```Aggregate Expenditure
CHAPTER
15
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Distinguish between autonomous expenditure and
induced expenditure and explain how real GDP
influences expenditure plans.
2
Explain how real GDP adjusts to achieve equilibrium
expenditure.
3
Describe and explain the expenditure multiplier.
4
Derive the AD curve from equilibrium expenditure.
A QUICK REVIEW AND PREVIEW
 The Economy at Full Employment
At full employment, real GDP equals potential GDP and
the unemployment rate equals the natural
unemployment.
Potential GDP and the natural unemployment rate are
determined by real factors and are independent of the
price level.
A QUICK REVIEW AND PREVIEW
The quantity of money and money equilibrium
determine nominal GDP.
Nominal GDP and potential GDP determine the price
level.
So changes in the quantity of money change nominal
GDP and the price level but have no effect on potential
GDP.
A QUICK REVIEW AND PREVIEW
 Departures from Full Employment
Aggregate supply and aggregate demand determine
equilibrium real GDP and the price level.
Fluctuations in aggregate supply and aggregate
demand bring fluctuations around full employment.
In this chapter, you’ll learn amore about the forces that
change aggregate demand.
A QUICK REVIEW AND PREVIEW
Fixed Price Level
In the aggregate expenditure model, the price level is
fixed.
The model explains
• What determines the quantity of real GDP
demanded at a given price level.
• What determines changes the quantity of real GDP
at a given price level.
15.1 EXPENDITURE PLANS AND REAL GDP
From the circular flow of expenditure and income,
aggregate expenditure is the sum of
• Consumption expenditure, C
• Investment, I
• Government expenditure on goods and services, G
• Net exports, NX
Aggregate expenditure = C + I + G + NX.
15.1 EXPENDITURE PLANS AND REAL GDP
 Planned and Unplanned Expenditures
Motorola decides to produce 11 million cell phones in
2005.
Motorola plans to sell 10 million phones and to put 1
million into inventory.
People and firms makes their expenditure plans, and
they decide to buy 9 million phones from Motorola.
Planned expenditure on phones is 10 million (9 million +
1 million), which is less than production of 11 million.
15.1 EXPENDITURE PLANS AND REAL GDP
Aggregate expenditure equals aggregate income and
real GDP.
But aggregate planned expenditure might not equal real
GDP because firms might end up with up more or less
inventories than planned.
Aggregate planned expenditure is planned
consumption expenditure plus planned investment plus
planned government expenditure plus planned exports
minus planned imports.
15.1 EXPENDITURE PLANS AND REAL GDP
Firms make their planned production and they pay
incomes that equal the value of production, so
aggregate income equals real GDP.
Households and governments make their planned
purchases and net exports are as planned.
Firms make their planned expenditure on new buildings,
plant, and equipment, and their planned inventory
changes.
15.1 EXPENDITURE PLANS AND REAL GDP
If aggregate planned expenditure equals GDP, the
change in firms’ inventories equals the planned change.
If aggregate planned expenditure exceeds GDP, firms’
inventories are smaller than planned.
If aggregate planned expenditure is less than GDP,
firms’ inventories are larger than planned.
15.1 EXPENDITURE PLANS AND REAL GDP
Notice that actual expenditure, which equals planned
expenditure plus the unplanned change in firms’
inventories, always equals GDP and aggregate income.
Unplanned changes in firms’ inventories lead to
changes in production and incomes.
• If unwanted inventories have piled up, firms
decrease production, which decreases real GDP.
• If inventories have fallen below their target levels,
firms increase production, which increases real
GDP.
15.1 EXPENDITURE PLANS AND REAL GDP
Autonomous Expenditure and Induced
Expenditure
Autonomous expenditure
The components of aggregate expenditure that do
not change when real GDP changes.
Autonomous expenditure equals investment plus
government expenditure plus exports plus the
components of consumption expenditure and
imports that are not influenced by real GDP.
15.1 EXPENDITURE PLANS AND REAL GDP
Induced expenditure
The components of aggregate expenditure that
change when real GDP changes.
Induced expenditure equals consumption
expenditure minus imports (excluding the elements
of consumption expenditure and imports that are
part of autonomous expenditure).
15.1 EXPENDITURE PLANS AND REAL GDP
The Consumption Function
Consumption function
The relationship between consumption expenditure and
disposable income, other things remaining the same.
Disposable income is aggregate income (GDP) minus
net taxes.
Net taxes are taxes paid to the government minus
transfer payments received from the government.
15.1 EXPENDITURE PLANS AND REAL GDP
Figure 15.1 shows the
consumption function.
Each dot corresponds to
a column of the table.
