 1.Aggregate Expenditure and Aggregate Demand
2006 Thomson/SouthWestern 2. Aggregate Expenditure and
Income

 Each dollar spent on production translates directly into a
dollar of aggregate income: GDP equals aggregate income

 Investment, government purchases, and net exports are
autonomous, independent of the level of income
3. Aggregate Expenditures
 Equals the amount that households, firms, governments, and the
rest of the world plan to spend on U.S. output at each level of
real GDP:

 Consumption is the only spending component that varies with the
level of real GDP
4. Aggregate Expenditures
 Plannedinvestment: amount of investment that firms plan to
undertake during a year
 Actualinvestment: amount of investment actually undertaken;
equals planned investment plus unplanned changes in
inventories
5. Exhibit 1: Real GDP with Net Taxes andGovernment Purchases
(trillions of dollars)
 Suppose the price level in the economy is 130, 30% higher than
in the base year.
 This table presents the information that is needed on the
various components of aggregate demand and expenditure: MPC is
assumed to be 4/5 and the MPS is 1/5
6. Exhibit 1: Real GDP with Net Taxes andGovernment Purchases
(trillions of dollars)
 Government purchases equals net taxes: governments budget is
balanced
 The final column lists any unplanned inventory adjustment:
equals real GDP minus planned aggregate expenditures
 When the amount of planned spending equals the amount produced,
there are no unplanned inventory adjustments.Here, this occurs
where planned aggregate expenditures and real GDP equal $12.0
trillion
7. Exhibit 1: Real GDP with Net Taxes andGovernment Purchases
(trillions of dollars)
 When real GDP is $11 trillion, planned aggregate expenditure is
$11.2, which exceeds the amount produced by $0.2 trillion
 Firms rely upon inventories to make up the shortfall (unplanned
inventory investment of $0.2) and respond by increasing
output
8. Exhibit 1: Real GDP with Net Taxes andGovernment Purchases
(trillions of dollars)
 If the amount produced exceeds planned spending, firms get
stuck with unsold goods: unplanned increases in inventories
 When real GDP is $13 trillion, planned aggregate expenditure is
only $12.8, and$0.2 trillion in output remains unsold
 Firms respond by cutting output
9. Real GDP Demanded
 Aggregate expenditure line: shows the relationship, for a given
price level, of planned spending at each income, or real GDP
 The total ofC1I1G1 ( X2M ) at each income, or real GDP
10. Real GDP Demanded
 Incomeexpenditure model: a relationship between aggregate
income and aggregate spending that determines, for a given price
level, where the amount people plan to spend is equal to the amount
produced
11. Exhibit 2: Deriving the Real GDP Demanded for a Given Price
Level
 45 degree line identifies all points where planned expenditure
= real GDP
 Planned aggregate expenditure is measured on the vertical
axis.
 Aggregate output demanded at any given price level occurs where
real GDP equals planned aggregate expenditures, at pointe
12. Exhibit 2: Deriving the Real GDP Demanded for a Given Price
Level Real GDP (trillions of dollars) 0 C + I + G + (X M)
45Aggregate expenditure (trillions of dollars)
 Consider what happens when real GDP is initially less than $12
trillion, say $11 trillion.Planned aggregate expenditures of $11.2
trillion (point b) exceeds output by $0.2 trillion
 Because we assume prices will remain constant, firms will
reduce inventories
 But unplanned inventory reductions cannot continue
indefinitely; firms will increase employment increasing income,
increasing consumer spending.This process will continue until
planned spending equals real GDP at pointe.
e 12.0 12.0 11.0 a 11.0 11.2 b 13. Exhibit 2: Deriving Aggregate
Output Real GDP (trillions of dollars)0 C + I + G + (X M) 45d 13.0
12.8 13.0 c Aggregate expenditure (trillions of dollars)
 When aggregate expenditures exceed real GDP, for example at
$13.0, planned spending (pointc ) falls short of production (point
d).
 Since real GDP exceeds the amount people want to spend, unsold
goods accumulate by $0.2 trillion more than firms planned
 Rather than allow inventories to pile up indefinitely, firms
reduce production, which reduces employment and income.
e 12.0 12.0 14. Exhibit 3: Effect of an Increase in Investment C
+ I + G + (X M) A g g r e g a t e e x p e n d i t u r e ( t r i l l
i o n s o f d o l l a r s ) 0 12.0 12.5 12.0 e Real GDP(trillions
of dollars) 12.5 450.1 12.1 f g C + I' + G + (X M)
 Investment increases by $0.1 trillion
 Upward shift of the AE line means that at initial real GDP
level of $12 trillion, planned spending exceeds output by $0.1
trillion (the distance between pointseandf )
 Reduced inventories prompt firms to expand production by 100
billion (movement fromftog)
 Those who receive the additional $100 billion spend $80 on
goods (movement fromgtoh )
 Firms respond by increasing output (movement fromhtoi )
 This $80 billion will stimulate new spending of $64 billion
(moving fromitoj ), which causes firms to increase output (fromjtok
, etc.)
k h i e' 12.1 j 15. Exhibit 4:Tracking the Rounds of Spending
Following a $100 Billion Increase in investment (billions of
dollars)
 Exhibit 4 summarizes the multiplier process, showing the first
three rounds, round ten, and the cumulative effect of all
rounds

