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AE = C + I + G + NX C = C onsumption expenditures

A ggregate E xpenditure. AE = C + I + G + NX C = C onsumption expenditures Durable goods: T.V.’s, and cars. Does not include houses Non-durable goods: clothing, food, and fuel Services: health care, education I = I nvestment expenditures

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AE = C + I + G + NX C = C onsumption expenditures

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  1. Aggregate Expenditure AE = C + I + G + NX C = Consumption expenditures • Durable goods: T.V.’s, and cars. Does not include houses • Non-durable goods: clothing, food, and fuel • Services: health care, education I = Investment expenditures • Business fixed investment on structures (factories, warehouses) and equipment (vehicles, furniture, computers) • Residential investment on the construction of new homes G = Government expenditures on goods and services • New aircraft carriers, Air Force I, Presidential limo, FBI vehicles, etc. • Does the government buy US products only? NX = net exports = eXports – iMports • X is the amount spent by foreigners on goods built in the USA • M is the amount spent by Americans on goods from outside of the USA

  2. Consumption expenditure Simulated consumption • The Consumption function is the relationship between consumption and disposable income • Disposable income (DI) is aggregate income (GDP) minus net taxes (T). DI = Y – T where T = taxes paid to the government minus transfer payments received from the government. • The diagram to the right shows how C and DI evolve over time. • Download the data, use Excel to derive the C function http://research.stlouisfed.org/fred2/graph/?g=o4I

  3. Consumption expenditure Simulated consumption A =W + Ye – PL – r C = A + mpc∙DI C = [W + Ye – PL – r ]+ mpc∙DI • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [W+ Ye– PL – r ] + mpc∙DI

  4. Consumption expenditure Simulated consumption A =W + Ye – PL – r C = A + mpc∙DI C = [W + Ye – PL – r ]+ mpc∙DI • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [5 + Ye– PL – r ] + mpc∙DI

  5. Consumption expenditure Simulated consumption A =W + Ye – PL – r C = A + mpc∙DI C = [W + Ye – PL – r ]+ mpc∙DI • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [5 + 7 – PL – r ] + mpc∙DI

  6. Consumption expenditure Simulated consumption A =W + Ye – PL – r C = A + mpc∙DI C = [W + Ye – PL – r ]+ mpc∙DI • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [5 + 7 – 8 – r ] + mpc∙DI

  7. Consumption expenditure Simulated consumption A =W + Ye – PL – r C = A + mpc∙DI C = [W + Ye – PL – r ]+ mpc∙DI • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [5 + 7 – 8 – 2] + mpc∙DI

  8. Consumption expenditure Simulated consumption A =W + Ye – PL – r C = A + mpc∙DI C = [W + Ye – PL – r ]+ mpc∙DI • Example:Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [5 + 7 – 8 – 2] + 0.75∙DI

  9. Consumption expenditure Simulated consumption A =W + Ye – PL – r C = A + mpc∙DI C = [W + Ye – PL – r ]+ mpc∙DI • Example: Suppose consumer wealth is $5 trillion, expected future income is $7 trillion, the price level is $8 thousand, the real rate of interest is 2 percent, net tax revenue is $3 trillion, government expenditure is $3.5 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = 2 + 0.75∙DI

  10. Consumption expenditure Simulated consumption • Example (continued): C = 2 + 0.75DI When DI = 0 C = 2 + 0.75(0) C = 2 When DI = 8 C = 2 + 0.75(8) C = 2 + 6 C = 8 C 8 2 0 8 DI

  11. Consumption expenditure Simulated consumption • Example (continued): C = 2 + 0.75DI When consumption lies on the 45° line, all disposable income is consumed and saving is zero. Saving = DI – C = 8 – 8 = 0 C 45o 8 2 0 8 DI

  12. Consumption expenditure Simulated consumption • Example (continued): C = 2 + 0.75DI When consumption lies below the 45° line, saving occurs. When DI = 9 C = 2 + 0.75(9) = 2 + 6.75 = 8.75 S = DI – C = 9 – 8.75 = 0.25 C 45o 8.75 2 0 9 DI

