© 20015 pearson - weebly

© 20015 Pearson

How big is the government

expenditure multiplier?

© 20015 Pearson

30

When you have completed your

study of this chapter, you will be able to

1 Explain how real GDP influences expenditure plans.

2 Explain how real GDP adjusts to achieve equilibrium

expenditure.

3 Explain the expenditure multiplier.

4 Derive the AD curve from equilibrium expenditure.

CHAPTER CHECKLIST

Aggregate Expenditure

Multiplier

© 20015 Pearson

30.1 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.

© 20015 Pearson


Aggregate planned expenditure is the sum of the

spending plans of households, firms, and governments.

Aggregate planned expenditure is planned

consumption expenditure, plus planned investment,

plus planned government expenditure, plus planned

exports, minus planned imports.

We divide aggregate expenditure plans into

autonomous expenditure and induced expenditure.

© 20015 Pearson


Autonomous expenditure is 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.

© 20015 Pearson


Induced expenditure is 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).

© 20015 Pearson


The Consumption Function

Consumption function is 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.

© 20015 Pearson


Figure 30.1 shows the

consumption function.

As disposable income

increases, consumption

expenditure increases—

induced consumption.

Each dot corresponds to

a column of the table.

Point A shows that

autonomous consumption

is $2 trillion.

© 20015 Pearson


Along the 45°line,

consumption expenditure

equals disposable

income.

1. When the consumption

function is above the

45°line, saving is

negative (dissaving

occurs).

© 20015 Pearson


3. At the point where the consumption function intersects the 45°line, all disposable income is consumed and saving is zero.

2. When the consumption

function is below the

45°line, saving is

positive.

© 20015 Pearson


Marginal Propensity to Consume

Marginal propensity to consume (MPC) is the

fraction of a change in disposable income that is spent

on consumption.

MPC = Change in consumption expenditure

Change in disposable income

© 20015 Pearson


Figure 30.2 shows how to calculate the marginal propensity to consume.

1. A $3 trillion change in

disposable income brings …

2. A $2 trillion change in

consumption expenditure,

so ...

3. The MPC equals

$2 trillion ÷ $3 trillion = 2/3.

© 20015 Pearson


Other Influences on Consumption Expenditure

The factors that influence consumption plans are

• Real interest rate

• Wealth

• Expected future income

© 20015 Pearson


Real Interest Rate

When the real interest rate falls, consumption

expenditure increases and saving decreases.

When the real interest rate rises, consumption

expenditure decreases and saving increases

Wealth and Expected Future Income

When wealth or expected future income increases,

consumption expenditure increases.

When wealth or expected future income decreases,

consumption expenditure decreases.

© 20015 Pearson


Figure 30.3 shows shifts in

the consumption function.

1. Consumption expenditure

increases and the

consumption function shifts

upward if

• The real interest rate

falls.

• Wealth increases.


increases.

© 20015 Pearson


2. Consumption expenditure

decreases and the

consumption function shifts

downward if

• The real interest rate

rises.

• Wealth decreases.


decreases.

© 20015 Pearson


Imports and Real 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

it about.

© 20015 Pearson

30.2 EQUILIBRIUM EXPENDITURE

Aggregate Planned Expenditure and Real

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.

© 20015 Pearson


Investment (I),

Exports (X),

Aggregate expenditure is the sum of

Government expenditure (G),

Consumption expenditure (C)

minus Imports (M).

Figure 30.4 shows the AE curve.

© 20015 Pearson


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.

© 20015 Pearson


Figure 30.5 shows equilibrium

expenditure.

1. When aggregate planned

expenditure exceeds real GDP,

an unplanned decrease in

inventories occurs.


expenditure is less than real

GDP, an unplanned increase in

inventories occurs.

© 20015 Pearson



expenditure equals real GDP,

there are no unplanned

inventories and real GDP

remains at equilibrium

expenditure.

Part (b) shows the unplanned

changes in inventories that

bring about equilibrium

expenditure.

© 20015 Pearson


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

adjusts.

© 20015 Pearson


Convergence from Below Equilibrium

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.

