How big is the government

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How big is the government expenditure multiplier?
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14
Aggregate Expenditure Multiplier
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1 Explain how real GDP influences expenditure
plans. 2 Explain how real GDP adjusts to achieve
equilibrium expenditure. 3 Explain the
expenditure multiplier. 4 Derive the AD curve
from equilibrium expenditure.
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14.1 EXPENDITURE PLANS AND REAL GDP

• From the circular flow of expenditure and income,
  aggregate expenditure is the sum of
• Consumption expenditure, C
• Investment, I
• Government expenditure on goods and services, G
• Net exports, NX
• Aggregate expenditure C I G NX.

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14.1 EXPENDITURE PLANS AND REAL GDP

• Aggregate planned expenditure is the sum of the
  spending plans of households, firms, and
  governments.
• Aggregate planned expenditure is planned
  consumption expenditure, plus planned investment,
  plus planned government expenditure, plus planned
  exports, minus planned imports.
• We divide aggregate expenditure plans into
  autonomous expenditure and induced expenditure.

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14.1 EXPENDITURE PLANS AND REAL GDP

• Autonomous expenditure is the components of
  aggregate expenditure that do not change when
  real GDP changes.
• Autonomous expenditure equals investment, plus
  government expenditure, plus exports, plus the
  components of consumption expenditure and imports
  that are not influenced by real GDP.

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14.1 EXPENDITURE PLANS AND REAL GDP

• Induced expenditure is the components of
  aggregate expenditure that change when real GDP
  changes.
• Induced expenditure equals consumption
  expenditure minus imports (excluding the elements
  of consumption expenditure and imports that are
  part of autonomous expenditure).

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14.1 EXPENDITURE PLANS AND REAL GDP

• The Consumption Function
• Consumption function is the relationship between
  consumption expenditure and disposable income,
  other things remaining the same.
• Disposable income is aggregate income (GDP) minus
  net taxes.
• Net taxes are taxes paid to the government minus
  transfer payments received from the government.

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14.1 EXPENDITURE PLANS AND REAL GDP

• Figure 14.1 shows the consumption function.

Each dot corresponds to a column of the table.
Point A shows that autonomous consumption is 2
trillion.
As disposable income increases, consumption
expenditure increasesinduced consumption.
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14.1 EXPENDITURE PLANS AND REAL GDP

• Along the 45 line, consumption expenditure
  equals disposable income.

1. When the consumption function is above the 45
line, saving is negative (dissaving occurs).
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14.1 EXPENDITURE PLANS AND REAL GDP
2. When the consumption function is below the 45
line, saving is positive.

• 3. At the point where the consumption function
  intersects the 45 line, all disposable income is
  consumed and saving is zero.

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14.1 EXPENDITURE PLANS AND REAL GDP

• Marginal Propensity to Consume
• Marginal propensity to consume (MPC) is the
  fraction of a change in disposable income that is
  spent on consumption.

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14.1 EXPENDITURE PLANS AND REAL GDP

• Figure 14.2 shows how to calculate the marginal
  propensity to consume.

1. A 3 trillion change in disposable income
brings
2. A 2 trillion change in consumption
expenditure, so...
3. The MPC is 2 trillion 3 trillion 2/3.
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14.1 EXPENDITURE PLANS AND REAL GDP

• Other Influences on Consumption Expenditure
• The factors that influence consumption plans are
• Real interest rate
• Wealth
• Expected future income

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14.1 EXPENDITURE PLANS AND REAL GDP

• Real Interest Rate
• When the real interest rate falls, consumption
  expenditure increases and saving decreases.
• When the real interest rate rises, consumption
  expenditure decreases and saving increases
• Wealth and Expected Future Income
• When wealth or expected future income increases,
  consumption expenditure increases.
• When wealth or expected future income decreases,
  consumption expenditure decreases.

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14.1 EXPENDITURE PLANS AND REAL GDP

• Figure 14.3 shows shifts in the consumption
  function.

