Eco 1: Principles of Economics
Eco 1
Chapter 3 Where Prices Come From:
Chapter 22:of
The Interaction Aggregate
DemandExpenditure
and Supply
Aggregate Expenditure Model
Amount produced = aggregate output = Y
Amount that people want to buy = planned aggregate expenditures =AE
In this model the equilibrium is when AE = Y
• Aggregate expenditure model: A macroeconomic model that
focuses on the short-run relationship between total spending
and real GDP, assuming that the price level is constant.
• Aggregate expenditure (AE): Total spending in the economy: the sum of
consumption, planned investment, government purchases, and net exports.
The model focuses on short-run determination of total output in the economy.
Who buys the goods?
Consumption (C): Spending by households on goods and services
Planned investment (I): Planned spending by firms on capital goods, and by households
on new homes
Government purchases (G): Spending on all levels of government on goods and services
Net exports (NX): The value of exports minus the value of imports
Aggregate expenditure is the sum of these:
AE = C + I + G + NX
Planned Investment vs. Actual Investment
Main difference between GDP vs. AE is actual investment vs. planned investment
The difference is that planned investment spending does not include the build-up of
inventories: goods that have been produced but not yet sold:
Planned investment = Actual investment – unplanned change in inventories
Adjustments to Macroeconomic Equilibrium
Equilibrium in the economy occurs when spending on output is
equal to the value of output produced; that is: AE=Y
Consumption tends to follow a relatively smooth, upward trend; its growth
declines during periods of recession. What affects the level of consumption?
Current disposable income. Consumer expenditure is largely determined by how much money consumers receive in a
given year. We measure this by personal income, minus personal income taxes, plus government transfer payments such
as Social Security. Income expands most years; hence so does consumption.
Household wealth. It can be thought of as its assets (like homes, stocks and bonds, and bank accounts) minus its liabilities
(mortgages, student loans, etc.). Households with greater wealth will spend more on consumption, even with similar incomes. Recent studies estimate that an extra
$1,000 in wealth will result in $40-$50 in extra annual consumption spending, holding constant the effect of income.
Expected future income. Most people prefer to keep their consumption fairly stable from year to year, a process known as
consumption-smoothing. Example: Salespeople working on commission might have high incomes in some years, and low incomes in others. In order to predict their
consumption, we would need to know what they believed their income would be in the future.
The price level. As prices rise, household wealth falls. If you have $100,000 in the bank, that will buy fewer products at higher prices. Consequently, higher
prices result in lower consumption spending.
The interest rate. Higher real interest rates encourage saving rather than spending; so they result in lower spending,
especially on durable goods.
The Consumption Function
There is a very strong
relationship between income
and consumption
The line, which represents the relationship between consumption and disposable income (figure b) , is called the
consumption function. The slope of the consumption function is the marginal propensity to consume, the relationship
between consumption spending and disposable income. Households spend a consistent fraction of each extra dollar of real
disposable income on consumption.
Change in consumption ∆𝐶
𝑀𝑃𝐶 = =
Change in disposable income ∆𝑌𝐷
Consumption and National Income
The distinction between national income and GDP is relatively minor; we will assume they are equal, and use the terms interchangeably. So, GDP = Y
Disposable income = National income − Net taxes
Since “net taxes” are equal to taxes minus transfer payments, we can write:
National income = GDP = Disposable income + Net taxes
If we assume that net taxes do not change as national income changes, we have
the result that any change in disposable income is the same as the change in
national income.
Income, Consumption, and Saving
By definition, disposable income not spent is saved. Therefore we can write:
National income = Consumption + Saving + Taxes
Y=C+S+T
Any change in national income can be decomposed into changes in the items on the right
hand side:
∆Y = ∆C + ∆S + ∆T
We assume net taxes do not change, so ∆T = 0; then:
∆Y = ∆C + ∆S
Now divide through by ∆Y:
Y C S
= +
Y Y Y
Marginal Propensity to Save
Y C S
= +
Y Y Y
∆S/ ∆Y is the amount by which savings changes, when (disposable)
income changes. This is known as the marginal propensity to save.
