tm 11-1 copyright © 1998 addison wesley longman, inc. fixed prices and expenditure plans in the...

TM 11-1Copyright © 1998 Addison Wesley Longman, Inc.

Fixed Prices and Expenditure Plans

• In the very short term, firms’ prices are fixed.

• The quantities they sell depend on demand, not supply.



• The Aggregate Implications of Fixed Prices

1) Because each firm’s price is fixed, the price level is fixed.



• The Aggregate Implications of Fixed Prices

2) Because demand determines the quantities that each firm sells,

aggregate demand determines the aggregate quantity of goods and services sold, which equals GDP.



• The aggregate expenditure model explains fluctuations in aggregate demand by identifying the forces that determine expenditure plans.



• Expenditure Plans

• The components of aggregate expenditure are:

1) Consumption expenditure

2) Investment

3) Government purchases of goods and services

4) Net exports (exports minus imports)




• Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government purchases plus planned exports minus planned imports.




• In the very short term all are fixed except planned consumption expenditure and planned imports.

• They depend on the level of GDP.



• A Two-Way Link Between Aggregate Expenditure and GDP

1) An increase in real GDP increases aggregate planned expenditure



• A Two-Way Link Between Aggregate Expenditure and GDP

1) An increase in real GDP increases aggregate planned expenditure

2) An increase in aggregate expenditure increases real GDP



• Consumption Function and Saving Function

• We are going to focus on the relationship between consumption and disposable income when other factors are constant.

• The reason: Disposable income and consumption are interrelated.



• The main factors that influence consumption and saving are:

1) Real interest rate

2) Disposable income

3) Purchasing power of net assets

4) Expected future income



• Consumption Function and Saving Function

• The consumption function shows the relationship between consumption expenditure and disposable income.

• The saving function shows the relationship between saving and disposable income.


Consumption Function and Saving Function

a 00.75 -0.75

b 11.50 -0.50

c 22.25 -0.25

d 33.00 0

e 43.75 0.25

f 54.5 0.50

PlannedDisposable consumption Plannedincome expenditure saving

(trillions of 1992 dollars per year)



Disposable income (trillions of 1992 dollars per year

Con

sum

pti

on e

xpen

dit

ure

(t

rill

ion

s of

199

2 d

olla

rs/y

ear.

1

2

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1 2 3 4 5




Con

sum

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on e

xpen

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ure

(t

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s of

199

2 d

olla

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ear.

1

2

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0 1 2 3 4 5




Con

sum

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on e

xpen

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(t

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s of

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2 d

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ear.

1

2

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0 1 2 3 4 5

a

b

c d

e

f




Con

sum

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xpen

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ure

(t

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s of

199

2 d

olla

rs/y

ear.

1

2

3

4

5

0

a

b

c d

e

fSaving

DissavingConsumptionfunction

1 2 3 4 5


Consumption Functionand Saving Function

• Consumption expenditure that occurs when disposable income is zero is autonomous consumption.

• Consumption in excess of this is called induced consumption.



0

-1

1

1 3 4 52

Sav

ing

(tri

llio

ns

of 1

992

dol

lars

per

yea

r)

Disposable income(trillions of 1992 dollars per year)



0

-1

1

1

Savingfunction

3 4 5

a bc

de

f

Sav

ing

(tri

llio

ns

of 1

992

dol

lars

per

yea

r)




0

-1

1

1 3 4 5

Dissaving

SavingSavingfunction

a bc

de

f


Sav

ing

(tri

llio

ns

of 1

992

dol

lars

per

yea

r)



• Marginal Propensities to Consume and Save

• The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed.

YD

CMPC



• Marginal Propensities to Consume and Save

• The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved.

YD

SMPS



Marginal Propensities to Consume and Save

1

YD

S

YD

C

Divide both sides of the equation by the changein disposable income to obtain:

YDSC



• These two values are the marginal propensity to consume and the marginal propensity to save, so:

1 MPSMPC



• Slopes and Marginal Propensities

• The slopes of the consumption function and the saving function are the marginal propensities to consume and save.




