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## Aggregate Expenditure

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**Aggregate Expenditure**• Outline • Components of aggregate expenditure • Planned and unplanned expenditure • The consumption function • Imports and GDP • Equilibrium expenditure • The expenditure multiplier**Components of Aggregate Expenditure**• Recall from Chapter 5 that aggregate expenditure for final goods and services equals the sum of • Consumption expenditure, C • Investment, I • Government purchases of goods and services, G • Net exports, NX Thus:Aggregate expenditure = C + I + G + NX**Planned and Unplanned Expenditures**Aggregate expenditure aggregate income and real GDP. But aggregate planned expenditure might not equal real GDP because firms can end up with larger or smaller inventories than they had intended.**Autonomous versus induced Expenditure**• Autonomous expenditure: The components of aggregate expenditure that do not change when real GDP changes. • Induced expenditure: The components of aggregate expenditure that change when real GDP changes.**The Consumption Function**The consumption function shows the relationship between consumption expenditure and disposable income, holding all other influences on influences on household spending behavior constant.**What is disposable income?**• Disposable income is aggregate income (GDP) minus net taxes • Net taxes are taxes paid to government minus transfer payments received from government.**www.bea.gov**1991**450 line**Consumption (trillions of 1996 dollars) Saving F Consumption function E D 6.0 Dissaving C Saving is zero B 2.0 A 2.0 6.0 10.0 Disposable income (trillions of 1996 dollars) (trillions of 1996 dollars)**Notice that autonomous consumption is given by point A. This**is planned consumption expenditure when disposable income is zero ($1.5 trillion). This spending must be financed by past saving or by borrowing**Marginal Propensity to Consume (MPC)**The marginal propensity to consume (MPC) is the fraction of the change in disposable income that is spent on consumption. That is: Change in consumption expenditure MPC = Change in disposable income Notice that when disposable income increases from $6 to $8 trillion, consumption expenditure changes from $6.0 to $7.5 trillion. Thus we have:**MPC gives the slope of the consumption function**Consumption function E 7.5 D rise Consumption (trillions of 1996 dollars) 6.0 K run 0 6.0 8.0 Disposable income (trillions of 1996 dollars)**Determinants of**Consumption Expenditure Disposable income + (Expected) real interest rate - RealConsumptionSpending + The buying power of net assets + Expected future disposable income**Shifts of the consumption function**• CF0 to CF1 • Decrease in the real interest rate. • Buying power of net assets increases. • Rise in expected future disposable income. CF1 CF0 CF2 Consumption (trillions of 1996 dollars) 0 Disposable income (trillions of 1996 dollars)**Falling interest rates have stimulated consumer spending**recently**Imports and GDP**Imports are a component of induced expenditure. Imports depend partly on the health of the domestic economy.**Marginal Propensity to import (MPI)**The marginal propensity to import (MPI) is the fraction of the change in disposable income that is spent on imports . That is: Change imports MPI = Change in disposable income Suppose that, ceteris paribus, when disposable income increases from $2 trillion, imports increase by $0.3 trillion. Thus we have:**Aggregate Expenditure and Real GDP**Note: Y is real GDP**I + G + C + X**Agg. Exp. (billions of 1996 dollars) imports AE D Consumption expenditure C I + G + X 4.5 A 3 I + G I 0 9 GDP (Billions of 1996 dollars)**AE (trillions of 1996 dollars)**AE J 12 F D 9 B 6 K 450 0 3 9 15 GDP (trillions of 1996 dollars)**Case 1: GDP = $3 trillion**• AE > GDP by vertical distance B-K • Plans of producing and spending units do not coincide • Unplanned inventory investment = - $3 trillion • Tendency for firms (on average) to step up the pace of production and offer more employment**Case 2: GDP = $15 trillion**• GDP > AE by vertical distance J-F • Plans of producing and spending units do not coincide • Unplanned inventory investment =$3 trillion • Tendency for firms (on average) to scale back the on production and offer less employment**Case 3: GDP = $9 trillion**• AE = GDP • Plans of producing and spending units coincide. • Unplanned inventory investment = 0 • No tendency for firms (on average) to step up the pace of production and offer more employment. Nor is there a tendency for firms to scale back on production and offer less employment.