Chapter 10

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Chapter 10Aggregate Expenditures
MACROECONOMICS EXPLORE APPLYby Ayers and
Collinge
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Learning Objectives

1. Summarize the perspective of Keynesian and
   Keynesian economics.
2. Illustrate the income-expenditure.
3. Explain the adjustment process to an expenditure
   equilibrium.
4. Describe how new spending can have a ripple
   effect throughout the economy.

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Learning Objectives

1. Distinguish the types of multipliers in the
   Keynesian model.
2. Graph the relationship of the income-expenditure
   model to aggregate demand.
3. (EA) Compare economic analyses of the Great
   Depression.

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10.1IN THE LONG RUN, WE ARE ALL DEAD

• Keynes chose to ignore long-run tendencies toward
  full employment.
• In his view the problems of unemployment could be
  solved only if people and government would buy
  more goods and services.
• Consumption spending is 70 of GDP, and it
  motivates investment spending.
• The Keynesian model is based around understanding
  how much spending is likely to occur at different
  levels of spending, and how government can
  influence that spending to ensure full employment.

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10.2THE INCOME-EXPENDITURE MODEL
One persons spending is another persons
income.
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The Income Expenditure Model

• The aggregate expenditures function tells what
  the economys planned spending will be at each
  level of real GDP.
• There will be only one GDP that does match up
  planned spending and actual spending.
• That GDP occurs at the expenditure equilibrium,
  where the AE function and the 45-degree line
  intersect.

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The Income Expenditure Model
45o Spendingproduction
Aggregate Expenditure Function
Expenditures
10 trillion
5 trillion
Real GDP (income)
10 trillion
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Components of Aggregate Expenditures

• Spending can be divided into two types
• Autonomous spending spending that would occur
  even if people had no income.
• Induced spending spending that depends upon
  income.

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Components of Aggregate Expenditures

• Autonomous spending includes both investments and
  goods.
• Draw upon previous wealth and savings.
• College students with no earnings drawing down
  their parents bank accounts to pay for room and
  board at school.
• Graphically, autonomous spending is a positive
  amount that shows up as a horizontal line.

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Components of Aggregate Expenditures

• Since induced spending is entirely dependent upon
  income, graphically it starts at zero starts at
  zero and GDP rises from there.
• When autonomous spending and induced spending are
  added together, the result is an aggregate
  expenditure function that has both a positive
  vertical intercept, and a positive slope.

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Aggregate Expenditures
Expenditures
10 trillion
5 trillion
0
Real GDP (income)
10 trillion
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Components of Aggregate Expenditures

• The components of aggregate expenditures are
  merely the components of GDP.
• GDP C I G (X-M)
• The consumption function because of autonomous
  spending has a positive vertical intercept.
• From there, it slopes upward because of the
  marginal propensity to consume (mpc).

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MPC and MPS

• The marginal propensity to consume (MPC) is the
  fraction of additional income that people spend.
• The marginal propensity to save (MPS) is the
  fraction of additional income that people save.

MPC MPS 1
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The Aggregate Expenditures Function

• Investment and government purchases are of
  roughly comparable size.
• If planned government purchases and investment
  spending are assumed to be completely autonomous,
  they will be constant as GDP changes.
• For this reason, the slope of the AE function and
  the consumption function are the same.

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Modeling the Expenditure Equilibrium

• When the economy is not at equilibrium, actual
  GDP and planned spending differ.
• Unintended inventory changes show up as the
  difference between planned and actual investment.

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Modeling the Expenditure Equilibrium
Expenditure equilibrium aggregate expenditures
actual GDP
where
Aggregate expenditures consumption planned
investment government net exports
and
GDP consumption actual investment
government net exports
Expenditure equilibrium planned investment
actual investment
which implies
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Modeling the Expenditure Equilibrium
45o Spendingproduction
1 if the economy starts here
2 A progression of inventory buildups less
production leads to the expenditures
equilibrium here.
Expenditures
Aggregate Expenditure Function
Real GDP (income)
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10.3CHANGING THE EXPENDITURE EQUILIBRIUM

• When there are changes in autonomous spending,
  the changes are magnified by the multiplier
  effect.
• Adding autonomous spending causes a higher GDP,
  which causes more induced spending.
• Thats because money that one person spends
  autonomously adds to income of others, which in
  turn induces them to buy more output.
• At each stage in this cycle, however, some income
  is saved, thus eventually bringing the cycle to a
  halt.

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The Multiplier Effect
Aggregate expenditure function
Expenditures
The multiplier effect causes a small increase in
autonomous expenditures to have a much larger
effect on GDP.
Real GDP (income)
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The Multiplier Effect

• The strength of the multiplier effect depends
  upon the proportion of income that is devoted to
  consumption.
• To the extent that people save their incomes,
  savings represents a leakage out of the
  multiplier process.
• A negative value for savings means that there is
  dissaving spending out of existing savings.

