Transcript Document

Aggregate Expenditure
and Aggregate Demand
CHAPTER
25
© 2003 South-Western/Thomson Learning
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Aggregate Expenditure and Income
Here we build on the income-consumption
connection to uncover the tie between
income and total spending
Assumptions
No capital depreciation
No business saving
Each dollar spent on production translates
directly into a dollar of aggregate income 
GDP equals aggregate income
Investment, government purchases, and net
exports are autonomous  independent of the
level of income
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Components of Aggregate Expenditure
To develop the aggregate demand
curve, we begin by asking how
much aggregate output would be
demanded at a given price level
Our objective is to analyze the
relationship between aggregate
spending in the economy and
aggregate income, or real GDP
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Aggregate Expenditures
Aggregate expenditures equals the
amount that households, firms,
governments, and the rest of the world
plan to spend on U.S. output at each
level of real GDP
Consumption, C
Planned investment, I
Government purchases, G
Net exports, X – M
Consumption is the only spending
component that varies with the level of real
GDP
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Simple Spending Multiplier
If we continue to assume that the price
level remains unchanged, we can trace
the effects of changes in planned
spending on aggregate output
demanded
The key point is that like a stone thrown
into a still pond, the effect of any shift
in planned spending ripples through the
economy, generating changes in
aggregate output that may far exceed
the initial shift in planned spending
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Simple Spending Multiplier
The cumulative spending resulting from
an infinite series of rounds equals
1 / (1 – MPC) which in our example
where the MPC was 0.8  1 / 0.2  5
Thus, the initial increase in planned
investment of $100 billion will
eventually boost real GDP by 5 times this
$100 billion, or $500 billion
Simple Spending Multiplier =1/(1–MPC)
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Simple Spending Multiplier
The multiplier depends on the value of
the MPC
Specifically, the larger the fraction of an
increase in income that is spent each
round, the larger the spending
multiplier  the larger the MPC, the
larger the simple multiplier
With an MPC of 0.8, the multiplier is 5
With an MPC of 0.9, the multiplier is 10
With an MPC of 0.75, the multiplier is 4
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Simple Spending Multiplier
Recall from previous discussions that
the MPC and the MPS must add up to 1
Therefore, we can define the simple
spending multiplier in terms of the MPS
as follows:
Simple spending multiplier = 1 / MPS
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Simple Spending Multiplier
In our example, the multiplier process
started because of an increase in
investment
The same impact would occur if any one
of the components of aggregate
expenditures changed
Finally, if the higher level of planned
investment is not sustained in future
years, real GDP would fall back and the
multiplier process would work in
reverse
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Deriving the Aggregate Demand Curve
Thus far we have used the aggregate
expenditure line to determine real GDP
demanded for a given price level
What happens to the aggregate
expenditure line if the price level
changes
As will be seen, for each price level
there is a specific aggregate
expenditure line which yields a unique
real GDP demanded  by altering the
price level, we can derive the aggregate
demand curve
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A Higher Price Level
What is the effect of a higher price level on
the economy’s aggregate expenditure line
and, in turn, on real GDP demanded?
A higher price level
reduces consumption because it reduces the
real value of dollar-denominated assets held by
households
increases the market rate of interest which
reduces investment
makes U.S. goods relatively more expensive
abroad  imports rise and exports fall
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Aggregate Demand and Expenditures
The aggregate expenditure line and the
aggregate demand curve portray real
output from different perspectives
The aggregate expenditure line shows, for a
given price level, how planned spending relates
to the level of real GDP in the economy
The aggregate demand curve shows, for
various price levels, the quantities of real GDP
demanded
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Multiplier and Aggregate Demand
Suppose we return to the situation
where the price level is assumed to be
constant
What we want to do now is trace
through the effects of a shift in any of
the components of spending on
aggregate demand, while assuming that
the price level does not change, e.g., we
want to look at the multiplier and shifts
in aggregate demand
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Limitations of the Multiplier
Our discussion of the simple spending
multiplier exaggerates the actual effect we
might expect from a given shift in the
aggregate expenditure line
We have assumed that the price level remains
constant. However, as we will see later, once
we incorporate aggregate supply into the
analysis, changes in the price level reduce the
impact of the multiplier
Leakages such as higher income taxes and
increased spending on imports all reduce the
size of the multiplier
The spending multiplier takes time to work itself
out  the process does not occur instantly
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