1. 1 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run CHAPTER 11 Aggregate Expenditure and Output in the Short Run Fernando Quijano Prepared by:

2. 2 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Aggregate Expenditure and Output in the Short Run Aggregate expenditure (A.E.) The total amount of spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

3. 3 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model Aggregate expenditure model A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant. Aggregate Expenditure (A.E.) Consumption (C) Planned investment (I) Government purchases (G) Net exports (NX) Understand how macroeconomic equilibrium s determined in the aggregate expenditure model. 11.1 LEARNING OBJECTIVE

4. 4 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model A.E. = Consumption + Planned investment + Government purchases + Net exports or A.E. = C + I + G + NX Understand how macroeconomic equilibrium s determined in the aggregate expenditure model. 11.1 LEARNING OBJECTIVE

5. 5 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model Inventories Goods that have been produced but not yet sold. The Difference between “Planned” Investment and “Actual” Investment *According to the Keynesian school of economic thought, macroeconomic equilibrium must occur where A.E. = GDP.* Understand how macroeconomic equilibrium s determined in the aggregate expenditure model. 11.1 LEARNING OBJECTIVE

6. 6 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Aggregate Expenditure Model Adjustments to Macroeconomic Equilibrium IF …THEN …AND … A.E. = GDP inventories are unchanged the economy is in macroeconomic equilibrium. A.E. < GDPinventories rise GDP and employment decrease. A.E. > GDPinventories fall GDP and employment increase. Table 11-1 The Relationship between Aggregate Expenditure and GDP Understand how macroeconomic equilibrium s determined in the aggregate expenditure model. 11.1 LEARNING OBJECTIVE

7. 7 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy EXPENDITURE CATEGORY EXPENDITURE (BILLIONS OF 2009 DOLLARS) Consumption$10,518 Planned investment2,436 Government purchases2,963 Net exports−431 Table 11-2 Components of Real Aggregate Expenditure, 2012 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

8. 8 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Consumption FIGURE 11-1 Real Consumption Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE Consumption follows a smooth, upward trend, interrupted only infrequently by brief recessions.

9. 9 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Disposable income (Y D ) Wealth Expected future income The price level (P) The real interest rate (r) Consumption The following are the five most important variables that determine the level of consumption: Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

10. 10 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy The most important determinant of consumption is the current disposable income of households. Disposable Income (Y D ) Wealth Consumption depends in part on the wealth of households. A person’s wealth is the value of his/her assets minus the value of his/her liabilities. Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

11. 11 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Consumption depends in part on expected future income. Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly. Expected future income The price level (P) The price level measures the average prices of goods and services in the economy. Consumption is affected by changes in the price level. The real interest rate (r) When the interest rate is high, the reward for saving is increased, and households are likely to save more and spend less. Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

12. 12 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Do Changes in Housing Wealth Affect Consumption Spending? Making the Connection Many macroeconomic variables, such as GDP, housing prices, consumption spending, and investment spending, rise and fall at about the same time during the business cycle Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

13. 13 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run FIGURE 11-2 The Relationship between Consumption and Income, 1960– 2008 Determining the Level of Aggregate Expenditure in the Economy The Consumption Function Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE Panel (a) shows the relationship between consumption and income. The points represent combinations of C and Y D for 1960 - 2008. In panel (b), we draw a straight line through the points from panel (a). The line represents the relationship between C and Y D. This line is called the consumption function. The slope of the consumption function is the MPC.

14. 14 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Consumption function The relationship between consumption spending and disposable income. Marginal propensity to consume (MPC) The slope of the consumption function; the amount by which consumption spending changes when disposable income changes. Determining the Level of Aggregate Expenditure in the Economy The Consumption Function Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

15. 15 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run or Change in consumption = Change in disposable income * MPC Determining the Level of Aggregate Expenditure in the Economy The Consumption Function We can also use the MPC to determine how much consumption will change as income changes: Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

16. 16 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run We can rearrange the equation like this: National income = GDP = Disposable income + Net taxes Disposable income = National income − Net taxes Determining the Level of Aggregate Expenditure in the Economy The Relationship between Consumption and National Income Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

17. 17 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run FIGURE 11-3 The Relationship between Consumption and National Income Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE Because national income differs from disposable income only by net taxes—which, for simplicity, we assume are constant—we can graph the consumption function using national income rather than disposable income. We can also calculate the MPC, which is the slope of the consumption function, using either the change in national income or the change in disposable income and always get the same value. The slope of the consumption function between point A and point B is equal to the change in consumption—$1,500 billion— divided by the change in national income—$2,000 billion—or 0.75.

