The Economy at Full Employment

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A QUICK REVIEW AND PREVIEW

• The Economy at Full Employment
• At full employment, real GDP equals potential GDP
  and the unemployment rate equals the natural
  unemployment.
• Potential GDP and the natural unemployment rate
  are determined by real factors and are
  independent of the price level.

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A QUICK REVIEW AND PREVIEW

• The quantity of money and money equilibrium
  determine nominal GDP.
• Nominal GDP and potential GDP determine the price
  level.
• So changes in the quantity of money change
  nominal GDP and change the price level but have
  no effect on potential GDP.

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A QUICK REVIEW AND PREVIEW

• Departures from Full Employment
• Aggregate supply and aggregate demand determine
  equilibrium real GDP and the price level.
• Fluctuations in aggregate supply and aggregate
  demand bring fluctuations around full employment.

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A QUICK REVIEW AND PREVIEW

• Fixed Price Level
• In the aggregate expenditure model, the price
  level is fixed.
• The model explains
• What determines the quantity of real GDP demanded
  at a given price level
• What changes in that quantity of real GDP at a
  given price level.

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15.1 EXPENDITURE PLANS AND REAL GDP

• From the circular flow of expenditure and income,
  aggregate expenditure is the sum of
• Consumption expenditure, C
• Investment, I
• Government purchases of goods and services, G
• Net exports, NX
• Aggregate expenditure C I G NX.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Planned and Unplanned Expenditures
• Motorola decides to produce 11 million cell
  phones in 2001.
• Motorola plans to sell 10 million phones and to
  put 1 million into inventory.
• People and firms makes their expenditure plans
  and they decide to buy 9 million phones from
  Motorola.
• Planned expenditure on phones is 10 million (9
  million 1 million), which is less than
  production of 11 million.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Aggregate expenditure equals aggregate income and
  real GDP.
• But aggregate planned expenditure might not equal
  real GDP because firms might end up with up 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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15.1 EXPENDITURE PLANS AND REAL GDP

• Firms make their production plans, they pay
  incomes that equal the value of production, so
  aggregate income equals real GDP.
• Households and governments make their planned
  purchases and net exports are as planned.
• Firms make their planned purchases of new
  buildings, plant, and equipment, and their
  planned inventory changes.

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15.1 EXPENDITURE PLANS AND REAL GDP

• If aggregate planned expenditure equals GDP, the
  change in firms inventories is the planned
  change.
• If aggregate planned expenditure exceeds GDP,
  firms inventories are smaller than planned.
• If aggregate planned expenditure is less than
  GDP, firms inventories are larger than planned.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Notice that actual expenditure, which equals
  planned expenditure plus the unplanned change in
  firms inventories, always equals GDP and
  aggregate income.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Unplanned changes in firms inventories lead to
  changes in production and incomes.
• If unwanted inventories have piled up, firms
  decrease production, which decreases real GDP.
• If inventories have fallen below their target
  levels, firms increase production, which
  increases real GDP.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Induced Expenditure and Autonomous Expenditure
• Autonomous expenditure
• The components of aggregate expenditure that do
  not change when real GDP changes.
• Autonomous expenditure equals investment plus
  government purchases plus exports plus the
  components of consumption expenditure and imports
  that are not influenced by real GDP.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Induced expenditure
• The components of aggregate expenditure that
  change when real GDP changes.
• Induced expenditure equals consumption
  expenditure minus imports (excluding the elements
  of consumption expenditure and imports that are
  part of autonomous expenditure).

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15.1 EXPENDITURE PLANS AND REAL GDP

• The Consumption Function
• Consumption function
• 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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15.1 EXPENDITURE PLANS AND REAL GDP

• Marginal Propensity to Consume
• Marginal propensity to consume (MPC) is the
  fraction of a change in disposable income that is
  spent on consumption.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Other Influences on Consumption
• The factors that influence planned consumption
  are
• Disposable income
• Real interest rate
• The buying power of money
• Expected future disposable income

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15.1 EXPENDITURE PLANS AND REAL GDP

• 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 the
  buying power of money increases, or expected
  future income increases, consumption expenditure
  increases.

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15.1 EXPENDITURE PLANS AND REAL GDP

• Imports and GDP
• Consumption expenditure is one major component of
  induced expenditure, imports are the other.
• In the short run, the factor influencing imports
  is U.S. real GDP.
• Marginal propensity to import is the fraction of
  an increase in real GDP that is spent on imports.
  
• The marginal propensity to import equals the
  change in imports divided by the change in real
  GDP that brought it about.

