© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 8: The Goods Market and the Aggregate Expenditures Model Prepared by: Kevin Richter,

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.

1

Chapter 8:The Goods Market and the Aggregate Expenditures ModelPrepared by:Kevin Richter, Douglas CollegeCharlene Richter, British Columbia Institute of Technology


2

The Historical Development of Modern Macroeconomics

The Great Depression of the 1930s led to the development of macroeconomics and aggregate demand tools to deal with recessions.

During the Depression, output fell by 30 percent and unemployment rose to 25 percent.


3

Keynes is the author of The General Theory of Employment, Interest and Money, which provided the new framework for macroeconomic policy.

Keynes is pronounced “canes”



4

Classical Economists

The Classical economists' approach was laissez-faire (leave the market alone).

They believed the market was self-adjusting.

They concentrated on the long run and largely ignored the short run.


5

Classical Economics

They used microeconomic supply and demand arguments to explain the Great Depression.

Their solution to the high unemployment was to eliminate labour unions and government policies that kept wages too high.


6


Before the Depression, the prominent ideology was laissez-faire -- keep the government out of the economy.

After the Depression, most people believed government should have a role in regulating the economy.


7

The Layperson's Explanation for Unemployment

Laypeople believed that the depression was caused by an oversupply of goods that glutted the market.

They wanted the government to hire the unemployed even if the work was not needed.


8

The Layperson's Explanation for Unemployment

Classical economists opposed deficit spending, arguing that the money to create jobs had to be borrowed.

This money would have financed private economic activity and jobs, so everything would cancel out.


9

The Essence of Keynesian Economics Keynes thought that the economy could get

stuck in a rut as wages and price level adjusted to sudden decreases in expenditures.


10

The Essence of Keynesian Economics According to Keynes:

a decrease in spending job layoffs

fall in consumer demand firms decrease production

more job layoffs further fall in consumer demand,

and so forth


11

Equilibrium Income Fluctuates Income is not fixed at the economy's long-run

potential income – it fluctuates.

For Keynes there was a difference between equilibrium income and potential income.


12

Equilibrium Income Fluctuates Equilibrium income – the level toward which

the economy gravitates in the short run because of the cumulative cycles of declining or increasing production.


13

Equilibrium Income Fluctuates Potential income – the level of income that

the economy technically is capable of producing without generating accelerating inflation.


14

Equilibrium Income Fluctuates Keynes felt that at certain times the economy

needed help to reach its potential income.

He believed that market forces would not work fast enough and would not be strong enough to get the economy out of a recession


15

Equilibrium Income Fluctuates Because short-run aggregate production

decisions and expenditure decisions were interdependent, the downward spiral could start at any time.


16

The Paradox of Thrift

Incomes would fall as people lost their jobs causing both consumption and saving to fall as well.

The economy would reach a new equilibrium which could be at an almost permanent recession.


17

The Paradox of Thrift

Paradox of thrift – an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.


18

The Aggregate Expenditures Model Using a few simplifying assumptions,

economists can construct a model of the economy.

The Aggregate Expenditures (AE) Model looks at how real income is determined in an economy.


19

The Aggregate Expenditures Model The AE model assumes that the price level is

fixed, and explores how an initial shift in expenditures changes equilibrium output.

The AE model quantifies the effect of changes in aggregate expenditures on aggregate output.


20

Aggregate Production

Aggregate production –the total amount of goods and services produced in every industry in an economy.

Production creates an equal amount of income.

Thus, actual production and actual income are always equal.


21

Aggregate Production

Graphically, aggregate production in the AE model is represented by a 45° line through the origin

At all points on this Aggregate Production Curve, income equals production.


22

The Aggregate Production Curve

Aggregate production(production = income)

A

45º$4,0000

Real production

Real income

$4,000

Potential income

C


23

Aggregate Expenditures

Aggregate expenditures – the total amount of spending on final goods and services in the economy:

Consumption – spending by households. Investment – spending by business. Spending by government. Net foreign spending on Canadian goods – the

difference between Canadian exports and imports.


24

Autonomous and Induced Expenditures

Autonomous expenditures are expenditures that are independent of income. Autonomous expenditures change because

something other than income changes.

Induced expenditures – expenditures that change as income changes.


25


Autonomous expenditures is the level of expenditures that would exist at zero income.

They remain constant at all levels of income.


26


Induced expenditures are those that change as income changes.

When income rises, induced expenditures rise by less than the change in income.


27

Expenditures Function

The relationship between expenditures and income can be expressed more concisely as an expenditures function.

An expenditures function is a representation of the relationship between aggregate expenditures and income.


28

The Expenditures Function The relationship between aggregate

expenditures and income can be expressed mathematically:

AE = AEo + mpcY

AE = aggregate expenditures

AEo = autonomous expenditures mpc = marginal propensity to consume Y = income


29

The Marginal Propensity to Consume Marginal propensity to consume (mpc) –

the change in consumption that occurs with a change in income.

