Transcript Chapter 6

Chapter 6
Aggregate expenditures model
and multipliers
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Learning objectives
• Describe the assumptions underlying
the aggregate expenditures model
• Explain the consumption–income and saving–
income relationships upon which the aggregate
expenditures model is based
• Examine the determinants of the level
of investment (firms’ purchases of capital
equipment), and analyse the impact of
changes in its level on equilibrium real
GDP, income and employment
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6-2
Learning objectives (cont.)
• Discuss the rationale for the presence of
the multiplier and the multiplier effect
• Apply the aggregate expenditures model
to a discussion of the paradox of thrift
• Examine the difference that may exist between
the equilibrium level of output and that corresponding
to the full-employment level
of output, allowing discussion of the nature
of recessionary and inflationary gaps
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6-3
Learning objectives (cont.)
• Analyse the macroeconomic impacts
of the government sector and foreign
trade on equilibrium GDP
• Apply the model to explain the concept
of the balanced-budget multiplier
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6-4
Aggregate expenditures model
Assumptions
1. Two sectors i.e. closed economy with
no government
2. All savings are treated as personal savings
3. Depreciation and net Australian income earned
abroad are zero
4. Businesses make investment decisions
5. Real interest rates influence investment (I)
6. Fixed prices and wages or price–wage inflexibility
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Aggregate expenditures (AE)
• Sum of expenditures on consumption (C),
investment (I), government spending (G)
and net exports (NX)
• Determines the level of output and employment
in economy
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Consumption and savings
• Both consumption and savings level
are determined by household disposable
income (DI)
• Households consume most of their DI
• DI that is not consumed is called ‘savings’
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Consumption schedule
• A schedule of the income–consumption relationship
• Shows the various amounts households plan
or intend to consume at various possible levels
of disposable income
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Saving schedule
• A schedule of the income–saving relationship
• Shows the various amounts households plan
or intend to save at various levels of disposable
income
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Consumption & saving schedules
Consumption
C
425
410
405
400
Saving $5 billion
Consumption
schedule
375
Dissaving $5 billion
Saving
0
45
o
370 390 410 430 450
Disposable income
S
Dissaving $5 billion
0
Saving $5 billion
370 390 410 430 450
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Saving
schedule
Disposable income
6-10
Average propensity to consume
(APC)
• The fraction of any total income that is spent
on consumption
• APC =
Consumption
Income
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Average propensity to save
(APS)
• That fraction of total income that is saved
• APS =
Saving
Income
• APC + APS = 1
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6-12
Marginal propensity to consume
• That fraction of each additional dollar of income that
is consumed
• MPC =
Change in consumption
Change in income
• Represented as the slope of the consumption
schedule
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Marginal propensity to save
• That fraction of each additional dollar of income that
is saved
• MPS =
Change in saving
Change in income
• Represented as the slope of the saving schedule
• MPC + MPS = 1
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Consumption & saving schedules
Consumption
SAVING
C
Consumption
schedule
MPC = Slope of C
0
45
o
Saving
Dissaving
0
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Disposable income
Saving
schedule
MPS = Slope of S
S
Saving
Disposable income
6-15
The marginal propensity to consume
and the marginal propensity to save
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Non-income determinants of
consumption & savings
•
•
•
•
•
•
Wealth
Price level
Expectations
Consumer debt levels
Taxation
Changes in these determinants cause a shift
(up or down) of the curves
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Consumption
Shifts in the consumption & saving schedules
C1
C0
An
increase in
consumption...
C
C
45
0
o
Saving
Disposable income
Means
a decrease
in saving
S0
S1
0
Disposable income
S
S
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Consumption
Shifts in the consumption & saving schedules
(cont.)
C
C1
A
decrease in
consumption...
C
45
0
o
Means
an increase
in saving
Disposable income
Saving
S
S
0
S
S
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Disposable income
6-19
Determinants of investment
Two determinants of investment
• Expected rate of net profits that businesses
hope to realise from investment spending
• The real rate of interest
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Expected rate of net profit
• Businesses are motivated by profit
• Businesses invest if they expect a net profit
from this investment
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Real rate of interest
• The inflation-adjusted cost associated with borrowing
money
• Equals nominal interest rate minus the
inflation rate
• Investment projects will only be undertaken
if net expected profit rate exceeds real
interest rate
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Investment demand curve
• Shows graphically the investment–interest
rate relationship
• Shows cumulative levels of investment at possible
levels of investment at some point in time
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Investment demand curve
and interest rate (per cent)
Expected rate of net profits
16
14
12
10
8
6
4
2
0
5
10
15
20
25
30
35
40
Investment (billions of dollars)
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Shifts in investment demand
Other determinants of investment:
• Acquisition, operation and maintenance costs
• Business taxes
• Technological change
• Business expectations
• Stock of capital goods on hand
• Expectations
Changes in these factors shift the investment
demand curve
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Investment and income
• Autonomous investment
– Desired level of investment based upon long-term
profit expectations
• Induced investment
– Level of investment induced by the current level
of income
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Investment (billions of dollars)
The investment schedule: two possibilities
60
40
Autonomous
Induced
Investment Schedule Investment Schedule
I′
I
20
0
370
390
410
450
430
450
490
510
Real domestic product, GDP (billions of dollars)
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Instability of investment
• Consumption (especially non-durables)
is relatively stable but
• Investment is unstable. Why?