We can rewrite the equation above as:
1 = MPC + MPS
That is, the marginal propensity to consume plus the marginal propensity to save must equal 1. This
is because part of any increase in income is consumed, and the rest is saved.
Planned Investment and What Affects It?
Investment has increased over time, but unlike consumption, it has not increased smoothly, and recessions decrease investment more.
Investment is subject to larger changes than is consumption. Investment declined significantly during the recessions of 1980, 1981–1982,
1990–1991, 2001, and 2007–2009.
Expectations of future profitability. Investment goods, such as factories, office buildings, machinery, and
equipment, are long-lived. Firms build more of them when they are optimistic about future profitability. Recessions reduce
confidence in future profitability, hence during recessions, firms reduce planned investment. Purchases of new housing are
included in planned investment. In recessions, households have reduced wealth, and less incentive to invest in new housing.
Interest rate. Since business investment is sometimes financed by borrowing, the real interest rate is an important
consideration for investing. A higher real interest rate results in less investment spending, and a lower real interest rate results
in more investment spending.
Taxes. Higher corporate income taxes on profits decrease the money available for reinvestment and decrease incentives to
invest by diminishing the expected profitability of investment. Similarly, investment tax incentives tend to increase investment.
Cash flow. Firms often pay for investments out of their own cash flow, the difference between the cash revenues received
by a firm and the cash spending by the firm. The largest contributor to cash flow is profit. During recessions, profits fall for
most firms, decreasing their ability to finance investment.
Government Purchases
Real government purchases include purchases at all levels of government: federal, state, and local.
This category does not include transfer payments; only purchases for which the government receives some good or
service.
Government purchases have generally, though not consistently, increased over time; exceptions include the early 1990s
(end of cold war) and due to state and local cutbacks after 2009
Net Exports
Net exports equals exports minus imports. The value of net exports is affected by:
✓ Price level in U.S. vs. the price level in other countries
✓ U.S. growth rate vs. growth rate in other countries
✓ U.S. dollar exchange rate
U.S. net exports have been negative for the last few decades. The value typically becomes higher (less
negative) during a recession, as spending on imports falls.
Determinants of Net Exports
Adjustment to Macroeconomic Equilibrium
In this economy, macroeconomic equilibrium
occurs at $10 trillion.
What if real GDP were lower, say $8 trillion?
Aggregate expenditure would be higher than GDP,
so inventories would fall. This would signal firms to
increase production, increasing GDP.
The reverse would occur if real GDP were above
$10 trillion.
Macroeconomic equilibrium can occur
anywhere on the 45° line. Ideally, we would like it
to occur at the level of potential GDP.
If equilibrium occurs at this level,
unemployment will be low—at the natural
rate of unemployment, or the full employment
level.
But for various reasons, this might not occur. For example,
maybe firms are pessimistic and reduce investment
spending.
A Numerical Example of Macroeconomic Equilibrium
The table below shows several hypothetical combinations of real GDP and planned aggregate expenditure.
Planned
Planned Government Aggregate Unplanned
Real GDP Consumption Investment Purchases Net Exports Expenditure Change in Real GDP
(Y) (C) (I) (G) (NX) (AE) Inventories Will…
$8,000 $6,200 $1,500 $1,500 −$500 $8,700 −$700 increase
9,000 6,850 1,500 1,500 −500 9,350 −350 increase
10,000 7,500 1,500 1,500 −500 10,000 0 be in
equilibrium
11,000 8,150 1,500 1,500 −500 10,650 +350 decrease
12,000 8,800 1,500 1,500 −500 11,300 +700 decrease
As real GDP changes, consumption changes but planned investment, government purchases, and net exports stay constant.
