C H A P T E R C H E C K L I S T

2. 1 2 3 4 C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • Distinguish between autonomous expenditure and induced expenditure and explain how real GDP influences expenditure plans. Explain how real GDP adjusts to achieve equilibrium expenditure. • Describe and explain the expenditure multiplier. Derive the AD curve from equilibrium expenditure.

3. A QUICK REVIEW AND PREVIEW • The Economy at Full Employment • At full employment, real GDP equals potential GDP and the unemployment rate equals the natural unemployment. • Potential GDP and the natural unemployment rate are determined by real factors and are independent of the price level.

4. A QUICK REVIEW AND PREVIEW • The quantity of money and money equilibrium determine nominal GDP. • Nominal GDP and potential GDP determine the price level. • So changes in the quantity of money change nominal GDP and change the price level but have no effect on potential GDP. • Since 1959, unit money supply (M2/Y) has risen by 3.7% per year while the price level (P) has risen by 3.8% per year.

5. A QUICK REVIEW AND PREVIEW • Departures from Full Employment • Aggregate supply and aggregate demand determine equilibrium real GDP and the price level. • Fluctuations in aggregate supply and aggregate demand bring fluctuations around full employment.

6. A QUICK REVIEW AND PREVIEW • Fixed Price Level • In the aggregate expenditure model, the price level is fixed. • Keynes wrote the model to explain an economy in a deep recession, when firms could produce more without raising prices. • It explains the forces that determine real GDP at a given price level.

7. 15.1 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 purchases of goods and services, G • Net exports, NX = X - M • Aggregate expenditure = C + I + G + X - M.

8. 15.1 EXPENDITURE PLANS AND REAL GDP • Planned and Unplanned Expenditures • Motorola decides to produce 11 million cell phones, planning to sell 10 million phones and to put 1 million into inventory. • People plan to and buy 9 million phones from Motorola. • Planned expenditure is 10 million phones (9 million + 1 million), which is less than production of 11 million. • Motorola’s inventories rise by 2 million phones, 1 million more than planned, so Motorola cuts production.

9. 15.1 EXPENDITURE PLANS AND REAL GDP • Aggregate planned expenditure is planned consumption expenditure plus planned investment plus planned government expenditure plus planned exports minus planned imports. • Notice that actual expenditure, which equals planned expenditure plus the unplanned change in firms’ inventories, always equals GDP and aggregate income. • But aggregate planned expenditure might not equal real GDP because firms might end up with up more or less inventories than planned.

10. 15.1 EXPENDITURE PLANS AND REAL GDP • If aggregate planned expenditure (AE) equals real GDP (Y), firms’ inventories are as planned – this is expenditure equilibrium. • If AE > Y, firms’ inventories are smaller than planned; firms increase production. • If AE < Y, firms’ inventories are larger than planned; firms reduce production.

11. 15.1 EXPENDITURE PLANS AND REAL GDP • Unplanned changes in firms’ inventories lead to changes in production and incomes. • When firms have unwanted inventories, they decrease production. Real GDP falls. • When inventories fall below planned levels, firms increase production. Real GDP rises.

12. 15.1 EXPENDITURE PLANS AND REAL GDP • Induced Expenditure and Autonomous Expenditure Autonomous expenditure, A The components of aggregate expenditure that do not change when real GDP changes. A = I + G + X + C0 + M0, where C0 and M0 are the portions of consumption expenditure and imports that are independent of real GDP.

13. 15.1 EXPENDITURE PLANS AND REAL GDP Induced expenditure The components of aggregate expenditure that change when real GDP changes. Induced expenditure equals consumption expenditure minus imports (excluding C0 + M0).

14. 15.1 EXPENDITURE PLANS AND REAL GDP • The Consumption Function • Consumption function • The relationship between consumption expenditure and disposable income, other things remaining the same. • Disposable income is aggregate income (GDP) minus net taxes. YD = Y - T • Net taxes are taxes paid to the government minus transfer payments received from the government. • T = Ta + tY - Tr

15. 15.1 EXPENDITURE PLANS AND REAL GDP Figure 15.1 shows the consumption as a function of disposable income C = a + bYD When YD = 0, C = a = $1.5 trillion. This portion of C is independent of YD, hence autonomous. As disposable income increases, consumption expenditure increases—induced consumption.