The mpc is between 0 and 1 because individuals tend to save a portion of an increase in income.


30

The Marginal Propensity to Consume The mpc is the fraction spent from an

additional dollar of income.

Y

C

income in change

nconsumptio in changempc


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The Marginal Propensity to Consume The marginal propensity to consume

(mpc) is the ratio of a change in consumption (C) to a change in income (Y).


32

Expenditures Function

Autonomous expenditures is the sum of the autonomous components of expenditures:

AE = C + I + G + X – IM


33

Graphing the Expenditures Function The graphical representation of the

expenditures function is called the aggregate expenditures curve.

The slope of the expenditures function tells us how much expenditures change with a particular change in income.


34

Graphing the Expenditures Function

045º

AE = 1,000 + 0.8Y

Real

exp

endi

ture

s (A

E)

$12,200

10,000

8,000

6,000

4,000

2,000

5,000

1,000$5,000 $11,250$14,000$8,750 Real income

AE = 2,000

Y = 2,500

Aggregate production

2,500

2,000

Y

AE slope

0.8 Y

AE mpc


35

Shifts in the Expenditures Function The aggregate expenditure curve shifts when

autonomous C, I, G, or (X – IM) change.

Autonomous Consumption expenditures respond to changes in:

interest rates household wealth expectations of future conditions


36

Shifts in the Expenditures Function Autonomous Investment is the most volatile

component of GDP.

It responds to changes in: interest rates capital goods prices consumer demand conditions expectations regarding future economic conditions


37

Autonomous exports and imports depend on foreign and domestic incomes and relative prices.

Autonomous Government expenditures may also change as policies change.

Shifts in the Expenditures Function


38

Determining the Equilibrium Level of Aggregate Income

At equilibrium, planned expenditures must equal production.

Graphically, it is the income level at which AE equals AP.


39

Solving for Equilibrium Graphically

45°

Aggregate expenditures AE = 1,000 + 0.8Y


12,200

0

Real

exp

endi

ture

s (A

E)

5,000

1,000

$5,000 $14,000

$14,000

10,000

8,000

Real income$2,000 $10,000

2,600 AE0 = $1,000

E


40

In equilibrium, Y = AE.

Substituting in for aggregate expenditures, we have

Y = AE0 + mpcY

Solving for Equilibrium Algebraically


41

Now solve for equilibrium income:

Y – mpcY = AE0

Y (1 – mpc) = AE0

Y = [ 1/ (1 – mpc) ] * AE0

Solving for Equilibrium Algebraically


42

The Multiplier Equation

The multiplier equation tells us that income equals the multiplier times autonomous expenditures.

Y = Multiplier X Autonomous expenditures


43

The Multiplier Equation

The multiplier process amplifies changes in autonomous expenditures.

What forces are operating to ensure that the income level we determined is actually the equilibrium income level?


44

The Multiplier Process

When aggregate production do not equal aggregate expenditures:

Businesses change production levels,

which changes income,

which changes expenditures,

which changes production,

which changes income, which changes . . . etc.


45


The process ends when aggregate production equals aggregate expenditures.

Firms are selling all they produce, so they have no reason to change their production levels.


46


C, I, G, (X – IM)

A2

A1

C

B1

B2

0

Real

exp

endi

ture

s (A

E)

6,000

2,000

$5,000 $14,000

$14,000

10,000


Aggregate expenditures

45°


$13,200

AE = 1,000 + 0.8Y


47

The Circular Flow Model and the Multiplier Process

The circular flow model provides the intuition behind the multiplier process.

The flow of expenditures equals the flow of income.


48


Expenditures are injections into the circular flow.

The mpc measures the percentage of expenditures that get injected back into the economy each round of the circular flow.

But there are withdrawals.


49


Economists use the term the marginal propensity of save (mps) to represent the percentage of income flow that is withdrawn from the economy for each round of the circular flow.


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By definition:

mpc + mps = 1

Alternatively expressed:

mps = 1 - mpc

multiplier = 1/mps


51


Aggregate income

Aggregate expenditures

Households Firms


52

The AE Model in Action

The AE model illustrates how a change in autonomous expenditures changes the equilibrium level of income.


53

The Multiplier Model in Action Autonomous expenditures are determined

outside the model and are not affected by changes in income.

When autonomous expenditures shift, the multiplier process is called into play.


54

The Steps of the Multiplier Process The income adjustment process is directly

related to the multiplier.

Any initial shock (a change in autonomous AE) is multiplied in the adjustment process.


55

The Steps of the Multiplier Process The multiplier process repeats and repeats

until a new equilibrium level is finally reached.


