Chapter 12 Aggregate Expenditures and Income

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Chapter 12Aggregate Expenditures and Income
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Introduction to Aggregate Expenditure

• Recessions and booms can result from shifts in
  the demand for goods and services.
• When demand falls firms scale back production,
  and lay off workers, and unemployment rises.
• When demand increases firms increase their
  production, and hire new workers, and
  unemployment falls.
• This chapter explores more deeply the
  relationship between demand or aggregate
  expenditures and equilibrium output or income.

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The Definition of Aggregate Expenditure

• The aggregate expenditures schedule traces out
  the relationship between aggregate expenditures
  and national income, holding real interest rates
  and inflation fixed.
• Aggregate expenditure is the total spending on
  goods in a domestic economy.
• AE C I G X M

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The Aggregate Expenditures Function
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The Slope of the Aggregate Expenditures Curve

• The AE schedule is upward sloping when national
  income rises, aggregate expenditures rise.
• The slope of the AE curve is less than 1.
• If national income rises by 1 billion, aggregate
  expenditures rise by less than 1 billion because
  some of the extra income is not spent but saved.
• When income is very low, AE exceed aggregate
  income because households will consume out of
  savings.

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The National Income-Output Identity

• Aggregate Output is always somebody's income.
• Aggregate Output GDP Y national income

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Equilibrium Output

• In equilibrium, aggregate output must be bought,
  so expenditures must equal output.
• In equilibrium Y AE.
• Where the AE curve intersects the 45-degree line,
  Y AE.
• Everything that is produced is purchased.
• Production equals spending or supply equals
  demand.

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When Spending Exceeds Output

• If AE gt Y, spending exceeds output.
• This is possible only if firms sell out of their
  inventories.
• So inventories fall.
• Firms respond by producing more, so output and
  income increase Y increases.

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When Output Exceeds Spending

• If AE lt Y, then total spending falls short of
  buying all output.
• Unsold goods cause inventories to rise.
• With accumulating inventories, firms produce
  less, so output and income fall until they equal
  AE.

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Shifts in the Aggregate Expenditures Schedule

• Shifts in the AE schedule occur whenever
  households, firms, the government, or foreigners
  want to buy more domestic goods.
• If aggregate expenditure increases by 1 billion,
  then output increases by more than 1 billion.

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Shift in Aggregate Expenditures

• When aggregate expenditures increase
• Spending exceeds output.
• Inventories fall.
• Firms respond by producing more.
• This extra spending becomes somebodys income,
  which they spend elsewhere in the economy.
• This second round of spending causes firms to
  increase production yet again.
• Called the multiplier process
• An injection of spending by increasing income
  which is spent elsewhere increases total spending
  and total output by a multiple of the initial
  injection.

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Mathematical Formulation

• If the AE curve is steep, then the increase in
  output and income once the economy has reached
  its new equilibrium will be large.
• Suppose consumption C a MPCY, where MPC
  slope of AE, 0 lt MPC lt 1.
• Also suppose that AE C.
• In equilibrium, Y AE.
• So Y C a MPCY.
• Solving for Y yields
• Y a/(1 - MPC)
• The larger the MPC the larger Y for any level of
  a.

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Showing Shifts in the AE Curve

• ?Y 1/(1 - MPC)?a gt ?a
• If b 0.9, then 1/(1 - b) 10 this is the
  multiplier.
• This says a 1 shift upward in the AE curve
  causes a 10 increase in equilibrium output and
  income with given interest rates and inflation
  rates.

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Showing Shifts in the AE Curve
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Consumption

• Consumption is the largest component of the U.S.
  GDP.
• Approximately 67 of GDP
• In the United States consumption and income are
  very closely related.
• The function C a MPCYd captures this.

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Consumption and Real GDP
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Consumption and Disposable Income
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The Marginal Propensity to Consume

• C a MPCYd, where Yd disposable, or
  after-tax, income.
• MPC marginal propensity to consume the amount
  consumption increases when disposable income
  increases by 1.
• Variable a changes and shifts consumption with
  changes in expectations, or consumer confidence,
  about the economy.
• MPC ?C/?Yd
• Yd C S ?Yd ?C ?S
• 1 MPC ?S/?Yd

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The Marginal Propensity to Save

• MPS the marginal propensity to save
• 1 MPC MPS
• MPS the amount private saving increases when
  disposable income increases by 1

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The MPC is the Slope of the AE Curve

• The MPC is the slope of the AE curve.
• When the MPC is large, the AE curve is steep.
• When the MPC is small, the AE curve is flat.
• C a MPCY assume no taxes for now.
• AE C I G a MPCY I G a MPCY
  E where E I G
• In equilibrium, Y AE
• Y a MPCY E
• Y (a E)/(1 - MPC)

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Taxes and the Slope of the Aggregate Expenditures
Schedule

• An increase in taxes reduces disposable income
  and consumption.
• An increase in income increases tax collections.
• Taxes T tY, where t income tax rate, 0 lt t
  lt 1.
• Yd Y - T Y tY (1 t)Y
• AE C E a MPCYd E where E I G
• AE a MPC(1 t)Y E
• The slope of the AE curve b(1 - t), which is
  smaller than before.
• The AE curve is flatter, so the multiplier is
  smaller.
• With income tax, there is greater leakage from
  aggregate expenditures.

