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Aggregate Expenditureand 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 thetie between income and total spending
AssumptionsNo 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 netexports are autonomous independent of the level of income
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Components of Aggregate Expenditure
To develop the aggregate demandcurve, we begin by asking howmuch aggregate output would bedemanded at a given price level
Our objective is to analyze therelationship between aggregate
spending in the economy andaggregate income, or real GDP
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Aggregate Expenditures
Aggregate expenditures equals theamount that households, firms,governments, and the rest of theworld plan to spend on U.S. output
at each level of real GDPConsumption, C
Planned investment, I
Government purchases, G
Net exports, X – MConsumption is the only spendingcomponent that varies with the level of real GDP
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Exhibit 1: Table for 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
First column lists a range of possible levels of real GDP symbolized by Y
When we subtract net taxes, column (2), we get disposable income in column (3)
Households only have two possible uses for disposable income
Consumption, MPC assumed to be 4/5Saving, MPS assumed to be 1/5
Real
GDP
(Y)
(1)
Net
Taxes
(NT)
(2)
Disposable
Income
(Y-NT)
(3)=(1)-2)
Consumption
(C)
(4)
Saving
(S)
(5)
Planned
Investment
(I)
(6)
Government
Purchases
(G)
(7)
Net
Exports
(X-M)
(8)
PlannedAggregate
Expenditur
e
(AE)
(9)
UnintendedInventory
Adjustment
(Y-AE)
(10)=(1)-
(9)
9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02
9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1
10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0
10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1
11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2
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Real
GDP
(Y)
(1)
Net
Taxes
(NT)
(2)
Disposable
Income
(Y-NT)
(3)=(1)-2)
Consumption
(C)
(4)
Saving
(S)
(5)
Planned
Investment
(I)
(6)
Government
Purchases
(G)
(7)
Net
Exports
(X-M)
(8)
Planned
AggregateExpenditur
e
(AE)
(9)
Unintended
InventoryAdjustment
(Y-AE)
(10)=(1)-
(9)
9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02
9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1
10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0
10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1
11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2
Columns (6), (7), and (8) list the injections into the circular flow: planned investment,
government purchases and net exports.
Government purchases equals net taxes government’s budget is balanced
The final column lists any unplanned inventory adjustment which equals real GDP minus
planned aggregate expenditures
When the amount people plan to spend equals the amount produced, there are no
unplanned inventory adjustments. In our example, this occurs where planned aggregateexpenditures and real GDP equal 10.0
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If, however, real GDP is $9.0 trillionPlanned aggregate expenditure is $9.2 trillion firms must reduce inventories to make up the
shortfall in output
When the amount produced exceeds planned spending, firms get stuck with unsold goods which
become unplanned increases in inventories
For example, if real GDP is $11.0 trillion, planned aggregate expenditure is only $10.8 trillion
$0.2 million in output remains unsold firms respond by reducing output and do so untilthey produce the amount that people want to buy
Real GDP (Y)(1)
NetTaxes(NT)(2)
DisposableIncome(Y-NT)(3)=(1)-2)
Consumption(C)(4)
Saving(S)(5)
PlannedInvestment(I)(6)
GovernmentPurchases(G)(7)
NetExports(X-M)(8)
Planned
AggregateExpenditure(AE)(9)
Unintended
InventoryAdjustment(Y-AE)(10)=(1)-(9)
9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02
9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1
10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0
10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1
11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2
Exhibit 1: Table for Real GDP With Net Taxes and
Government Purchases (trillions of dollars)
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Exhibit 2: Deriving Aggregate Output
Real GDP(trillions of dollars)
0
C + I + G + (X – M)
e10.0
10.0
45º
A
ggrega
teexpend
iture
(trillionsofdoll
ars)
This graph is often called the income-expenditure model. The aggregate
expenditure line reflects the sum of consumption, investment, government
purchases, and net exports
Planned aggregate expenditure
is measured on the vertical
axis. Real GDP , measured on
the horizontal axis, can be
viewed in two ways: 1) the
value of aggregate output ,and 2) as the aggregate income
generated by that level of
output for a given price level
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Exhibit 2: Deriving Aggregate Output
Real GDP
(trillions of dollars)
0
C + I + G + (X – M)
e10.0
10.0
45º
A
ggrega
teexpend
iture
(trillionsofdoll
ars)
The special feature of the 45-
degree line is that it identifies all points where planned expenditure
equals real GDP.