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15.2 EQUILIBRIUM EXPENDITURE

• Aggregate Planned Expenditure and GDP
• Consumption expenditure increases when disposable
  income increases.
• Disposable income equals aggregate
  incomeGDPminus net taxes, so disposable income
  and consumption expenditure increase when GDP
  increases.
• We use this link between consumption expenditure
  and GDP to determine equilibrium expenditure.

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15.2 EQUILIBRIUM EXPENDITURE

• 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.

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15.2 EQUILIBRIUM EXPENDITURE

• Convergence to Equilibrium
• At equilibrium expenditure, production plans and
  spending plans agree, and there is no reason to
  change production or spending.
• But when aggregate planned expenditure and actual
  aggregate expenditure are unequal, production
  plans and spending plans are misaligned, and a
  process of convergence toward equilibrium
  expenditure occurs.
• Throughout this convergence process, real GDP
  adjusts.

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15.3 THE EXPENDITURE MULTIPLIER

• When investment increases, aggregate expenditure
  and real GDP also increase.
• But the increase in real GDP is larger than the
  increase in investment.
• The multiplier is the amount by which a change in
  investment is magnified or multiplied to
  determine the change that it generates in
  equilibrium expenditure and real GDP.

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15.3 THE EXPENDITURE MULTIPLIER

• The Basic Idea of the Multiplier
• The initial increase in investment brought an
  even bigger increase in aggregate expenditure
  because it induced an increase in consumption
  expenditure.
• The multiplier determines the magnitude of the
  increase in aggregate expenditure that results
  from an increase in investment or another
  component of autonomous expenditure.
• Consumption expenditure decisions, imports, and
  income taxes that open a gap between disposable
  income and real GDP all influence the multiplier.

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15.3 THE EXPENDITURE MULTIPLIER

• The Size of the Multiplier
• The multiplier
• The amount by which a change in autonomous
  expenditure is multiplied to determine the change
  in equilibrium expenditure that it generates.
• That is,

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15.3 THE EXPENDITURE MULTIPLIER

• Why Is the Multiplier Greater Than 1?
• The multiplier is greater than 1 because an
  increase in autonomous expenditure induces an
  increase in aggregate expenditure in addition to
  the increase in autonomous expenditure.

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15.3 THE EXPENDITURE MULTIPLIER

• The Multiplier and the MPC
• The greater the marginal propensity to consume,
  the larger is the multiplier.
• Ignoring imports and income taxes, the change in
  real GDP (?Y) equals the change in consumption
  expenditure (?C) plus the change in investment
  (?I).
• That is,
• ?Y ?C ?I

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15.3 THE EXPENDITURE MULTIPLIER

• ?Y ?C ?I
• But the change in consumption expenditure is
  determined by the change in real GDP and the
  marginal propensity to consume.
• It is
• ?C MPC ? ?Y
• Now substitute MPC ? ?Y for ?C in the equation at
  the top of the screen
• ?Y MPC ? ?Y ?I

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15.3 THE EXPENDITURE MULTIPLIER

• Now solve for ?Y as
• (1 MPC) ? ?Y ?I
• Rearrange to get

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15.3 THE EXPENDITURE MULTIPLIER

• Now, divide both sides of the by the ?I to give

When MPC is 0.75, so the multiplier is
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15.3 THE EXPENDITURE MULTIPLIER

• Imports and Income Taxes
• The multiplier depends, in general, not only on
  consumption decisions but also on imports and
  income taxes.
• Imports make the multiplier smaller that it
  otherwise would be because only expenditure on
  U.S.-made goods and services increases U.S. real
  GDP.
• The larger the marginal propensity to import, the
  smaller is the change in U.S. real GDP that
  results from a change in autonomous expenditure.

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15.3 THE EXPENDITURE MULTIPLIER

• Income taxes make the multiplier smaller than it
  would otherwise be.
• With increased incomes, income tax payments
  increase and disposable income increases by less
  than the increase in real GDP.
• Because disposable income influences consumption
  expenditure, the increase in consumption
  expenditure is less than it would if income tax
  payments had not changed.

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15.3 THE EXPENDITURE MULTIPLIER

• The marginal tax rate determines the extent to
  which income tax payments change when real GDP
  changes.
• The marginal tax rate is the fraction of a change
  in real GDP that is paid in income taxesthe
  change in tax payments divided by the change in
  real GDP.
• The larger the marginal tax rate, the smaller is
  the change in disposable income and real GDP that
  results from a given change in autonomous
  expenditure.

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15.3 THE EXPENDITURE MULTIPLIER

• The marginal propensity to import and the
  marginal tax rate together with the marginal
  propensity to consume determine the multiplier.
• Their combined influence determines the slope of
  the AE curve.
• The general formula for the multiplier is

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