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Chapters 10 & 11
Aggregate Expenditures
Short Run Macro Model
-- John Maynard Keyenes’ model explaining
how changes in spending affects real
GDP (spending affects business
fluctuations)
-- The short run is devoted to analyzing
business fluctuations
-- Assumption is that spending is the only
variable influencing real GDP (all others
held constant)
Planned Aggregate Expenditure Model
Planned Aggregate Expenditure (PAE)
-- total amount of planned spending in the economy
Planned Aggregate Expenditure Model
-- model defining the relationship between total planned
spending and real GDP (price level held constant)
-- used to explain business fluctuations
-- shows that real GDP is determined by planned aggregate
expenditures
4 categories of Planned Aggregate Expenditure
1) Consumption (C)
3) Gov’t Purchases
2) Planned Investment (IP)
4) Net Exports (Xn)
PAE = C + IP + G + Xn
Macroeconomic Equilibrium
-- When Planned Aggregate Expenditure
(total planned spending)
= GDP
(total output)
Other Scenarios
1) When planned aggregate expenditure > GDP
-- typically results in decrease in inventories and
increase in GDP and employment (surge in sales
causes an increase in production  inc in
employment)
2) When planned aggregate expenditure < GDP
-- typically results in increase in inventories and
decrease in GDP and employment (drop in sales
causes excess inventories leading to less
production and unemployment)
Components of Planned Aggregate Expenditure
I] Consumption Spending
-- largest component
Variables influencing consumption spending
1) Disposable Income (YD)
-- main determinant
YD = Income + Transfer Payments – Taxes
-- as YD ↑, consumption spending ↑
-- as YD ↓, consumption spending ↓
2) Price Level
-- increase in price level causes consumption ↓
-- decrease in price level causes consumption ↑
Variables influencing consumption spending, cont.
3) Interest Rate (r)
-- as r ↑, consumption spending ↓ (people are more willing to
save)
-- as r ↓, consumption spending ↑
-- interest rate has a larger effect on durable goods
4) Wealth
Wealth = Assets - Liabilities
-- as wealth ↑, consumption spending ↑
-- as wealth ↓, consumption spending ↓
5) Expectations about Futures
-- Optimistic about future earnings, consumption spending ↑
-- Concerned about future earnings, consumption spending ↓
Consumption Spending and Disposable Income
-- close relationship between consumption and
disposable income
Consumption Function
-- a positive linear relationship between consumption
spending and disposable income
Point
Real Disposable
Income (YD) in
billions $
Real Consumption
Spending (C) in
billions $
A
$
$
B
C
D
E
Real Consumption (In
billions)
320
E
250
D
180
C
110
40
B
A
Real Disposable
Income (in billions)
100
200
300
400
Equation of Consumption Function
C = a + bYD
where a = C intercept
b = slope
2 Important Characteristics
1) Intercept
-- level of consumption where YD (disposable
income) = 0 or pt A
-- known as autonomous consumption spending
-- amount of consumption spending independent of
disposable income
-- includes items such as wealth and interest rates
(those other items affecting consumption)
-- changes in autonomous consumption causes
parallel shifts in the consumption function (i.e. slope
remains the same)
2) Slope
-- slope is rise/run or slope = ∆C/∆YD
-- since consumption function is linear, slope is constant
Finding slope:
Pt C  YD = 200 C = 180
Pt D  YD = 300 C = 250
-- slope of consumption function is known as Marginal
Propensity to Consume (MPC)
MPC =
Interpretation
-- amount by which consumption spending ↑ for every $1
increase in disposable income (consumption spending
increases by $ for every $
increase in disposable
income)
-- 0 < MPC < 1
as disposable income ↑, consumption ↑ but consumers
will not spend entire increase in income
Restating Equation to find ∆C as Income Changes
∆C = MPC * ∆YD
Example: If MPC = .75 and ∆YD is $5 billion, find ∆C
∆C =
∆C =
Interpretation: a $ billion increase in income will
cause consumption to increase by $
billion.
Consumption and National Income (Y)
-- Rewriting relationship between consumption and
disposable income to show relationship between
national income and consumption
YD = Y – Net Taxes
where Net taxes = Taxes – Transfer Payments
Y = National Income = GDP
then Y = GDP = YD + Net taxes
Assumption: Taxes are a fixed amount
Real National
Income or Real
GDP (billions $)
Net Taxes
(billions $)
Real Disposable
Income (YD) in
billions $
Real
Consumption
Spending (C) in
billions $
$
$
$
$
Consumption Income Line
-- A line showing consumption spending at each level of national
income (Y) or GDP
Real Consumption (In
billions)
ConsumptionIncome Line
320
250
180
110
40
Real National
Income (in billions)
100
200
300
400
500
Unique Characteristic
Slope of Consumption Line and Consumption Function are
the same
-- slope is unaffected by changes in taxes (parallel
curves)
-- occurs only when taxes are fixed
-- Since slope of consumption function = MPC = ∆C/∆YD,
and slope of consumption lines = slope of
consumption function, MPC can also be written as
∆C/∆Y. Essentially then the change in disposable
income is the same as the change in national
income.
