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CHAPTER 9
Building the Aggregate Expenditures Model
In this chapter, we only consider two aggregates: consumers and
businesses. So we are dealing with consumption and investment
expenditures.
The basic premise of the aggregate expenditures model is that the amount
of goods and services produced and therefore the level of employment
depend on the level of aggregate expenditures.
Consumption is the largest component of aggregate expenditures.
People do not spend all there money, they save some of it. So disposable
income equals consumption plus savings.
The relationship between consumption and income is illustrated in
consumption function diagram. In this diagram a 45 degree line
represents consumption equaling income. If consumption does not
take up all income, then savings will occur and this is shown as a
separation of the consumption function from the 45 degree line.
CONSUMPTION AND SAVING
Consumption
SAVING
C
Consumption
schedule
C
DISSAVING
o
45
MPC = Slope of C
o
MPC + MPS = 1
Saving
Disposable Income
DISSAVING
Saving
schedule
MPS = Slope of S
S
SAVING
o
S
Disposable Income
The consumption schedule or function specifies the relationship between
consumption expenditures and disposable income.
We can calculate the average and marginal propensities to consume or
save. The APC is the total level of consumption divided by income.
The MPC is the change in consumption for a change in income. The
APS is saving divided by income. The MPS is the change is saving
for a change in income.
APC + APS=1
MPC + MPS=1
The marginal propensity to consume is the slope of the consumption
function.
There are non-income determinants of consumption and saving: wealth,
expectations, taxation, the interest rate, and household debt.
These factors shift the consumption function up or down. If people have
more wealth, they are more willing to spend out of current income. If
people have positive expectations, they will spend. Lowering taxes
means more spending. Less debt means more money to spend
currently. Lower interest means people can borrow more cheaply.
TERMINOLOGY, SHIFTS, & STABILITY
Consumption
C1
C0
Increases in
Consumption
Means…
o
45
o
Saving
Disposable Income
A Decrease
S0
S1 In Saving
o
Disposable Income
Consumption
TERMINOLOGY, SHIFTS, & STABILITY
C0
C2
Decreases in
Consumption
Means…
o
45
o
Saving
Disposable Income
S2 An Increase
S0
In Saving
o
Disposable Income
Investment consists of expenditures on new plants, capital
equipment, machinery, inventories, and so on.
Investments are more likely to occur if the expected rate of
return on an investment is higher, and if the real interest
rate is lower. The real interest rate is the nominal rate less
inflation.
We can combine all investments decisions in an economy into
an investment demand curve with the expected rate of
return and the real interest rate on the vertical axis and
investment on the horizontal axis. The higher the expected
rate of return the lower the interest rate so they are placed
on the vertical axis.
This curve can shift for the following reasons: operating
costs, business taxes, technological change, stock of capital
goods on hand, and expectations.
Investment is unstable and thought be a cause of the business
cycle.
Interest Rate – Investment
Relationship
and interest rate, i (percents)
Expected rate of return,
r,
16
14
INVESTMENT
DEMAND
CURVE
12
10
8
6
4
2
ID
0
5
10
15
20
25
30
35
40
Investment (billions of dollars)
We can combine the consumption and investment schedules to explain the
equilibrium levels of output, income, and employment.
We can identify the equilibrium level of output and income graphically
buy placing the added investment and consumption functions on the 45
degree line. The C + I function then crosses the 45 degree line at one
point, and this is the equilibrium level.
Any level above or below this point represents dis-equilibrium. No level
but the equilibrium level can be sustained. At levels of GDP below
equilibrium, the economy wants to spend at higher levels than the
current level of production, so production will increase. At levels of
GPD above equilibrium, the economy is overproducing relative to
spending, so the economy will cut back on production.
At equilibrium, GDP=C + Ig
Private spending, C + I g (billions of dollars)
EQUILIBRIUM GDP
(C + I g = GDP)
$530
C + Ig
Equilibrium
510
C
490
470
Ig = $20 Billion
450
430
410
C =$450 Billion
390
370
45
o
o
370 390 410 430 450 470 490 510 530 550
Real domestic product, GDP (billions of dollars)
The Multiplier
• More spending results in higher GDP. Less
spending results in less GDP.
• But a change in spending results in changing
output and income by more than the original
amount of spending.
• The multiplier determines how much larger that
change will be. The multiplier is:
m=change in GDP
initial change in spending
The Multiplier Continued
• It follows that an initial change in spending will set off a
chain of spending throughout the economy
• You spend $100. Some one gets the $100 and he spends
part of it and saves the rest. If he spends 80%, he spends
$80. Then the next person who gets the $80 will spend
80% of that which is $64. Then the next person who gets
the $64 will spend 80% of that.
• In general, if we know the multiplier, we multiply the
multiplier by the initial spending to get the full amount of
spending in the economy.
• Another way to define the multiplier is:
• m=1/1-mpc or 1/mps where the mpc is the marginal
propensity to consume and mps is the marginal propensity
to save.
THE MULTIPLIER EFFECT
(2)
(3)
Change in
Change in
(1)
Saving
Change in Consumption
Income (MPC = .75) (MPS = .25)
Increase in
Investment of $5
$ 5.00
$ 3.75
$ 1.25
Second Round
3.75
2.81
.94
Third Round
2.81
2.11
.70
Fourth Round
2.11
1.58
.53
Fifth Round
1.58
1.19
.39
All Other
Rounds
4.75
3.56
1.19
$20.00
$15.00
$ 5.00
Total
The Multiplier
• The bigger the mpc, the smaller the mps and the
bigger the multiplier.
• So as people spend more out of their income, the
larger will be the impact on the economy.
• The multiplier works in reverse too. If people save
more and spend less, the lower the multiplier and
subsequent impact on the economy.
THE MULTIPLIER EFFECT
MPC and the Multiplier
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
3
2