  13. Consumption expenditure Simulated consumption • Example (continued): C = 2 + 0.75DI When consumption lies above the 45° line, dissaving occurs. When DI = 7 C = 2 + 0.75(7) = 2 + 5.25 = 7.25 S = DI – C = 7 – 7.25 = –0.25 C 45o 7.25 2 0 7 DI

  14. Consumption expenditure Simulated consumption • Example (continued): With real GDP held constant at 11 trillion dollars, show what happens to the consumption model when • consumer wealth rises to 5.5 trillion dollars • expected future income decreases to 6.5 trillion dollars • price level increases to 8.5 thousand dollars • mpc increases to 0.8 • real rate of interestincreases by 0.5 pct. points • tax revenue is cut by 0.5 trillion dollars • government expenditure is raised by 0.5 trillion dollars What is monetary policy, and who conducts it? What is fiscal policy, and who conducts it? Compute the budget balance. Is there a budget deficit or surplus?

  15. Consumption expenditure Simulated consumer expenditure • Because AE, AD, SRAS, and LRAS are graphed with Y on the horizontal axis, C should be too: C = [W + Ye – PL – r ] + mpc∙DI DI = Y – T C = [ W + Ye – PL – r ] + mpc∙(DI) C = [ W + Ye – PL – r ] + mpc∙(Y – T) C = [ W + Ye – PL – r ] + mpc∙Y – mpc∙T C = [ W + Ye – PL – r – mpc∙T] + mpc∙Y

  16. Consumption expenditure Simulated consumer expenditure • Example (continued): With real GDP held constant at 11 trillion dollars, show what happens to the consumption model when • consumer wealth rises to 5.5 trillion dollars • expected future income decreases to 6.5 trillion dollars • price level increases to 8.5 thousand dollars • mpc increases to 0.8 • real rate of interestincreases by 0.5 pct. points • tax revenue is cut by 0.5 trillion dollars • government expenditure is raised by 0.5 trillion dollars What is monetary policy, and who conducts it? What is fiscal policy, and who conducts it? Compute the budget balance. Is there a budget deficit or surplus?

  17. Net foreigner expenditure Import function • Money is spent on domestic products (C ) & imported products (M ). M is the amount spent by Americans on goods from outside of the USA. • In the short run, the factor influencing imports is U.S. real GDP • If Y = 0, products cannot be imported (M = 0) • As Y rises, expenditures on imports increase. • Download the following data to generate an empirical iMport function • http://research.stlouisfed.org/fred2/graph/?g=o4M • Marginal Propensity to iMport is the fraction of a rise in Y spent on imports. • M = mpm∙Y • Simulated net foreigner expenditure • eXports are exogenous • NX = X – M • NX = X – mpm∙Y • Example: In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • NX = 0.5– 0.25∙Y

  18. Aggregate Expenditure Simulated AE AE =[C]+ I + G + NX }

  19. Aggregate Expenditure Simulated AE AE =[C]+ I + G + {NX} NX = X – mpm∙ Y C = W + Ye – PL – r – mpc∙ T + mpc∙ Y AE =[W + Ye – PL – r – mpc∙ T + mpc∙ Y] + I + G + {X –mpm∙ Y} AE =[W + Ye – PL – r – mpc∙ T + I + G + X]+mpc∙ Y – mpm∙ Y AE =[W + Ye – PL – r – mpc∙ T + I + G + X]+{mpc– mpm}∙ Y

  20. Aggregate Expenditure Simulated AE AE =[C]+ I + G + {NX} M = mpm∙ Y C = W + Ye – PL – r – mpc∙ T + mpc∙ Y AE = [W + Ye – PL – r – mpc∙ T + mpc∙ Y]+ I + G + X – {mpm∙ Y } AE = [W + Ye – PL – r – mpc∙ T + I + G + X]+ mpc∙ Y – mpm∙ Y AE = [W + Ye – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y

  21. Aggregate Expenditure • Example: In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. Simulated AE

  22. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [W + Ye – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y Simulated AE

  23. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + Ye – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y Simulated AE

  24. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – PL – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y Simulated AE

  25. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – r – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y Simulated AE