∆Y = 100 ∆C = 70 same as
Slope = 70/100 or .7
∆YD = 100 ∆C = 70
Real Consumption (In
billions)
ConsumptionFunction
ConsumptionIncome Line
320
250
180
110
40
Real Income (in
billions)
100
200
300
400
500
Movement Along the Consumption-Income Line
-- If income ↑, and taxes remained unchanged,
consumption spending ↑
Influence of ∆ Taxes on Consumption-Income Line
-- If taxes ↓  Disposable Income ↑  causing
consumption at every income level to ↑, causing
consumption-income line to shift upward.
Note: Consumption changes by MPC x ∆T at any income
level
Example: If taxes decrease by $10 billion, at income level
of $250 billion, curve will shift upward to a point where
consumption would change by .7 x 10 or $7 billion to $187
billion.
Consumption (In
billions)
ConsumptionIncome Line’
ConsumptionIncome Line
320
250
180
110
40
National Income
(in billions)
100
200
300
400
500
Components of Planned Aggregate Expenditure
II] Planned Investment Spending (IP)
-- Business purchase of plant and equipment and
household purchases of new home construction
-- Excludes inventories because they are typically
unplanned  therein lies the distinction between
actual vs. planned inventories
a) actual investment > planned investment when there
is an unplanned increase in inventories
b) actual investment < planned investment when there
is an unplanned decrease in inventories
c) actual investment = planned investment when there
is no planned change in inventories
Variables Determining Level of Investment
1) Expectations of Future Profits
-- machinery, buildings and other big purchase items
involve much planning and make up a big part of
capital expenditures thus future state of the economy
has a big influence on firm’s decision
Pending Recession  postpone buying investment
goods
Pending Expansion  buy or move forward with
purchase of investment goods
Variables Determining Level of Investment, cont.
2) Interest rate
-- Borrowing or financing remains a viable option as a
means to gain the funds for purchasing investment
goods; therefore, the interest rate remains a key
variable in this decision.
-- spans not only businesses but households (new
home construction)
-- the higher the interest rate, the less motivated firms
are to borrow or finance for purchase of investment
goods
Variables Determining Level of Investment, cont.
3) Taxes
-- Federal Gov’t imposes taxes on profits of firms.
a) Corporate Income Tax
-- A decrease in the corporate income tax increases
the after tax profitability of investment spending
making investment spending attractive
-- An increase in the corporate income tax reduces the
after tax profitability making of investment spending
making investment spending less attractive
b) Investment Tax Incentives
-- Provides firms with a tax reduction for monies
spent on investments
-- Provides addt’l incentive to engage in investment
spending
Variables Determining Level of Investment, cont.
4) Cash Flow (Cash Revenue Received – Cash Spending)
-- Firms may decide to use their own cash to fund
investment spending
-- Cash flow is the amount of money on hand to make
these particular purchases
-- In expansionary periods, firms experience more
profitability hence greater cash flow than in
recessionary periods. The increased cash flow makes
investment spending an attractive option in the
booming periods.
Components of Planned Aggregate Expenditure
III] Government Purchases
-- Spending by Federal, State and Local Gov’t
IV] Net Exports
-- Net Exports = TTL Exports – TTL Imports
Net Exports are influenced by the following:
1) Price level in U.S. vs Price Level in Other Countries
-- when inflation rate is lower in U.S. vs other nations
 prices of U.S. goods are increasing slower than
that of other countries making U.S. goods more
attractive. Boosts exports while reducing imports
(causing net exports to ↑)
2) Growth rate of GDP in U.S. vs other countries
-- when incomes in U.S. increase faster than other
countries  U.S. consumers’ purchase of foreign
goods will be greater than that of foreign consumers’
purchase of U.S. goods. Leads to ↓ in net exports
since exports ↓ and imports ↑
3) Exchange Rate: As the value of the dollar
increases, foreign currency price of U.S. goods in
other countries increase & dollar price of foreign
products sold in U.S. drops causing ↑ in imports and ↓
in exports causing net exports to fall
Example:
Euro (€) and U.S. dollar exchange rate is .64
Euros = $1.00
Product that is $1.00 in U.S. is ___ Euros in
Europe and 1 Euro product in Europe is $
in U.S.
If exchange rate ↑ to ____ Euros = $1.00,
product that is $1.00 in U.S. is now ____ Euros
in Europe causing quantity demanded in
Europe to drop. However, the 1 Euro product
in Europe now sells for $____ in U.S.
increasing quantity demanded in U.S.