• 1. Consumption expenditure increases and the
  consumption function shifts upward if
• The real interest rate falls
• Wealth increases
• Expected future income increases

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14.1 EXPENDITURE PLANS AND REAL GDP

• 2. Consumption expenditure decreases and the
  consumption function shifts downward if
• The real interest rate rises
• Wealth decreases
• Expected future income decreases

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14.1 EXPENDITURE PLANS AND REAL GDP

• Imports and Real GDP
• Consumption expenditure is one major component
  of induced expenditure, imports are the other.
• In the short run, the factor influencing imports
  is U.S. real GDP.
• Marginal propensity to import is the fraction of
  an increase in real GDP that is spent on imports.
  
• The marginal propensity to import equals the
  change in imports divided by the change in real
  GDP that brought it about.

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14.2 EQUILIBRIUM EXPENDITURE

• Aggregate Planned Expenditure and Real GDP
• Consumption expenditure increases when disposable
  income increases.
• Disposable income equals aggregate incomereal
  GDPminus net taxes, so disposable income and
  consumption expenditure increase when real GDP
  increases.
• We use this link between consumption expenditure
  and real GDP to determine equilibrium expenditure.

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14.2 EQUILIBRIUM EXPENDITURE

• Figure 14.4 shows the AE curve.

Aggregate expenditure is the sum of
Investment (I),
Government expenditure (G),
Exports (X),
Consumption expenditure (C)
minus Imports (M).
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14.2 EQUILIBRIUM EXPENDITURE

• Equilibrium Expenditure
• Equilibrium expenditure is the level of aggregate
  expenditure when aggregate planned expenditure
  equals real GDP.
• Equilibrium expenditure equals the real GDP at
  which the AE curve intersects the 45 line.

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14.2 EQUILIBRIUM EXPENDITURE

• Figure 14.5 shows equilibrium expenditure.

1. When aggregate planned expenditure exceeds
real GDP, an unplanned decrease in inventories
occurs.
2. When aggregate planned expenditure is less
than real GDP, an unplanned increase in
inventories occurs.
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14.2 EQUILIBRIUM EXPENDITURE
3. When aggregate planned expenditure equals real
GDP, there are no unplanned inventories and real
GDP remains at equilibrium expenditure. Part
(b) shows the unplanned changes in inventories
that bring about equilibrium expenditure.
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14.2 EQUILIBRIUM EXPENDITURE

• Convergence to Equilibrium
• At equilibrium expenditure, production plans and
  spending plans agree, and there is no reason to
  change production or spending.
• But when aggregate planned expenditure and actual
  aggregate expenditure are unequal, production
  plans and spending plans are misaligned, and a
  process of convergence toward equilibrium
  expenditure occurs.
• Throughout this convergence process, real GDP
  adjusts.

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14.2 EQUILIBRIUM EXPENDITURE

• Convergence from Below Equilibrium
• When aggregate planned expenditure is less than
  real GDP, firms cut production. Real GDP
  decreases.
• When real GDP decreases, aggregate planned
  expenditure decreases.
• But real GDP decreases by more than planned
  expenditure, so eventually the gap between
  planned expenditure and actual expenditure closes.

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14.2 EQUILIBRIUM EXPENDITURE

• Convergence from Above Equilibrium
• When aggregate planned expenditure exceeds real
  GDP, firms increase production. Real GDP
  increases.
• But real GDP increases by more than the increase
  in planned expenditure.
• Eventually, the gap between planned expenditure
  and actual expenditure is closed.

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14.3 EXPENDITURE MULTIPLIERS

• When autonomous expenditure (e.g. investment)
  increases, aggregate expenditure and real GDP
  also increase.
• But the increase in real GDP is larger than the
  increase in investment.
• The multiplier is the 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.

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14.3 EXPENDITURE MULTIPLIERS

• The Basic Idea of the Multiplier
• The initial increase in investment brings an even
  bigger increase in aggregate expenditure because
  it induces an increase in consumption
  expenditure.
• The multiplier determines the magnitude of the
  increase in aggregate expenditure that results
  from an increase in investment or another
  component of autonomous expenditure.

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14.3 EXPENDITURE MULTIPLIERS

• Figure 14.6 illustrates the multiplier.

1. A 0.5 trillion increase in investment shifts
the AE curve upward by 0.5 trillion from AE0 to
AE1.
2. Equilibrium expenditure increases by 2
trillion from13 trillion to 15 trillion.
3. The increase in equilibrium expenditure is 4
times the increase in investment, so the
multiplier is 4.
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14.3 EXPENDITURE MULTIPLIERS

• 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.
• That is,

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14.3 EXPENDITURE MULTIPLIERS

• Why Is the Multiplier Greater Than 1?
• The multiplier is greater than 1 because an
  increase in autonomous expenditure induces an
  increase in aggregate expenditure in addition to
  the increase in autonomous expenditure.