16. 15.1 EXPENDITURE PLANS AND REAL GDP Along the 45° line, y = x. At D, consumption expenditure equals disposable income. 1.When the consumption function is above the 45° line, saving is negative (dissaving occurs).

17. 15.1 EXPENDITURE PLANS AND REAL GDP 3.At the point where the consumption function intersects the 45° line, all disposable income is consumed and saving is zero. 2.When the consumption function is below the 45° line, saving is positive.

18. Change in consumption expenditure MPC = Change in disposable income 15.1 EXPENDITURE PLANS AND REAL GDP • Marginal propensity to consume (MPC) is the fraction of a change in disposable income that is spent on consumption. It is the slope of C = a + b YD. MPC = b.

19. 15.1 EXPENDITURE PLANS AND REAL GDP Figure 15.2 shows how to calculate the marginal propensity to consume. 1. A $2 trillion change in disposable income brings 2.A $1.5 trillion change in consumption expenditure, so... 3. The MPC is $1.5 trillion ÷ $2.0 = 0.75.

20. 15.1 EXPENDITURE PLANS AND REAL GDP • Other Influences on Consumption • The factors that influence planned consumption are: • Disposable income • Real interest rate • The buying power of net assets (e.g., money) • Expected future disposable income

21. 15.1 EXPENDITURE PLANS AND REAL GDP • A change in disposable income leads to a change in consumption expenditure and a movement along the consumption function. • A change in any other influence on planned consumption shifts the consumption function, C. • For example, C shifts upward when • The real interest rate decreases • The buying power of net assets increases • Expected future income increases

22. 15.1 EXPENDITURE PLANS AND REAL GDP Figure 15.3 shows shifts in the consumption function. 1.A fall in the real interest rate or an increase in either the buying power of money or expected future income increases consumption expenditure and shifts the consumption function upward from CF0 to CF1.

23. 15.1 EXPENDITURE PLANS AND REAL GDP 2.A rise in the real interest rate or a decrease in either the buying power of money or expected future income decreases consumption expenditure and shifts the consumption function downward from CF0 to CF2.

24. 15.1 EXPENDITURE PLANS AND REAL GDP • Imports and GDP • Short run changes in imports are directly related to, or induced by, changes in real GDP. • Marginal propensity to import, m, 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.

25. 15.2 EQUILIBRIUM EXPENDITURE • Writing consumption as a function of real GDP • YD = Y – T; definition of disposable income • T = Ta + tY – Tr ; definition of net taxes • C = a + b YD ; consumption as a function of YD. Substitute for YD • C = a + b (Y– T); substitute for T • C = a + b (Y – (Ta + tY –Tr )); multiply through by -1 • C = a + b (Y – Ta – tY + Tr ); multiply through by b • C = a + b Y – bTa – btY + bTr ; rearrange to group like terms • C = (a – bTa + bTr )+ b Y – btY; Let C0 = a – bTa + bTr • C = C0 + b Y – btY; factor out b and Y • C = C0 + b (1 – t) Y; Result is C as a function of Y.

26. 15.2 EQUILIBRIUM EXPENDITURE • Aggregate Planned Expenditure and GDP • M = M0 + mY, but let’s assume M0 = 0, so M = mY • AE = C + I + G + X – M; substitute for C and M. AE = C0 + b (1 – t) Y + I + G + X – mY; rearrange AE = C0 + I + G + X + b (1 – t) Y – mY Let A = C0 + I + G + X; factor out Y AE = A + (b (1 – t) – m)Y; Let g = b (1 – t) – m AE = A + gY

27. 15.2 EQUILIBRIUM EXPENDITURE • In equilibrium, Y = AE. To find equilibrium expenditure, substitute for AE and solve for Y • Y = A + gY; subtract gY from both sides • Y – gY = A; factor out Y • Y(1 – g) = A; divide both sides by 1 – g

28. 15.2 EQUILIBRIUM EXPENDITURE • The Autonomous Expenditure Multiplier … equals the change in real GDP divided by the change in autonomous expenditure:

29. 15.2 EQUILIBRIUM EXPENDITURE • The Lump-sum Tax Multiplier … equals the change in real GDP divided by the change in lump-sum taxes.

