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Copyright 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved,Click to edit Master text styles,Second level,when second level runs longer than one line we want no hanging indent,Ive also set the gap between points at 0.5 lines.,Third level,CLICK,Copyright 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved,Click to edit Master text styles,Second level,when second level runs longer than one line we want no hanging indent,Ive also set the gap between points at 0.5 lines.,CLICK,Copyright 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved,Click to edit Master text styles,Second level,when second level runs longer than one line we want no hanging indent,Ive also set the gap between points at 0.5 lines.,CLICK,Copyright 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved,Copyright 2018, 2015, 2013 Pearson Education, Inc. All Rights Reserved,How big is the government,expenditure multiplier?,14,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.,CHAPTER CHECKLIST,Aggregate Expenditure Multiplier,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.,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.,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.,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).,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.,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.,14.1 EXPENDITURE PLANS AND REAL GDP,As disposable income increases, consumption expenditure increases,induced,consumption.,Along the,45 line, consumption expenditure equals disposable income.,14.1 EXPENDITURE PLANS AND REAL GDP,When the consumption function is above the 45 line, saving is negative (dissaving occurs).,When the consumption function is below the 45 line, saving is positive.,14.1 EXPENDITURE PLANS AND REAL GDP,At the point where the consumption function intersects the 45 line, all disposable income is consumed and saving is zero.,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.,MPC,=,Change in consumption expenditure,Change in disposable income,14.1 EXPENDITURE PLANS AND REAL GDP,Figure 14.2 shows how to calculate the marginal propensity to consume.,A $3 trillion change in disposable income brings ,A $2 trillion change in consumption expenditure, so .,The,MPC,equals $2 trillion $3 trillion = 2/3.,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,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.,14.1 EXPENDITURE PLANS AND REAL GDP,Figure 14.3 shows shifts in the consumption function.,Consumption expenditure increases and the consumption function shifts upward if,The real interest rate falls.,Wealth increases.,Expected future income increases.,14.1 EXPENDITURE PLANS AND REAL GDP,C,onsumption expenditure decreases and the consumption function shifts downward if,The,real interest rate rises.,Wealth decreases.,Expected future income decreases.,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.,14.2 EQUILIBRIUM EXPENDITURE,Induced Expenditure and Autonomous Expenditure,Induced expenditure,equals consumption expenditure minus imports.,Autonomous expenditure,equals investment plus government expenditure, plus exports.,Aggregate planned expenditure equals autonomous expenditure plus induced expenditure.,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.,14.2 EQUILIBRIUM EXPENDITURE,Figure 14.4 shows the,AE,curve.,Aggregate expenditure is the sum of ,14.2 EQUILIBRIUM EXPENDITURE,Investment (,I,),Government expenditure (,G,),Exports (,X,),Consumption expenditure (,C,),minus,Imports (,M,).,14.2 EQUILIBRIUM EXPENDITURE,Equilibrium,E,xpenditure,Equilibrium expenditure,is t,he 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.,14.2 EQUILIBRIUM EXPENDITURE,Figure,14.,5,shows,equilibrium expenditure.,When aggregate planned expenditure exceeds real GDP, an,unplanned,decrease in,inventor,ies occurs.,When aggregate planned expenditure is less than real GDP, an,unplanned,increase in,inventor,ies occurs.,14.2 EQUILIBRIUM EXPENDITURE,When aggregate planned expenditure equals real GDP, there are no,unplanned inventor,ies and real GDP remains at equilibrium expenditure.,Part (b) shows the unplanned changes in inventories that bring about equilibrium expenditure.,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.,14.2 EQUILIBRIUM EXPENDITURE,Convergence from Below 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.,14.2 EQUILIBRIUM EXPENDITURE,Convergence from Above 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.,14.3 EXPENDITURE MULTIPLIERS,When autonomous expenditure (investment, government expenditure, or exports) 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.,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.,14.3 EXPENDITURE MULTIPLIERS,Figure 14.6 illustrates the multiplier.,A $0.5 trillion increase in investment shifts the,AE,curve upward by $0.5 trillion from,AE,0,to,AE,1,.,Equilibrium expenditure increases by $2 trillion from $16 trillion to $18 trillion.,14.3 EXPENDITURE MULTIPLIERS,The increase in equilibrium expenditure is 4 times the increase in investment, so the multiplier is 4.,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,Multiplier =,Change in equilibrium expenditure,Change in autonomous expenditure,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.,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,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,14.3 EXPENDITURE MULTIPLIERS,Now solve for,Y,as,(1 ,MPC,),Y,=,I,Rearrange to get,Y,=,I,(1 ,MPC,),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,(1 ,MPC,),1,Y,I,=,Y,=,I,(1 ,MPC,),(1 0.75),1,Y,I,=,=,0.25,1,= 4.,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.,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.,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 taxes,the 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.,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:,(1 Slope of,AE,curve),Y,I,=,1,14.3 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.,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. Th,e,multiplier is 2.,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.,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.,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.,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.,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.,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.,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.,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.,Figure 14.8 shows the connection between the,AE,curve and the,AD,curve.,1.When the price level is 105, the,AE,curve is,AE,0,.,Equilibrium expenditure is $16 trillion at point,B,.,At the price level 105, the quantity of real GDP demanded is $16 trillion,one point on the,AD,curve.,14.4 THE,AD,CURVE AND EQUILIBRIUM EXPENDITURE,14.4 THE,AD,CURVE AND EQUILIBRIUM EXPENDITURE,When the price level rises to 125, the,AE,curve shifts downward to,AE,1,.,Equilibrium expenditure decreases to $15 trillion at point,A,.,At the price level 125, the quantity of real GDP demanded is $15 trillion,a movement along,the,AD,curve to point,A,.,When the price level falls to 85, the,AE,curve shifts upward to,AE,2,.,Equilibrium expenditure increases to $17 trillion at point,C,.,At the price level 85, t,he quantity of real GDP demanded,is $17 trillion,a movement along,the,AD,curve to point,C,.,14.4 THE,AD,CURVE AND EQUILIBRIUM EXPENDITURE,Christina Romer, former 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.,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.,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.,A big multiplier can occur only if there is substantial slack in the economywhen the recessionary gap is large.,
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