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W H AT I S E C O N O M I C S ? 95 1 EXPENDITURE MULTIPLIERS** The Big Picture Where we have been: Chapter 11 uses the background provided in Chapters and 10 to focus on aggregate expenditure and aggregate demand It builds on the division of GDP into C + I + G + (X – M) explained in Chapter and then derives the aggregate demand curve previously used in Chapter 10 Where we are going: Chapter 11 examines the details of the AS-AD model by focusing on the factors that determine the AD curve The AD curve is important in all the core shortrun macroeconomic chapters The material in this chapter is used in Chapters 12-14 on the business cycle, fiscal policy, and monetary policy N e w i n t h e Tw e l f t h E d i t i o n The data in this chapter have been updated to reflect 2014 information The Economics In The News feature reports the BEA statistics for 2014 with economic analysis using the Aggregate Expenditure model The Mathematical Note now includes a short exercise at the end Using data on disposable income and consumption expenditure, the Worked Problem shows the calculation and effect of the multiplier It also asks the students to use the multiplier to determine the effect an increase in autonomous expenditure has on real GDP To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems 95 Lecture Notes Expenditure Multipliers The Keynesian model focuses on the short run In the Keynesian model, business cycle fluctuations are driven by changes in the components of aggregate expenditure, especially investment The multiplier effect describes the amplified effect on real GDP from changes in expenditure Historical background If you want to talk about Keynes and his contribution to economics, this is probably the best place to it The model, now generally called the aggregate expenditure model, presented in this section is the essence of Keynes General Theory According to Don Patinkin, a leading historian of economic thought and Keynes scholar, the innovation of the General Theory was to replace price with income (GDP) as the equilibrating variable This version of the model cannot be found in the General Theory, mainly because Keynes was writing before the national income accounting system had been developed So he made up his own aggregates, based on employment and a money wage measure of the price level But the words and equations of the General Theory can be translated readily into the textbook version of the model This version of the model first appeared in The Elements of Economics, a textbook authored by Lorie Tarshis published in 1947 It was popularized by Paul Samuelson in the first edition of his celebrated text published in 1948 The main difference between the Keynesian cross model of the 1940s and the aggregate expenditure model of today is that from the 1940s through the mid-1960s, economists believed that the fixed price level assumption was an acceptable (if not exactly accurate) description of reality, so the model was seen as actually determining real GDP, and the multiplier was seen as an empirically relevant phenomenon In contrast, today, we see the model as part of the aggregate demand story The value of the model today—and it is valuable today and not, as some people claim, eclipsed by the AS-AD model and irrelevant —is that it explains the multiplier that translates a change in autonomous expenditure into a shift of the AD curve and it explains the multiplier convergence process that pulls the economy toward the AD curve (When an unintended change in inventories occurs, the economy is of the AD curve but moving toward it.) I Fixed Prices and Expenditure Plans The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services As a result, the price level is fixed and so aggregate demand determines real GDP Expenditure Plans Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports In the very short term, planned investment, planned government expenditure, and planned exports are fixed Planned consumption expenditure and planned imports are not fixed, but depend on aggregate income An increase in real GDP increases aggregate expenditure and an increase in aggregate expenditure increases real GDP Consumption Function and Saving Function Consumption expenditure and saving depend on the real interest rate, disposable income, wealth, and expected future income Disposable income is aggregate income minus taxes plus transfer payments The relationship between consumption expenditure and disposable income, other things remaining the same, is called the E X P E N D I T U R E M U LT I P L I E R S consumption function The relationship between saving and disposable income, other things remaining the same, is called the saving function 111 112 CHAPTER 11 The figure shows a consumption function Along the 45 degree line, consumption equals disposable income When the consumption function is above the 45 degree line, there is dissaving When the consumption function is below the 45 degree line, there is saving The consumption expenditure when disposable income is zero, $4 trillion in the figure, is autonomous consumption Consumption expenditure in excess of this amount is induced consumption The 45° line Don’t assume that your students immediately understand the 45° line! Spend a bit of time explaining how to “read” it Fundamentally, it shows all points where x = y This line happens to be a 45° line when the scales along the x-axis and the y- axis are the same Then point out that the horizontal distance to a point along the x-axis equals the vertical distance from that point to the 45° line So at all points along the 45° line, x = y If you wish, you can go on to show the students how the x = y line changes its appearance if we stretch or squeeze the scale on the y-axis holding the scale on the x-axis constant Emphasize