Aggregate output demanded at
any given price level occurs where
real GDP equals planned
aggregate expenditure, at point e
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Real GDP
(trillions of dollars)
0
C + I + G + (X – M)
e10.0
10.0
45º
9.0 a
9.0
9.2b
A
ggrega
teexpend
iture
(trillionsofdoll
ars)
Exhibit 2: Deriving Aggregate Output
Consider what happens when realGDP is initially less than $10.0
trillion, say $9.0 trillion. Planned
aggregate expenditures of $9.2
trillion (point b) exceed real GDP:
planned expenditures exceed the
amount that firms produce.
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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Exhibit 2: Deriving Aggregate Output
Real GDP
(trillions of dollars)
0
C + I + G + (X – M)e
10.0
10.0
45º
d
11.0
10.811.0
c
A
ggrega
teexpend
iture
(trillionsofdoll
ars)
When aggregate
expenditures exceed real
GDP - for example at
$11.0 - planned spending
(point c on the AE line)
falls short of production
(point d). Since real GDP
exceeds the amount people
want to spend, unsold
goods accumulate. Rather
than allow inventories to
pile up indefinitely, firmsreduce production, which
reduces employment and
income.
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Simple Spending Multiplier
If we continue to assume that theprice level remains unchanged, wecan trace the effects of changes inplanned spending on aggregate
output demanded
The key point is that like a stonethrown into a still pond, the effect of
any shift in planned spending ripplesthrough the economy, generatingchanges in aggregate output thatmay far exceed the initial shift inplanned spending
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Exhibit 3: Effect of an Increase In Autonomous
Investment on Real GDP Demanded
Aggregateexpenditure(trill
ionsofdollars)
0
10.0
10.5
10.0
e
Real GDP(trillions of dollars)
10.5
45º
0.1
10.1a
Assume that we begin at
equilibrium at point e
and that firms become
more optimistic about
future prospects. As a
result they increase their
planned investment,
from I to I'.
In our example,
investment is assumed to
have increased by $0.1trillion per year. What is
important to note is that
real GDP increased by
$0.5 trillion.
C+I´+G+(X-M)
C+I+G+(X-M)
e´
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Exhibit 3: Autonomous Increase In Investment
C + I + G + (X – M)
Aggregateexpenditure(trill
ionsofdollars)
0
10.0
10.5
10.0
e
Real GDP
(trillions of dollars)
10.5
45º
g c
d
e'
10.1
f
0.1
10.1a
b
Round 1: The upward shift
of the AE line means that at
the initial real GDP level of
$10.0 trillion, planned
spending now exceeds output
by $0.1 trillion: e a
Initially, inventories may bereduced, prompting firms to
expand production: a b
e b shows the first round
in the multiplier process.Those who receive this
additional income spend
some of it and save the rest,
laying the basis for round
two of spending and income.
C + I' + G + (X – M)
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Simple Spending Multiplier
The cumulative spending resulting from aninfinite series of rounds equals
1 / (1 – MPC) which in our example where theMPC was 0.8 1 / 0.2 5
Thus, the initial increase in plannedinvestment of $100 billion will eventuallyboost 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 valueof the MPC
Specifically, the larger the fraction of
an increase in income that is spenteach round, the larger the spendingmultiplier the larger the MPC, thelarger the simple multiplier
With an MPC of 0.8, the multiplier is 5With 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 discussionsthat the MPC and the MPS mustadd up to 1
Therefore, we can define the simplespending multiplier in terms of the
MPS as follows:
Simple spending multiplier = 1 /MPS
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Simple Spending Multiplier
In our example, the multiplierprocess started because of anincrease in investment
The same impact would occur if anyone of the components of aggregate expenditures changed
Finally, if the higher level of planned investment is notsustained in future years, real GDPwould 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 GDPdemanded for a given price level
What happens to the aggregate
expenditure line if the price levelchanges
As will be seen, for each price levelthere is a specific aggregateexpenditure line which yields a uniquereal GDP demanded by altering theprice level, we can derive theaggregate demand curve
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A Higher Price Level
What is the effect of a higher price levelon the economy’s aggregate expenditureline and, in turn, on real GDP demanded?
