Aggregate Expenditure Multiplier

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14. Aggregate Expenditure Multiplier. CHECKPOINTS. Checkpoint 14.1. Checkpoint 14.2. Checkpoint 14.3. Problem 1. Problem 1. Problem 1. Clicker version. Problem 2. Problem 2. Problem 2. Clicker version. Problem 3. Problem 3. Problem 3. Clicker version. Clicker version.

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14

Aggregate Expenditure Multiplier

CHECKPOINTS

Checkpoint 14.1

Checkpoint 14.2

Checkpoint 14.3

Problem 1

Problem 1

Problem 1

Clicker

version

Problem 2

Problem 2

Problem 2

Clicker

version

Problem 3

Problem 3

Problem 3

Clicker

version

Clicker

version

Problem 4

Problem 4

Clicker

version

Problem 4

Clicker

version

Problem 5

Problem 5

Checkpoint 14.4

Problem 1

Problem 2

Problem 3

Practice Problem 1

The marginal propensity to consume is 0.8.

If disposable income increases by \$0.5 trillion, by how much will consumption expenditure change?

CHECKPOINT 14.1

Solution

The marginal propensity to consume is the fraction of a change in disposable income that is spent on consumption.

Consumption expenditure will increase by 0.8 multiplied by the change in disposable income of \$0.5 trillion.

Consumption expenditure will increase \$0.4 trillion.

CHECKPOINT 14.1

Practice Problem 2

Explain how each of the following events influences the U.S. consumption function:

The marginal propensity to consume decreases.

U.S. autonomous consumption decreases.

Americans expect an increase in future income.

CHECKPOINT 14.1
Solution

The marginal propensity to consume equals the slope of the consumption function.

So when the marginal propensity to consume decreases, the consumption function becomes flatter.

Autonomous consumption is the y-axis intercept of the consumption function.

So when autonomous expenditure decreases, the consumption function shifts downward.

CHECKPOINT 14.1

When expected future income increases, current consumption expenditure increases.

The consumption function shifts upward.

CHECKPOINT 14.1

Study Plan Problem

When the marginal propensity to consume decreases, the U.S. consumption function ___________.

A. becomes flatter

B. becomes steeper

C. shifts upward

D. shifts downward

CHECKPOINT 14.1

When when autonomous expenditure decreases, the U.S. consumption function ___________.

A. becomes flatter

B. becomes steeper

C. shifts upward

D. shifts downward

CHECKPOINT 14.1

When expected future income increases, the U.S. consumption function ___________.

A. becomes flatter

B. becomes steeper

C. shifts upward

D. shifts downward

CHECKPOINT 14.1

Practice Problem 3

The figure shows the consumption function.

What is the marginal propensity to consume, and what is autonomous consumption?

CHECKPOINT 14.1
Solution

When disposable income increases by \$100 billion, consumption expenditure increases by \$80 billion.

MPC is \$80 billion ÷ \$100 billion. = 0.8.

Autonomous consumption (consumption expenditure that is independent of disposable income) equals the y-axis intercept and is \$80 billion.

CHECKPOINT 14.1

Practice Problem 4

Americans cut back sharply on spending

In December 2007, consumer spending grew at the slowest rate in seven years. Despite the fact that average wages and salaries did not fall, consumer confidence, a barometer of economic health, plunged. Spending across the country dropped, but it was worse in states like Florida and California where home prices have fallen the most.

Source: The New York Times, January 14, 2008

Explain why consumers cut their spending when consumer confidence drops and house prices fall.

Does the drop in consumer spending arise from a movement along the consumption function or a shift of the consumption function? Explain.

CHECKPOINT 14.1
Solution

Consumer confidence drops when people become less certain about their future income.

A fall in house prices decreases consumers’ wealth.

Both the fall in expected future income and the decrease in wealth shift the consumption function downward.

CHECKPOINT 14.1

Practice Problem 1

The table gives real GDP (Y) and its components in billions of dollars.

Calculate aggregate planned expenditure when real GDP is \$200 billion and when real GDP is \$600 billion.

CHECKPOINT 14.2
Solution

Aggregate planned expenditure equals

C + I + G + X – M.

When real GDP is \$200 billion, aggregate planned expenditure equals

(\$170 + \$50 + \$60 + \$60  \$30) billion

= \$310 billion.

CHECKPOINT 14.2

Aggregate planned expenditure equals

C + I + G + X – M.

When real GDP is \$600 billion, aggregate planned expenditure equals

(\$410 + \$50 + \$60 + \$60  \$90) billion

= \$490 billion.

CHECKPOINT 14.2

Study Plan Problem

The table gives real GDP (Y) and its components in billions of dollars.

