2. Outline: Summing up aggregate expenditure (AE) Income and aggregate expenditure Inventories and equilibrium GDP The 45 degree line Determining equilibrium real GDP Equilibrium real GDP and employment Effect of a change in planned investment (I P ) The expenditure multiplier

3. We we say that a particular component of spending is autonomous, we mean it is determined “outside” our model and is independent of current GDP or real income

4. We assume that planned investment (I P), government expenditures (G), net taxes (T), and net exports (NX) are autonomous variables. Real GDP 0 IPIP G NX 700 500 400

5. (1) Income or GDP (2) C (3) I P (4) G (5) NX (6)= (2)+(3) +(4)+(5) AE (7) Inv. I 2,000 7005004003,600-1,600 3,0002,6007005004004,200-1,200 4,0003,2007005004004,800-800 5,0003,8007005004005,400-400 6,0004,4007005004006,0000 7,0005,0007005004006,600400 8,0005,6007005004007,200800 9,0006,2007005004007,8001,200 10,0006,8007005004008,4001,600 All figures in billions per year

6. C C + I P C + I P + G C + I P + G + NX AE (billions) GDP (billions) 0 800 2400 1500 2000

7. AE (Billions) 0 Real GDP (Billions) 45 0 At every point on the line, AE = GDP 5,000 7,000

8. 3,0006,0009,000 6,000 4,200 7,800 C + I P + G + NX J K E H A 0 45 0 AE GDP

9. AE > GDP by vertical distance K-J Plans of producing and spending units do not coincide Unplanned inventory investment = - $1,200 Tendency for firms (on average) to step up the pace of production and offer more employment

10. GDP > AE by vertical distance A-H Plans of producing and spending units do not coincide Unplanned inventory investment = $1,200 Tendency for firms (on average) to scale back the on production and offer less employment

11. AE = GDP Plans of producing and spending units coincide. Unplanned inventory investment = 0 No tendency for firms (on average) to step up the pace of production and offer more employment. Nor is there a tendency for firms to scale back on production and offer less employment.

12. Classical (Special) Case: Full Employment Equilibrium Full employment GDP AE GDP C + I P + G + NX AE touches the 45 0 line at potential GDP

13. General (Keynesian) Case: Underemployment Equilibrium Full employment GDP AE GDP C + I P + G + NX Y* A H

14. Equilibrium GDP and employment 45 0 Real GDP AE Real GDP 0 0 Employ- ment Y FE Y1Y1 Y1Y1 Production function L FE L1L1 AE 1 AE 2 FE subscript means “full employment”

15. Assume the economy is in equilibrium when real GDP = $6,000. What would happen if, other things being equal, planned investment (I P ) increased by $1,000?

16. 8,500 AE GDP AE 1 6,000 11 H 22 AE 2 45 0 2,400 3,400 IPIP  GDP How did a $1,000 change in I P bring about a $2,500 change in GDP? 0

17. It’s a bird It’s a plane No, it’s the multiplier effect!

19. When firms increase investment by $1,000 billion, sales revenues at investment goods manufacturers (Boeing, Westinghouse, Cincinnati Milacron) will increase by $1,000 billion Chain of causation The $1,000 billion in revenue will be distributed as factor payments to those supplying resources necessary to produce capital goods—hence the change in spending generates $1,000 in income in the first round.

20. Now households have $1,00 in additional income. What do they do with it? Their spending will increase by the MPC times the change in income—that is:  C =.6  $1,000 = $600. Hence, households spend $600 billion and save $400 billion But the story does not end here, since McDonalds’s, Disney, Kraft, American Airlines, and Amheiser Busch will see their sales increase by $600 billion, and will distribute $600 billion in wages, salaries, rental income, and profits to those who supplied resources necessary to produce the additional consumer goods.

21. Those who earned additional income in consumer goods industries will now increase their spending. By how much?  C =.6  $600 = $320. This will result in additional production and factor payments. Spending will then increase. And so on. And so on.

22. Round Additional Spending in This Round (Billions) Additional Spending in All Rounds (Billions) Initial increase in I P 1,000 26001,600 33601,960 42162,176 51302,306 6782,384......... All other roundsVery close to 116Very close to 2,500

23. Algebraic derivation of the multiplier Based on what we have learned so far, we can say (all figures in billions):  GDP = $1,000 + $6,000 + $360 + $216 +... Factoring out $1,000 in I P, this becomes:  GDP = $1,000[1 + 0.6 + 0.36 + 0.216 +...] = $1,000[1 + 0.6 + 0.6 2 + 0.6 3 +... ] We know that the $1,000 is the change in I P and the MPC is 0.6. To find the change in GDP resulting from any change in I P and any MPC:  GDP =  I P  [1 + (MPC) + (MPC) 2 + (MPC) 3 +...]

24. Let H be any variable with a value between 0 and 1. We can show that the infinite sum: 1 + H 2 + H 3 + H 4 +... Always has a value of 1/(1 – H). We can replace H with MPC or b, since 0 < b < 1. Thus the multiplier is given by 1/(1- MPC). Using the general formula, we can restate what happens when investment spending changes: