Aggregate Expenditure And Aggregate Demand

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Aggregate Expenditure and Aggregate Demand

Chapter 25

© 2006 Thomson/South-Western

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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

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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, CPlanned investment, IGovernment purchases, GNet exports, X – MConsumption is the only spending component

that varies with the level of real GDP

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Aggregate Expenditures

Planned investment: amount of investment that firms plan to undertake during a year

Actual investment: amount of investment actually undertaken; equals planned investment plus unplanned changes in inventories

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Exhibit 1: Real GDP with Net Taxes and Government 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

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Government purchases equals net taxes: government’s budget is balancedThe final column lists any unplanned inventory adjustment: equals real GDP minus planned aggregate expendituresWhen 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

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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

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If the amount produced exceeds planned spending, firms get stuck with unsold goods: unplanned increases in inventoriesWhen real GDP is $13 trillion, planned aggregate expenditure is only $12.8, and $0.2 trillion in output remains unsoldFirms respond by cutting output

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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 of C 1 I 1 G 1 (X 2 M) at each income, or real GDP

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Real GDP Demanded

Income-expenditure 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

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Exhibit 2: Deriving the Real GDP Demanded for a Given Price Level

45 degree line identifies all points where planned expenditure = real GDPPlanned 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 point e

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Real GDP (trillions of dollars)

0

C + I + G + (X – M)

e12.0

12.0

45º

11.0 a

11.0

11.2b

Agg

rega

te e

xpen

dit

ure

(tri

llio

ns

of d

olla

rs)

Exhibit 2: Deriving the Real GDP Demanded for a Given Price Level

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 trillionBecause we assume prices will remain constant, firms will reduce inventoriesBut 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 point e.

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Exhibit 2: Deriving Aggregate Output


0

C + I + G + (X – M)

e12.0

12.0

45º

d

13.0

12.813.0

c

Ag

gre

gat

e ex

pen

dit

ure

(tri

llio

ns

of

do

llars

)

When aggregate expenditures exceed real GDP, for example at $13.0, planned spending (point c) 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 plannedRather than allow inventories to pile up indefinitely, firms reduce production, which reduces employment and income.

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Exhibit 3: Effect of an Increase in Investment

C + I + G + (X – M)

Ag

gre

gat

e e

xp

en

dit

ure

(tr

illio

ns

of

do

llars

)

0

12.0

12.5

12.0

e


12.5

45º

khi

e'

12.1

j

0.1

12.1f

g

C + I' + G + (X – M)

Investment increases by $0.1 trillionUpward 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 points e and f)Reduced inventories prompt firms to expand production by 100 billion (movement from f to g )Those who receive the additional $100 billion spend $80 on goods (movement from g to h)Firms respond by increasing output (movement from h to i)This $80 billion will stimulate new spending of $64 billion (moving from i to j), which causes firms to increase output (from j to k, etc.)

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Exhibit 4:Tracking the Rounds of Spending Following a $100Billion 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

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New Spending Cumulative New Saving CumulativeRound This Round New Spending This Round New Saving

1 100 100 - -2 80 180 20 203 64 244 16 36

10 13.4 446.3 3.35 86.60 500 0 100

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Simple Spending Multiplier

Refers to the factor by which real GDP demanded changes for a given initial change in spending

Simple Spending Multiplier =1/(1–MPC)In our example, the MPC = 0.8 a

multiplier of 5Initial increase in investment spending of

$100 billion will eventually boost real GDP demanded by 5 times this amount, or $500 billion

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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 multiplier the 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

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Simple spending multiplier = 1 / MPSIn 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

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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

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A Higher Price Level

What is the effect of a higher price level on the economy’s aggregate expenditure line and, in turn, on real GDP demanded?

A higher price level reduces consumption because it reduces the real value

of dollar-denominated 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

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Exhibit 5: Income-Expenditure and Aggregate Demand

0 Real GDP (trillions of dollars)

0

140

Ag

gre

gat

e e

xpen

dit

ure

(t

rill

ion

s o

f d

oll

ars)

e

AE (P = 130)

e

130

12.0

12.0 Real GDP (trillions of dollars)

45°

(a) Income-expenditure model

(b) Aggregate demand curve

In panel (a), the AE function intersects the 45 degree line at point e to yield $12 trillion in real GDP demandedPanel 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

Pri

ce l

eve

l

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0 Real GDP (trillions of dollars)A

gg

reg

ate

ex

pe

nd

itu

re

(tri

llio

ns

of

do

lla

rs)

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 trillionIf the price level falls, the opposite occurs: consumption, investment, and net exports increase at each real GDPThe AE function shifts to AE': real GDP increases to $12.5 trillionConnecting these three equilibrium points yields the AD curve

Exhibit 5: Income-Expenditure and Aggregate Demand


0

140

AD

e'

11.5

e130

12.0 Real GDP (trillions of dollars)

120e"

12.5

Pri

ce

le

ve

l


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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

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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

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Exhibit 6: Shifts in Aggregate Expenditures and Aggregate Demand

Ag

gre

gat

e e

xpen

dit

ure

(t

rill

ion

s o

f d

oll

ars)

0 12.0 Real GDP (trillions of dollars)

C + I + G + (X – M)

45º

e

0 12.0 Real GDP (trillions of dollars)

AD

130

Pri

ce l

eve

l

12.5

e'

C + I' + G + (X – M)

0.1

12.5

AD'

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'



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Limitations of the Multiplier

Once aggregate supply is incorporated into the analysis, changes in the price level reduce the impact of the multiplierLeakages 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

Technology

Aggregate Expenditure And Aggregate Demand