–
–
–
–
Durable and therefore postponable purchases
Irregularity of innovation
Profit variability
Variable expectations (consider the new global
competitive environment!)
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The volatility of investment
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Equilibrium income/GDP
Two approaches to determine the equilibrium levels
of output and income:
• Expenditures–output approach
• Leakages–injections approach
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Expenditures–output approach
• Utilises relationship between AE and income
• In a two-sector economy, AE = C + I
• Equilibrium occurs where the total output (measured
by GDP) and aggregate expenditures (C + I ) for a
two sector economy are equal
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Equilibrium GDP:
expenditures–output approach
Private spending (billions of dollars)
(C + I = GDP)
Equilibrium
C+I
C+I
C
C+I
C
45
0
o
GDP (billions of dollars)
370 390 410 430 450 470 490 510
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Leakages–injections approach
• Utilises the relationship between leakages
and injections back to the expenditure flow
• Two sectors: S = I at all levels I = total investment
• At equilibrium: S = planned investment
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Saving and Investment
(billions of dollars)
Equilibrium GDP:
leakages–injections approach
S=I
60
40
20
Unplanned
inventory
decrease
I
At this level
of GDP
S
I
{
0
–5
S
(S = I = $20)
Equilibrium
370 390 410 430 450 470 490 510 530 550
Real domestic product, GDP (billions of dollars)
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Saving and investment
(billions of dollars)
Equilibrium GDP:
leakages–injections approach
S=I
60
At this level
of GDP
40
20
(S = I = $20)
Equilibrium
I
S
{
}
Unplanned
inventory
increase
S
0
-5
S
I
370 390 410 430 450 470 490 510 530 550
Real domestic product, GDP (billions of dollars)
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Planned vs unplanned
investment
• Investment has two components
– Ip = planned investment as determined by
investment demand schedule
– Iu = unplanned investment is unintended changes in
the level of inventories
– Actual investment = sum of planned and unplanned
investment
• At equilibrium: Iu = zero
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Achieving equilibrium
• Difference in savings and planned investment
causes
• Mismatching of production and spending causes
• Revision of production plans by firms until
equilibrium is once again re-established
• The level of GDP would be stable only where
savings and planned investment are equal
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Changes in equilibrium GDP
• GDP is seldom stable. It is characterised
by cyclical fluctuations
• Changes in investment schedule or the savingsconsumption schedule will lead to changes in
equilibrium GDP
• Investment expenditures are generally less stable
due to changes in the expected rate of net profit
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Autonomous expenditure
changes
• Shifts in the AE curve due to changes
in autonomous expenditure
– Result in new equilibrium levels of output (GDP)
– How much output changes by depends on the
size of the expenditure multiplier
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6-39
Expenditure multiplier
• A change in autonomous expenditure results
in a change in equilibrium income that is a
multiple of the initial change
• The multiplier is defined as the ratio of the
change in GDP arising from a change in autonomous
spending
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Changes in equilibrium GDP and the multiplier
(C + I ) 1
(C + I ) 0
Private spending
(billions of dollars)
510
490
Equilibrium GDP
at I1 level of investment
470
450
Saving and investment
(billions of dollars)
430
0
45
o
Real GDP
390
450
470
490
If I
S
I1
increases...
I0
Real GDP
20
0
510
390
450
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470
490
510
6-41
Saving and investment
(billions of dollars)
Private spending
(billions of dollars)
Changes in equilibrium GDP and the multiplier
(C + I ) 0
510
(C + I ) 2
490
Equilibrium GDP
at I2 level of investment
470
450
430
0
45
o
430
450
470
490
510
Real GDP
S
20
I0
I2
0
430
450
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470
490
If I
decreases...
