Aggregate Expenditure and Aggregate Demand

1
Aggregate Expenditure and Aggregate Demand

• Chapter 10

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Aggregate Expenditure and Income

• Each dollar spent on production translates
  directly into a dollar of aggregate income
  RememberGDP equals aggregate income
• Investment, government purchases, and net exports
  are autonomous, independent of the level of
  income (some of this will be relaxed in later
  chapters).

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, C
• Planned investment, I
• Government purchases, G
• Net exports, X M
• Consumption 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
• Whats left over??? Its unplanned
  investmentthis is an increase or decrease in
  inventories that is not anticipatedSALE!!!

5
Exhibit 1 Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
Autonomous

• Suppose the price level in the economy is 130,
  30 higher than in the base year.
• Can we calculate the MPS and MPC from this table?
  (the answer is yes).
• This table presents the information that is
  needed on the various components of aggregate
  demand and expenditure MPC is 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
  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 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 inventories, however for now, they
  arent allowed to reduce prices to sell the
  excess inventorieswhat do they adjust???
  Production!
• When real GDP is 13 trillion, planned aggregate
  expenditure is only 12.8, and 0.2 trillion in
  output remains unsold
• Firms, under the assumption of a fixed price
  level, respond by cutting output

9
Real GDP Demanded

• The aggregate expenditure line shows the
  relationship, for a given price level, of planned
  spending at each income, or real GDP.
• The total of C, I, G, and (X - M) at each income
  level, or real GDP.
• Each row in the table above represents a single
  point on the AE line.

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Real GDP Demanded

• From this we develop the Income-expenditure
  model a relationship between aggregate income
  and aggregate spending that determines, for a
  given price level, where spending (AE) is equal
  to the amount produced (GDP).

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 point e

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Exhibit 2 Deriving the Real GDP Demanded for a
Given Price Level
C I G (X M)

• 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 point e.

Aggregate expenditure (trillions of dollars)

AE(b)gtGDP(a)
45º
0
Real GDP (trillions of dollars)
13
Exhibit 2 Deriving Aggregate Output

• 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 planned
• Rather than allow inventories to pile up
  indefinitely, firms reduce production, which
  reduces employment and income.

AE(c)ltGDP(d)
d
13.0
12.8

c
C I G (X M)

Aggregate expenditure (trillions of dollars)

45º
13.0
0
Real GDP (trillions of dollars)
14
Exhibit 2 The Real GDP Demanded for a Given
Price Level

• At a given price level, any movement away from e
  will result in adjustments in inventories,
  employment, income and finally consumption to
  bring the economy back to point e, where
  expenditures output.

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Exhibit 3 Shifting the AE Line(The Effect of an
Increase in Investment)

• 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 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 again
  (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, yet again (from j to k,
  etc.)
• The initial infusion of 0.1 trillion (or 100
  billion) increases output by 0.5 trillion (or
  500 million)!!!

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C I G (X M)
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C I' G (X M)
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12.1
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45º
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12.0
12.5
Real GDP
(trillions of dollars)
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Exhibit 4Tracking the Rounds of Spending
Following a 100Billion Increase in investment
(billions of dollars)
8
?

• 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
  roundsthere is a shortcut.

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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/(1MPC)
• In our example, the MPC 0.8 ? a 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

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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

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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, (C,
  I, G, or X-M)
• 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, reducing GDP by a multiple effect.

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Spending Multiplier Whats its importance

• Its used in all types of economic development
  work. The reason we provide incentives for
  industry to locate in GA is that investment
  dollars are multiplied in our economy.
• We use a similar multiplier to estimate the
  effect of new industries locating in our area.

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Spending Multiplier Air Travel after 9/11

• Lets think of a specific example of how the
  multiplier works after a specific event.
• After 9/11 very few people were flying.
• Immediate layoffs
• Investment in aircraft falls
• Income falls in airline jobs and any industry
  supporting airlines
• Airline workers spend less on groceries
• Businesses throughout the economy see sales fall
• More jobs are lost in unrelated industries
• and, so on

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Another way of 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, so a change in price level
  shifts the AE line.
• By altering the price level, we can derive the
  aggregate demand curve in a different way than we
  learned previously.

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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?
• A higher price level
• reduces consumption because it reduces the real
  value of dollar-denominated assets (i.e., cash
  holdings) held by householdspeople feel poorer.
• An increasing price level increases the market
  rate of interest, which reduces investment
• An increasing price level makes U.S. goods
  relatively more expensive abroad imports rise
  and exports fall
• All of these results in an inward shift in AE.

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Exhibit 5 Income-Expenditure and Aggregate Demand
(a) Income-expenditure model

Aggregate expenditure (trillions of dollars)

• In panel (a), the AE function intersects the 45
  degree line at point e to 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

45

0
Real GDP (trillions of dollars)
(b) Aggregate demand curve
140
Price level

0
Real GDP (trillions of dollars)
25
Exhibit 5 Income-Expenditure and Aggregate Demand

• 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

AE" (P 120)
e"
AE (P 130)
AE' (P 140)

Aggregate expenditure (trillions of dollars)
e
(a) Income-expenditure model
e'
45
12.5

0
Real GDP (trillions of dollars)
11.5
12.0
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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
C I G (X M)

• 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

(a) Income-expenditure model
Aggregate expenditure (trillions of dollars)
e
45º
0
12.0
Real GDP (trillions of dollars)
(b) Aggregate demand curve
e'
e
130
Price level

AD
0
12.0
Real GDP (trillions of dollars)
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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 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