expenditure multipliers. . 248 fixed prices and expenditure plans in the very short term, firms’...

ExpenditureMultipliers

ExpenditureMultipliers

.

2 Fixed Prices and Expenditure Plans

In the very short term, firms’ prices are fixed.

The quantities they sell depend on demand, not supply.

.

3 Fixed Prices and Expenditure Plans

The Aggregate Implications of Fixed Prices

1) Because each firm’s price is fixed, the price level is fixed.

.

4 Fixed Prices and Expenditure Plans

The Aggregate Implications of Fixed Prices

2) Because demand determines the quantities that each firm sells,

aggregate demand determines the aggregate quantity of goods and services sold, which equals GDP.

.

5 Fixed Prices and Expenditure Plans

The aggregate expenditure model explains fluctuations in aggregate demand by identifying the forces that determine expenditure plans.

.

6 Fixed Prices and Expenditure Plans

Expenditure Plans

The components of aggregate expenditure are:

1) Consumption expenditure

2) Investment

3) Government purchases of goods and services

4) Net exports (exports minus imports)

.

7 Fixed Prices and Expenditure Plans

Expenditure Plans (cont.)

Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government purchases plus planned exports minus planned imports.

.

8 Fixed Prices and Expenditure Plans

Expenditure Plans (cont.)

In the very short term all are fixed except planned consumption expenditure and planned imports.

They depend on the level of GDP.

.

9 Fixed Prices and Expenditure Plans

A Two-Way Link Between Aggregate Expenditure and GDP (cont.)

1) An increase in real GDP increases aggregate planned expenditure

.

10 Fixed Prices and Expenditure Plans

A Two-Way Link Between Aggregate Expenditure and GDP (cont.)

2) An increase in aggregate expenditure increases real GDP

How does real GDP influence planned consumption expenditure and saving?

.

11 Fixed Prices and Expenditure Plans

Consumption Function and Saving Function

We are going to focus on the relationship between consumption expenditures and disposable income when other factors are constant.

The reason: disposable income and consumption expenditures are interrelated.

.

12 Fixed Prices and Expenditure Plans

The main factors that influence consumption and saving are:

1) Real interest rate

2) Disposable income

3) Purchasing power of net assets

4) Expected future income

.

13 Fixed Prices and Expenditure Plans

Consumption Function and Saving Function

• The consumption function shows the relationship between consumption expenditure and disposable income.

• The saving function shows the relationship between saving and disposable income.

.

14Consumption Function and Saving Function

a 0 0.75 -0.75

b 11.50 -0.50

c 22.25 -0.25

d 33.00 0

e 43.75 0.25

f 54.5 0.50

PlannedDisposable consumption Plannedincome expenditure saving

(trillions of 1992 dollars per year)

.

15Consumption Function and Saving Function

Disposable income (trillions of 1992 dollars per year)

Con

sum

ptio

n ex

pend

iture

(t

rilli

ons

of 1

992

dolla

rs/y

ear)

1

2

3

4

5

0

a

b

c d

e

fSaving

DissavingConsumptionfunction

1 2 3 4 5

.

16 Consumption Functionand Saving Function

• Consumption expenditure that occurs when disposable income is zero is autonomous consumption.

• Consumption in excess of this is called induced consumption.

.

17 Consumption Functionand Saving Function

0

-1

1

1 3 4 5

Dissaving

SavingSavingfunction

a bc

de

f

Disposable income(trillions of 1992 dollars per year)

Sav

ing

(tri

llion

s of

199

2 do

llars

per

yea

r)

.

18 Fixed Prices and Expenditure Plans

Marginal Propensities to Consume and Save

The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed.

YD

CMPC

.

19 Fixed Prices and Expenditure Plans

Marginal Propensities to Consume and Save

The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved.

YD

SMPS

.

20 Fixed Prices and Expenditure Plans

Marginal Propensities to Consume and Save

Example:

• An increase in disposable income from $3 trillion to $4 trillion increases saving from zero to $0.25 trillion.

• The $1 trillion increase in disposable income increases saving by $0.25 trillion.

• The MPS is $0.25 trillion divided by $1 trillion, or 0.25.

.

21 Fixed Prices and Expenditure Plans

Marginal Propensities to Consume and Save

Example:

• The MPS plus the MPC always equals 1.

• Therefore, the MPC is 0.75.

.