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14.3 EXPENDITURE MULTIPLIERS

• The Multiplier and the MPC
• The greater the marginal propensity to consume,
  the larger is the multiplier.
• Ignoring imports and income taxes, the change in
  real GDP (?Y) equals the change in consumption
  expenditure (?C) plus the change in investment
  (?I).
• That is,
• ?Y ?C ?I

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14.3 EXPENDITURE MULTIPLIERS

• ?Y ?C ?I
• But the change in consumption expenditure is
  determined by the change in real GDP and the
  marginal propensity to consume.
• It is
• ?C MPC ? ?Y
• Now substitute MPC ? ?Y for ?C in the equation at
  the top of the screen
• ?Y MPC ? ?Y ?I

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14.3 EXPENDITURE MULTIPLIERS

• Now solve for ?Y as
• (1 MPC) ? ?Y ?I
• Rearrange to get

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14.3 EXPENDITURE MULTIPLIERS

• Now, divide both sides of the equation by the ?I
  to give

When MPC is 0.75, so the multiplier is
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14.3 EXPENDITURE MULTIPLIERS

• The Multiplier, Imports, and Income Taxes
• The size of the multiplier depends not only on
  consumption decisions but also on imports and
  income taxes.
• Imports make the multiplier smaller than it
  otherwise would be because only expenditure on
  U.S.-made goods and services increases U.S. real
  GDP.
• The larger the marginal propensity to import, the
  smaller is the change in U.S. real GDP that
  results from a change in autonomous expenditure.

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14.3 EXPENDITURE MULTIPLIERS

• Income taxes make the multiplier smaller than it
  would otherwise be.
• With increased incomes, income tax payments
  increase and disposable income increases by less
  than the increase in real GDP.
• Because disposable income influences consumption
  expenditure, the increase in consumption
  expenditure is less than it would if income tax
  payments had not changed.

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14.3 EXPENDITURE MULTIPLIERS

• The marginal tax rate determines the extent to
  which income tax payments change when real GDP
  changes.
• The marginal tax rate is the fraction of a change
  in real GDP that is paid in income taxesthe
  change in tax payments divided by the change in
  real GDP.
• The larger the marginal tax rate, the smaller is
  the change in disposable income and real GDP that
  results from a given change in autonomous
  expenditure.

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14.3 EXPENDITURE MULTIPLIERS

• The marginal propensity to import and the
  marginal tax rate together with the marginal
  propensity to consume determine the multiplier.
• Their combined influence determines the slope of
  the AE curve.
• The general formula for the multiplier is

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14.3 EXPENDITURE MULTIPLIERS

• Figure 14.7 shows the multiplier and the slope of
  the AE curve.

With no imports and income taxes, the slope of
the AE curve equals the marginal propensity to
consume, which in this example is 0.75.
A 0.5 trillion increase in investment increases
real GDP by 2 trillion. The multiplier is 4.
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14.3 EXPENDITURE MULTIPLIERS

• With imports and income taxes, the slope of the
  AE curve is less than the marginal propensity to
  consume.

In this example, the slope of the AE curve is 0.5.
A 0.5 trillion increase in investment increases
real GDP by 1 trillion. The multiplier is 2.
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14.3 EXPENDITURE MULTIPLIERS

• Business Cycle Turning Points
• The forces that bring business-cycle turning
  points are the swings in autonomous expenditure
  such as investment and exports.
• The mechanism that gives momentum to the
  economys new direction is the multiplier.

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14.3 EXPENDITURE MULTIPLIERS

• An expansion is triggered by an increase in
  autonomous expenditure that increases aggregate
  planned expenditure.
• At the moment the economy turns the corner into
  expansion, aggregate planned expenditure exceeds
  real GDP.
• In this situation, firms see their inventories
  taking an unplanned dive.

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14.3 EXPENDITURE MULTIPLIERS

• The expansion now begins.
• To meet their inventory targets, firms increase
  production, and real GDP begins to increase.
• This initial increase in real GDP brings higher
  incomes, which stimulate consumption expenditure.
  
