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1
Aggregate Expenditure and Aggregate Demand
Chapter 25
© 2006 Thomson/South-Western
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, CPlanned investment, IGovernment purchases, GNet exports, X – MConsumption is the only spending component
that varies with the level of real GDP
4
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
5
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
6
Exhibit 1: Real GDP with Net Taxes and Government Purchases (trillions of dollars)
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
7
Exhibit 1: Real GDP with Net Taxes and Government 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 and Government Purchases (trillions of dollars)
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
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 of C 1 I 1 G 1 (X 2 M) at each income, or real GDP
10
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
11
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
12
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.
13
Exhibit 2: Deriving Aggregate Output
Real GDP (trillions of dollars)
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.
14
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
Real GDP (trillions of dollars)
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.)
15
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
8
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
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/(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
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 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
18
Simple Spending Multiplier
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
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 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
21
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
22
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
(a) Income-expenditure model
0
140
AD
e'
11.5
e130
12.0 Real GDP (trillions of dollars)
120e"
12.5
Pri
ce
le
ve
l
(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
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'
(a) Income-expenditure model
(b) Aggregate demand curve
26
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