that x and y can be anything In the figure above, x is disposable income and y is consumption expenditure; in the figure below, x is real GDP and y is aggregate planned expenditure Marginal Propensities to Consume and Save The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed, C/YD The MPC is the slope of the consumption function, which is 0.67 in the figure The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved, S/YD The MPS is the slope of the saving function The sum of the MPC plus the MPS equals 1.0 Marginal propensities The text defines the MPC and MPS, and shows that they sum to one because disposable income can only be consumed or saved Students generally relate to percentages better, so you can explain it as percent but stress that we use the decimal number for analytical purposes Other Influences on Consumption Expenditure and Saving A change in any other factor influencing consumption and saving besides disposable income (such as the real interest rate, wealth, and expected future income) shifts the consumption function and the saving function An increase in wealth or expected future income and a decrease in the real interest rate increases consumption—and shifts the consumption function upward—and decreases saving—and shifts the saving function downward The U.S MPC is about 0.9 Since the 1960s, increases in expected future income and wealth have shifted the consumption function upward E X P E N D I T U R E M U LT I P L I E R S Consumption as a Function of Real GDP and the Import Function For a given level of taxes and transfers, disposable income changes when real GDP changes, so consumption also is a function of real GDP We use this observation when we derive the aggregate expenditure function Just as consumption of domestically produced goods and services depends on real GDP, so imports The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports II Real GDP with a Fixed Price Level Real GDP (Y) Consumpti on expenditur e (C) Investme nt (I) Governme nt expenditur e (G) Export s (X) Import s (M) Aggregate planned expenditure (AE=C+I+G+X M) 0.8 0.9 1.0 1.1 14.4 15.2 16.0 17.8 (trillions of 2009 dollars) 14.0 15.0 16.0 17.0 10.2 11.1 12.0 12.9 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 1.0 1.0 1.0 1.0 Aggregate Planned Expenditure and Real GDP Aggregate planned expenditure, AE, is the sum of planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports The above table shows the calculation of an aggregate planned expenditure schedule The figure shows the resulting AE curve Consumption expenditure minus imports vary with real GDP and are induced expenditure The sum of investment, government expenditures, and exports not vary with real GDP and are autonomous expenditure Consumption expenditure and imports also have an autonomous component Actual expenditure can differ from planned expenditure because firms not always sell what they plan to, in which case they have unplanned inventory investment For instance, a car that is manufactured but not immediately sold is part of that firm’s actual inventory investment regardless of whether the firm planned to add it to inventory or not Equilibrium Expenditure and Convergence to the Equilibrium Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP In the figure, equilibrium expenditure is $12 trillion If aggregate expenditure does not equal its equilibrium, forces lead to convergence For example, if real GDP exceeds aggregate planned expenditure, firms find their 113 114 CHAPTER 11 inventories are increasing more than planned The unplanned inventory accumulation leads firms to cut production so that real GDP decreases, which decreases aggregate planned expenditures Real GDP still exceeds aggregate planned expenditure, but by less than before The process continues until real GDP equals aggregate planned expenditure so that there is no unplanned inventory accumulation III 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 When there is an autonomous change in a component of expenditure such as investment, additional changes in aggregate expenditure are set in motion Because of the feedback between real GDP and consumption expenditure, the total change in real GDP is larger than the initial change in autonomous expenditure The multiplier effect operates for a decrease as well as an increase in autonomous expenditure Work through an example of a change in government spending Suppose there are no taxes, no imports, no exports and the MPC is 0.9 If the government purchases $5 billion of weapons from Nuc’s-R-US, what happens to that spending? Nuc’s has to pay all of its employees, subcontractors and material suppliers among other costs These costs to Nuc’s turn into income (Y) for others (remind your students of the circular flow) These other people are going to consume 90 percent of that income, $45 billion, at stores such as JCPenney Now JCPenney must pay its costs, which again turns into other people’s income, of which 90 percent again gets spent again ($40.5 billion) and so on and so on and so on… Explain to the students that we have a short-cut to explain this iterative process and capture the total change in income (Y) from the change in government spending (G) That short-cut is the multiplier, which shows that the change in GDP is given by GDP = 1/ (1 MPC) × G Why is the Multiplier Greater Than 1? An increase in autonomous expenditure increases real GDP and the increase in real GDP induces an additional increase in aggregate expenditure (primarily an increase in consumption expenditure) Each additional increase in aggregate expenditure increases real GDP further, leading to yet further increases in aggregate expenditure The process converges because the increase in aggregate expenditure is smaller at each step of the process The Multiplier and the Marginal Propensities to