Real GDP
510
6-42
The multiplier effect
• A change in autonomous spending gives rise
to a larger change in GDP
• The multiplier effect arises because initial increase in
aggregate expenditure will induce successive rounds
of increased expenditure
• The multiplier = changes in real GDP/changes
in I
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Multiplier and marginal
propensities
• A relationship exists between the MPS (the
amount of leakage) and the multiplier
• Multiplier = 1/MPS = 1/(1 – MPC)
• The simple multiplier is defined as 1/MPS, when
the leakage in the economy is only saving
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S, I & the paradox of thrift
• Paradox of thrift
– If society attempts to save more, it may end up
actually saving the same amount or even less, as a
result of the multiple decline in equilibrium GDP
caused by the withdrawal of aggregate expenditure
• For savings to be beneficial it must be matched
by injection, especially I
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Saving and investment
(billions of dollars)
The paradox of thrift
60
S2
40
S1
20
I
S2
0
–5
I
S1
S
370 390 410
430
450
470 490 510
Real domestic product, GDP (billions of dollars)
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Recessionary gap
• The amount by which aggregate expenditures
are deficient to that required to generate the
full-employment level of GDP
• Produces a concretionary impact upon
the economy
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Private
spending (billions of dollars)
Recessionary gap (cont.)
(C + I )0
(C + I )1
}
Recessionary
gap
Full employment
0
45
o
470
490
510
Real GDP (billions of dollars)
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Inflationary gap
• The amount by which aggregate spending exceeds
that required to achieve full employment
• Produces an inflationary effect on the economy
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Inflationary gap (cont.)
(C + I )1
Private
spending (billions of dollars)
Inflationary
Gap
(C + I )0
{
Full employment
0
45
o
470
490
510
Real GDP (billions of dollars)
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Discretionary fiscal policy
• Deliberate manipulation of taxes (T) and spending
(G) by government for the purpose of altering real
GDP and employment, controlling inflation and
stimulating economic growth
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Government purchases (G)
• Added to AE
• Changes to autonomous government expenditure
impact equilibrium real GDP through the multiplier
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Three-sector economy equilibrium
• Aggregate expenditure = C + I + G = real GDP
and
• S=I+G
where
• C is after-tax consumption
• S is after-tax saving
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Government expenditure and equilibrium GDP
C+I +G
S, I + G
(billions of dollars)
C +I +G
(billions of dollars)
Government
spending
$20 billion
0
45
C+I
C
o
470
510
550
Real GDP
(billions of dollars)
S
40
I +G
20
I
0
470
510
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550
Real GDP
(billions of dollars)
6-54
Taxes and equilibrium GDP
• Taxes are assumed to be lump-sum
– A tax that collects the same amount at each level of
GDP
• Reduces levels of both saving and consumption
• How much S and C are affected depends
on the MPC and MPS
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Taxes and equilibrium GDP
C+I +G
C+I+G
(billions of dollars)
$15 billion
decrease in
consumption
S + T, I + G
(billions of dollars)
0
45
Ca + I + G
o
490
550
Sa + T
40
S
Sa
I +G
I
20
0
Real GDP
($ billions)
$20 billion increase
in taxes
490
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$5 billion decrease
in saving
550
Real GDP
( $billions )
6-56
Fiscal policy over the business
cycle
Expansionary fiscal policy
• Increased G
• Decreased T
• Or both
• Moves budget towards a deficit in recessionary
times
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Fiscal policy over the business
cycle (cont.)
Contractionary fiscal policy
• Decreased G
• Increased T
• Or both
• Moves budget towards a surplus in
inflationary times
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The multiplier and fiscal policy
If the tax function is of the form
T = TLS + MPT(Y )
where MPT = marginal propensity to tax,
Multiplier =
1
[MPT + MPS (1 – MPT)]
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Balanced-budget multiplier
• The effect of an equal increase (or decrease)
of both the level of government expenditure
and taxation
• Increases (decreases) the level of equilibrium
GDP by exactly the amount of the increase
(or decrease) in G and T
• Thus, equal increases in G and T are expansionary
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Foreign trade and equilibrium
GDP
• Exports (X ) and imports (M ) are introduced
into the model
• Net exports (NX) = X – M
• AE = C + I + G + NX
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Exports (X)
• Level of X depends on foreign countries’
income, not on domestic income
• Therefore X is an autonomous variable
in the model
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Imports (M)
• Level of M is dependent on domestic income
or GDP
• Given autonomous exports, a rise in imports
due to a rise in income results in a fall in NX
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Equilibrium GDP with a rise in NX
Spending (billions of dollars)
(C + I + G + NX)2
(C + I + G)
(C + I + G + NX)0
(C + I + G + NX)1
510
490
470
450
45
0
o
450
470
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490
510
Real GDP
($ billions)
530
6-64
Open-economy multiplier
• The introduction of foreign trade reduces
– The expenditure multiplier
– The slope of the AE curve
• The open-economy multiplier = 1/[MPS + MPM],
If taxes are lump sum with
No marginal propensity to tax
MPM is the marginal propensity to import
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The complex multiplier for
an open economy
• The multiplier that arises when all leakages
— savings, taxes, and imports — are taken
into account:
1
k=
[MPT + MPS (1 – MPT) + MPM]
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