Result: Imports ↑ Exports ↓ (Net Exports ↓)
Income and Planned Aggregate Expenditure (data in billions $)
Pt
A
B
C
D
E
Real
Income /
Real GDP
(Y)
C
G
IP
Xn
PAE
∆ Unplanned
Inventories
Notes:
1) Assume IP, G and NX are fixed
2) ∆ inventories = Real GDP – PAE
3) As Y ↑, PAE ↑, but ∆PAE < ∆Y
Example: Pt C to Pt D
∆PAE =
∆Y =
Why? Consumption is only variable that is not fixed
and consumption and income are related by the
MPC
Finding Equilibrium Real GDP Using PAE and Inventories
Pt
A
B
C
D
E
Real Income
or Real GDP
(in billions)
Planned
Aggregate
Expenditure
(in billions)
∆ inventories
(in billions)
Finding Equilibrium Real GDP Using PAE and Inventories
a) When PAE > Real GDP
 ∆ Inventories < 0
 Real GDP or output ↑ in future
Example: Pt B
PAE = $
billion and Real GDP = $
billion
Result: Inventories are depleting so output ↑ in future
b) When PAE < Real GDP
 ∆ Inventories > 0
 Real GDP or output ↓ in future
Example: Pt D
PAE = $
billion and Real GDP = $
billion
Result: Inventories are increasing so output ↓ in future
c) Equilibrium occurs where PAE = Real GDP or ∆ Inventories = 0
-- occurs at Pt C
-- Firms are selling what they produce
Graphing Equilibrium
-- Use of 45° Line
$
45° Line
C
B
45°
$
D
A
Properties
-- At Pt B, distance along horizontal axis (DA) = distance along
vertical axis (DC) or distance DA = distance DC
-- Distance DA = distance AB
Using PAE curve and 45° line to find equilibrium
PAE
45° line
500
G
PAE
400
E
300
C
D
B
200
A
100
H
I
100
F
200
300
400
500
Real GDP(in
billions)
a) 45° Line is above PAE Curve
At Real GDP = $450 billion:
-- From 45° line, real GDP is distance FG
-- PAE is $390 billion or distance FE
Since real GDP > PAE, inventories are accumulating
∆ inventories = GDP – PAE or distance EG Thus real GDP ↓
PAE
45° line
500
G
PAE
? inventories
400
E
300
C
D
Real GDP
B
200
AE
A
100
H
I
100
F
200
300
400
500
Real GDP(in
billions)
b) 45° Line is below PAE Curve
At Real GDP = $50 billion:
-- From 45° line, real GDP is distance HI
-- AE is $110 billion or distance AI
Since real GDP < PAE, inventories are shrinking
∆ inventories = GDP – PAE or distance AH Thus real GDP ↑
PAE
45° line
500
G
PAE
400
E
300
C
B
200
100
D
A
? inventories
AE
H
I
F
Real GDP
100
200
300
400
500
Real GDP(in
billions)
c) 45° Line intersects PAE Curve (Equilibrium)
At Real GDP = $250 billion:
-- PAE curve intersects 45° Line or PAE = Real GDP
-- ∆ inventories = 0
-- Occurs at Pt C
PAE
45° line
500
PAE
400
300
200
E
C
D
B
A
100
100
200
300
400
500
Real GDP(in
billions)
Impact When Fixed Variables Change
1) Impact of ∆ in investment spending
-- Find the impact of an increase in IP of $10 billion on
real GDP and PAE
(Assume equilibrium or real GDP = PAE and
Assume MPC = .3)
-- When firms ↑ IP of $10 billion  $10 billion of goods
becomes factor payments for those firms supplying
goods.
-- MPC determines how much income is spent by
households. The income that is spent becomes the
next set of factor payments
-- This cycle continues as shown on next slide
Round
Initial
Round 2
Addt’l Spending
Per Round
$10 billion (IP)
$3 billion (C)
Cumulative
Spending
$10 billion
$13 billion
(MPC x previous
spending)
Round 3
$.9 billion (C)
$13.9 billion
(MPC x previous
spending)
.
.
.
.
.
.
.
.
.
≈ $14.3 billion
Expenditure Multiplier
-- In total, IP ↑ by $10 billion and overall spending (PAE)
and real output ↑ by an amount greater than IP.
-- Specifically, ∆ real GDP or ∆PAE = 1.43 x ∆ IP
where 1.43 is expenditure multiplier
Derivation of Expenditure Multiplier
• # by which ∆ IP must be multiplied to find ∆
equilibrium GDP
• Multiplier = 1/(1-MPC)
Example: If IP ↑ by $12 billion and MPC = .6
∆ real GDP = ____________
Expenditure Multiplier Effect for other fixed variables:
a) ∆ real GDP =(1/1-MPC) x ∆G
b) ∆ real GDP =(1/1-MPC) x ∆NX