Consume and Save The change in real GDP can be divided into the change in induced expenditure plus the change in autonomous expenditure, Y = N + A, where Y is real GDP, N is induced expenditures, and A is autonomous expenditure The slope of the AE curve = N÷Y, so N = (slope of AE curve) Y Using this equality in the previous formula shows Y = (slope of AE curve) Y + A Solving for the change in GDP, Y, gives Y = A This last result shows that the multiplier slope of the AE curve E X P E N D I T U R E M U LT I P L I E R S equals In the previous figure, the slope of the AE curve is slope of the AE curve 0.8, so the multiplier is 5.0 If there are no imports or income taxes, the slope of AE curve equals the MPC so the multiplier equals 1 or, equivalently, MPC MPS The size of the multiplier depends on the MPC and the MPS The smaller the MPC or, equivalently, the larger the MPS, the smaller the increase in expenditure at each step of the multiplier process and so the smaller the multiplier The basic idea and practice Students need quite a lot of practice using multipliers One good problem involves working out the effects on consumption as well as on GDP of a change in investment (when the price level is fixed) The best way to present this problem to the students seems to be sequentially Begin by giving them the data necessary to deduce how real GDP changes from an increase in investment Tell them there is no foreign trade, so that there are no exports or imports, and no income taxes Tell them that the marginal propensity to consume is b (pick any valid number you like), and that investment has changed by I (pick any valid number you like) Then, after the students have computed the change in GDP, ask them what the change in consumption expenditure is Review their attempts to answer this question as follows: The change in GDP, Y, is given by the equation: Y = C + I Given I from the initial statement of the problem and Y from the first set of calculations, the students can readily calculate C Focusing the students’ attention on the change in consumption is important because it reinforces the point that a change in autonomous expenditure (investment in this example) leads to an induced change in consumption expenditure and that this increase in consumption expenditure is the source of the multiplier An Economics in Action detail analyzes the multiplier in the Great Depression The analysis concludes that the multiplier during that episode in history equaled 1.6 The Efect of Imports and Income Taxes on the Multiplier; Business Cycle Turning Points Imports and income taxes both mean that the increase in expenditure on domestic production will be smaller at each step of the multiplier process and so the multiplier is smaller An unexpected decrease in autonomous expenditure is signaled by a buildup of unplanned inventories The buildup in inventories sets the multiplier process in motion that decreases aggregate expenditure and real GDP so that a recession follows An unexpected increase in autonomous expenditure is signaled by an unwanted depletion of inventories The depletion in inventories sets the multiplier process in motion and an expansion follows The idea that prices are fixed, even in the very short run, is controversial in economics However, the fact that changes in inventories have long been a good leading indicator of business cycles is less controversial IV The Multiplier and the Price Level In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices But eventually they also change prices To study 115 116 CHAPTER 11 the determination of the price level and real GDP the AS-AD model must be used The AD curve is related to the AE curve The Aggregate Expenditure Curve and the Aggregate Demand Curve The AE curve is the relationship between aggregate planned expenditures and real GDP, all other influences (such as the price level) remaining the same The AD curve is the relationship between the aggregate quantity of goods and services demanded and the price level When the price level changes, the AE curve shifts and there is a movement along the AD curve A change in the price level has two effects on consumption expenditure: Wealth Effect: A rise in the price level decreases the purchasing power of consumers’ real wealth, which decreases their consumption expenditures Substitution Effects: A rise in the price level makes purchasing today more expensive relative to the future (an intertemporal substitution effect) It also makes U.S goods and services more expensive relative to imports (an international substitution effect) The multiplier and the price level: Emphasize the key point of this section: That the AE model and the multiplier tell us how far the AD curve shifts when autonomous expenditure changes It is through the multiplier process that expenditure and GDP respond to unplanned changes in inventories I like to draw out the model with AE curve on top and the AD and AS curves on the bottom Then: ‡ Shift AE curve upward by change in G ‡ Show the larger change in Y due to multiplier ‡ Shift the AD curve rightward by an amount equal to the change in Y holding the price level constant Ask the students, “Will the economy get the full change in Y?” They will see that in that the upward sloping SAS curve means that there is an increase in the price level, lowering the multiplier effect ‡ Next, show them the price level effect in the AE graph (a smaller downward shift in the AE curve) Now ask them, “How big is the multiplier in the long run?” You should be able to get a few to mumble “Zero” So, tell them the conclusion: There is no multiplier in the long run! If the long run is not so long, then it is questionable to increase G in order to increase Y Students appreciate learning about the tension in economics surrounding this issue since it relates well with politics too