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Spending Depends upon the Marginal Propensity to
Consume (mpc)
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The Expenditure Multiplier
Expenditure multiplier 1/mps or 1/(1-MPC)
? Autonomous spending x 1/mps

? Expenditure equilibrium
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The Multiplier Effect

• The multiplier is multiplied by a change in
  autonomous spending to reveal the change in
  equilibrium GDP.
• There must be some idle resources for the
  multiplier effect to occur.
• Keynesian multiplier analysis assumes a constant
  price level.

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Recession and Inflation within the
Income-Expenditure Model

• If the expenditure equilibrium lies below
  full-employment GDP, it is called an unemployment
  equilibrium.
• Along with the unemployment equilibrium comes an
  output gap, in which actual GDP falls below
  full-employment GDP.
• At an unemployment equilibrium, there is to
  little spending for the economy to achieve full
  employment GDP.

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Recession and Inflation within the
Income-Expenditure Model
The shortfall in spending is called a
recessionary gap.

• If the expenditure equilibrium lies below
  full-employment GDP, it is called an unemployment
  equilibrium.
• Along with the unemployment equilibrium comes an
  output gap, in which actual GDP falls below
  full-employment GDP.
• At an unemployment equilibrium, there is to
  little spending for the economy to achieve full
  employment GDP.

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Recession and Inflation within the
Income-Expenditure Model

• If the expenditure equilibrium occurs past the
  full-employment GDP, multiplier analysis does not
  apply, because inflation will not allow it to
  stay there.
• This possibility is referred to as an
  inflationary gap, which is the excess of the
  aggregate expenditure function above that
  consistent with a full employment equilibrium.

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Making Policy with Multipliers

• Keynesian analysis suggest that govern can use
  taxes to stimulate the economy.
• However people might save some of their higher
  after tax income rather than spend it. The tax
  multiplier, which is the expansionary, or
  contractionary effect of a tax cut, or increase
  would be less than the multiplier by the amount
  of the initial round of spending.

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Making Policy with Multipliers
Tax Multiplier -mpc/(1-mpc)
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Balanced Budget Multiplier

• Keynesians view extra government spending as the
  most effective policy to cure a recession.
• The balanced-budget multiplier combines the
  expenditure multiplier for an increase in
  government spending and the tax multiplier
  because taxes would increase to finance that
  spending.

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Making Policy with Multipliers
Balanced Budget Multiplier 1/(1-mpc)
mpc/(1-mpc) (1-mpc)/(1-mpc)1
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10.4 AGGREGATE DEMAND
45o Spendingproduction
Expenditures
Actual Real GDP (income)
Price Level
Real GDP
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10.5 EXPLORE APPLYThe Great Depression

• The 1920s era of prosperity peaked in early
  1929.
• A few months later the stock market crashed.
• The Great Depression began and did not end for
  over a decade.
• Keynesian aggregate expenditure analysis can be
  used to describe the depression and the policy
  action to correct it.

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Terms Along the Way

• income-expenditures model
• aggregate expenditures
• aggregate expenditures function
• expenditure equilibrium

• autonomous spending
• induced spending
• consumption function
• marginal propensity to consume
• marginal propensity to save

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Terms Along the Way

• multiplier effect
• expenditure multiplier
• unemployment equilibrium
• output gap

• recessionary gap
• inflationary gap
• tax multiplier
• balanced budget multiplier

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Test Yourself

• John Maynard Keynes offered a long-run
  perspective on the macro-economy in the general
  theory.
• If you had no income you could still engage in
  induced spending.
• The marginal propensity to consume must be 1 or
  less.
• An expenditure equilibrium occurs where the
  aggregate expenditure function intersects the
  vertical axis.
• An injection of new autonomous spending will
  leave equilibrium real GDP unchanged when the
  marginal propensity to save equals 0.5.

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Test Yourself

• 2. Suppose actual spending equals planned
  spending. Then we can say
• the economy is at an expenditure equilibrium.
• real GDP is the most it can possibly be.
• autonomous spending equals zero.
• aggregate demand has shifted to the left.

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Test Yourself

• 3. In the income expenditures model the 45-degree
  line shows
• the amount of autonomous spending.
• the amount of induced spending.
• the expenditure multiplier.
• that the economys expenditures are actually the
  same as its output. .

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Test Yourself

• 4. Aggregate expenditures include all of the
  following except
• consumption.
• planned investment.
• net exports.
• unintended changes in business inventories.

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Test Yourself

• 5. The marginal propensity to consume equals
• the fraction of their total income that people
  consume.
• the fraction of additional income that people
  consume.
• the fraction of their savings that people plan to
  spend within the next year.
• one in most cases..

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Test Yourself

• 6. The paradox of thrift, if true suggest that
  people should
• save more.
• spend more.
• vote more often.
• spend the same amount of money, but spend it more
  wisely.

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The End! Next Chapter 11 Fiscal Policy in Action"