56

Shifts in the Aggregate Expenditure Curve

C, I

$4,200

4,100

832

4,160

4,060

8120


$100

20E1

E0

20


AE0 = 832 + .8YAE1 = 812 + .8Y

E1

100

E0

D AEA = $20$20

$1612.8

D AEA = $16D AEA = $12.8


57

mpc = 0.5

Multiplier = 1/(1-0.5) = 2

100

50

2512.5 6.25

First Five Steps of Four Multipliers

100

75

56.25

42.1931.64

Multiplier = 1/(1-0.75) = 4

mpc = 0.75


58

First Five Steps of Four Multipliers

100

80

64

51.240.96

mpc = 0.8

Multiplier = 1/(1-0.8) = 5

10090

8172.9

65.61

Multiplier = 1/(1-0.9) = 10

mpc = 0.9


59

Examples of the Effect of Shifts in Aggregate Expenditures There are many reasons for shifts in

autonomous expenditures:

Natural disasters. Changes in investment caused by technological

developments. Shifts in government expenditures. Large changes in the exchange rate.


60

The Effect of Shifts in Aggregate Expenditures

An understanding of these shifts can be enhanced by tying them to the formula:

AE = C + I + G + X - IM


61

Upward Shift of AE


1,052.5

AE1

30

30

4,090

$4,090

$4,210

$4,210

$120

Real expenditures

0 Real income

1,022.5

AE0

120 AE4

AE0.75-1

1 Y

0

0


62

$90

$4,152

$4,152

$4,062

4,062

AE0

1,412

AE1

1,382

Downward Shift of AE

Real expenditures

30

30

0 Real income


90 AE3

AE0.66-1

1 Y

0

0


63

Real World Examples

Canada in 2000.

Japan in the 1990s.

The 1930s depression.


64

Canada in 2000

Consumer confidence rose substantially causing autonomous consumption expenditures to increase more than economists had predicted.

While economists had expected the economy to grow slowly, it boomed.


65

Japan in the 1990s

Aggregate income and production fell during the 1990s.

A dramatic rise in the yen cut Japanese exports. Autonomous consumption decreased as

consumers’ confidence fell Suppliers responded by laying off workers and

cutting production.


66

The 1930s Depression

The 1929 stock market crash, which continued into 1930, threw the financial markets into chaos.

This resulted in a downward shift of the AE curve.


67

The 1930s Depression Frightened business people decreased

investment and laid off workers.

Frightened consumers decreased autonomous consumption and increased savings, thereby increasing withdrawals from the system.

Governments cut spending to balance their budgets, as tax revenue declined.


68


Business people responded by decreasing output, which decreased income, starting a downward cycle, thereby confirming the fears of the businesspeople.

The process continued until the economy settled at a low-level equilibrium, far below the potential level of income.


69


The process caused the paradox of thrift, whereby individuals attempting to save more, spent less, and caused income to decrease.

They ended up saving not more, but less.


70

AE Model Is Not a Complete Model The AE model determines income given

autonomous expenditures.

These autonomous expenditures, however, are determined by economic variables which are not in our simple model.


71

The AE model uses aggregate expenditures to determine equilibrium income.

It does not explain production.

It assumes firms can supply the output demanded.

AE Model Is Not a Complete Model


72

Model of Aggregate Demand

Shifts may be simultaneous shifts in supply and demand that do not necessarily reflect suppliers responding to changes in demand.

Expansion of this line of thought has led to the real business cycle theory of the economy.


73

Real business cycle theory of the economy – changes in aggregate supply are the principle way for real income to change.

Model of Aggregate Demand


74

Prices are Fixed

The multiplier model assumes that the price level is fixed.

The price level can change in response to changes in aggregate demand.


75

Does Not Include Expectations People's forward-looking expectations make

the adjustment process much more complicated.

Most people, however, act upon their expectations of the future.

Business people may not automatically cut back production and lay-off workers if they think a fall in sales is temporary.


76

Forward-Looking Expectations Complicate the Adjustment Process Rational expectations model – captures the

effect expectations have on individuals’ behaviour.

Expectations can be self-fulfilling.


77

Consumption Behaviour

People may base their spending on lifetime income, not yearly income.

Permanent income hypothesis -- the hypothesis that expenditures are determined by permanent or lifetime income.


78

We can increase the power of our AE model by adding more detail.

For example, adding taxes to the model Changes consumption expenditures. Introduces government budget deficits and

surpluses. Changes the multiplier.

Expanded AE Model


79

Budget Surplus Function

Budget Surplus

Income0

T - G


80

Expanded AE Model

Adding income-induced imports

Changes import spending.

Changes net exports, and introduces trade surpluses and deficits.

Changes the multiplier.


81

The marginal propensity to import (mpi) gives the increase in import spending from an additional $1 of disposable income. Disposable = after-tax

Mpi lies between 0 and 1

Expanded AE Model


82

The Goods Market and the Aggregate Expenditures Model

End of Chapter 8

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 8: The Goods Market and the Aggregate Expenditures Model Prepared by: Kevin Richter,