If real GDP is \$200 billion, then aggregate planned expenditure is _____.

A. \$340 billion

B. \$370 billion

C. \$310 billion

D. \$280 billion

CHECKPOINT 14.2

If real GDP is \$600 billion, then aggregate planned expenditure is _____.

A. \$670 billion

B. \$490 billion

C. \$580 billion

D. \$550 billion

CHECKPOINT 14.2
Practice Problem 2

The table gives real GDP (Y) and its components in billions of dollars.

Calculate equilibrium expenditure.

CHECKPOINT 14.2
Solution

Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP.

When real GDP is \$400 billion, aggregate planned expenditure equals

(\$290 + \$50 + \$60 + \$60 – \$60) billion

= \$400 billion.

Equilibrium expenditure is \$400 billion.

CHECKPOINT 14.2

Practice Problem 3

The table gives real GDP (Y) and its components in billions of dollars.

If real GDP is \$200 billion, explain the process that moves the economy toward equilibrium expenditure.

CHECKPOINT 14.2
Solution

If real GDP is \$200 billion, aggregate planned expenditure is \$310 billion.

Aggregate planned expenditure exceeds real GDP, so firms’ inventories decrease.

Expenditure plans are not fulfilled.

CHECKPOINT 14.2

Firms increase production to restore their inventories

Real GDP increases.

As long as aggregate planned expenditure exceeds real GDP, firms will increase production to restore their inventories to their target level.

Real GDP will increase until real GDP is \$400 billion—equilibrium expenditure.

CHECKPOINT 14.2

Study Plan Problem

If real GDP (Y) is \$200 billion, an unplanned ______ in inventories leads firms to_____ production, which _____ real GDP toward equilibrium.

CHECKPOINT 14.2

A. increase; decrease; decreases

B. decrease; decrease; decreases

C. increase; decrease; increases

D. decrease; increase; increases

E. decrease; increase; decreases

Practice Problem 4

The table gives real GDP (Y) and its components in billions of dollars.

If real GDP is \$600 billion, explain the process that moves the economy toward equilibrium expenditure.

CHECKPOINT 14.2
Solution

If real GDP is \$600 billion, aggregate planned expenditure is \$490 billion.

Aggregate planned expenditure is less than real GDP, so firms’ inventories increase.

Firms cut production and try to reduce their inventories.

Real GDP decreases.

CHECKPOINT 14.2

As long as aggregate planned expenditure is less than real GDP, firms’ inventories will increase.

Firms will cut production and try to reduce their inventories to their target level.

Real GDP decreases.

CHECKPOINT 14.2

Study Plan Problem

If real GDP is \$600 billion, an unplanned _______ in inventories leads firms to _______ production, which ______ real GDP toward equilibrium.

CHECKPOINT 14.2

A. increase; decrease; decreases

B. decrease; decrease; decreases

C. increase; decrease; increases

D. decrease; increase; increases

E. decrease; increase; decreases

Practice Problem 5

Wholesale inventories decline, sales rise

The Commerce Department reported that wholesale inventories fell 1.3 percent in August for a record 12th consecutive month, evidence that companies are trimming orders to factories, which helped depress economic output during the recession. Economists hope that the rising sales will encourage businesses to begin restocking their inventories, which would boost factory production and help bolster broad economic growth in coming months.

Source: The New York Times, October 8, 2009

Explain why a fall in inventories is associated with recession and a restocking of inventories might bolster economic growth.

CHECKPOINT 14.2

Solution

When firms reduce their target level of inventories, planned investment falls and equilibrium expenditure and real GDP decrease—as occurred during the year to August 2009.

When firms plan to restock their inventories, the reverse occurs. Equilibrium expenditure and real GDP increase.

CHECKPOINT 14.2

Practice Problem 1

An economy has no imports and no income taxes, MPC is 0.80, and real GDP is \$150 billion.

Businesses increase investment by \$5 billion.

Calculate the multiplier and the change in real GDP.

CHECKPOINT 14.3

Solution

The multiplier equals 1/(1 – MPC).

MPC is 0.8, so the multiplier is 5.

The multiplier = Change in real GDP ÷ Investment

Change in real GDP = Investment × Multiplier

= \$5 billion × 5.

Real GDP increases by \$25 billion.

The increase in investment increases real GDP by the multiplier (5) times the change in investment (\$5 billion).

CHECKPOINT 14.3

Practice Problem 2

An economy has no imports and no income taxes, MPC is 0.80, and real GDP is \$150 billion.

Businesses increase investment by \$5 billion.

Calculate the new level of real GDP and explain why real GDP increases by more than \$5 billion.

CHECKPOINT 14.3

Solution

The multiplier equals 1/(1 – MPC).