Macroeconomic equilibrium can occur only at $10,000 billion; otherwise, the unplanned change in inventories will cause
firms to change production and real GDP will change.
Autonomous and Induced Expenditures
Small change in planned aggregate expenditure causes a larger change in
equilibrium real GDP.
Planned investment, government purchases, and net exports
are autonomous expenditures: their level does not depend
on the level of GDP.
But consumption has both an autonomous and induced effect. So
its level does depend on the level of GDP, and this produces the
upward-sloping AE line.
An increase in an autonomous expenditure shifts the aggregate
expenditure line upward.
When this happens, real GDP increases by more than the change in
autonomous expenditures; this is the multiplier effect.
The value of the increase in equilibrium real GDP divided by the
increase in autonomous expenditures is the multiplier.
The Multiplier Effect in Action
Initially, real GDP rises by the amount of the increase in autonomous expenditure. This causes an
increase in real GDP, which causes an increase in production, which causes an increase in real GDP…
Eventual Effect of the Multiplier
We cannot say how long this adjustment to macroeconomic equilibrium will
take—how many “rounds”, back and forth.
But we can calculate the value of the multiplier, as the eventual change in
real GDP divided by the change in autonomous expenditures (planned
investment, in this case):
Y Change in real GDP $400 billion
= = =4
I Change in investment spending $100 billion
With a multiplier of 4, each $1 increase in planned investment (or any other autonomous
expenditure) eventually increases equilibrium real GDP by $4.
The Multiplier in Reverse
The multiplier can work in reverse too, like it did
during the Great Depression of the 1930s. Several
events, including the stock market crash of October 1929, led to
reductions in investments by firms.
Real GDP fell, so consumers cut back on spending, prompting
firms to reduce production more, so consumers spent even
less…Aggregate expenditures fell initially, due to the
decrease in investment.
This prompted a multiplied effect on equilibrium real GDP.
Recovery from the Great Depression took many years;
unemployment remained above 10% until the U.S. entered
World War II in 1941.
The Multiplier and the Marginal Propensity to Consume
How can we know the eventual value of the multiplier?
In each “round”, the additional income prompts households to consume some fraction (the marginal
propensity to consume).
The total change in equilibrium real GDP equals:
The initial increase in planned investment spending = $100 billion
Plus the first induced increase in consumption = MPC × $100 billion
Plus the second induced increase in consumption = MPC × (MPC × $100 billion)
= MPC2 × $100 billion
Plus the third induced increase in consumption = MPC × (MPC2 × $100 billion)
= MPC3 × $100 billion
Plus the fourth induced increase in consumption = MPC × (MPC3 × $100 billion)
= MPC4 × $100 billion
And so on …
A Formula for the Multiplier
This becomes the infinite sum:
Total change in GDP =$100billion + MPC×$100 billion+MPC2×$100billion + MPC3×$100billion + MPC4×$100billion +…
Which we can rewrite as: Total change in GDP = $100 billion × (1 + MPC + MPC2 + MPC3 + MPC4 + …)
by factoring out the initial $100 billion increase in investment. Since MPC is less than 1, the expression in
parentheses is:
1
1 − MPC
In our case, MPC = 0.75; so the multiplier is 1/(1-0.75) = 4. A $100 billion increase in investment
eventually results in a $400 billion increase in equilibrium real GDP. The general formula for the
multiplier is: Change in equilibriu m real GDP 1
Multiplier = =
Change in autonomous expenditur e 1 − MPC
Summarizing the Multiplier Effect
1. The multiplier effect occurs both for an increase and a decrease in planned aggregate
expenditure.
2. Because the multiplier is greater than 1, the economy is sensitive to changes in
autonomous expenditure.
3. The larger the MPC, the larger the value of the multiplier.
4. Our model is somewhat simplified, omitting some real-world complications. For
example, as real GDP changes, imports, inflation, interest rates, and income taxes will
change. This generally means that the value we estimate for the multiplier, from the
MPC, is too high.