1. AE = C + I + G + NX C = Consumption expenditures  Durable goods: T.V.’s, and cars. Does not include houses  Non-durable goods: clothing, food, and fuel  Services: health care, education I = Investment expenditures  Business fixed investment on structures (factories, warehouses) and equipment (vehicles, furniture, computers)  Residential investment on the construction of new homes G = Government expenditures on goods and services  New aircraft carriers, Air Force I, Presidential limo, FBI vehicles, etc.  Does the government buy US products only? NX = net exports = eXports – iMports  X is the amount spent by foreigners on goods built in the USA  M is the amount spent by Americans on goods from outside of the USA Aggregate Expenditure

2. Consumption expenditure  The Consumption function is the relationship between consumption and disposable income  Disposable income (DI) is aggregate income (GDP) minus net taxes (T). DI = Y – T where T = taxes paid to the government minus transfer payments received from the government.  The diagram to the right shows how C and DI evolve over time.  Download the data, use Excel to derive the C function http://research.stlouisfed.org/fred2/graph/?g=o4I Simulated consumption

3. Consumption expenditure Simulated consumption A = W + Y e – PL – r C = A + mpc ∙ DI C = [ W + Y e – PL – r ] + mpc ∙ DI  Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [ W + Y e – PL – r ] + mpc ∙ DI

4. Consumption expenditure Simulated consumption A = W + Y e – PL – r C = A + mpc ∙ DI C = [ W + Y e – PL – r ] + mpc ∙ DI  Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [ 8 + Y e – PL – r ] + mpc ∙ DI

5. Consumption expenditure Simulated consumption A = W + Y e – PL – r C = A + mpc ∙ DI C = [ W + Y e – PL – r ] + mpc ∙ DI  Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [ 8 + 12 – PL – r ] + mpc ∙ DI

6. Consumption expenditure Simulated consumption A = W + Y e – PL – r C = A + mpc ∙ DI C = [ W + Y e – PL – r ] + mpc ∙ DI  Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [ 8 + 12 – 14.5 – r ] + mpc ∙ DI

7. Consumption expenditure Simulated consumption A = W + Y e – PL – r C = A + mpc ∙ DI C = [ W + Y e – PL – r ] + mpc ∙ DI  Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [ 8 + 12 – 14.5 – 3.5 ] + mpc ∙ DI

8. Consumption expenditure Simulated consumption A = W + Y e – PL – r C = A + mpc ∙ DI C = [ W + Y e – PL – r ] + mpc ∙ DI  Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = [ 8 + 12 – 14.5 – 3.5 ] + 0.75 ∙ DI

9. Consumption expenditure Simulated consumption A = W + Y e – PL – r C = A + mpc ∙ DI C = [ W + Y e – PL – r ] + mpc ∙ DI  Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function. C = 2 + 0.75 ∙ DI

10. Consumption expenditure  Example (continued): C = 2 + 0.75 DI When DI = 0 C = 2 + 0.75(0) C = 2 When DI = 8 C = 2 + 0.75(8) C = 2 + 6 C = 8 0 2 DI C 8 8 Simulated consumption

11. Consumption expenditure 0 2 DI C 8 8  Example (continued): C = 2 + 0.75 DI When consumption lies on the 45° line, all disposable income is consumed and saving is zero. Saving = DI – C = 8 – 8 = 0 45 o Simulated consumption

12. Consumption expenditure  Example (continued): C = 2 + 0.75 DI When consumption lies below the 45° line, saving occurs. When DI = 9.5 C = 2 + 0.75(9.5) = 2 + 7.125 = 9.125 S = DI – C = 9.5 – 9.125 = 0.3750 9.5 0 2 DI C 45 o 9.125 Simulated consumption

13. Consumption expenditure  Example (continued): C = 2 + 0.75 DI When consumption lies above the 45° line, dissaving occurs. When DI = 6 C = 2 + 0.75(6) = 2 + 4.5 = 6.5 S = DI – C = 6 – 6.5 = –0.5 6 0 2 DI C 45 o 6.5 Simulated consumption

14. Consumption expenditure  Example (continued): With real GDP held constant at 15 trillion dollars, show what happens to the consumption model when consumer wealth rises to 8.5 trillion dollars expected future income decreases to 11.5 trillion dollars price level increases to 14.5 thousand dollars mpc increases to 0.8 real rate of interest increases by 0.5 pct. points tax revenue is cut by 0.5 trillion dollars government expenditure is raised by 0.5 trillion dollars What is monetary policy, and who conducts it? What is fiscal policy, and who conducts it? Compute the budget balance. Is there a budget deficit or surplus? Simulated consumption

15. Consumption expenditure  Because AE, AD, SRAS, and LRAS are graphed with Y on the horizontal axis, C should be too: C = [ W + Y e – PL – r ] + mpc ∙ DI DI = Y – T C = [ W + Y e – PL – r ] + mpc ∙ (DI) C = [ W + Y e – PL – r ] + mpc ∙ (Y – T ) C = [ W + Y e – PL – r ] + mpc ∙ Y – mpc ∙ T C = [ W + Y e – PL – r – mpc ∙ T ] + mpc ∙ Y Simulated consumer expenditure

16. Consumption expenditure Simulated consumer expenditure  Example (continued): With real GDP held constant at 15 trillion dollars, show what happens to the consumption model when consumer wealth rises to 8.5 trillion dollars expected future income decreases to 11.5 trillion dollars price level increases to 14.5 thousand dollars mpc increases to 0.8 real rate of interest increases by 0.5 pct. points tax revenue is cut by 0.5 trillion dollars government expenditure is raised by 0.5 trillion dollars What is monetary policy, and who conducts it? What is fiscal policy, and who conducts it? Compute the budget balance. Is there a budget deficit or surplus?

