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, 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

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 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  When real GDP is $13 trillion, planned aggregate expenditure is only $12.8, and $0.2 trillion in output remains unsold  Firms 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 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

12 Real GDP (trillions of dollars) 0 C + I + G + (X – M) e º 11.0 a 11.2 b Aggregate expenditure (trillions of dollars) 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 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.

13 Exhibit 2: Deriving Aggregate Output Real GDP (trillions of dollars) 0 C + I + G + (X – M) e º d c Aggregate expenditure (trillions of dollars)  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.

14 Exhibit 3: Effect of an Increase in Investment C + I + G + (X – M) A g g r e g a t e e x p e n d i t u r e ( t r i l l i o n s o f d o l l a r s ) e Real GDP (trillions of dollars) º k h i e' 12.1 j f g C + I' + G + (X – M)  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 (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 $100 Billion 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 SpendingCumulativeNew SavingCumulative RoundThis RoundNew SpendingThis RoundNew Saving 

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 5  Initial 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 / 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  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) Aggregate expenditure (trillions of dollars ) e AE (P = 130) e 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 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 Price level

22 0 Real GDP (trillions of dollars) Aggregate expenditure (trillions of dollars) AE' (P = 140) e' 11.5 AE (P = 130) e 12.0 AE" (P = 120) e" °  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 Exhibit 5: Income-Expenditure and Aggregate Demand (a) Income- expenditure model AD e' 11.5 e Real GDP (trillions of dollars) 120 e" 12.5 Price level (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 Aggregate expenditure (trillions of dollars) Real GDP (trillions of dollars) C + I + G + (X – M) 45º e Real GDP (trillions of dollars) AD 130 Price level 12.5 e' C + I' + G + (X – M) 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'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 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