  26. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – 2 – mpc∙ T + I + G + X]+ {mpc– mpm}∙ Y Simulated AE

  27. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – 2 – 0.75∙ T + I + G + X]+ {0.75– mpm}∙ Y Simulated AE

  28. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 + I + G + X]+ {0.75– mpm}∙ Y Simulated AE

  29. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + G + X]+ {0.75– mpm}∙ Y Simulated AE

  30. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + 3.5 + X]+ {0.75– mpm}∙ Y Simulated AE

  31. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + 3.5 + 0.5]+ {0.75– mpm}∙ Y Simulated AE

  32. Aggregate Expenditure • Example:In addition to W = 5, Ye = 7, PL = 8, r = 2, mpc = 0.75, and T = 3, assume, investment expenditures total $1 trillion, government expenditures total $3.5 trillion, exports total $0.5 trillion, and mpm= 0.25. Derive the AE equation. • AE = [5 + 7 – 8 – 2 – 0.75∙ 3 +1 + 3.5 + 0.5]+ {0.75– 0.25}∙ Y • AE = 4.75 + 0.5Y When Y = 0 AE = 4.75 + 0.5(0) = 4.75 When Y = 9.5 AE = 4.75 + 0.5(9.5) = 9.5 Simulated AE

  33. Aggregate Expenditure Simulated AE • Example: Point 1 Y = 0 AE = 4.75 Point 2 Y = 9.5 AE = 9.5 • Since aggregate planned expenditure equals GDP, the change in firms’ inventories equals the planned change. • The AE model has reached an equilibrium AE 45o 9.5 4.75 0 9.5 Y

  34. Aggregate Expenditure Simulated AE • Example: Suppose real GDP is $12 trillion. AE = 4.75+ 0.5(12) = 4.75 + 6 = 10.75 AE < Y • When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs. AE 45o 10.75 0 12 Y

  35. Aggregate Expenditure Simulated AE • Example: Suppose real GDP is $12 trillion. AE = 4.75+ 0.5(12) = 4.75 + 6 = 10.75 AE < Y • When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs. • firms cut production. Real GDP decreases until it reaches equilibrium. AE 45o 10.75 9.5 AE = Y 0 9.5 12 Y

  36. Aggregate Expenditure Simulated AE • Example: Suppose real GDP is $8 trillion. AE = 4.75+ 0.5(8) = 4.75 + 4 = 8.75 AE > Y • When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs. AE 45o 8.75 0 8 Y

  37. Aggregate Expenditure Simulated AE • firms raise production. Real GDP increases until it reaches equilibrium. • Example: Suppose real GDP is $8 trillion. AE = 4.75+ 0.5(8) = 4.75 + 4 = 8.75 AE > Y • When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs. AE 45o 9.5 8.75 AE = Y 0 8 9.5 Y

  38. Aggregate Expenditure Simulated AE • Example: (continued): With real GDP equal to 9.5 trillion dollars, show what happens if • consumer wealth rises to 5.5 trillion dollars • expected future income decreases to 6.5 trillion dollars • The price level increases to 8.5 thousand dollars • investment expenditure falls to 0.5 trillion dollars • exports rise to 1 trillion dollars • real rate of interestincreases by 0.5 pct. points • tax revenue is cut by 0.5 trillion dollars. Compute the tax cut multiplier. Compute the budget balance. • government expenditure is raised by 0.5 trillion dollars. Compute the government expenditure multiplier. Compute the budget balance. What is monetary policy, and who conducts it? What is fiscal policy, and who conducts it?

  39. 5.25 Aggregate Expenditure Simulated AD • Example: (continued) What happens if the price level falls by $0.5 thousand? AE = [5 + 7 – 8 – 2 – 0.75∙3 + 1 + 3.5 + 0.5]+ {0.75– 0.25}∙Y AE = 5.25+ 0.5Y 7.5 AE PL 45o AE > Y Unplanned decrease in inventories Real GDP rises 8 7.5 AE = 5.25 + 0.5 Y Y = 5.25 + 0.5 Y 4.75 AD 0.5Y= 5.25 Y= 10.5 0 0 9.5 10.5 10.5 9.5 Y Y

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