Point A shows that
autonomous consumption
is \$1.5 trillion.
As disposable income
increases, consumption
expenditure increases—
induced consumption.
15.1 EXPENDITURE PLANS AND REAL GDP
Along the 45° line,
consumption expenditure
equals disposable
income.
1. When the consumption
function is above the
45° line, saving is
negative (dissaving
occurs).
15.1 EXPENDITURE PLANS AND REAL GDP
2. When the consumption
function is below the
45° line, saving is
positive.
3. At the point where the
consumption function
intersects the 45° line,
all disposable income is
consumed and saving
is zero.
15.1 EXPENDITURE PLANS AND REAL GDP
Marginal Propensity to Consume
Marginal propensity to consume (MPC) is the
fraction of a change in disposable income that is spent
on consumption.
Change in consumption expenditure
MPC =
Change in disposable income
15.1 EXPENDITURE PLANS AND REAL GDP
Figure 15.2 shows how to
calculate the marginal
propensity to consume.
1. A \$2 trillion change in
disposable income brings
2. A \$1.5 trillion change in
consumption expenditure,
so...
3. The MPC is
\$1.5 trillion ÷ \$2.0 = 0.75.
15.1 EXPENDITURE PLANS AND REAL GDP
Other Influences on Consumption
The factors that influence planned consumption are
• Disposable income
• Real interest rate
• The buying power of net assets
• Expected future disposable income
15.1 EXPENDITURE PLANS AND REAL GDP
A change in disposable income leads to a change in
consumption expenditure and a movement along the
consumption function.
A change in any other influence on planned
consumption shifts the consumption function.
For example,
• When the real interest rate decreases, or the
buying power of net assets increases, or expected
future income increases, consumption expenditure
increases.
15.1 EXPENDITURE PLANS AND REAL GDP
• When the real interest rate increases, or the
buying power of net assets decreases, or expected
future income decreases, consumption
expenditure decreases.
15.1 EXPENDITURE PLANS AND REAL GDP
Figure 15.3 shows shifts in
the consumption function.
1. Consumption expenditure
increases and the
consumption function shifts
upward if
• The real interest rate falls
• The buying power of net
assets increases
• Expected future income
increases
15.1 EXPENDITURE PLANS AND REAL GDP
2. Consumption expenditure
decreases and the
consumption function shifts
downward if
• The real interest rate rises
• The buying power of net
assets decreases
• Expected future income
decreases
15.1 EXPENDITURE PLANS AND REAL GDP
Imports and GDP
Consumption expenditure is one major component of
induced expenditure, imports are the other.
In the short run, the factor influencing imports is U.S.
real GDP.
Marginal propensity to import is the fraction of an
increase in real GDP that is spent on imports.
The marginal propensity to import equals the change in
imports divided by the change in real GDP that brought
15.2 EQUILIBRIUM EXPENDITURE
Aggregate Planned Expenditure and GDP
Consumption expenditure increases when disposable
income increases.
Disposable income equals aggregate income—real
GDP—minus net taxes, so disposable income and
consumption expenditure increase when real GDP
increases.
We use this link between consumption expenditure and
real GDP to determine equilibrium expenditure.
15.2 EQUILIBRIUM EXPENDITURE
Figure 15.4 shows the AE curve.
Aggregate expenditure is the sum of
Investment (I),
Government expenditure (G),
Exports (X),
Consumption expenditure (C)
minus Imports (M).
15.2 EQUILIBRIUM EXPENDITURE
Equilibrium Expenditure
Equilibrium expenditure is the level of aggregate
expenditure when aggregate planned expenditure
equals real GDP.
Equilibrium expenditure equals the real GDP at which
the AE curve intersects the 45° line.
15.2 EQUILIBRIUM EXPENDITURE
Figure 15.5 shows
equilibrium expenditure.
1. When aggregate planned
expenditure exceeds real GDP,
an unplanned decrease in
inventories occurs.
2. When aggregate planned
expenditure is less than real
GDP, an unplanned increase in
inventories occurs.
15.2 EQUILIBRIUM EXPENDITURE
3. When aggregate planned
expenditure equals real GDP,
there are no unplanned
inventories and real GDP
remains at equilibrium
expenditure.
15.2 EQUILIBRIUM EXPENDITURE
Convergence to Equilibrium
At equilibrium expenditure, production plans and
spending plans agree, and there is no reason to change
production or spending.
But when aggregate planned expenditure and actual
aggregate expenditure are unequal, production plans
and spending plans are misaligned, and a process of
convergence toward equilibrium expenditure occurs.
