Transcript Chapter 30

Aggregate Expenditure
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
Consumption expenditure
Simulated consumption

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
Consumption expenditure
Simulated consumption
A = W + Ye – PL – r
C = A + mpc ∙ DI
C = [ W + Ye – 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 + Ye – PL – r ] + mpc ∙ DI
Consumption expenditure
Simulated consumption
A = W + Ye – PL – r
C = A + mpc ∙ DI
C = [ W + Ye – 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 + Ye – PL – r ] + mpc ∙ DI
Consumption expenditure
Simulated consumption
A = W + Ye – PL – r
C = A + mpc ∙ DI
C = [ W + Ye – 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
Consumption expenditure
Simulated consumption
A = W + Ye – PL – r
C = A + mpc ∙ DI
C = [ W + Ye – 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
Consumption expenditure
Simulated consumption
A = W + Ye – PL – r
C = A + mpc ∙ DI
C = [ W + Ye – 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
Consumption expenditure
Simulated consumption
A = W + Ye – PL – r
C = A + mpc ∙ DI
C = [ W + Ye – 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
Consumption expenditure
Simulated consumption
A = W + Ye – PL – r
C = A + mpc ∙ DI
C = [ W + Ye – 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
Consumption expenditure
Simulated consumption

Example (continued):
C
C = 2 + 0.75 DI
When DI = 0
C = 2 + 0.75(0)
8
C=2
When DI = 8
2
C = 2 + 0.75(8)
C=2+6
C=8
0
8
DI
Consumption expenditure
Simulated consumption

Example (continued):
C
45 o
C = 2 + 0.75 DI
When consumption lies on
the 45° line, all disposable
income is consumed and
saving is zero.
8
Saving = DI – C
=8–8
=0
2
0
8
DI
Consumption expenditure
Simulated consumption

Example (continued):
C
45 o
C = 2 + 0.75 DI
When consumption lies
below the 45° line, saving
occurs.
9.125
When DI = 9.5
C = 2 + 0.75(9.5)
= 2 + 7.125
= 9.125
S = DI – C
= 9.5 – 9.125
= 0.3750
2
0
9.5
DI
Consumption expenditure
Simulated consumption

Example (continued):
C
45 o
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
6.5
2
0
6
DI
Consumption expenditure
Simulated consumption

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?
Consumption expenditure
Simulated consumer expenditure

Because AE, AD, SRAS, and LRAS are graphed with Y on the horizontal axis, C
should be too:
C = [ W + Ye – PL – r ] + mpc ∙ DI
DI = Y – T
C = [ W + Ye – PL – r ] + mpc ∙ (DI)
C = [ W + Ye – PL – r ] + mpc ∙ (Y – T )
C = [ W + Ye – PL – r ] + mpc ∙ Y – mpc ∙ T
C = [ W + Ye – PL – r – mpc ∙ T ] + mpc ∙ Y
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?
Net foreigner expenditure
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, Ye = 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
Aggregate Expenditure
Simulated AE
AE = [C ]+ I + G + NX }
Aggregate Expenditure
Simulated AE
AE = [C ]+ I + G + {NX}
NX = X – mpm∙ Y
C = W + Ye – PL – r – mpc ∙ T + mpc ∙ Y
AE = [W + Ye – PL – r – mpc ∙ T + mpc ∙ Y ] + I + G + {X – mpm∙ Y }
AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + mpc ∙ Y – mpm∙ Y
AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y
Aggregate Expenditure
Simulated AE
AE = [C ]+ I + G + {NX}
M = mpm∙ Y
C = W + Ye – PL – r – mpc ∙ T + mpc ∙ Y
AE = [W + Ye – PL – r – mpc ∙ T + mpc ∙ Y ]+ I + G + X – {mpm∙ Y }
AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + mpc ∙ Y – mpm∙ Y
AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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 + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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 + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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 – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
Aggregate Expenditure
Simulated AE

Example: In addition to W = 8, Ye = 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
When Y = 0
AE = 7.5 + 0.5 (0) = 7.5
When Y = 15
AE = 7.5 + 0.5 (15) = 15
Aggregate Expenditure
Simulated AE

Example:
AE
45 o
Point 1
Y=0
AE = 7.5
15
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
7.5
0
15
Y
Aggregate Expenditure
Simulated AE

Example: Suppose real
GDP is $19 trillion.
AE
45 o
AE = 7.5 + 0.5(19)
= 7.5 + 9.5
= 17
17
AE < Y

When aggregate planned
expenditure is less than real
GDP, an unplanned increase
in inventories occurs.
0
19
Y
Aggregate Expenditure
Simulated AE

Example: Suppose real
GDP is $19 trillion.
AE
45 o
AE = 7.5 + 0.5(19)
= 7.5 + 9.5
= 17
17
15
AE = Y
AE < Y

When aggregate planned
expenditure is less than real
GDP, an unplanned increase
in inventories occurs.

firms cut production. Real
GDP decreases until it
reaches equilibrium.
0
15
19
Y
Aggregate Expenditure
Simulated AE

Example: Suppose real
GDP is $11 trillion.
AE
45 o
AE = 7.5 + 0.5(11)
= 7.5 + 5.5
= 13
AE > Y

13
When aggregate planned
expenditure exceeds real
GDP , an unplanned
decrease in inventories
occurs.
0
11
Y
Aggregate Expenditure
Simulated AE

Example: Suppose real
GDP is $11 trillion.
AE
45 o
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.

firms raise production. Real
GDP increases until it
reaches equilibrium.
15
AE = Y
13
0
11
15
Y
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?
Aggregate Expenditure
Simulated AD

Example (continued): What happens if the price level rises by 1 thousand dollars?
AE = [8 + 12 – 14.5
15.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + 2 ] + { 0.75 – 0.25 }∙ Y
AE
45 o
PL
(PL = 14.5)
15.5
AE > Y
Unplanned increase
in inventories
Real GDP will fall
14.5
(PL = 15.5)
AE = 5.25 + 0.5 Y
Y = 5.25 + 0.5 Y
7.5
AD
0.5 Y= 5.25
6.5
Y= 10.5
13
15
Y
13
15
Y