18. 18 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run National income = Consumption + Saving + Taxes Change in national income = Change in consumption + Change in saving + Change in taxes Y = C + S + T Determining the Level of Aggregate Expenditure in the Economy Income, Consumption, and Saving and To simplify, we can assume that taxes are always a constant amount, in which case ΔT = 0, so the following is also true: ΔY = ΔC + ΔS Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

19. 19 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Marginal propensity to save (MPS) The change in saving divided by the change in disposable income. Determining the Level of Aggregate Expenditure in the Economy Income, Consumption, and Saving or MPC + MPS = 1 Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

20. 20 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Solved Problem 11-2 Calculating the Marginal Propensity to Consume and the Marginal Propensity to Save REAL GDP (Y) CONSUMPTION (C) SAVING (S) MARGINAL PROPENSITY TO CONSUME (MPC) MARGINAL PROPENSITY TO SAVE (MPS) $9,000$8,000$1,000—— 10,0008,6001,4000.60.4 11,0009,2001,8000.60.4 12,0009,8002,2000.60.4 13,00010,4002,6000.60.4 Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

21. 21 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run FIGURE 11-4 Real Investment Determining the Level of Aggregate Expenditure in the Economy Planned Investment Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE Investment is much more volatile than consumption. Investment declined significantly during the recessions of 1980, 1981–1982, 1990–1991, 2001, and 2007–2009.

22. 22 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Expectations of future profitability The real interest rate (r) Taxes (τ) Cash flow Determining the Level of Aggregate Expenditure in the Economy Planned Investment The four most important variables that determine the level of investment are: Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

23. 23 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Expectations of future profitability The optimism or pessimism of firms is an important determinant of investment spending. The real interest rate (r) A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. Determining the Level of Aggregate Expenditure in the Economy Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

24. 24 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy Taxes (τ) Firms focus on the profits that remain after they have paid taxes. Cash flow The difference between the cash revenues received by a firm and the cash spending by the firm. Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE

25. 25 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run FIGURE 11-5 Real Government Purchases Determining the Level of Aggregate Expenditure in the Economy Government Purchases Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE Government purchases grew steadily for most of the 1979–2009 period, with the exception of the early 1990s, when concern about the federal budget deficit caused real government purchases to fall for three years, beginning in 1992.

26. 26 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run FIGURE 11-6 Real Net Exports Determining the Level of Aggregate Expenditure in the Economy Net Exports Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE Net exports were negative in most years between 1979 and 2009. Net exports have usually increased when the U.S. economy is in recession and decreased when the U.S. economy is expanding, although they fell during most of the 2001 recession.

27. 27 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Determining the Level of Aggregate Expenditure in the Economy The price level in the United States relative to the price level in other countries If inflation in the United States is lower than inflation in other countries, prices of U.S. products increase more slowly than the prices of products of other countries. The growth rate of GDP in the United States relative to the growth rate of GDP in other countries When incomes in the United States rise more slowly than incomes in other countries, net exports will rise. The exchange rate between the U.S. dollar and other currencies As the value of the U.S. dollar rises, the foreign currency price of U.S. products sold in other countries rises, and the dollar price of foreign products sold in the United States falls. Learning Objective 23.2 Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save. 11.2 LEARNING OBJECTIVE The following are the three most important variables that determine the level of net exports:

28. 28 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Graphing Macroeconomic Equilibrium FIGURE 11-7 An Example of a 45°-Line Diagram Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE In geometry, a 45° line shows all the points that are equal distances from both axes.

29. 29 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run FIGURE 11-8 The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram Graphing Macroeconomic Equilibrium Learning Objective 23.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE Every point of macroeconomic equilibrium is on the 45° line, where A.E. ≡ GDP.

30. 30 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Graphing Macroeconomic Equilibrium FIGURE 11-9 Macroeconomic Equilibrium on the 45°-Line Diagram Learning Objective 23.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE Macroeconomic equilibrium occurs where the A.E. function crosses the 45° line.