© 20015 Pearson


Convergence from Above Equilibrium

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.

© 20015 Pearson

30.3 EXPENDITURE MULTIPLIERS

When autonomous expenditure (investment, government

expenditure, or exports) 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.

© 20015 Pearson


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.

© 20015 Pearson


Figure 30.6 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

$16 trillion to $18 trillion.

3. The increase in equilibrium

expenditure is 4 times the

increase in investment, so the

multiplier is 4.

© 20015 Pearson


The Size of the Multiplier

The multiplier is 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

© 20015 Pearson


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.

© 20015 Pearson


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

© 20015 Pearson


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

© 20015 Pearson


Now solve for Y as

(1 – MPC) Y = I

Rearrange to get

Y = I

(1 – MPC)

© 20015 Pearson


Now, divide both sides of the equation by the I to give

(1 – MPC)

1Y

I=

When MPC is 0.75, so the multiplier is

Y = I

(1 – MPC)

(1 – 0.75)

1Y

I= =

0.25

1= 4.

© 20015 Pearson


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.

© 20015 Pearson


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.

© 20015 Pearson


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.

© 20015 Pearson


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

(1 – Slope of AE curve)

Y

I=

1

© 20015 Pearson


Figure 30.7 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.

© 20015 Pearson


With imports and income

taxes, the slope of the AE

curve is less than the

marginal propensity to

consume.

A $0.5 trillion increase in investment increases real GDP by $1 trillion. Themultiplier is 2.

In this example, the slope of the AE curve is 0.5.

© 20015 Pearson


Business Cycle Turning Points

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.

© 20015 Pearson


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.

© 20015 Pearson


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.

© 20015 Pearson


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.

© 20015 Pearson


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.

© 20015 Pearson

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.

30.4 THE AD CURVE AND EQUILIBRIUM

EXPENDITURE

© 20015 Pearson

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.


EXPENDITURE

© 20015 Pearson

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.


EXPENDITURE

© 20015 Pearson

1. When the price level is 105, the

AE curve is AE0.

The quantity of real GDP

demanded at the price level of

105 is $16 trillion—one point

on the AD curve.

Equilibrium expenditure is $16

trillion at point B.

Figure 30.8 shows the connection

between the AE curve and the AD

curve.


EXPENDITURE

© 20015 Pearson

2. When the price level rises to 125,

the AE curve shifts downward

to AE1.


demanded at the price level of

125 is $15 trillion—a

movement along the AD curve

to point A.

Equilibrium expenditure

decreases to $15 trillion at point A.


EXPENDITURE

© 20015 Pearson

3. When the price level falls to 85,

the AE curve shifts upward

to AE2.


demanded at the price level

of 85 is $17 trillion—a

movement along the AD

curve to point C.

Equilibrium expenditure

increases to $17 trillion at

point C.


EXPENDITURE

© 20015 Pearson

Christina Romer, former Chair of the President’s Council of

Economic Advisers (CEA), has estimated the government

expenditure multiplier to be 1.6.

This number led administration economists to predict that

the stimulus plan that increased government expenditure

would prevent the unemployment rate from rising much

above 8 percent.

This prediction turned out to be optimistic.

One reason might be that the multiplier assumption was also

too optimistic.

© 20015 Pearson

Robert Barro, a leading macroeconomist at Harvard

University, has studied the effects of very large increases in

government expenditure during wars.

Barro finds that the multiplier is only 0.8.

Barro’s multiplier means that real GDP increases by less

than the increase in government expenditure.

The reason is that some private expenditure, mainly

investment, gets “crowded out” and real GDP falls.

© 20015 Pearson

John Taylor of Stanford University, another leading

macroeconomist, agrees with Barro that the government

expenditure multiplier is less than 1.

Taylor says that crowding out gets more severe as time

passes.

So Taylor says that the multiplier gets smaller after two years

and smaller still after three years.

The figure on the next slide shows the range on estimates of

the expenditure multiplier.

© 20015 Pearson

A big multiplier can occur only if there is substantial slack

in the economy—when the recessionary gap is large.

© 20015 pearson - weebly

Documents