The mechanics of the relationship between the AE and AD curves Students need a lot of help and clear explanation of the mechanics of the link between these two curves Here’s what to stress: The AE curve shows how aggregate planned expenditure depends on real GDP (through the effects of disposable income), other things remaining the same The AD curve shows how equilibrium aggregate expenditure depends on the price level, other things remaining the same The next two points are really hard for students: A change in the price level changes autonomous expenditure, which shifts the AE curve, generates a new level of equilibrium expenditure, and creates a new point on the AD curve A change in autonomous expenditure at a given price level shifts the AE curve, generates a new level of equilibrium expenditure, and shifts the AD curve by an amount equal to the change in autonomous expenditure multiplied by the multiplier E X P E N D I T U R E M U LT I P L I E R S The wealth effect and the substitution effects show that a rise in the price level decreases consumption expenditure So, as shown in the figure below to the left, a rise in the price level from 120 to 140 decreases aggregate planned expenditure and shifts the AE curve downward from AE0 to AE In the figure, equilibrium expenditure decreases to $14 trillion The diagram to the right, below, shows that when the price level rises from 120 to 140, there is a movement along the AD curve from point a to point b The aggregate quantity of real GDP demanded decreases from $16 trillion (which is the initial equilibrium expenditure in the AE diagram to the left) to $14 trillion (which is the new equilibrium expenditure along AE1 in the AE diagram to the left) If the AE curve shifts for any reason other than a change in the price level, then the AD curve also shifts For instance, an increase in autonomous expenditures shifts the AE curve upward and increases equilibrium expenditure by a multiplied amount In this case, the AD curve shifts rightward and the amount of the rightward shift is equal to the increase in equilibrium expenditure In the figure to the right, autonomous expenditure increases so that the AD curve shifts rightward The multiplied increase in autonomous expenditure has created a $2 trillion increase in equilibrium expenditure, so the AD curve shifts rightward by $2 trillion (which equals the length of the double headed arrow) from AD0 to AD1 Equilibrium Real GDP and the Price Level Aggregate demand and short-run aggregate supply determine the equilibrium price level and real GDP In the short run: An increase in aggregate demand raises the price level and increases real GDP In the figure to the right, the increase in aggregate demand and rightward shift of the aggregate demand curve from AD0 to AD1 creates a movement from point a to point b so that the price level rises from 120 to 130 and real GDP increases from $13 trillion to $14 trillion 117 118 CHAPTER 11 In The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate planned expenditure In terms of the AE curve, the increase in the price level shifts the AE curve downward Because the actual increase in real GDP is less than the initial increase in equilibrium expenditure, the multiplier is smaller once price level effects are taken into account The more that the price level changes (that is, the steeper the SAS curve), the smaller the multiplier in the short run the long run: Real GDP exceeds potential GDP and employment exceeds full employment So the money wage rate rises, which decreases the short-run aggregate supply and shifts the SAS curve leftward The economy moves along the AD curve so that the price level rises and real GDP decreases In the figure above, the economy moves along AD1 from point b to point c (The shift in the SAS curve is not illustrated in order to simplify the figure.) The price level rises from 130 to 140 and real GDP decreases from $14 trillion back to potential GDP of $13 trillion The further increase in the price level further decreases aggregate planned expenditure In terms of the AE curve, the AE curve shifts downward and eventually returns to its initial level As a result, the long-run multiplier is equal to zero It is important to emphasize that the aggregate expenditure model is not without connection to the AS-AD model Point out to the students that the AE model provides the underpinnings for the AD curve in the AS-AD model used throughout macroeconomics That is, the students can now understand why the AD curve shifts, why it is downward sloping, and why changes in the price level lead to movements along the AD curve It may be a good time to remind students that, just as the Keynesian AE model provides underpinnings for the AD curve, the labor market/aggregate production function model discussed in Chapter provides underpinnings for the long-run aggregate supply curve Thus, the mechanics of the model have not changed, but the students now have a deeper understanding of the forces behind those mechanics The Economics in the News section studies expenditure changes in the 2014 expansion It analyzes the growth during the second quarter in terms of the aggregate expenditure model It focuses on which changes in autonomous expenditure were responsible for increasing aggregate expenditure and hence real GDP E X P E N D I T U R E M U LT I P L I E R S Additional Problems a How is it possible for households to have a negative savings rate? What has caused this negative household savings rate? b Is this negative household savings rate sustainable in the long-run? Why is the multiplier only a short-run influence on GDP? When the economy is in a recession and the government enacts a stimulus package, why might a low MPS be good in the short-run in this situation, but not in the long-run? Solutions to Additional Problems a Households