**Say’s Law1**• “Supply creates its own demand.” • By producing goods and services, firms create a total demand for goods and services equal to what they have produced. Say’s law apparently rules out the possibility of a widespread glut of goods. 1 J.B. Say. Treatise on Political Economy, 1903.**Say’s law implies that full-employment equilibrium is the**normal state of affairs AE C + I + G + NX AE touchesthe 450 line at potential GDP Full employment GDP GDP**General (Keynesian) Case: Underemployment Equilibrium**AE A C + I + G + NX H Y* Full employment GDP GDP**What happens when things change?**• Assume the economy is in equilibrium when real GDP = $3 trillon. • What would happen if, other things being equal, planned investment (I) increased by $0.5 trillion?**How did a $0.5 trillion change in Ibring about a $2 trillion**change in GDP? AE2 AE 2 AE1 1 5 I 4.5 GDP 450 0 9.0 11.0 GDP**It’s a bird**It’s a plane No, it’s the multiplier effect!**The expenditure multiplier**The multiplier is amount by which a change in any component of autonomous expenditure is magnified or multiplied to determine the change that it generates in equilibrium expenditure and real GDP. Change in equilibrium expenditure Multiplier = Change in autonomous expenditure Thus in our case the multiplier is given by:**Chain of causation**When firms increase investment by $0.5 trillion, sales revenues at investment goods manufacturers (Boeing, Westinghouse, Cincinnati Milacron) will increase by $0.5 trillion 1 The $0.5 trillion in revenue will be distributed as factor payments to those supplying resources necessary to produce capital goods—hence the change in spending generates $0.5 trillion in income in the first round. 2**Now households have $1,000 in additional income. What do**they do with it? Their spending will increase by the MPC times the change in income—that is: C = .75 $0.5 trillion = $0.375 trillion Hence, households spend $375 billion and save $125billion 3 But the story does not end here, since McDonalds’s, Disney, Kraft, American Airlines, and Amheiser Busch, etc. will see their sales increase by $375 billion, and will distribute $375 billion in wages, salaries, rental income, and profits to those who supplied resources necessary to produce the additional consumer goods. 4**Those who earned additional income in consumer goods**industries will now increase their spending. By how much?C = .75 $375 = $281.85. 5 This will result in additional production and factor payments. Spending will then increase. And so on. And so on. 6**Why is the multiplier greater than 1?**As we see from the preceding illustration, a change in autonomous expenditure (in this case, I) induces a change in consumption expenditure.**The Multiplier and the MPC**We will now illustrate why the magnitude of the multiplier depends on the MPC. For the moment, assume no imports, exports, or taxes. Thus: [1] Where: [2] Now substitute [2] into [1] to obtain: [1]**Now solve for Y**[4] Now rearrange [4] [5] Divide both sides of [5] byI to obtain the multiplier The expenditure multiplier**You can see from the math that the size of the multiplier is**positively linked to the MPC. The higher the MPC, the greater the “induced” expenditure resulting from a change in autonomous expenditure**Taxes, Imports, and the Multiplier**Once we allow for imports and taxes, the multiplier depends not only on the MPC, but also on the marginal propensity to import (MPI) and the marginal tax rate (MTR)**Marginal Tax Rate (MTR)**The marginal tax rate (MTR) is the fraction of the change in real GDP that is paid income taxes. That is: Change in tax payments MTR = Change in real GDP Suppose that, ceteris paribus, when real GDP increases by $0.5 trillion, tax payments increase by $0.05 trillion. Thus we have:**The “real” expenditure multiplier**The multiplier is given by The slope of the AE curve is given by: Slope of AE curve = MPC – (MPI + MTR) Thus the multiplier can be written as:**In this case, MPC = 0.75; MPI = 0.15; MTR = 0.1**Slope = 0.5 AE2 AE 2 AE1 1 5 I 4.5 Y 450 0 9.0 10.0 GDP