22 Fixed Prices and Expenditure Plans

Marginal Propensities to Consume and Save

1

YD

S

YD

C

Divide both sides of the equation by the changein disposable income to obtain:

YDSC

.

23 Fixed Prices and Expenditure Plans

These two values are the marginal propensity to consume and the marginal propensity to save, so:

1 MPSMPC

.

24 Fixed Prices and Expenditure Plans

Slopes and Marginal Propensities

The slopes of the consumption function and the saving function are the marginal propensities to consume and save.

.

25

Consumptionfunction

Marginal Propensities to Consume and Save

Disposable income (trillions of 1992 dollars per year)

Con

sum

ptio

n ex

pend

itur

e (t

rill

ions

of

1992

dol

lars

/yea

r)

1

2

3

4

5

0 1 2 3 4 5

a

b

c d

e

f

45o line

1$YD trillion

75.0$C trillion

MPC= 0.75

.

26

0

-1

1

1

Savingfunction

3 4 5

a bc

de

f

Sav

ing

(tri

llion

s of

199

2 do

llars

per

yea

r)

Disposable income(trillions of 1992 dollars per year)

MPS= 0.25

1$YD trillion

25.0$S

Marginal Propensities to Consume and Save

.

27 Fixed Prices and Expenditure Plans

Other Influences on Consumption Expenditure and Saving

Changes in disposable income leads to movements along the consumption function and saving function.

.

28 Fixed Prices and Expenditure Plans

Other Influences on Consumption Expenditure and Saving

A change in any other factor that influences consumption expenditure and saving shifts both the consumption function and the saving function.

.

29 Fixed Prices and Expenditure Plans

The other factors that change consumption expenditure and saving are:

1) Real interest rates

2) The purchasing power of net assets

3) Expected future income

.

30 Shifts in the Consumptionand Saving Function

Disposable income (trillions of 1992 dollars per year)

Con

sum

ptio

n ex

pend

itur

e (t

rill

ions

of

1992

dol

lars

/yea

r)

1

2

3

4

5

0 1 2 3 4 5

45o line

CF0

CF1

CF2

.

31

0

-1

1

1 4 5

Sav

ing

(tri

llion

s of

199

2 do

llars

per

yea

r)

Disposable income(trillions of 1992 dollars per year)

2

SF0

SF1

SF2

3

Shifts in the Consumptionand Saving Function

.

32

The U.S. Consumption Function

.

33 Fixed Prices and Expenditure Plans

Consumption as a Function of Real GDP

• Consumption changes when disposable income changes.

• Disposable income changes when either real GDP changes or net taxes change.

.

34 Fixed Prices and Expenditure Plans

Consumption as a Function of Real GDP

• Holding taxes constant, consumption depends not only on disposable income, but also on real GDP.

• Imports are also influenced by real GDP.

.

35 Fixed Prices and Expenditure Plans

Import Function

• The greater the U.S. real GDP, the larger is the quantity of U.S. imports, other things remaining the same.

• The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports.

.

36

Learning Objectives

• Explain how expenditure plans are determined when the price level is fixed

• Explain how real GDP is determined when the price level is fixed

• Explain the expenditure multiplier

• Explain how imports and taxes influence the multiplier

.

37 Real GDP with a Fixed Price Level

How does aggregate expenditure plans interact to determine real GDP when the price level is fixed?

.

38 Real GDP with a Fixed Price Level

• First, we will study the relationship between aggregate planned expenditure and real GDP.

• Second, we’ll learn about the key distinction between planned expenditure and actual expenditure.

.

39 Real GDP with a Fixed Price Level

• An aggregate expenditure schedule lists aggregate planned expenditure generated at each level of real GDP.

• An aggregate expenditure curve is a graph of the aggregate expenditure schedule.

.

40Aggregate Planned Expenditure

a 0 0.75 0.5 0.55 1.2 0.0 3

b 2 2.25 0.5 0.55 1.2 0.5 4

c 4 3.75 0.5 0.55 1.2 1.0 5

d 6 5.25 0.5 0.55 1.2 1.5 6

e 8 6.75 0.5 0.55 1.2 2.0 7

f 10 8.25 0.5 0.55 1.2 2.5 8

AggregateConsumption Government planned

Real GDP expenditure Investment purchases Exports Imports expenditure(Y) (C) (I) (G) (X) (M) (AE=C+I+G+X–M)

(trillions of 1992 dollars)

Planned expenditure

.