can have a negative saving rate by borrowing Households increase their borrowing if their wealth rises, if the real interest rate falls, or if their expected future income rises Any or all of these factors could lead to a negative saving rate b A negative saving rate is not sustainable in the long run In the long run the saving rate must be positive, if for no other reason than to repay the borrowing The multiplier has only a short-run influence on real GDP because in the long run the money wage rate changes The change in the money wage rate affects short-run aggregate supply and lowers the price level The fall in the price level restores aggregate planned expenditure back to its initial level and moves the economy back to its long-run equilibrium The long-run change in aggregate expenditure offsets the initial multiplier effect on real GDP In the short run, the fear is that a stimulus package while not have enough force to move the economy back to potential GDP In this situation a small MPS is desirable because it means more spending from any increase in disposable income However in the long run the economy needs saving to help it grow Saving in the United States is quite low so in the long run a small value for the MPS is not helpful Additional Discussion Questions 11 Why is there a “two-way” link between consumption and GDP? Consumption is part of aggregate expenditure so an increase in consumption increases aggregate expenditure and hence increases GDP Simultaneously GDP is equal to aggregate income so an increase in GDP increases disposable income and hence increases consumption 12 How does an increase in disposable income affect the consumption function? An increase in expected future income? An increase in disposable income leads to a movement upward along the consumption function An increase in expected future income shifts the consumption function upward 13 If the consumption function shifts upward, what happens to the saving function? Why? If the consumption function shifts upward, the saving function shifts downward The upward shift in the consumption function means that for each level of disposable income consumption increases If consumption increases at each level of disposable income, saving necessarily must decrease The decrease in saving at each level of disposable income means that the saving function shifts downward 119 120 CHAPTER 11 14 When is actual aggregate expenditure different from planned aggregate expenditure? What happens to bring the two back to equality? Actual aggregate expenditure differs from planned aggregate expenditure whenever the economy is not at its equilibrium These amounts differ as a result of unplanned inventory changes Take, for instance, the situation when actual aggregate expenditure exceeds equilibrium expenditure In this case the 45° line, which shows actual aggregate expenditure, lies above the aggregate planned expenditure curve, which shows planned aggregate expenditure Hence actual aggregate expenditure exceeds planned aggregate expenditure In this situation actual inventory change—which is the measure of inventory change that is included in actual aggregate expenditure—exceeds planned inventory change—which is the measure of inventory change that is included in planned aggregate expenditure Because actual inventory change exceeds the planned inventory change, firms are finding that their inventories are accumulating in an undesired fashion They respond to this state of affairs by decreasing their production As production decreases, real GDP and hence aggregate expenditure decrease until aggregate expenditure eventually equals equilibrium expenditure 15 Explain why income taxes reduce the size of the expenditure multiplier The expenditure multiplier results because an increase in autonomous expenditure increases disposable income and induces additional consumption expenditure In turn the additional consumption expenditure increases disposable income once again, which then induces still additional consumption expenditure The result that expenditure increases because of the initial increase in autonomous expenditure and then also because of the induced increase in consumption expenditure is why the expenditure multiplier exists Income taxes decrease the size of the increase in disposable income that results from an increase in expenditure Therefore the resulting (induced) increase in consumption expenditure is smaller so that the overall expenditure multiplier is smaller 16 Explain the difference between the aggregate expenditure curve and the aggregate demand curve The aggregate expenditure curve shows how aggregate expenditure changes when GDP changes The aggregate demand curve shows how (equilibrium) expenditure and GDP change when the price level changes 17 Suppose that exports (autonomously) increase What happens to the aggregate expenditure curve? The equilibrium level of aggregate expenditure? The aggregate demand curve? The aggregate expenditure curve shifts upward Through the multiplier process the equilibrium level of aggregate expenditure increases The aggregate demand curve shifts rightward by an amount equal to the increase in equilibrium expenditure ... unexpected fashion, they change their production not their prices But eventually they also change prices To study 115 116 CHAPTER 11 the determination of the price level and real GDP the AS-AD model... and the MPS The smaller the MPC or, equivalently, the larger the MPS, the smaller the increase in expenditure at each step of the multiplier process and so the smaller the multiplier The basic... called the saving function 111 112 CHAPTER 11 The figure shows a consumption function Along the 45 degree line, consumption equals disposable income When the consumption function is above the
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