17. Import function  Money is spent on domestic products (C ) & imported products (M ). M is the amount spent by Americans on goods from outside of the USA.  In the short run, the factor influencing imports is U.S. real GDP If Y = 0, products cannot be imported (M = 0) As Y rises, expenditures on imports increase.  Download the following data to generate an empirical iMport function http://research.stlouisfed.org/fred2/graph/?g=o4M  Marginal Propensity to iMport is the fraction of a rise in Y spent on imports. M = mpm ∙ Y Simulated net foreigner expenditure  eXports are exogenous  NX = X – M NX = X – mpm ∙ Y Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. NX = 0.5 – 0.25 ∙ Y Net foreigner expenditure

18. Aggregate Expenditure AE = [ C ] + I + G + NX } Simulated AE

19. AE = [ C ] + I + G + { NX } NX = X – mpm ∙ Y C = W + Y e – PL – r – mpc ∙ T + mpc ∙ Y AE = [ W + Y e – PL – r – mpc ∙ T + mpc ∙ Y ] + I + G + { X – mpm ∙ Y } AE = [ W + Y e – PL – r – mpc ∙ T + I + G + X ] + mpc ∙ Y – mpm ∙ Y AE = [ W + Y e – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm } ∙ Y Aggregate Expenditure Simulated AE

20. AE = [ C ] + I + G + { NX } M = mpm ∙ Y C = W + Y e – PL – r – mpc ∙ T + mpc ∙ Y AE = [ W + Y e – PL – r – mpc ∙ T + mpc ∙ Y ] + I + G + X – { mpm ∙ Y } AE = [ W + Y e – PL – r – mpc ∙ T + I + G + X ] + mpc ∙ Y – mpm ∙ Y AE = [ W + Y e – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm } ∙ Y Aggregate Expenditure Simulated AE

21. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ W + Y e – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm } ∙ Y

22. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + Y e – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm } ∙ Y

23. Aggregate Expenditure AE = [ 8 + 12 – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm } ∙ Y Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation.

24. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – r – mpc ∙ T + I + G + X ] + { mpc – mpm } ∙ Y

25. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – 3.5 – mpc ∙ T + I + G + X ] + { mpc – mpm } ∙ Y

26. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – 3.5 – 0.75 ∙ T + I + G + X ] + { 0.75 – mpm } ∙ Y

27. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + I + G + X ] + { 0.75 – mpm } ∙ Y

28. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + G + X ] + { 0.75 – mpm } ∙ Y

29. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + X ] + { 0.75 – mpm } ∙ Y

30. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + 2 ] + { 0.75 – mpm } ∙ Y

31. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + 2 ] + { 0.75 – 0.25 } ∙ Y

32. Aggregate Expenditure Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = [ 7.5 ] + { 0.5 } ∙ Y

33. Aggregate Expenditure When Y = 0 AE = 7.5 + 0.5 (0) = 7.5 When Y = 15 AE = 7.5 + 0.5 (15) = 15 Simulated AE  Example: In addition to W = 8, Y e = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation. AE = 7.5 + 0.5 ∙ Y

34.  Example: Point 1 Y = 0 AE = 7.5 Point 2 Y = 15 AE = 15  Since aggregate planned expenditure equals GDP, the change in firms’ inventories equals the planned change.  The AE model has reached an equilibrium 0 7.5 Y AE 15 45 o Aggregate Expenditure Simulated AE

35.  Example: Suppose real GDP is $19 trillion. AE = 7.5 + 0.5(19) = 7.5 + 9.5 = 17 AE < Y  When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs. 0 Y AE 45 o Aggregate Expenditure 19 17 Simulated AE

36. 0 Y AE 45 o Aggregate Expenditure 19 AE = Y Simulated AE 17 15  firms cut production. Real GDP decreases until it reaches equilibrium.  Example: Suppose real GDP is $19 trillion. AE = 7.5 + 0.5(19) = 7.5 + 9.5 = 17 AE < Y  When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs.

37. 13  Example: Suppose real GDP is $11 trillion. AE = 7.5 + 0.5(11) = 7.5 + 5.5 = 13 AE > Y  When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs. 0 Y AE 45 o Aggregate Expenditure 11 Simulated AE

38. 13  firms raise production. Real GDP increases until it reaches equilibrium. 0 Y AE 45 o Aggregate Expenditure 1115  Example: Suppose real GDP is $11 trillion. AE = 7.5 + 0.5(11) = 7.5 + 5.5 = 13 AE > Y  When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs. AE = Y Simulated AE

39. Aggregate Expenditure Simulated AE  Example (continued): With real GDP held constant at 15 trillion dollars, show what happens to the consumption model when consumer wealth rises to 8.5 trillion dollars expected future income decreases to 11.5 trillion dollars price level increases to 14.5 thousand dollars mpc increases to 0.8 real rate of interest increases by 0.5 pct. points tax revenue is cut by 0.5 trillion dollars. Compute the tax cut multiplier. Compute the budget balance. government expenditure is raised by 0.5 trillion dollars. Compute the government expenditure multiplier. Compute the budget balance. What is monetary policy, and who conducts it? What is fiscal policy, and who conducts it?

40. AE = [ 8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + 2 ] + { 0.75 – 0.25 } ∙ Y Y AE What happens if the price level rises by 1 thousand dollars? 15.5 AE > Y 13 AE = 5.25 + 0.5 Y Y = 5.25 + 0.5 Y 0.5 Y= 5.25 Y= 10.5 15 45 o Y PL 15 AD 13 Aggregate Expenditure Simulated AD  Example (continued): 6.5 7.5 (PL = 15.5) (PL = 14.5) 14.5 15.5 Unplanned increase in inventories Real GDP will fall