Con

sum

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(t

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2 d

olla

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a

b

c d

e

f

Consumptionfunction

45o line




Con

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(t

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0 1 2 3 4 5

a

b

c d

e

f

Consumptionfunction

45o line

MPC= 0.75

75.0$C trillion

1$YD trillion



0

-1

1

1

Savingfunction

3 4 5

a bc

de

f

Sav

ing

(tri

llio

ns

of 1

992

dol

lars

per

yea

r)




0

-1

1

1

Savingfunction

3 4 5

a bc

de

f

Sav

ing

(tri

llio

ns

of 1

992

dol

lars

per

yea

r)


MPS= 0.2525.0$S trillio

n

1$YD trillion



• The other factors that change consumption expenditure and saving are:

1) Real interest rates

2) The purchasing power of net assets

3) Expected future income


Shifts in the Consumptionand Saving Function


Con

sum

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on e

xpen

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(t

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0 1 2 3 4 5

45o line

CF0




Con

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(t

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45o line

CF0

CF1




Con

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1

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0 1 2 3 4 5

45o line

CF0

CF1

CF2



0

-1

1

1 3 4 5

Sav

ing

(tri

llio

ns

of 1

992

dol

lars

per

yea

r)


2

SF0

SF1



0

-1

1

1 4 5

Sav

ing

(tri

llio

ns

of 1

992

dol

lars

per

yea

r)


2

SF0

SF1

SF2

3


The U.S. Consumption Function



• Import Function

• The greater the U.S. real GDP, the larger is the quantity of U.S. imports, other things remaining the same.

• The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports.


Real GDP with a Fixed Price Level

• How does aggregate expenditure plans interact to determine real GDP when the price level is fixed?


Real GDP with a Fixed Price Level

• First, we will study the relationship between aggregate planned expenditure and real GDP.

• Second, we’ll learn about the key distinction between planned expenditure and actual expenditure.


Aggregate Planned Expenditure

a 0 0.75 0.5 0.55 1.2 0.0 3

b 2 2.25 0.5 0.55 1.2 0.5 4

c 4 3.75 0.5 0.55 1.2 1.0 5

d 6 5.25 0.5 0.55 1.2 1.5 6

e 8 6.75 0.5 0.55 1.2 2.0 7

f 10 8.25 0.5 0.55 1.2 2.5 8

AggregateConsumption Government planned

Real GDP expenditure Investment purchases Exports Imports expenditure(Y) (C) (I) (G) (X) (M) (AE=C+I+G+X–M)

(trillions of 1992 dollars)

Planned expenditure

Darken lines



Real GDP (trillions of 1992 dollars per year

Agg

rega

te p

lan

ned

exp

end

itu

re

(tri

llio

ns

of 1

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dol

lars

/yea

r.

2

4

6

8

10

0 2 4 6 8 10




Agg

rega

te p

lan

ned

exp

end

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re

(tri

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2

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6

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10

0 2 4 6 8 10

I




Agg

rega

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exp

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0 2 4 6 8 10

II + G




Agg

rega

te p

lan

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exp

end

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(tri

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of 1

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/yea

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2

4

6

8

10

0 2 4 6 8 10

II + G

I + G + X




Agg

rega

te p

lan

ned

exp

end

itu

re

(tri

llio

ns

of 1

992

dol

lars

/yea

r.

2

4

6

8

10

0 2 4 6 8 10

II + G

I + G + X

I + G + X + C

Consumptionexpenditure




Agg

rega

te p

lan

ned

exp

end

itu

re

(tri

llio

ns

of 1

992

dol

lars

/yea

r.

2

4

6

8

10

0 2 4 6 8 10

II + G

I + G + Xa b

cd

ef

AE

I + G + X + CImports

Consumptionexpenditure


Aggregate Planned Expenditure and Real GDP

• Equilibrium Expenditure

• Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.

• When aggregate planned expenditure and actual aggregate expenditure are unequal, a process of convergence toward equilibrium expenditure occurs.


