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ECON203 Principles of Macroeconomics

Topic: Expenditure Multipliers: The Keynesian Model

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EXPENDITURE PLANS AND EXPENDITURE PLANS AND REAL GDPREAL 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 (= difference between

spending on imports and receipts from exports (Balance of Payments)

– Aggregate expenditure = C + I + G + NX.

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EXPENDITURE PLANS AND EXPENDITURE PLANS AND REAL GDPREAL GDP

Aggregate planned expenditure might not equal real GDP because firms might end up with more or less inventories than planned.

Aggregate planned expenditure is planned consumption expenditure plus planned investment plus planned government expenditure plus planned exports minus planned imports.

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EXPENDITURE PLANS AND EXPENDITURE PLANS AND REAL GDPREAL 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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Dissaving

Point on Consumption Function line

A B C D E F

Disposable income 0 2.0 4.0 6.0 8.0 10.0Planned Consumption Expenditure

1.5 3.0 4.5 6.0 7.5 9.0

Consumption (trillions of dollars)

A

F

E

6.0

D

Saving is zeroB

C

Saving

450 line

6.0

3.0

2.0 10.0

5

1.5

4.5

4.0 8.0

7.5

9.0

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Consumption FunctionConsumption Function

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

• . 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.

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

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MPConsume– Marginal propensity to consume (MPC) is the

fraction of a change in disposable income that is spent on consumption.

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MPC = Change in consumption expenditure

Change in disposable income

Example : Notice that when disposable income increases from $6 to $8 trillion, consumption expenditure changes from $6.0 to $7.5 trillion. Then:

75.00.2$

5.1$MPC

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RealConsumption

Spending

Disposable income

(Expected) real interest rate

Wealth

Expected future disposable income

+

+

+

-

Other Influences on Consumption

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– 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.

– For example,

• When the real interest rate decreases, or wealth increases, or expected future income increases, consumption expenditure increases.

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Shifts of the consumption functionC

on

sum

pti

on

(tr

illi

on

s o

f 19

96 d

oll

ars)

Disposable income (trillions of 1996 dollars)

CF0

CF2

CF1

1. Consumption expenditure increases and the consumption function shifts upward if• The real interest rate

falls• Wealth increases• Expected future

income increases

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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Consumption and Saving• Since there are only two places income can

go: consumption or saving. The fraction of additional income that is not consumed is the fraction saved. The fraction of a change in income that is saved is called the marginal propensity to save (MPS).

MPC+MPS 1• Once we know how much consumption will Once we know how much consumption will

result from a given level of income, we know result from a given level of income, we know how much saving there will be. Thereforehow much saving there will be. Therefore,,

S Y C

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Equilibrium Expenditure • Using aggregate expenditure model (which

is called the Keynesian model), we can determine equilibrium in the economy when aggregate planned expenditure equals real GDP- the price level being constant.

        Planned Expenditures

[Y] [C] [I] [G] [X] [M] [AE = C + I + G +X - M]

    trillions of 1996 dollars  

A 0.00 0.00 2.00 1.00 1.50 0.00 4.50

B 3.00 2.25 2.00 1.00 1.50 0.75 6.00

C 6.00 4.50 2.00 1.00 1.50 1.50 7.50

D 9.00 6.75 2.00 1.00 1.50 2.25 9.00

E 12.00 9.00 2.00 1.00 1.50 3.00 10.50

F 15.00 11.25 2.00 1.00 1.50 3.75 12.00

Note: Y is real GDP

Aggregate expenditure is the sum of Consumption expenditure (C), Investment (I), Government expenditure (G), Net export (NX) [Export (X) minus Import (M)]

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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.

– In macroeconomics, equilibrium in the goods market is the point at which planned aggregate expenditure is equal to aggregate output

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EQUILIBRIUM EXPENDITURE1.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.

3.When aggregate planned expenditure equals real GDP, there are no unplanned inventories and real GDP remains at equilibrium expenditure

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– 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. Vice a Versa

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The Multiplier

• An autonomous change in aggregate spending leads to a chain reaction in which the change in real GDP is equal to the multiplier times the initial change in aggregate spending.

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The Multiplier

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. The size of the multiplier, 1/(1 − MPC), depends on the marginal propensity to consume, : the larger the MPC, the larger the change in real GDP for any given autonomous increase in aggregate spending.

,.

multip lierM PS

1

multip lierM PC

1

1, or

Marginal Propensity to Save MPS = 1-MPC

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THE EXPENDITURE MULTIPLIER• The Basic Idea of the Multiplier

– The initial increase in investment brings an even bigger increase in aggregate expenditure because it encourages an increase in consumption expenditure.

– The multiplier determines the amount of the increase in aggregate expenditure that results from an increase in investment or another component of autonomous expenditure.

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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 investment, so the multiplier is 4

THE EXPENDITURE MULTIPLIER

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THE AD CURVE AND EQUILIBRIUM– The AE curve is the relationship between

aggregate planned expenditure and real GDP when all other influences on expenditure plans remain the same.

– 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.

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when the price level changes, the AE curve shifts.

– 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.

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When the price level rises to 130, the AE curve shifts downward to AE2.

The quantity of real GDP demanded at the price level of 130 is $9 trillion—a movement along the AD curve to point A.

Equilibrium expenditure decreases to $9 trillion at point A.

THE AD CURVE AND EQUILIBRIUM

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Now it’s over for Now it’s over for today. Do you have today. Do you have any question?any question?