41

I + G + X + C

Aggregate Planned Expenditure

Real GDP (trillions of 1992 dollars per year)

Agg

rega

te p

lann

ed e

xpen

ditu

re(t

rill

ions

of

1992

dol

lars

/yea

r)

2

4

6

8

10

0 2 4 6 8 10

II + G

I + G + X

AE

a b

cd

ef

Imports

Consumptionexpenditure

.

42 Aggregate Planned Expenditure and Real GDP

• Induced expenditure is the sum of the components of aggregate expenditure that vary with real GDP.

• Autonomous expenditure is the sum of the components of aggregate expenditure that are not influenced by real GDP.

.

43 Aggregate Planned Expenditure and Real GDP

Actual Expenditure, Planned Expenditure, and Real GDP

• Actual aggregate expenditure is always equal to real GDP

• However, aggregate planned expenditure is not necessarily equal to actual aggregate expenditure and therefore is not necessarily equal to real GDP.

.

44 Aggregate Planned Expenditure and Real GDP

Actual Expenditure, Planned Expenditure, and Real GDP

Actual and planned expenditure sometimes differ because firms might end up with more inventories than planned or with less inventories than planned.

.

45 Aggregate Planned Expenditure and Real GDP

Equilibrium Expenditure

• Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.

• When aggregate planned expenditure and actual aggregate expenditure are unequal, a process of convergence toward equilibrium expenditure occurs.

.

46 Aggregate Planned Expenditure and Real GDP

Convergence to Equilibrium

• When actual and planned expenditure are unequal, unplanned changes in business inventories (investment) occur.

• GDP either increases or decreases until actual expenditures equal planned expenditures.

.

47Equilibrium Expenditure

a 0 3–3

b 2 4 –2

c 4 5 –1

d 6 60

e 8 71

f 10 82

Aggregate planned UnplannedReal GDP expenditure inventory change

(Y) (AE) (Y-AE)

(trillions of 1992 dollars)

.

48

d

Plannedexpenditureexceeds real GDP

Equilibrium Expenditure

Real GDP (trillions of 1992 dollars per year)

Agg

rega

te p

lann

ed e

xpen

ditu

re(t

rill

ions

of

1992

dol

lars

/yea

r)

2.0

4.0

6.0

8.0

10.0

0 2 4 6 8 10

a

b c

e

f

Real GDP exceedsplanned expenditure

45o line

Equilibriumexpenditure

.

49Equilibrium Expenditure

0

–2.0

2.0

2 8 10

Unp

lann

ed in

vent

ory

chan

ge (

tril

lion

s of

199

2 do

llar

s pe

r ye

ar)

Real GDP(trillions of 1992 dollars per year)

4 6

4.0

–4.0

d

ab

c

e

f

Unplannedinventory investment

Unplannedincrease ininventories

Unplanneddecrease ininventories

.

50

The Multiplier

A fall in real interest rates, a wave of innovation, or an increase in the demand for U.S. exports will lead to an increase in autonomous expenditure.

.

51

The Multiplier

The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.

.

52

The Multiplier

The Basic Idea of the Multiplier

• Suppose that investment increases.

• This means that aggregate expenditure and real GDP increases.

• Disposable income increases.

• Consumption expenditures increase.

.

53

The Multiplier

The Basic Idea of the Multiplier

• Aggregate expenditure increases again.

• Real GDP, disposable income, and consumption expenditure increase more.

• The initial increase in investment brings an even bigger increase in aggregate expenditure because it induces an increase in consumption expenditure.

.

54The Multiplier

5 a 5.25 a' 5.75

6 b 6.00 b' 6.50

7 c 6.75 c' 7.25

8 d 7.50 d' 8.00

9 e 8.25 e' 8.75

Real GDP Original New(Y) (AE0) (AE1)

(trillions of 1992 dollars)

Aggregate planned expenditure

.

55The Multiplier

Real GDP (trillions of 1992 dollars)

Agg

rega

te e

xpen

ditu

re

(tri

llion

s of

199

2 do

llars

)

5

6

7

8

9

5 6 7 8 9

45o line

ab

c

d

e

e' AE0

…increasesreal GDP by$2 trillion

A $0.5 trillionincrease ininvestment...

AE1

a'

b'

c'

d'

0

.

56

The Multiplier

The Size of the Multiplier

The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure that it generates.

.

57

The Multiplier

The multiplier is (from the table shown earlier):

Multiplier =Change in equilibrium expenditureChange in autonomous expenditure

= = 4$2 trillion

$0.5 trillion

.

