expenditure occurs. • Throughout this convergence process, real GDP adjusts.

32. 15.2 EQUILIBRIUM EXPENDITURE • Back at Motorola – our simple illustration • Recall that in 2001 Motorola had an unwanted inventory increase. • So in 2002, Motorola cuts production. • Where does the process end? • The process ends when expenditure equilibrium is reached -- in other words, when producers sell all they plan to sell, planned aggregate expenditure equals real GDP. The essence of the model is that demand for output determines output, but output is income which influences demand for output via the consumption function.

33. 15.2 EQUILIBRIUM EXPENDITURE • When aggregate planned expenditure is less than real GDP, firms cut production and real GDP decreases. • Aggregate planned expenditure decreases, but real GDP decreases by more than the planned expenditure change because of the induced change in addition to the planned change, so eventually the gap between planned expenditure and actual expenditure closes.

34. 15.2 EQUILIBRIUM EXPENDITURE • Similarly, when aggregate planned expenditure exceeds real GDP, firms increase production and real GDP increases. • But real GDP increases by more than the increase in planned expenditure, because of the induced expenditure. • Eventually, the gap between planned expenditure and actual expenditure is closed.

35. 15.3 THE EXPENDITURE MULTIPLIER When investment increases, aggregate expenditure and real GDP also increase. Real GDP increasing increases disposable income which induces increased consumption expenditure, increasing real GDP further. So the final, equilibrium, increase in real GDP is larger than the initial increase in investment. Definition: The multiplier is the amount by which a change in investment is magnified or multiplied to determine the change that it generates in equilibrium expenditure and real GDP.

36. 15.3 THE EXPENDITURE MULTIPLIER • The Basic Idea of the Multiplier • The initial increase in investment brought an even bigger increase in aggregate expenditure because it induced an increase in consumption expenditure. • The multiplier determines the magnitude of the increase in aggregate expenditure that results from an increase in investment or another component of autonomous expenditure. • Consumption expenditure decisions, imports, and income taxes that make the change in disposable income smaller than the change in real GDP all influence the size of the multiplier.

37. 15.3 THE EXPENDITURE MULTIPLIER Figure 15.6 illustrates the multiplier. 1.A $0.5 trillion increase in investment shifts the AE curve upward by $0.5 trillion from AE0 to AE1. 2.Equilibrium expenditure increases by $2 trillion from $9 trillion to $11 trillion. 3.The increase in equilibrium expenditure is 4 times the increase in autonomous expenditure, so the multiplier is 4

38. Change in equilibrium expenditure Multiplier = Change in autonomous expenditure 15.3 THE EXPENDITURE MULTIPLIER • The Size of the Multiplier • The multiplier • The amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure that it generates. • That is,

39. 15.3 THE EXPENDITURE MULTIPLIER • Why Is the Multiplier Greater Than 1? • The multiplier is greater than 1 because an increase in autonomous expenditure induces an increase inaggregate expenditure in addition to the initial increase in autonomous expenditure.

40. 15.3 THE EXPENDITURE MULTIPLIER • The Multiplier and the MPC • The greater the marginal propensity to consume, the bigger the multiplier. • Ignoring imports and income taxes, the change in real GDP (Y) equals the change in consumption expenditure (C) plus the change in investment (I). • That is, • Y = C + I

41. 15.3 THE EXPENDITURE MULTIPLIER • Y = C + I But the change in consumption expenditure is determined by the change in real GDP and the marginal propensity to consume. It is: C = MPCY Now substitute MPCY for C in the equation at the top of the screen Y = MPCY + I

42. I Y = (1 – MPC) 15.3 THE EXPENDITURE MULTIPLIER Now solve for Y as: (1 – MPC) Y = I Rearrange to get

43. 1 = (1 – MPC) Y Y I I I Y = 1 1 (1 – MPC) = 4. = = 0.25 (1 – 0.75) 15.3 THE EXPENDITURE MULTIPLIER Now, divide both sides of the by the I to give: When MPC is 0.75, the multiplier is:

44. 15.3 THE EXPENDITURE MULTIPLIER • Imports and Income Taxes • The multiplier depends, in general, not only on consumption decisions but also on imports and income taxes. • Imports make the multiplier smaller than it otherwise would be because only expenditure on U.S.-made goods and services increases U.S. real GDP. • The larger the marginal propensity to import, the smaller is the change in U.S. real GDP that results from a change in autonomous expenditure.

45. 15.3 THE EXPENDITURE MULTIPLIER • Income taxes make the multiplier smaller than it would otherwise be. • When incomes increase, income tax payments increase and disposable income increases by less than the increase in real GDP. • Because disposable income determines consumption expenditure, the increase in consumption expenditure is less than it would be if income tax payments had not changed. • Note that if the MPC varies with income, as it does, the distributional structure of the income tax will also influence the size of the multiplier.

46. 15.3 THE EXPENDITURE MULTIPLIER • The marginal tax rate determines the extent to which income tax payments change when real GDP changes. • Definition: The marginal tax rate is the fraction of a change in real GDP that is paid in taxes that vary with income — the change in payments to government divided by the change in real GDP. Note in reality, this would include social security contributions, corporate income taxes, sales and excise taxes, and any other taxes that vary with income or expenditure, in addition to the personal income tax. • The larger the marginal tax rate, the smaller is the multiplier and the change in disposable income and real GDP that results from a given change in autonomous expenditure.

47. Y I 1 = (1 – Slope of AE curve) 15.3 THE EXPENDITURE MULTIPLIER • The marginal propensity to import and the marginal tax rate together with the marginal propensity to consume determine the multiplier. • Their combined influence determines the slope of the AE curve, which is the “marginal propensity to re-spend GDP on US-produced output,” i.e. the fraction of an extra $ of GDP spent on buying US-produced output. • The general formula for the multiplier is:

48. 15.3 THE EXPENDITURE MULTIPLIER Figure 15.7 shows the multiplier and the slope of the AE curve. With no imports and income taxes, the slope of the AE curve equals the marginal propensity to consume, which in this example is 0.75. A $0.5 trillion increase in autonomous expenditure increases real GDP by $2 trillion—the multiplier is 4.

49. 15.3 THE EXPENDITURE MULTIPLIER With imports and income taxes, the slope of the AE curve is less than the marginal propensity toconsume. In this example, the slope of the AE curve is 0.5. A $0.5 trillion increase in autonomous expenditure increases real GDP by $1 trillion—the multiplier is 2.

50. 15.3 THE EXPENDITURE MULTIPLIER Business-Cycle Turning Points Business-cycle turning points can be brought about by swings in autonomous expenditure such as investment and exports, or government purchases. The mechanism that then gives momentum to the economy’s new direction is the multiplier.