1 More on Planned Aggregate Expenditure - PAE

2 In the previous set of notes I mentioned that the level of output is determined by the planned aggregate spending in the economy. The essential reason for that was inventory adjustment. Here I wanted to elaborate on some of the components of planned aggregate expenditure and then I will show you the income multiplier. Remember we have 4 basic sectors of the economy: households, businesses, governments and the rest of the world. The output that is made is taken by these sectors and we call each component, respectively, consumption expenditure C, investment expenditure I, government expenditure G and net exports X (last section I switched from NX to just X for ease of typing.) Since these sectors take the economies output, if their plans change we would expect output to change. Let’s look at each again.

3 Actual output or income Planned aggregate expenditure. C 1) This is traditionally called the intercept and it will have to do with what is called autonomous expenditure 2) If actual income should change… 3) This is a change in consumption because income changed. This is called an induced expenditure change.

4 On the previous slide you see a graph that has what is called the consumption function on it. Note in the graph the horizontal axis is actual output or income. This is the actual RGDP. What is on the vertical axis is the planned expenditure amounts for C, Ip, G and X. When the planned values on the vertical axis depend on the actual value on the horizontal axis we say the planned values are induced expenditure. When the planned values on the vertical depend on things other than what is on the horizontal axis we say the planned values are autonomous expenditure. Consumption has features of both autonomous expenditure and induced expenditure. Let’s turn to that next.

5 Consumption depends on income and taxes. When people get more income they tend to spend more so planned expenditure on consumption is induced from income. Here we move along the consumption function. When people have to pay more in taxes this is like they have less income and thus we expect them to consume less. In this case the whole consumption function would shift down. This is like the intercept has changed to a lower level. This is the autonomous part. On the next slide you see a horizontal line that could represent the planned investment, government or net export spending and for us these are all autonomous.

6 Actual output or income Planned aggregate expenditure. 1) As income changes…. 2) There is no change in the autonomous spending part.

7 Actual income Planned expenditure 45 degree line PAE1 Y1

8 On the previous slide we see that with PAE1 we get income Y1. On the next slide let’s have an increase in autonomous spending. This will shift the curve up. Note that the curve shifts up by the change in spending. But, the change in income is way more than the change in spending. Why is this? Why NOT!! The real reason for this is summarized with the word multiplier. Before we explain this idea make sure you see it in the diagram on the next slide. The PAE line shifts up by A to C, or the same amount D to E. The income change is Y1 to Y2 and I have this as A to B. Since the two dots are on the 45 degree line the distance A to B is equal to B to E (this part may not look right in the graph.)

9 PAE components Actual income PAE2 PAE1 Y1 Y2 A B C D E

10 Here is a way to understand the multiplier. Autonomous changes lead to induced changes in the economy. The MPC (marginal propensity to consume) is an idea that means when income goes up by $1 households consume more by the amount known as the MPC. The MPC is less than 1 throughout the whole economy (although maybe a family or 2 will earn an additional buck and spend $1.05.). Let’s say the MPC is 0.8. Say autonomous spending goes up by $10 (maybe households feel wealthier because the stock market went up a large amount and it is felt that the stocks will stay this way.) The PAE line shifts up by $10 and indeed we have income start to move to the right by 10. With the increase in spending of $10 someone earns this as income and this would not have been earned if households did not feel wealthier. Now who ever earned the $10 now has $10 more in income and since the MPC is.8 this person will spend $8.

11 Whoever earns the $8 will spend 80% or $6.40 and this means someone will have income and they will spend 80%, and so on. The process looks like … = 10( …) and this all simplifies to 10[1/(1-.8)] or in general we have autonomous change times 1/(1 – MPC). This term 1/(1 – MPC) is called the multiplier and when MPC =.8 the multiplier is 1/(1 -.8) = 1/.2 = 5. So a $10 change in autonomous spending (D to E in the graph before) leads to a total change in income of $50 (B to E). The $10 to the $50 means $40 (B to D) was induced from the original change.

12 Fiscal Policy again We said fiscal policy was federal gov change in G or taxes. G is an autonomous component. So, if the government changes G by 50 the PAE line shifts by 50 and if the MPC is.8 total income changes by 250 due to the multiplier. Taxes work through the consumer. Remember consumers change their spending by the MPC times the change in their spendable income (spendable is not really a word – I should use disposable income). If taxes are lowered by 50 consumers will only raise their autonomous consumption by 40 and thus the curve shifts by 40. Then the multiplier kicks in and income changes by 200. The deal here is consumers as a large group tend to save some of the tax saving – here 20%. G is a more potent fiscal tool than taxes, on a dollar per dollar basis.