58

The Multiplier

The Multiplier and the Marginal Propensity to Consume and Save

The larger the marginal propensity to consume, the larger the multiplier.

.

59

The Multiplier

A change in real GDP equals the change in consumption expenditure plus the change in investment:

ICY

.

60

The Multiplier

But the change in consumption expenditure is determined by the change in real GDP and the marginal propensity to consume:

YMPCxC

.

61

The Multiplier

Substituting in the previous equation we get:

IYMPCY )(

YMPC

.

62

The Multiplier

Solving for we get:

MPC

IY

1

Y

.

63

The Multiplier

Dividing both sides of this equation by we get:

MPCI

YMultiplier

1

1

I

.

64

The Multiplier

Using this formula, with MPC = 0.75, the multiplier is:

425.0

1

)75.01(

1

Multiplier

.

65The Multiplier Process

Expenditure roundIncrease in current round

Cumulative increase from previous rounds

0

0.5

1.0

1.5

2.0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

.

66The Multiplier Process

Imports and Income Taxes

• The marginal propensity to import and the marginal tax rate also affects the multiplier.

• Imports and income taxes reduce the multiplier.

.

67

AE1

The Multiplier and theSlope of the AE Curve

Real GDP (trillions of 1992 dollars)

Agg

rega

te e

xpen

ditu

re(t

rilli

ons

of 1

992

dolla

rs)

5

6

7

8

9

5 6 7 8 9

45o line

bAE0

When the slope of the AEcurve is 0.75, the multiplier is

475.01

1

0

.

68 The Multiplier and theSlope of the AE Curve

Real GDP (trillions of 1992 dollars)

Agg

rega

te e

xpen

ditu

re(t

rilli

ons

of 1

992

dolla

rs)

5

6

7

8

9

5 6 7 8 9

AE1

45o line

AE0

When the slope of the AEcurve is 0.50, the multiplier is

250.01

1

0

.

69

The Multiplier

Business Cycle Turning Points

An Expansion Begins

• An expansion is triggered by an increase in autonomous expenditure that increases aggregate planned expenditure.

• At the trough of the business cycle, aggregate planned expenditure exceeds real GDP.

.

70

The Multiplier

Business Cycle Turning Points

An Expansion Begins

• Business inventories take an unplanned dive.

• Production increases and incomes increase.

• The multiplier effect causes the expansion to gain speed.

.

71

The Multiplier

Business Cycle Turning Points

A Recession Begins

• A recession is triggered by an decrease in autonomous expenditure that decreases aggregate planned expenditure.

• At the peak of the business cycle, real GDP exceeds aggregate planned expenditure.

.

72

The Multiplier

Business Cycle Turning Points

A Recession Begins

• Unplanned inventories begin to increase.

• Production decreases and incomes decrease.

• The multiplier effect causes the recession to take hold.

.

73

The Multiplier

Business Cycle Turning Points

The Next U.S. Recession?

• The U.S. economy has been in a business cycle expansion since 1991.

• Inventories began to increase in 1994, but they were planned increases.

• Recessions will occur — predicting them far in advance with any accuracy is virtually impossible.

.

74 The Multiplier andthe Price Level

When firms inventories fall below the desired level, they increase production.

• At some point, they also increase their prices.

When firms inventories are above the desired level, they decrease production.

• Eventually, they cut their prices.

.

75 The Multiplier andthe Price Level

We will use the aggregate supply-aggregate demand model to study the determination of real GDP and the price level.

.

76 The Multiplier andthe Price Level

• We must understand the distinction between the aggregate expenditure and aggregate demand.

• Furthermore, we must understand the distinction between their corresponding curves.

.

77 The Multiplier andthe Price Level

• The aggregate expenditure curve illustrates the relationship between the aggregate planned expenditure and real GDP.

• The aggregate demand curve illustrates the relationship between aggregate demand and the price level.

Let's look at how these are related

.

78 The Multiplier andthe Price Level

Aggregate Expenditure and the Price Level

The aggregate demand curve is downward sloping for two main reasons

1) Wealth effect

2) Substitution effects

.

79

AE2

AE0

Aggregate Demand

Real GDP (trillions of 1992 dollars)

Agg

rega

te p

lann

ed e

xpen

ditu

re(t

rilli

ons

of 1

992

dolla

rs)

5

6

7

8

9

5 6 7 8 9

AE1

45o lineEffect ofdecrease in price level

Effect ofincrease in price level

a

b

c

0

.

80Aggregate Demand

Real GDP (trillions of 1992 dollars)

Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

90

100

110

120

130

5 6 7 8 9

140

AD

a

b

c

Effect ofincreasein price level

Effect ofdecreasein price level

0

.

81

AE1

A Change in Aggregate Demand

Real GDP (trillions of 1992 dollars)

Agg

rega

te p

lann

ed e

xpen

ditu

re

(tri

llion

s of

199

2 do

llars

)

7

8

9

10

7 8 9 10

AE0

45o line

a

b

A $1 trillion increasein investment increasesaggregate planned expenditure...

0

.

82

AD1

Real GDP (trillions of 1992 dollars)

Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

90

100

110

120

130

140

a

b

AD0

…and increasesaggregate demand.The multiplier in thisexample is 2.

A Change in Aggregate Demand

7 8 9 100

.

83

A Change in Aggregate Demand

Summary

1) If some factor other that a change in the price level increases autonomous expenditure,

the AE curve shifts upward and the AD curve shifts rightward.

2) The size of the AD curve shift depends on the change in autonomous expenditure and the multiplier.

.

84 The Multiplier andthe Price Level

An Increase in Aggregate Demand in the Short Run

When price level effects are taken into account, an increase in investment still has a multiplier effect on real GDP, but the effect is smaller than it would be if the price level were fixed.

.

85 The Multiplier andthe Price Level

An Increase in Aggregate Demand in the Short Run

The steeper the slope of the short-run aggregate supply curve, the larger is the increase in the price level and the smaller is the multiplier effect on real GDP.

.

86

AE2

AE1

The Multiplier in the Short Run

Real GDP (trillions of 1992 dollars)

Agg

rega

te p

lann

ed e

xpen

ditu

re

(tri

llion

s of

199

2 do

llars

)

7

8

9

10

7 8 9 10

AE0

45o line

a

b

An increase in investmentincreases aggregate planned expenditure...

8.6

8.6

…but the pricelevel rises, whichdecreases aggregateplanned expenditure

c

0

.

87

AD1

The Multiplier in the Short Run

Real GDP (trillions of 1992 dollars)7 8 9 10

a

AD0

8.6

Pri

ce le

vel

(GD

P d

efla

tor,

199

2 =

100

)

90

100

110

130

140

116

SAS

b

c

…but the pricelevel rises, whichdecreases aggregateplanned expenditure

An increase in investmentincreases aggregate planned expenditure...

0

.

88 The Multiplier andthe Price Level

An Increase in Aggregate Demand in the Long Run

• In the long run, an increase in aggregate demand leaves real GDP unchanged but increases the price level.

• In the long run, the multiplier is zero.

.

89

AE2

AE1

The Multiplier in the Long Run

Real GDP (trillions of 1992 dollars)

Agg

rega

te p

lann

ed e

xpen

ditu

re

(tri

llion

s of

199

2 do

llars

)

6

7

8

9

7 8 9

AE0

45o line

a

6

b

c

a'

0

.

90The Multiplier in the Long Run

Real GDP (trillions of 1992 dollars)

Agg

rega

te p

lann

ed e

xpen

ditu

re

(tri

llion

s of

199

2 do

llars

)

6

7

8

9

7 8 9

AE0

45o line

a

6

a'

0

.

91

SAS1

AD1

The Multiplier in the Long Run

Real GDP (trillions of 1992 dollars)

a

AD0

90

100

110

130

140

SAS0

150

7 8 96

LAS

b116

c

8.6

a'

Pri

ce le

vel (

GD

P d

efla

tor)

0

.

92

Review

• A change in the price level shifts the AE curve and brings a movement along the AD curve.

• A change in autonomous expenditure that is not caused by a change in the price level shifts both the AE curve and the AD curve, and the multiplier determines the magnitude of the shift in the AD curve.

.

93

Review

• In the short run, the increase in real GDP that results from an increase in autonomous expenditure is smaller than the increase in aggregate demand.

• In the long run, an increase in aggregate demand leaves real GDP unchanged but increases the price level. In the long run, the multiplier is zero.

.

94

The Algebra of the Multiplier

.

95

The Algebra of the Multiplier

.

96

The Algebra of the Multiplier

.

97

Next:

The Federal Budget and

Fiscal Policy