Transcript The Art and Science of Economics

Chapter 25
Aggregate Expenditure and
Aggregate Demand
© 2006 Thomson/South-Western
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Aggregate Expenditure and Income
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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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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Aggregate Expenditures
Planned investment: amount of
investment that firms plan to undertake
during a year
Actual investment: amount of investment
actually undertaken; equals planned
investment plus unplanned changes in
inventories
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Exhibit 1: Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
Suppose the price level in the economy is 130, 30% higher than in the base year.
This table presents the information that is needed on the various components of
aggregate demand and expenditure: MPC is assumed to be 4/5 and the MPS is 1/5
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Exhibit 1: Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
Government purchases equals net taxes: government’s budget is balanced
The final column lists any unplanned inventory adjustment: equals real GDP
minus planned aggregate expenditures
When the amount of planned spending equals the amount produced, there are
no unplanned inventory adjustments. Here, this occurs where planned aggregate
expenditures and real GDP equal $12.0 trillion
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Exhibit 1: Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
When real GDP is $11 trillion, planned aggregate expenditure is $11.2, which exceeds the
amount produced by $0.2 trillion
Firms rely upon inventories to make up the shortfall (unplanned inventory investment of
-$0.2) and respond by increasing output
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Exhibit 1: Real GDP with Net Taxes and
Government Purchases (trillions of dollars)
If the amount produced exceeds planned spending, firms get stuck with unsold
goods: unplanned increases in inventories
When real GDP is $13 trillion, planned aggregate expenditure is only $12.8, and
$0.2 trillion in output remains unsold
Firms respond by cutting output
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Real GDP Demanded
Aggregate expenditure line: shows the
relationship, for a given price level, of
planned spending at each income, or real
GDP
The total of C 1 I 1 G 1 (X 2 M) at each
income, or real GDP
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Real GDP Demanded
Income-expenditure model: a relationship
between aggregate income and aggregate
spending that determines, for a given price
level, where the amount people plan to
spend is equal to the amount produced
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Exhibit 2: Deriving the Real GDP
Demanded for a Given Price Level
45 degree line
identifies all
points where
planned
expenditure = real
GDP
Planned
aggregate
expenditure is
measured on the
vertical axis.
Aggregate
output demanded
at any given price
level occurs where
real GDP equals
planned aggregate
expenditures, at
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point e
Exhibit 2: Deriving the Real GDP
Demanded for a Given Price Level
Aggregate expenditure
(trillions of dollars)
C + I + G + (X – M)
e
12.0
b
11.2
11.0
a
45º
0
11.0
12.0
Real GDP (trillions of dollars)
Consider what happens
when real GDP is initially
less than $12 trillion, say $11
trillion. Planned aggregate
expenditures of $11.2 trillion
(point b) exceeds output by
$0.2 trillion
Because we assume prices
will remain constant, firms
will reduce inventories
But unplanned inventory
reductions cannot continue
indefinitely; firms will
increase employment –
increasing income, increasing
consumer spending. This
process will continue until
planned spending equals real
GDP at point e.
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(trillions of dollars)
Aggregate expenditure
Exhibit 2: Deriving Aggregate Output
d
13.0
12.8
C + I + G + (X – M)
c
e
12.0
45º
0
12.0
13.0
Real GDP (trillions of dollars)
When aggregate
expenditures exceed real
GDP, for example at
$13.0, planned spending
(point c) falls short of
production (point d).
Since real GDP exceeds
the amount people want
to spend, unsold goods
accumulate by $0.2
trillion more than firms
planned
Rather than allow
inventories to pile up
indefinitely, firms reduce
production, which
reduces employment and
income.
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Aggregate expenditure (trillions of dollars)
Exhibit 3: Effect of an Increase in Investment
C + I + G + (X – M)
e'
12.5
C + I' + G + (X – M)
j
h
k
i
f
12.1
g
12.0
e
0.1
45º
0
12.0 12.1
Real GDP
(trillions of dollars)
12.5
Investment increases by $0.1
trillion
Upward shift of the AE line
means that at initial real GDP level
of $12 trillion, planned spending
exceeds output by $0.1 trillion (the
distance between points e and f)
Reduced inventories prompt
firms to expand production by 100
billion (movement from f to g )
Those who receive the additional
$100 billion spend $80 on goods
(movement from g to h)
Firms respond by increasing
output (movement from h to i)
This $80 billion will stimulate
new spending of $64 billion
(moving from i to j), which causes
firms to increase output (from j to
k, etc.)