30. 15.2 EQUILIBRIUM EXPENDITURE • The Lump-sum Transfer Payments Multiplier … equals the change in real GDP divided by the change in lump-sum transfers.

31. 15.2 EQUILIBRIUM EXPENDITURE Figure 15.4 shows the AE curve. Aggregate expenditure (AE) is the sum of investment (I), government purchases (G), exports (X), consumption expenditure (C) minus imports (M).

32. 15.2 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.

33. 15.2 EQUILIBRIUM EXPENDITURE Figure 15.5 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.

34. 15.2 EQUILIBRIUM EXPENDITURE Figure 15.5 shows equilibrium expenditure. 3. When aggregate planned expenditure equals real GDP, there are no unplanned changes in inventories and real GDP remains at equilibrium expenditure.

35. 15.2 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.

36. 15.2 EQUILIBRIUM EXPENDITURE • Back at Motorola • Recall that Motorola has unwanted inventories. • So, Motorola cuts production. • Where does the process end? • The process ends when expenditure equilibrium is reached. • Equilibrium expenditure is reached because when real GDP changes by $1 aggregate planned expenditure changes by less than $1.

37. 15.2 EQUILIBRIUM EXPENDITURE • When aggregate planned expenditure is less than real GDP, firms cut production and 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.

38. 15.2 EQUILIBRIUM EXPENDITURE • Similarly, when aggregate planned expenditure exceeds real GDP, firms increase production and 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.

39. 15.3 THE EXPENDITURE MULTIPLIER When 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 investment is multiplied to determine the change that it generates in equilibrium expenditure and real GDP.

40. 15.3 THE EXPENDITURE MULTIPLIER • The Basic Idea of the Multiplier • The initial increase in investment brought an even bigger increase in aggregate expenditure because it induced 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. • The leakages, savings, imports, and income taxes, open a gap between expenditure decisions and real GDP. Each reduces the size of the multiplier.

41. 15.3 THE EXPENDITURE MULTIPLIER Figure 15.6 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 from $9 trillion to $11 trillion. 3.The increase in equilibrium expenditure is 4 times the increase in autonomous expenditure, so the multiplier is 4

42. Change in equilibrium expenditure Multiplier = Change in autonomous expenditure 15.3 THE EXPENDITURE MULTIPLIER • The Size of the Multiplier • The multiplier • The amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure that it generates. • That is,

43. 15.3 THE EXPENDITURE MULTIPLIER • Why Is the Multiplier Greater Than 1? • The multiplier is greater than 1 because an increase in autonomous expenditure induces an increase inaggregate expenditure in addition to the increase in autonomous expenditure.

44. 15.3 THE EXPENDITURE MULTIPLIER • 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

45. 15.3 THE EXPENDITURE MULTIPLIER • 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

46. I Y = (1 – MPC) 15.3 THE EXPENDITURE MULTIPLIER Now solve for Y as: (1 – MPC) Y = I Rearrange to get

47. 1 = (1 – MPC) Y Y I I I Y = 1 1 (1 – MPC) = 4. = = 0.25 (1 – 0.75) 15.3 THE EXPENDITURE MULTIPLIER Now, divide both sides of the by the I to give: When MPC is 0.75, so the multiplier is:

48. 15.3 THE EXPENDITURE MULTIPLIER • Imports and Income Taxes • The multiplier depends, in general, not only on consumption decisions but also on imports and income taxes. • Imports make the multiplier smaller that 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.

49. 15.3 THE EXPENDITURE MULTIPLIER • 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.

50. 15.3 THE EXPENDITURE MULTIPLIER • 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.