MPC is 0.8, so the multiplier is 5.

The increase in investment increases real GDP by the multiplier (5) times the change in investment (\$5 billion).

Real GDP increases by \$25 billion to \$175 billion.

Real GDP increases by more than \$5 billion because the increase in investment induces an increase in consumption expenditure.

CHECKPOINT 14.3

Practice Problem 3

An economy has no imports and no income taxes.

An increase in autonomous expenditure of \$2 trillion increases equilibrium expenditure by \$8 trillion.

Calculate the multiplier and the marginal propensity to consume.

CHECKPOINT 14.3

Solution

The multiplier equals the increase in equilibrium expenditure (\$8 trillion) divided by the increase in autonomous expenditure (\$2 trillion).

The multiplier is 4.

The multiplier is 1/(1 – MPC).

So 4 = 1/(1 – MPC), and MPC is 0.75.

The marginal propensity to consume is 0.75.

CHECKPOINT 14.3

Study Plan Problem

In an economy has no imports and no income taxes, an increase in autonomous expenditure of \$2 trillion increases equilibrium expenditure by \$8 trillion.

Calculate the multiplier and the marginal propensity to consume.

4; 0.25

0.25; –3.0

4; 0.75

D. 0.75; 4

CHECKPOINT 14.3

Practice Problem 4

An economy has no imports and no income taxes.

An increase in autonomous expenditure of \$2 trillion increases equilibrium expenditure by \$8 trillion.

What happens to the multiplier if an income tax is introduced?

CHECKPOINT 14.3

Solution

With an income tax the multiplier becomes

1/(1 – Slope of the AE curve).

If the government introduces an income tax, the slope of the AE curve becomes smaller.

So (1 – Slope of the AE curve) becomes larger and the multiplier becomes smaller.

CHECKPOINT 14.3

Study Plan Problem

In an economy has no imports and no income taxes, an increase in autonomous expenditure of \$2 trillion increases equilibrium expenditure by \$8 trillion. If an income tax is introduced, the multiplier ________ because the income tax _______the slope of the AE curve.

decreases; increases

decreases; decreases

increases; decreases

D. increases; increases

CHECKPOINT 14.3

Practice Problem 5

And the winner is ...

The game of winning the Olympic games has become popular with cities around the world. To win the 2016 games, Rio de Janeiro in Brazil spent some \$50 million. Now it will spend about \$50 billion to build new stadiums, other sports facilities, new bridges and roads, to extend the metro, and to double the number of hotel rooms.

Source: The Economist, October 8, 2009

Use the multiplier to explain why cities want to stage the Olympic games.

CHECKPOINT 14.3

Solution

The expenditure of \$50 billion will increase real GDP by more than \$50 billion because the expenditure multiplier exceeds 1.

When Rio embarks on its investment program (building new stadiums, sports facilities, roads, and bridges and extending the metro), new workers will be hired.

These workers will earn an income and they will spend part of it on consumption goods and services.

CHECKPOINT 14.3

With the increase in demand for goods and services, the sellers of those goods and services will hire more workers, who earn an income, and so on.

The \$50 billion of investment will increase real GDP by a multiple of \$50 billion.

CHECKPOINT 14.3

Practice Problem 1

The table sets out the aggregate expenditure schedules. Make a graph of the AE curves at each price level.On the graph, mark the equilibrium expenditure at each price level.

CHECKPOINT 14.4

Solution

CHECKPOINT 14.4

When the price level is 100, equilibrium expenditure is \$3 trillion.

When the price level is 110, equilibrium expenditure is \$2 trillion.

CHECKPOINT 14.4

Practice Problem 2

The table sets out the aggregate expenditure schedules. Construct the aggregate demand schedule and plot the AD curve.

CHECKPOINT 14.4

Solution

The quantity of real GDP demanded at each price level equals the equilibrium expenditure.

For example, at a price level of 90, the quantity of real GDP demanded is \$4 trillion.

CHECKPOINT 14.4

The table sets out the aggregate demand schedule and the figure plots the data.

CHECKPOINT 14.4

Practice Problem 3

Price jump worst since ‘91

The biggest annual jump in the CPI since 1991 has fanned fears about growing pressures on consumers. The Labor Department report confirms what every consumer in America has known for months now: Inflation is soaring and it’s having an adverse impact on the economy.

Source: CNN, July 16, 2008

Explain the effect of a rise in the price level on equilibrium expenditure.

CHECKPOINT 14.4

Solution

A rise in the price level decreases consumption expenditure, which decreases aggregate planned expenditure and shifts the AE curve downward.

Equilibrium expenditure decreases.

CHECKPOINT 14.4