1. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 Chapter 10 “Aggregate Expenditures”

2. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2 Learning Objectives 1.Summarize the perspective of Keynesian and Keynesian economics. 2.Illustrate the income-expenditure. 3.Explain the adjustment process to an expenditure equilibrium. 4.Describe how new spending can have a ripple effect throughout the economy. 1.Summarize the perspective of Keynesian and Keynesian economics. 2.Illustrate the income-expenditure. 3.Explain the adjustment process to an expenditure equilibrium. 4.Describe how new spending can have a ripple effect throughout the economy.

3. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3 Learning Objectives 5.Distinguish the types of multipliers in the Keynesian model. 6.Graph the relationship of the income- expenditure model to aggregate demand. 7.(E&A) Compare economic analyses of the Great Depression. 5.Distinguish the types of multipliers in the Keynesian model. 6.Graph the relationship of the income- expenditure model to aggregate demand. 7.(E&A) Compare economic analyses of the Great Depression.

4. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 4 10.1 “IN THE LONG RUN, WE ARE ALL DEAD”  Keynes chose to ignore long-run tendencies toward full employment.  In his view the problems of unemployment could be solved only if people and government would buy more goods and services.  Consumption spending is 70% of GDP, and it motivates investment spending.  The Keynesian model is based around understanding how much spending is likely to occur at different levels of spending, and how government can influence that spending to ensure full employment.  Keynes chose to ignore long-run tendencies toward full employment.  In his view the problems of unemployment could be solved only if people and government would buy more goods and services.  Consumption spending is 70% of GDP, and it motivates investment spending.  The Keynesian model is based around understanding how much spending is likely to occur at different levels of spending, and how government can influence that spending to ensure full employment.

5. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5 10.2 THE INCOME-EXPENDITURE MODEL “One person’s spending is another person’s income.” Aggregate National Income = Aggregate National Output

6. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 6  The aggregate expenditures function tells what the economy’s planned spending will be at each level of real GDP.  There will be only one GDP that does match up planned spending and actual spending.  That GDP occurs at the expenditure equilibrium, where the AE function and the 45-degree line intersect.  The aggregate expenditures function tells what the economy’s planned spending will be at each level of real GDP.  There will be only one GDP that does match up planned spending and actual spending.  That GDP occurs at the expenditure equilibrium, where the AE function and the 45-degree line intersect. The Income –Expenditure Model

7. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 7 Real GDP (income) Aggregate Expenditure Function 45 o : Spending=production $10 trillion $5 trillion $10 trillion #1 The aggregate expenditure function shows how much the economy plans to spend at each possible GDP #3 At the equilibrium value of GDP, actual spending equals planned spending. #2 The 4-degree line shows expenditures by repeating to the vertical axis the real GDP listed on the horizontal axis. The Income –Expenditure Model Expenditures

8. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8 Components of Aggregate Expenditures 4Spending can be divided into two types: 4Autonomous spending: spending that would occur even if people had no income. 4Induced spending: spending that depends upon income. 4Spending can be divided into two types: 4Autonomous spending: spending that would occur even if people had no income. 4Induced spending: spending that depends upon income.

9. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 9 Autonomous spending includes both investments and goods. Autonomous spending includes both investments and goods. Draw upon previous wealth and savings. Draw upon previous wealth and savings. College students with no earnings drawing down their parents bank accounts to pay for room and board at school. College students with no earnings drawing down their parents bank accounts to pay for room and board at school. Graphically, autonomous spending is a positive amount that shows up as a horizontal line. Graphically, autonomous spending is a positive amount that shows up as a horizontal line. Autonomous spending includes both investments and goods. Autonomous spending includes both investments and goods. Draw upon previous wealth and savings. Draw upon previous wealth and savings. College students with no earnings drawing down their parents bank accounts to pay for room and board at school. College students with no earnings drawing down their parents bank accounts to pay for room and board at school. Graphically, autonomous spending is a positive amount that shows up as a horizontal line. Graphically, autonomous spending is a positive amount that shows up as a horizontal line. Components of Aggregate Expenditures

10. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 10  Since induced spending is entirely dependent upon income, graphically it starts at zero starts at zero and GDP rises from there.  When autonomous spending and induced spending are added together, the result is an aggregate expenditure function that has both a positive vertical intercept, and a positive slope.  Since induced spending is entirely dependent upon income, graphically it starts at zero starts at zero and GDP rises from there.  When autonomous spending and induced spending are added together, the result is an aggregate expenditure function that has both a positive vertical intercept, and a positive slope. Components of Aggregate Expenditures

11. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11 Real GDP (income) $10 trillion $5 trillion $10 trillion Aggregates expenditures includes both autonomous and induced spending. Induced spending 0 Autonomous spending Aggregate Expenditure Function Expenditures Aggregate Expenditures

12. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 12 oThe components of aggregate expenditures are merely the components of GDP. GDP = C + I + G + (X-M) o The consumption function because of autonomous spending has a positive vertical intercept. oFrom there, it slopes upward because of the marginal propensity to consume (mpc). oThe components of aggregate expenditures are merely the components of GDP. GDP = C + I + G + (X-M) o The consumption function because of autonomous spending has a positive vertical intercept. oFrom there, it slopes upward because of the marginal propensity to consume (mpc). Components of Aggregate Expenditures

13. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 13 oThe marginal propensity to consume (MPC) is the fraction of additional income that people spend. oThe marginal propensity to save (MPS) is the fraction of additional income that people save. oThe marginal propensity to consume (MPC) is the fraction of additional income that people spend. oThe marginal propensity to save (MPS) is the fraction of additional income that people save. MPC + MPS = 1 MPC and MPS

14. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 14 The Aggregate Expenditures Function Investment and government purchases are of roughly comparable size.Investment and government purchases are of roughly comparable size. If planned government purchases and investment spending are assumed to be completely autonomous, they will be constant as GDP changes.If planned government purchases and investment spending are assumed to be completely autonomous, they will be constant as GDP changes. For this reason, the slope of the AE function and the consumption function are the same.For this reason, the slope of the AE function and the consumption function are the same. Investment and government purchases are of roughly comparable size.Investment and government purchases are of roughly comparable size. If planned government purchases and investment spending are assumed to be completely autonomous, they will be constant as GDP changes.If planned government purchases and investment spending are assumed to be completely autonomous, they will be constant as GDP changes. For this reason, the slope of the AE function and the consumption function are the same.For this reason, the slope of the AE function and the consumption function are the same.

15. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 15 Modeling the Expenditure Equilibrium  When the economy is not at equilibrium, actual GDP and planned spending differ.  Unintended inventory changes show up as the difference between planned and actual investment.  When the economy is not at equilibrium, actual GDP and planned spending differ.  Unintended inventory changes show up as the difference between planned and actual investment.

16. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 16 Modeling the Expenditure Equilibrium Expenditure equilibrium: aggregate expenditures = actual GDP Aggregate expenditures: consumption + planned investment government + net exports government + net exports GDP = consumption + actual investment + government +net exports + government +net exports Expenditure equilibrium: planned investment = actual investment where and whichimplies

17. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 17 Real GDP (income) Expenditures Aggregate Expenditure Function 45 o : Spending=production #2 A progression of inventory buildups less production leads to the expenditures equilibrium here. #1 if the economy starts here starts here Output decreases but at a decreasing rate. Modeling the Expenditure Equilibrium

18. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 18 10.3 CHANGING THE EXPENDITURE EQUILIBRIUM  When there are changes in autonomous spending, the changes are magnified by the multiplier effect.  Adding autonomous spending causes a higher GDP, which causes more induced spending.  That’s because money that one person spends autonomously adds to income of others, which in turn induces them to buy more output.  At each stage in this cycle, however, some income is saved, thus eventually bringing the cycle to a halt.  When there are changes in autonomous spending, the changes are magnified by the multiplier effect.  Adding autonomous spending causes a higher GDP, which causes more induced spending.  That’s because money that one person spends autonomously adds to income of others, which in turn induces them to buy more output.  At each stage in this cycle, however, some income is saved, thus eventually bringing the cycle to a halt.

19. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 19 Real GDP (income) The multiplier effect causes a small increase in autonomous expenditures to have a much larger effect on GDP. Increase in autonomous expenditures Increase in GDP The expenditure equilibrium moves higher Aggregate expenditure function Expenditures The Multiplier Effect

20. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 20 The strength of the multiplier effect depends upon the proportion of income that is devoted to consumption. To the extent that people save their incomes, savings represents a leakage out of the multiplier process. A negative value for savings means that there is dissaving – spending out of existing savings. The strength of the multiplier effect depends upon the proportion of income that is devoted to consumption. To the extent that people save their incomes, savings represents a leakage out of the multiplier process. A negative value for savings means that there is dissaving – spending out of existing savings. The Multiplier Effect

21. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 21 Spending Depends upon the Marginal Propensity to Consume (mpc):

22. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 22 The Expenditure Multiplier Expenditure multiplier = 1/mps or1/(1-MPC)  Autonomous spending x 1/mps  Expenditure equilibrium =

23. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 23 The multiplier is multiplied by a change in autonomous spending to reveal the change in equilibrium GDP. There must be some idle resources for the multiplier effect to occur. Keynesian multiplier analysis assumes a constant price level. The multiplier is multiplied by a change in autonomous spending to reveal the change in equilibrium GDP. There must be some idle resources for the multiplier effect to occur. Keynesian multiplier analysis assumes a constant price level. The Multiplier Effect

24. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 24 Recession and Inflation within the Income-Expenditure Model  If the expenditure equilibrium lies below full- employment GDP, it is called an unemployment equilibrium.  Along with the unemployment equilibrium comes an output gap, in which actual GDP falls below full-employment GDP.  At an unemployment equilibrium, there is to little spending for the economy to achieve full employment GDP.  If the expenditure equilibrium lies below full- employment GDP, it is called an unemployment equilibrium.  Along with the unemployment equilibrium comes an output gap, in which actual GDP falls below full-employment GDP.  At an unemployment equilibrium, there is to little spending for the economy to achieve full employment GDP.

25. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 25 Recession and Inflation within the Income-Expenditure Model  If the expenditure equilibrium lies below full- employment GDP, it is called an unemployment equilibrium.  Along with the unemployment equilibrium comes an output gap, in which actual GDP falls below full-employment GDP.  At an unemployment equilibrium, there is to little spending for the economy to achieve full employment GDP.  If the expenditure equilibrium lies below full- employment GDP, it is called an unemployment equilibrium.  Along with the unemployment equilibrium comes an output gap, in which actual GDP falls below full-employment GDP.  At an unemployment equilibrium, there is to little spending for the economy to achieve full employment GDP. The shortfall in spending in spending is called a recessionary gap. recessionary gap.

26. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 26  If the expenditure equilibrium occurs past the full-employment GDP, multiplier analysis does not apply, because inflation will not allow it to stay there.  This possibility is referred to as an inflationary gap, which is the excess of the aggregate expenditure function above that consistent with a full employment equilibrium.  If the expenditure equilibrium occurs past the full-employment GDP, multiplier analysis does not apply, because inflation will not allow it to stay there.  This possibility is referred to as an inflationary gap, which is the excess of the aggregate expenditure function above that consistent with a full employment equilibrium. Recession and Inflation within the Income-Expenditure Model

27. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 27 Making Policy with Multipliers Keynesian analysis suggest that govern can use taxes to stimulate the economy.Keynesian analysis suggest that govern can use taxes to stimulate the economy. However people might save some of their higher after tax income rather than spend it. The tax multiplier, which is the expansionary, or contractionary effect of a tax cut, or increase would be less than the multiplier by the amount of the initial round of spending.However people might save some of their higher after tax income rather than spend it. The tax multiplier, which is the expansionary, or contractionary effect of a tax cut, or increase would be less than the multiplier by the amount of the initial round of spending. Keynesian analysis suggest that govern can use taxes to stimulate the economy.Keynesian analysis suggest that govern can use taxes to stimulate the economy. However people might save some of their higher after tax income rather than spend it. The tax multiplier, which is the expansionary, or contractionary effect of a tax cut, or increase would be less than the multiplier by the amount of the initial round of spending.However people might save some of their higher after tax income rather than spend it. The tax multiplier, which is the expansionary, or contractionary effect of a tax cut, or increase would be less than the multiplier by the amount of the initial round of spending.

28. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 28 Making Policy with Multipliers Tax Multiplier = -mpc/(1-mpc)

29. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 29 Balanced Budget Multiplier Keynesians view extra government spending as the most effective policy to cure a recession.Keynesians view extra government spending as the most effective policy to cure a recession. The balanced-budget multiplier combines the expenditure multiplier for an increase in government spending and the tax multiplier because taxes would increase to finance that spending.The balanced-budget multiplier combines the expenditure multiplier for an increase in government spending and the tax multiplier because taxes would increase to finance that spending. Keynesians view extra government spending as the most effective policy to cure a recession.Keynesians view extra government spending as the most effective policy to cure a recession. The balanced-budget multiplier combines the expenditure multiplier for an increase in government spending and the tax multiplier because taxes would increase to finance that spending.The balanced-budget multiplier combines the expenditure multiplier for an increase in government spending and the tax multiplier because taxes would increase to finance that spending.

30. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 30 Making Policy with Multipliers Balanced Budget Multiplier = 1/(1-mpc) – mpc/(1-mpc)= 1/(1-mpc) – mpc/(1-mpc)=(1-mpc)/(1-mpc)=1

31. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 31 10.4 AGGREGATE DEMAND Actual Real GDP (income) Expenditures 45 o : Spending=production Aggregate Expenditures with lower price level P 1 P1P1 P2P2 Real GDP Aggregate Expenditures with higher price level P 2 GDP 1 GDP 2 Price Level Aggregate Demand

32. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 32 10.5 EXPLORE & APPLY The Great Depression  The 1920’s era of prosperity peaked in early 1929.  A few months later the stock market crashed.  The Great Depression began and did not end for over a decade.  Keynesian aggregate expenditure analysis can be used to describe the depression and the policy action to correct it.  The 1920’s era of prosperity peaked in early 1929.  A few months later the stock market crashed.  The Great Depression began and did not end for over a decade.  Keynesian aggregate expenditure analysis can be used to describe the depression and the policy action to correct it.

33. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 33 Terms Along the Way  income-expenditures model  aggregate expenditures  aggregate expenditures function  expenditure equilibrium  income-expenditures model  aggregate expenditures  aggregate expenditures function  expenditure equilibrium  autonomous spending  induced spending  consumption function  marginal propensity to consume  marginal propensity to save

34. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 34 Terms Along the Way  multiplier effect  expenditure multiplier  unemployment equilibrium  output gap  multiplier effect  expenditure multiplier  unemployment equilibrium  output gap  recessionary gap  inflationary gap  tax multiplier  balanced budget multiplier

35. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 35 Test Yourself 1.John Maynard Keynes offered a long-run perspective on the macro-economy in the general theory. a.If you had no income you could still engage in induced spending. b.The marginal propensity to consume must be 1 or less. c.An expenditure equilibrium occurs where the aggregate expenditure function intersects the vertical axis. d.An injection of new autonomous spending will leave equilibrium real GDP unchanged when the marginal propensity to save equals 0.5. 1.John Maynard Keynes offered a long-run perspective on the macro-economy in the general theory. a.If you had no income you could still engage in induced spending. b.The marginal propensity to consume must be 1 or less. c.An expenditure equilibrium occurs where the aggregate expenditure function intersects the vertical axis. d.An injection of new autonomous spending will leave equilibrium real GDP unchanged when the marginal propensity to save equals 0.5.

36. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 36 Test Yourself 2. Suppose actual spending equals planned spending. Then we can say a.the economy is at an expenditure equilibrium. b.real GDP is the most it can possibly be. c.autonomous spending equals zero. d.aggregate demand has shifted to the left. 2. Suppose actual spending equals planned spending. Then we can say a.the economy is at an expenditure equilibrium. b.real GDP is the most it can possibly be. c.autonomous spending equals zero. d.aggregate demand has shifted to the left.

37. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 37 Test Yourself 3.In the income expenditures model the 45-degree line shows a.the amount of autonomous spending. b.the amount of induced spending. c.the expenditure multiplier. d.that the economy’s expenditures are actually the same as its output.. 3.In the income expenditures model the 45-degree line shows a.the amount of autonomous spending. b.the amount of induced spending. c.the expenditure multiplier. d.that the economy’s expenditures are actually the same as its output..

38. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 38 Test Yourself 4.Aggregate expenditures include all of the following except a.consumption. b.planned investment. c.net exports. d.unintended changes in business inventories. 4.Aggregate expenditures include all of the following except a.consumption. b.planned investment. c.net exports. d.unintended changes in business inventories.

39. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 39 Test Yourself 5.The marginal propensity to consume equals a.the fraction of their total income that people consume. b.the fraction of additional income that people consume. c.the fraction of their savings that people plan to spend within the next year. d.one in most cases.. 5.The marginal propensity to consume equals a.the fraction of their total income that people consume. b.the fraction of additional income that people consume. c.the fraction of their savings that people plan to spend within the next year. d.one in most cases..

40. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 40 Test Yourself 6.The paradox of thrift, if true suggest that people should a.save more. b.spend more. c.vote more often. d.spend the same amount of money, but spend it more wisely. 6.The paradox of thrift, if true suggest that people should a.save more. b.spend more. c.vote more often. d.spend the same amount of money, but spend it more wisely.

41. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 41 The End! Next Chapter 11 “Fiscal Policy in Action"