Aggregate Planned Expenditure and Real GDP

• Convergence to Equilibrium

• When actual and planned expenditure are unequal, unplanned changes in business inventories (investment) occur.

• GDP either increases or decreases until actual expenditures equal planned expenditures.


Equilibrium Expenditure


Agg

rega

te p

lan

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exp

end

itu

re(t

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s of

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2 d

olla

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ear.

2.0

4.0

6.0

8.0

10.0

0 2 4 6 8 10

45o line


d



Agg

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exp

end

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ear.

2.0

4.0

6.0

8.0

10.0

0 2 4 6 8 10

a

b c

e

f

45o line


d

Plannedexpenditureexceeds real GDP



Agg

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te p

lan

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exp

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olla

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ear.

2.0

4.0

6.0

8.0

10.0

0 2 4 6 8 10

a

b c

e

f

Real GDP exceedsplanned expenditure

45o line

Equilibriumexpenditure


The Multiplier

• The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.


The Multiplier

• The Basic Idea of the Multiplier

• Suppose that investment increases


The Multiplier

• The Basic Idea of the Multiplier• Suppose that investment increases

• This means that aggregate expenditure and real GDP increases.


The Multiplier



• Disposable income increases


The Multiplier




• Consumption expenditures increase


The Multiplier




• Consumption expenditures increase

• Aggregate expenditure increases again


The Multiplier




• Consumption expenditures increase • Aggregate expenditure increases again

• Real GDP, disposable income, and consumption expenditure increase more.


The Multiplier• The Basic Idea of the Multiplier

• Suppose that investment increases



• Consumption expenditures increase • Aggregate expenditure increases again

• Real GDP, disposable income, and consumption expenditure increase more.

• The initial increase in investment brings an even bigger increase in aggregate expenditure because it induces an increase in consumption expenditure.


The Multiplier

Real GDP (trillions of 1992 dollars)

Agg

rega

te e

xpen

dit

ure

(tri

llio

ns o

f 19

92 d

olla

rs)

5

6

7

8

9

5 6 7 8 9

45o line

ab

c

d

e

AE0


The Multiplier


Agg

rega

te e

xpen

dit

ure

(tri

llio

ns o

f 19

92 d

olla

rs)

5

6

7

8

9

5 6 7 8 9

AE145o line

ab

c

d

e

a'

b'

c'

d'e' AE0


The Multiplier


Agg

rega

te e

xpen

dit

ure

(tri

llio

ns o

f 19

92 d

olla

rs)

5

6

7

8

9

5 6 7 8 9

AE145o line

ab

c

d

e

a'

b'

c'

d'e' AE0

…increasesreal GDP by$2 trillion

A $0,5 trillionincrease ininvestment...


The Multiplier

• 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.


The Multiplier

• The multiplier is (from the table shown earlier):

Multiplier =Change in equilibrium expenditureChange in autonomous expenditure

= = 4$2 trillion

$0.5 trillion


The Multiplier

• The Multiplier and the Marginal Propensity to Consume and Save

• The larger the marginal propensity to consume, the larger the multiplier.


The Multiplier

• A change in real GDP equals the change in consumption expenditure plus the change in investment:

ICY


The Multiplier

• But the change in consumption expenditure is determined by the change in real GDP and the marginal propensity to consume:

YMPCxC


The Multiplier

• Substituting in the previous equation we get:

IYMPCY )(

YMPC


The Multiplier

• Solving for we get:

MPC

IY

1

Y


The Multiplier

• Dividing both sides of this equation by we get:

MPCI

YMultiplier

1

1

I


The Multiplier

• Using this formula, with MPC = 0.75, the multiplier is:

425.0

1

)75.01(

1

Multiplier


The Multiplier Process

Expenditure roundIncrease in current round

Cumulative increase from previous rounds

0

0.5

1.0

1.5

2.0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

tm 11-1 copyright © 1998 addison wesley longman, inc. fixed prices and expenditure plans in the...

Documents

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