31. 31 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run FIGURE 11-10 Macroeconomic Equilibrium Graphing Macroeconomic Equilibrium Learning Objective 23.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE The Keynesian Cross

32. 32 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Graphing Macroeconomic Equilibrium FIGURE 11-11 Showing a Recession on the 45°-Line Diagram Learning Objective 23.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE How the Keynesian Cross illustrates a recession

33. 33 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Graphing Macroeconomic Equilibrium Whenever planned aggregate expenditure is less than real GDP, some firms will experience unplanned increases in inventories. The Important Role of Inventories Learning Objective 23.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE

34. 34 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Graphing Macroeconomic Equilibrium A Numerical Example of Macroeconomic Equilibrium REAL GDP (Y) CONSUMPTION (C) PLANNED INVESTMENT (I) GOVERNMENT PURCHASES (G) NET EXPORTS (NX) PLANNED AGGREGATE EXPENDITURE (A.E.) UNPLANNED CHANGE IN INVENTORIES REAL GDP WILL … $8,000$6,200$1,500 – $500$8,700–$700increase 9,0006,8501,500 –5009,350 –350increase 10,0007,5001,500 –50010,000 0 be in equilibrium 11,0008,1501,500 –50010,650 +350decrease 12,0008,8001,500 –50011,300 +700decrease Table 11-3 Macroeconomic Equilibrium Learning Objective 23.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE

35. 35 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Solved Problem 11-3 Determining Macroeconomic Equilibrium Real GDP (Y) Consumption (C) Planned Investment (I) Government Purchases (G) Net Exports (NX) Planned Aggregate Expenditure (A.E.) Unplanned Change in Inventories $8,000$6,200$1,675 $–500$9,050$–1,050 9,0006,8501,675 –5009,700–700 10,0007,5001,675 –50010,350–350 11,0008,1501,675 –50011,0000 12,0008,8001,675 –50011,650350 Planned aggregate expenditure (A.E.) = Consumption (C) + Investment (I) + Government purchases (G) + Net exports (NX) Unplanned change in inventories = Real GDP (Y) − Planned aggregate expenditure (A.E.) Learning Objective 23.3 Use a 45°-line diagram to illustrate macroeconomic equilibrium. 11.3 LEARNING OBJECTIVE

36. 36 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Multiplier Effect FIGURE 11-12 The Multiplier Effect Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 11.4 LEARNING OBJECTIVE The Keynesian Multiplier

37. 37 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Multiplier Effect Autonomous expenditure An expenditure that does not depend on the level of GDP. Keynesian Multiplier The increase in equilibrium real GDP divided by the increase in autonomous expenditure. Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 11.4 LEARNING OBJECTIVE

38. 38 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Multiplier Effect Table 11-4 The Multiplier Effect in Action ADDITIONAL AUTONOMOUS EXPENDITURE (INVESTMENT) ADDITIONAL INDUCED EXPENDITURE (CONSUMPTION) TOTAL ADDITIONAL EXPENDITURE = TOTAL ADDITIONAL GDP ROUND 1$100 billion$0$100 billion ROUND 2075 billion 175 billion ROUND 3056 billion 231 billion ROUND 4042 billion 273 billion ROUND 5032 billion 305 billion........................ ROUND 1008 billion 377 billion........................ ROUND 1502 billion 395 billion........................ ROUND 1901 billion 398 billion........................ n00$400 billion Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 11.4 LEARNING OBJECTIVE

39. 39 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Multiplier in Reverse: The Great Depression of the 1930s YEARCONSUMPTIONINVESTMENTNET EXPORTSREAL GDPUNEMPLOYMENT RATE 1929$737 billion$102 billion-$11 billion$977 billion3.2% 1933$601 billion$19 billion-$12 billion$716 billion24.9% Making the Connection The multiplier effect contributed to the very high levels of unemployment during the Great Depression. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 11.4 LEARNING OBJECTIVE

40. 40 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Multiplier Effect A Formula for the Keynesian Multiplier Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 11.4 LEARNING OBJECTIVE

41. 41 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Multiplier Effect Summarizing the Multiplier Effect 1.The multiplier effect occurs both when autonomous expenditure increases and when it decreases. 2.The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. 3.The larger the MPC, the larger the value of the multiplier. 4.The formula for the multiplier, [1 / (1 − MPC)], is oversimplified because it ignores some real-world complications, such as the effect that increases in GDP have on imports, inflation, interest rates, and individual income taxes. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 11.4 LEARNING OBJECTIVE

42. 42 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run The Multiplier Effect The Paradox of Thrift In discussing the aggregate expenditure model, John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing A.E. to fall. This would push the economy into a recession. The lower incomes in the recession might mean that total saving does not increase, despite the attempts by many individuals to increase their own saving. Keynes referred to this outcome as the paradox of thrift because what appears to be something favorable to the long- run performance of the economy might be counterproductive in the short-run. Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP. 11.4 LEARNING OBJECTIVE

43. 43 of 55 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 11: Aggregate Expenditure and Output in the Short Run Aggregate expenditure (A.E.) Aggregate expenditure model Autonomous expenditure Cash flow Consumption function Inventories Keynesian Multiplier Marginal propensity to consume (MPC) Marginal propensity to save (MPS) Multiplier effect KEY TERMS