Throughout this convergence process, real GDP
15.2 EQUILIBRIUM EXPENDITURE
Back at Motorola
Recall that in 2005 Motorola has unwanted inventories.
So in 2006, Motorola cuts production.
Where does the process end?
The process ends when expenditure equilibrium is
reached.
Equilibrium expenditure is reached because when real
GDP changes by \$1 aggregate planned expenditure
changes by less than \$1.
15.2 EQUILIBRIUM EXPENDITURE
When aggregate planned expenditure is less than real
GDP, firms cut production. Real GDP decreases.
When real GDP decreases, aggregate planned
expenditure decreases. But real GDP decreases by
more than planned expenditure, so eventually the gap
between planned expenditure and actual expenditure
closes.
15.2 EQUILIBRIUM EXPENDITURE
Similarly, when aggregate planned expenditure exceeds
real GDP, firms increase production. Real GDP
increases.
But real GDP increases by more than the increase in
planned expenditure.
Eventually, the gap between planned expenditure and
actual expenditure is closed.
15.3 THE EXPENDITURE MULTIPLIER
When investment increases, aggregate expenditure and
real GDP also increase.
But the increase in real GDP is larger than the increase in
investment.
The multiplier is the amount by which a change in any
component of autonomous expenditure is magnified or
multiplied to determine the change that it generates in
equilibrium expenditure and real GDP.
15.3 THE EXPENDITURE MULTIPLIER
 The Basic Idea of the Multiplier
The initial increase in investment brings an even bigger
increase in aggregate expenditure because it induces
an increase in consumption expenditure.
The multiplier determines the magnitude of the increase
in aggregate expenditure that results from an increase
in investment or another component of autonomous
expenditure.
15.3 THE EXPENDITURE MULTIPLIER
Figure 15.6 illustrates the multiplier.
1. A \$0.5 trillion increase in
investment shifts the AE curve
upward by \$0.5 trillion from
AE0 to AE1.
2. Equilibrium expenditure
increases by \$2 trillion from
\$9 trillion to \$11 trillion.
3. The increase in equilibrium
expenditure is 4 times the
increase in investment, so the
multiplier is 4.
15.3 THE EXPENDITURE MULTIPLIER
The Size of the Multiplier
The multiplier
• The amount by which a change in autonomous
expenditure is multiplied to determine the change
in equilibrium expenditure that it generates.
That is,
Multiplier =
Change in equilibrium expenditure
Change in autonomous expenditure
15.3 THE EXPENDITURE MULTIPLIER
Why Is the Multiplier Greater Than 1?
The multiplier is greater than 1 because an increase in
autonomous expenditure induces an increase in
aggregate expenditure in addition to the increase in
autonomous expenditure.
15.3 THE EXPENDITURE MULTIPLIER
The Multiplier and the MPC
The greater the marginal propensity to consume, the
larger is the multiplier.
Ignoring imports and income taxes, the change in real
GDP (Y) equals the change in consumption
expenditure (C) plus the change in investment (I).
That is,
Y = C + I
15.3 THE EXPENDITURE MULTIPLIER
Y = C + I
But the change in consumption expenditure is determined
by the change in real GDP and the marginal propensity to
consume.
It is
C = MPC  Y
Now substitute MPC  Y for C in the equation at the top
of the screen
Y = MPC  Y + I
15.3 THE EXPENDITURE MULTIPLIER
Now solve for Y as
(1 – MPC)  Y = I
Rearrange to get
Y =
I
(1 – MPC)
15.3 THE EXPENDITURE MULTIPLIER
I
Y =
(1 – MPC)
Now, divide both sides of the by the I to give
Y
I
=
1
(1 – MPC)
When MPC is 0.75, so the multiplier is
1
1
Y
=
=
0.25
I
(1 – 0.75)
= 4.
15.3 THE EXPENDITURE MULTIPLIER
 The Multiplier, Imports, and Income Taxes
The size of the multiplier depends not only on
consumption decisions but also on imports and income
taxes.
Imports make the multiplier smaller than it otherwise
would be because only expenditure on U.S.-made
goods and services increases U.S. real GDP.
The larger the marginal propensity to import, the smaller
is the change in U.S. real GDP that results from a
change in autonomous expenditure.
15.3 THE EXPENDITURE MULTIPLIER
Income taxes make the multiplier smaller than it would
otherwise be.
With increased incomes, income tax payments increase
and disposable income increases by less than the
increase in real GDP.
Because disposable income influences consumption
expenditure, the increase in consumption expenditure is
less than it would if income tax payments had not
changed.
15.3 THE EXPENDITURE MULTIPLIER
The marginal tax rate determines the extent to which
income tax payments change when real GDP changes.