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Exhibit 4:Tracking the Rounds of Spending Following a $100
Billion Increase in investment (billions of dollars)
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New Spending Cumulative
New Saving
Round
This Round New Spending This Round
1
100
100
2
80
180
20
3
64
244
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10
13.4
446.3
3.35

0
500
0
Cumulative
New Saving
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86.6
100
 Exhibit 4 summarizes the multiplier process, showing the first three
rounds, round ten, and the cumulative effect of all rounds
 The new spending generated in each round is shown in the second
column and the accumulation of new spending appears in the
third column
 Total new spending after 10 rounds sums to $446.3 billion
 But calculating the exact total would require us to work through
an infinite series of rounds
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Simple Spending Multiplier
Refers to the factor by which real GDP
demanded changes for a given initial change
in spending
Simple Spending Multiplier =1/(1–MPC)
In our example, the MPC = 0.8  a
multiplier of 5
Initial increase in investment spending of
$100 billion will eventually boost real GDP
demanded by 5 times this amount, or $500
billion
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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
Simple spending multiplier = 1 / MPS
In our example, the multiplier process
started because of an increase in
investment, but the same impact would
occur if any one of the components of
aggregate expenditures changed
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
What happens to the aggregate
expenditure line if the price level changes
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 expenditure
(trillions of dollars)
In panel (a), the AE
function intersects the
45 degree line at point e
to yield $12 trillion in
real GDP demanded
Panel b shows that
when the price level is
130, real GDP
demanded is $12
trillion and we have
one point on the
aggregate demand
curve, e
(a) Income-expenditure model
AE (P = 130)
e
45°
0
12.0
Real GDP (trillions of dollars)
(b) Aggregate demand curve
140
Price level
Exhibit 5: IncomeExpenditure and
Aggregate Demand
130
0
e
12.0
Real GDP (trillions of dollars)
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e"
AE" (P = 120)
AE (P = 130)
AE' (P = 140)
e
(a) Incomeexpenditure model
e'
45°
0
Price level
If the price level increases
to 140, the increase in the
price level reduces
consumption, planned
investment, and net exports
as shown by the downward
shift of the aggregate
expenditure line from AE to
AE' and real GDP demanded
declines from $12 trillion to
$11.5 trillion
If the price level falls, the
opposite occurs:
consumption, investment, and
net exports increase at each
real GDP
The AE function shifts to
AE': real GDP increases to
$12.5 trillion
Connecting these three
equilibrium points yields the
AD curve
Aggregate expenditure
(trillions of dollars)
Exhibit 5: Income-Expenditure and Aggregate Demand
140
11.5
12.0
12.5
Real GDP (trillions of dollars)
e'
e
130
(b) Aggregate
demand curve
e"
120
AD
0
11.5
12.0
12.5
Real GDP (trillions of dollars)
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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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C + I' + G + (X – M)
C + I + G + (X – M)
e'
0.1
(a) Incomeexpenditure
model
e
45º
0
12.0
12.5Real GDP (trillions of dollars)
(b) Aggregate
demand curve
Price level
At a price level of 130,
the aggregate expenditure
line intersects the 45
degree line at point e in
panel (a), and yields point
e on the aggregate
demand curve in panel (b)
When one component of
aggregate expenditure
increases and the price
level remains constant,
the aggregate demand
curve shifts from AD to
AD' and the new point of
equilibrium is shown as e’
in both panels
Aggregate expenditure
(trillions of dollars)
Exhibit 6: Shifts in Aggregate
Expenditures and Aggregate
Demand
130
e
e'
AD'
AD
0
12.0
12.5
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Real GDP (trillions of dollars)
Limitations of the Multiplier
Once aggregate supply is incorporated 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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