 The new spending generated in each round is shown in the second
column and the accumulation of new spending appears in the third
column

 Total new spending after 10 rounds sums to $446.3 billion

 But calculating the exact total would require us to work
through an infinite series of rounds
8 New Spending Cumulative New Saving Cumulative Round This Round
New Spending This Round New Saving 1 100 100   2 80 180 20 20 3
64 244 16 36 10 13.4 446.3 3.35 86.6 0 500 0 100 16. Simple
Spending Multiplier
 Refers to the factor by which real GDP demanded changes for a
given initial change in spending
 Simple Spending Multiplier =1/(1MPC)
 In our example, the MPC = 0.8a multiplier of 5
 Initial increase in investment spending of $100 billion will
eventually boost real GDP demanded by 5 times this amount, or $500
billion
17. Simple Spending Multiplier
 The multiplier depends on the value of the MPC
 Specifically, the larger the fraction of an increase in income
that is spent each round, the larger the spending multiplierthe
larger the MPC, the larger the simple multiplier

 With an MPC of 0.8, the multiplier is 5

 With an MPC of 0.9, the multiplier is 10

 With an MPC of 0.75, the multiplier is 4
18. Simple Spending Multiplier
 Simple spending multiplier = 1 / MPS
 In our example, the multiplier process started because of an
increase in investment, but the same impact would occur if any one
of the components of aggregate expenditures changed
 If the higher level of planned investment is not sustained in
future years, real GDP would fall back and the multiplier process
would work in reverse
19. Deriving the Aggregate Demand Curve
 What happens to the aggregate expenditure line if the price
level changes
 For each price level there is a specific aggregate expenditure
line which yields a unique real GDP demanded
 By altering the price level, we can derive the aggregate demand
curve
20. A Higher Price Level
 What is the effect of a higher price level on the economys
aggregate expenditure line and, in turn, on real GDP demanded?

 reduces consumption because it reduces the real value of
dollardenominated assets held by households

 increases the market rate of interest which reduces
investment

 makes U.S. goods relatively more expensive abroad: imports rise
and exports fall
21. Exhibit 5: IncomeExpenditure and Aggregate Demand 0 Real
GDP (trillions of dollars) 0 140Aggregate expenditure(trillions of
dollars ) Real GDP (trillions of dollars) 45 (a) Incomeexpenditure
model (b) Aggregate demand curve
 In panel (a), the AE function intersects the 45 degree line at
pointeto yield $12 trillion in real GDP demanded
 Panel b shows that when the price level is 130, real GDP
demanded is $12 trillion and we have one point on the aggregate
demand curve, e
Price level e AE( P=130) e 13012.0 12.0 22. Exhibit 5:
IncomeExpenditure and Aggregate Demand 0 Real GDP (trillions of
dollars) Aggregate expenditure(trillions of dollars) AE' (P = 140)
e' 11.5 AE (P = 130) e 12.0 AE" (P = 120) e" 12.5 45
 If the price level increases to 140, the increase in the price
level reduces consumption, planned investment, and net exports as
shown by the downward shift of the aggregate expenditure line from
AE to AE' and real GDP demanded declines from $12 trillion to $11.5
trillion
 If the price level falls, the opposite occurs: consumption,
investment, and net exports increase at each real GDP
 The AE function shifts to AE': real GDP increases to $12.5
trillion
 Connecting these three equilibrium points yields the AD
curve
(a) Incomeexpenditure model0 140AD e' 11.5 e 13012.0 Real GDP
(trillions of dollars) 120 e" 12.5 Price level ( b) Aggregate
demand curve 23. Aggregate Demand and Expenditures
 The aggregate expenditure line and the aggregate demand curve
portray real output from different perspectives

 The aggregate expenditure line shows, for a given price level,
how planned spending relates to the level of real GDP in the
economy

 The aggregate demand curve shows, for various price levels, the
quantities of real GDP demanded
24. Multiplier and Aggregate Demand
 Suppose we return to the situation where the price level is
assumed to be constant
 What we want to do now is trace through the effects of a shift
in any of the components of spending on aggregate demand, while
assuming that the price level does not change, e.g., we want to
look at the multiplier and shifts in aggregate demand
25. Exhibit 6: Shifts in Aggregate Expenditures and Aggregate
Demand Aggregate expenditure(trillions of dollars) 0 12.0 Real GDP
(trillions of dollars) C + I + G + (X M) 45e 0 12.0 Real GDP
(trillions of dollars) AD 130 Price level
 At a price level of 130, the aggregate expenditure line
intersects the 45 degree line at point e in panel (a), and yields
point e on the aggregate demand curve in panel (b)
 When one component of aggregate expenditure increases and the
price level remains constant, the aggregate demand curve shifts
from AD to AD' and the new point of equilibrium is shown as e in
both panels
e e' (a) Incomeexpenditure model(b) Aggregate demand curve 12.5
e' C + I' + G + (X M) 0.1 12.5 AD' 26. Limitations of the
Multiplier
 Once aggregate supply is incorporated into the analysis,
changes in the price level reduce the impact of the multiplier

 Leakages such as higher income taxes and increased spending on
imports all reduce the size of the multiplier

 The spending multiplier takes time to work itself out, the
process does not occur instantly