The marginal tax rate is the fraction of a change in
real GDP that is paid in income taxes—the change in
tax payments divided by the change in real GDP.
The larger the marginal tax rate, the smaller is the
change in disposable income and real GDP that results
from a given change in autonomous expenditure.
15.3 THE EXPENDITURE MULTIPLIER
The marginal propensity to import and the marginal tax
rate together with the marginal propensity to consume
determine the multiplier.
Their combined influence determines the slope of the
AE curve.
The general formula for the multiplier is
Y
I
1
=
(1 – Slope of AE curve)
15.3 THE EXPENDITURE MULTIPLIER
Figure 15.7 shows the
multiplier and the slope of the
AE curve.
With no imports and income
taxes, the slope of the AE
curve equals the marginal
propensity to consume,
which in this example is 0.75.
A \$0.5 trillion increase in
investment increases real
GDP by \$2 trillion. The
multiplier is 4.
15.3 THE EXPENDITURE MULTIPLIER
With imports and income
taxes, the slope of the AE
curve is less than the
marginal propensity to
consume.
In this example, the slope of
the AE curve is 0.5.
A \$0.5 trillion increase in
investment increases real
GDP by \$1 trillion. The
multiplier is 2.
15.3 THE EXPENDITURE MULTIPLIER
The forces that bring business-cycle turning points are the
swings in autonomous expenditure such as investment and
exports.
The mechanism that gives momentum to the economy’s
new direction is the multiplier.
15.3 THE EXPENDITURE MULTIPLIER
An expansion is triggered by an increase in autonomous
expenditure that increases aggregate planned expenditure.
At the moment the economy turns the corner into
expansion, aggregate planned expenditure exceeds real
GDP.
In this situation, firms see their inventories taking an
unplanned dive.
15.3 THE EXPENDITURE MULTIPLIER
The expansion now begins.
To meet their inventory targets, firms increase production,
and real GDP begins to increase.
This initial increase in real GDP brings higher incomes,
which stimulate consumption expenditure.
The multiplier process kicks in, and the expansion picks up
speed.
15.3 THE EXPENDITURE MULTIPLIER
The process works in reverse at a business cycle peak.
A recession is triggered by a decrease in autonomous
expenditure that decreases aggregate planned
expenditure.
At the moment the economy turns the corner into
recession, real GDP exceeds aggregate planned
expenditure.
15.3 THE EXPENDITURE MULTIPLIER
In this situation, firms see unplanned inventories piling
up.
The recession now begins.
To reduce their inventories, firms cut production, and
real GDP begins to decrease.
This initial decrease in real GDP brings lower incomes,
which cut consumption expenditure.
The multiplier process reinforces the initial cut in
autonomous expenditure, and the recession takes hold.
15.4 THE AD CURVE AND EQUILIBRIUM
 Deriving the AD Curve from Equilibrium
Expenditure
The AE curve is the relationship between aggregate
planned expenditure and real GDP when all other
influences on expenditure plans remain the same.
A movement along the AE curve arises from a change
in real GDP.
15.4 THE AD CURVE AND EQUILIBRIUM
The AD curve is the relationship between the quantity
of real GDP demanded and the price level when all
other influences on expenditure plans remain the
same.
A movement along the AD curve arises from a change
in the price level.
15.4 THE AD CURVE AND EQUILIBRIUM
Equilibrium expenditure depends on the price level.
When the price level changes, other things remaining
the same, aggregate planned expenditure changes
and equilibrium expenditure changes.
Aggregate planned expenditure changes because a
change in the price level changes the buying power of
net assets, the real interest rate, and the real prices of
exports and imports.
So when the price level changes, the AE curve shifts.
15.4 THE AD CURVE AND EQUILIBRIUM
Figure 15.8 shows the connection
between the AE curve and the AD
curve.
When the price level is 110, the
AE curve is AE0.
Equilibrium expenditure is \$10
trillion at point B.
The quantity of real GDP
demanded at the price level of
110 is \$10 trillion—one point on
15.4 THE AD CURVE AND EQUILIBRIUM
When the price level falls to 90, the
AE curve shifts upward to AE1.
Equilibrium expenditure increases
to \$11 trillion at point C.
The quantity of real GDP
demanded at the price level of 90
is \$11 trillion—a movement along
the AD curve to point C.
15.4 THE AD CURVE AND EQUILIBRIUM
When the price level rises to 130, the
AE curve shifts downward to AE2.
Equilibrium expenditure decreases
to \$9 trillion at point A.
The quantity of real GDP
demanded at the price level of
130 is \$9 trillion—a movement
along the AD curve to point A.