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Solution for Equilibrium Output

• To solve for the equilibrium level of output and
  income use Y AE.
• Supply of output equals demand for output.
• AE a MPC(1 t)Y E
• In equilibrium Y AE so Y a MPC(1 t)Y
  E.
• We get
• Y E/1 MPC(1 t)
• where 1/1 MPC(1 t) gt 1 and is called the
  multiplier.

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Equilibrium Example

• Let E 5 trillion
• MPC 0.80 and t 0.25
• Using the above Y E/1 MPC(1 t)
• We get
• Y (5 trillion)/1 0.80(1 0.25) 5
  trillion/0.4 12.5 trillion
• The multiplier is 1/0.4 2.5.
• This means a 1 increase in E (due to an increase
  in either I or G) increases equilibrium output
  and income by 2.5.

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Equilibrium Effects of Changing Government
Purchases

• Now let G increase by 1 trillion so that E 6
  trillion.
• From the above formula Y E/1 MPC(1 t)
• We get Y (6 trillion)/ 0.4 15 trillion.
• DY 2.5 trillion from a 1 trillion increase
  in government purchases

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Explaining the Multiplier

• Why do aggregate output and income increase by
  more than the injection of government purchases?
• An extra 1 trillion of government purchases
  injects 1 trillion of spending into the economy
  to buy government goods and services.
• This spending becomes somebodys income, most of
  which they spend somewhere else (some of this
  income is not spent as people must pay taxes and
  may also save these are leakages).
• This second round of spending creates somebody
  elses income which they spend elsewhere, and so
  on.
• Each successive round of spending is smaller
  than the previous round since taxes must be paid
  and some of the income is saved. In sum this
  process is called the multiplier process.

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Shifts of the Consumption Function

• Expectations of future income
• Permanent income changes by changing both current
  and future income are likely to increase spending
  more than temporary changes in income.
• Permanent tax cuts are more likely to increase
  current consumption, aggregate spending, output
  and income than temporary tax cuts.
• Wealth
• Wealthier households consume more than poorer
  households at equal levels of current income.
• The stock market boom of late 1990s caused
  households to feel wealthier so consumption
  increased.
• The stock market fall in 2000 reduced wealth and
  consumption.

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Investment

• Investment accounts for between 10 and 17 of GDP
  in the United States.
• Investment is the purchase of new capital goods,
  new buildings, software, desks, and equipment,
  new homes by households, and additions to
  inventories.

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Investment and GDP
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Inventory Investment

• Investment is the most volatile part of aggregate
  expenditures and is the principal cause of
  fluctuations.
• Inventories are the most volatile part of
  investment.
• In our analysis of AE and output, inventories are
  the first to adjust.

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Changes in Investment
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Changes in Investment

• Investment depends negatively on the interest
  rate.
• The slope of the investment function is negative.
• Shifts in investment are due to changes in
  profitability, sales, business expectations about
  the future, the availability of credit, and risk.

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Government Purchases

• Government purchases represent spending on goods
  and services.
• For example, Social Security spending by the
  federal government is not part of government
  purchases because the government is not buying
  goods or services.
• Includes purchases by all levels of government
  federal, state and local
• An increase in government spending increases AE
  and, in equilibrium, increases output.

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Government Purchases

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Government Purchases

• State and local purchases are twice federal
  purchases
• Federal expenditures gt State and local
  expenditures
• Because federal spending includes Social Security
  and other transfer payments that are not a direct
  purchase of goods and services
• Fed spending 3 trillion but fed purchases
  700 billion
• G need not change with taxes since the government
  can borrow.

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Net Exports

• Net Exports Exports Imports trade balance
• NX X M
• In the United States X lt M so NX lt 0 or a trade
  deficit.

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Net Exports

• Remember NX S - I
• In late 1990s the United States ran a trade
  deficit as investment spending rose.
• Recently the United States ran a large trade
  deficit as the government deficit rose, pushing
  national saving lower.

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Net Exports
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Imports

• Imports increase when income increases.
• Imports IM MPI(Yd), where MPI marginal
  propensity to import
• Imports also depend on the exchange rate.
• Every international transaction requires two
  transactions first, one must buy the currency
  and then one can buy the good.
• When the domestic currency appreciates, foreign
  currency is cheaper, so foreign goods are cheaper
  and imports rise.

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Exports

• Exports depend on foreign income and the exchange
  rate.
• When foreign income increases U.S. exports
  increase.
• When the dollar gains value domestic goods are
  more expensive to foreigners so exports fall.

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Macroeconomic Implications of Net Exports

• Net exports NX X M
• Net exports increase when
• Domestic income falls (since imports fall).
• The domestic currency loses value or depreciates.
• Foreign income rises.
• Domestic citizens have a reduced taste for
  foreign goods.
• Foreign citizens' tastes for domestic goods
  increases.

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The Real Interest Rate and the Aggregate
Expenditures Schedule

• If real interest rates ?, then investment ?,
  consumption ?, and net exports ?.
• This means when r ? AE ? in equilibrium AE GDP
  Y ?.

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Factors that Shift the AE Up and Increase
Equilibrium Y

• Wealth increases or expectations of higher
  disposable income in the future
• Perceived risk in the economy falls
• increases investment spending
• Lower value for the dollar
• increases exports and decreases imports so NX
  rises
• Lower real interest rate
• increases investment spending as the real cost of
  borrowing falls