• The multiplier process kicks in, and the
  expansion picks up speed.

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14.3 EXPENDITURE MULTIPLIERS

• The process works in reverse at a business cycle
  peak.
• A recession is triggered by a decrease in
  autonomous expenditure that decreases aggregate
  planned expenditure.
• At the moment the economy turns the corner into
  recession, real GDP exceeds aggregate planned
  expenditure.

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14.3 EXPENDITURE MULTIPLIERS

• In this situation, firms see unplanned
  inventories piling up.
• The recession now begins.
• To reduce their inventories, firms cut
  production, and real GDP begins to decrease.
• This initial decrease in real GDP brings lower
  incomes, which cut consumption expenditure.
• The multiplier process reinforces the initial cut
  in autonomous expenditure, and the recession
  takes hold.

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14.4 THE AD CURVE AND EQUILIBRIUM EXPENDITURE

• Deriving the AD Curve from Equilibrium
  Expenditure
• The AE curve is the relationship between
  aggregate planned expenditure and real GDP when
  all other influences on expenditure plans remain
  the same.
• A movement along the AE curve arises from a
  change in real GDP.

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14.4 THE AD CURVE AND EQUILIBRIUM EXPENDITURE

• The AD curve is the relationship between the
  quantity of real GDP demanded and the price level
  when all other influences on expenditure plans
  remain the same.
• A movement along the AD curve arises from a
  change in the price level.

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14.4 THE AD CURVE AND EQUILIBRIUM EXPENDITURE

• Equilibrium expenditure depends on the price
  level.
• When the price level changes, other things
  remaining the same, aggregate planned expenditure
  changes and equilibrium expenditure changes.
• Aggregate planned expenditure changes because a
  change in the price level changes the buying
  power of net assets, the real interest rate, and
  the real prices of exports and imports.
• So when the price level changes, the AE curve
  shifts.

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14.4 THE AD CURVE AND EQUILIBRIUM EXPENDITURE
Figure 14.8 shows the connection between the AE
curve and the AD curve.
1. When the price level is 110, the AE curve is
AE0.
Equilibrium expenditure is 14 trillion at
point B.
The quantity of real GDP demanded at the price
level of 110 is 14 trillionone point on the
AD curve.
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14.4 THE AD CURVE AND EQUILIBRIUM EXPENDITURE
2. When the price level rises to 130, the AE
curve shifts downward to AE1.
Equilibrium expenditure decreases to 13
trillion at point A.
The quantity of real GDP demanded at the price
level of 130 is 13 trilliona movement along
the AD curve to point A.
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14.4 THE AD CURVE AND EQUILIBRIUM EXPENDITURE
3. When the price level falls to 90, the AE
curve shifts upward to AE2.
Equilibrium expenditure increases to 15
trillion at point C.
The quantity of real GDP demanded at the price
level of 90 is 15 trilliona movement along
the AD curve to point C.
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How Big Is the Government Expenditure Multiplier?
Christina Romer, Chair of the Presidents Council
of Economic Advisers (CEA), has estimated the
government expenditure multiplier to be 1.6. This
number led administration economists to predict
that the stimulus plan that increased government
expenditure would prevent the unemployment rate
from rising much above 8 percent. This prediction
turned out to be optimistic. One reason might be
that the multiplier assumption was also too
optimistic.
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How Big Is the Government Expenditure Multiplier?
Robert Barro, a leading macroeconomist at Harvard
University, has studied the effects of very large
increases in government expenditure during
wars. Barro finds that the multiplier is only
0.8. Barros multiplier means that real GDP
increases by less than the increase in government
expenditure. The reason is that some private
expenditure, mainly investment, gets crowded
out and real GDP falls.
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How Big Is the Government Expenditure Multiplier?
John Taylor of Stanford University, another
leading macroeconomist, agrees with Barro that
the government expenditure multiplier is less
than 1. Taylor says that crowding out gets more
severe as time passes. So Taylor says that the
multiplier gets smaller after two years and
smaller still after three years. The figure on
the next slide shows the range on estimates of
the expenditure multiplier.
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How Big Is the Government Expenditure Multiplier?
A big multiplier can occur only if there is
substantial slack in the economywhen the
recessionary gap is large.