A higher price levelreduces consumption because it reduces thereal value of dollar-denominated assets heldby households
increases the market rate of interest whichreduces investment
makes U.S. goods relatively more expensiveabroad imports rise and exports fall
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Exhibit 5: Income-Expenditure and Aggregate Demand
0 Real GDP (trillions of dollars)
0
140
Aggregat e
exp
enditure
(trillionsofdollar
s)
e
AE (P = 130)
e
130
10.0
10.0 Real GDP (trillions of dollars)
45°
(a) Income-expenditure model
(b) Aggregate demand curve
In panel (a), the AE
function intersects the 45
degree line at point e to
yield $10.0 trillion in real
GDP demanded.
Panel (b) shows more
directly the link between
real GDP demanded and the
price level. When the price
level is 130, real GDPdemanded is $10.0 trillion.
This combination of price
level and real GDP is
identified by point e on the
aggregate demand curve.
Pricelevel
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0 Real GDP (trillions of dollars)
0
140
AD
Aggregat e
exp
enditure
(trillionsofdollar
s)
AE' (P = 140)
e'
e'
9.5
9.5
e
AE (P = 130)
e
130
10.0
10.0 Real GDP (trillions of dollars)
120
AE" (P = 120)
e"
e"
10.5
10.5
45°
If the price level increases to 140?
As a result of the decrease in
planned spending, real GDP
demanded declines from e e'
Exhibit 5: Income-Expenditure and Aggregate Demand
It increases consumption,
planned investment, and net
exports, as reflected panel (a) by
the upward shift in the spending
line from AE to AE"
The increase in planned spending at
each income level increases real GDP
demanded increases from e e"
(a) Income-
expenditure
model
Pricelevel
(b) Aggregate
demand curve
It reduces consumption,investment, and net exports, as
reflected in panel (a) by the
downward shift from AE to AE'
If the price level declines to120?
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Aggregate Demand and Expenditures
The aggregate expenditure line andthe aggregate demand curve portrayreal output from different perspectives
The aggregate expenditure line shows, fora given price level, how planned spendingrelates to the level of real GDP in theeconomy
The aggregate demand curve shows, forvarious price levels, the quantities of realGDP demanded
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Multiplier and Aggregate Demand
Suppose we return to the situationwhere the price level is assumed to beconstant
What we want to do now is tracethrough the effects of a shift in any of the components of spending onaggregate demand, while assuming
that the price level does not change,e.g., we want to look at the multiplierand shifts in aggregate demand
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Exhibit 6: Shifts
Aggregat
eexpenditure
(trillionso
fdollars)
0 10.0 Real GDP (trillions of dollars)
C + I + G + (X – M)
45º
e
0 10.0 Real GDP (trillions of dollars)
AD
130
Pricelevel
10.5
e'
C + I' + G + (X – M)
0.1
10.5
AD'
At a price level of 130, theaggregate 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,
the AE function shifts upward.
Because the price level is
assumed constant, the aggregatedemand curve shifts from AD to
AD' and the new point of
equilibrium is shown as e' in both
panels.
e e´
(a) Income-
expenditure
model
(b) Aggregate
demand curve
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Limitations of the Multiplier
Our discussion of the simple spending
multiplier exaggerates the actual effectwe might expect from a given shift inthe aggregate expenditure line
We have assumed that the price level
remains constant. However, as we will seelater, once we incorporate aggregate supplyinto the analysis, changes in the price levelreduce the impact of the multiplier
Leakages such as higher income taxes and
increased spending on imports all reduce thesize of the multiplier
The spending multiplier takes time to work itself out the process does not occurinstantly