EXPENDITURE MULTIPLIERS

10

CHAPTER

[ Notes 7 comes after Chapter 6 ]

Objectives
After studying this chapter, you will able to

Explain how expenditure plans and real GDP are determined when the price level is fixed
Explain the expenditure multiplier

Explain how recessions and expansions begin

Explain the relationship between aggregate expenditure and aggregate demand

Explain how the multiplier gets smaller as the price level changes

Economic Amplifier or Shock Absorber?

A voice can be a whisper or fill Central Park, depending on the amplification. A limousine with good shock absorbers can ride smoothly over terrible potholes.

Investment and exports can fluctuate like the amplified voice, or the terrible potholes; does the economy react like a limousine, smoothing out the bumps, or like an amplifier, magnifying the fluctuations? These are the questions this chapter addresses.

Fixed Prices and Expenditure Plans

The Aggregate Implications of Fixed Prices

We will consider a simplified Keynesian model, in which in the short run all prices are fixed.
In the very short run, prices are fixed and the aggregate amount that is sold depends only on the aggregate demand for goods and services. In this very short run, to understand real GDP fluctuations, we must understand aggregate demand fluctuations.

Fixed Prices and Expenditure Plans

Expenditure Plans

The four components of aggregate expenditure consumption expenditure, investment, government purchases of goods and services, and net exportssum to real GDP.
Aggregate planned expenditure equals planned consumption expenditure plus planned investment plus planned government purchases plus planned exports minus planned imports.

Fixed Prices and Expenditure Plans

A two-way link exists between aggregate expenditure and real GDP: An increase in real GDP increases aggregate expenditure

An increase in aggregate expenditure increases real GDP

Fixed Prices and Expenditure Plans

Consumption Function and Saving Function

Consumption and saving are influenced by:

The real interest rate Disposable income Wealth Expected future income Disposable income is aggregate income (GDP), minus taxes, plus transfer payments.

Fixed Prices and Expenditure Plans

To explore the two-way link between real GDP and planned consumption expenditure, we focus on the relationship between consumption expenditure and disposable income when the other factors are constant. The relationship between consumption expenditure and disposable income, other things remaining the same, is called the consumption function. And the relationship between saving and disposable income, other things remaining the same, is called the saving function.

Fixed Prices and Expenditure Plans

Figure 10.1 illustrates the consumption function and the saving function.

Fixed Prices and Expenditure Plans

Marginal Propensities to Consume and Save

The marginal propensity to consume (MPC) is the fraction of a change in disposable income spent on consumption.
It is calculated as the change in consumption expenditure, C, divided by the change in disposable income, YD, that brought it about. That is:

MPC = C/YD

Fixed Prices and Expenditure Plans

The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved. It is calculated as the change in saving, S, divided by the change in disposable income, YD, that brought it about.

That is:

MPS = S/YD

Fixed Prices and Expenditure Plans

The MPC plus the MPS equals one. This is because the way we define disposable income, the only things that can be done with it is consume it or save it. So the fraction of a change consumed plus the fraction saved must equal one all of it.

In symbols,

C + S = YD.
Divide this equation by YD to obtain,

C/YD + S/YD = YD/YD,

or

MPC + MPS = 1

Fixed Prices and Expenditure Plans

Slopes and Marginal Propensities Figure 10.2 shows that the MPC is the slope of the consumption function and the MPS is the slope of the saving function.

Fixed Prices and Expenditure Plans

Other Influences on Consumption Expenditure and Saving When an influence other than disposable income changesthe real interest rate, wealth, or expected future incomethe consumption function and saving function shift.
Figure 10.3 illustrates these effects.

Fixed Prices and Expenditure Plans

The U.S. Consumption Function In 1960, the U.S. consumption function was CF61. The dots show consumption and disposable income for each year from 1961 to 2001.

Fixed Prices and Expenditure Plans

The consumption function has shifted upward over time because economic growth has created greater wealth and higher expected future income. The assumed MPC in the figure is 0.9.

Fixed Prices and Expenditure Plans

Consumption as a Function of Real GDP

Disposable income changes when either real GDP changes or when net taxes change. [Net taxes are total taxes minus transfer payments jargon]
If net taxes dont change, real GDP is the only influence on disposable income, so consumption expenditure is a function of real GDP. We use this relationship to determine equilibrium expenditure.

Fixed Prices and Expenditure Plans

Import Function

In the short run, imports are influenced primarily by U.S. real GDP. [Remember, we assume all prices fixed].
The marginal propensity to import is the fraction of a change in real GDP spent on imports. In recent years, NAFTA and increased integration in the global economy have increased U.S. imports. Removing the effects of these influences, the U.S. marginal propensity to import is probably about 0.2 about 20% of a change in GDP goes to imports.

Real GDP with a Fixed Price Level

The relationship between aggregate planned expenditure and real GDP can be described by an aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each level of real GDP. The relationship can also be described by an aggregate expenditure curve, which is a graph of the aggregate expenditure schedule.

Real GDP with a Fixed Price Level

Aggregate Planned Expenditure and Real GDP Figure 10.5 shows how the aggregate expenditure curve is built from its components.

Real GDP with a Fixed Price Level

Consumption expenditure minus imports, which vary with real GDP, is called induced expenditure. The sum of investment, government purchases, and exports, which do not vary with GDP, is called autonomous expenditure. Consumption expenditure and imports can [and do] have an autonomous component. Most people continue to consume even if they have no current income. [How? They borrow or reduce assets spend past saving]. Another word often used for autonomous is exogenous determined outside the model.

Real GDP with a Fixed Price Level

Actual Expenditure, Planned Expenditure, and Real GDP Actual aggregate expenditure is always equal to real GDP. Aggregate planned expenditure may differ from actual aggregate expenditure because firms can have unplanned changes in inventories. A change in inventory is counted as investment [the firm bought the inventory and kept it], so an unplanned change in inventory is counted as part of actual investment.

Real GDP with a Fixed Price Level

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

When planned expenditure differs from actual real GDP, there will be an unplanned change in inventories that will make actual expenditure equal to actual real GDP.

Real GDP with a Fixed Price Level

Figure 10.6 illustrates equilibrium expenditure, which occurs at the point at which the aggregate expenditure curve crosses the 45 line and there are no unplanned changes in business inventories.

Real GDP with a Fixed Price Level

Convergence to Equilibrium Figure 10.6 also illustrates the process of convergence toward equilibrium expenditure.

Real GDP with a Fixed Price Level

If aggregate planned expenditure is greater than real GDP (the AE curve is above the 45 line), an unplanned decrease in inventories induces firms to hire workers and increase production [to rebuild inventories], so real GDP increases.

Real GDP with a Fixed Price Level

If aggregate planned expenditure is less than real GDP (the AE curve is below the 45 line), an unplanned increase in inventories induces firms to fire workers and decrease production, to get inventories back down to the desired level, so real GDP decreases.

Real GDP with a Fixed Price Level

If aggregate planned expenditure equals real GDP (the AE curve intersects the 45 line), no unplanned changes in inventories occur, so firms maintain their current production and real GDP remains constant.

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

The Multiplier
The Basic Idea of the Multiplier An increase in investment (or any other component of autonomous expenditure) increases aggregate expenditure and thus real GDP, and the increase in real GDP leads to an increase in induced expenditure specifically, consumption. The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP. That process then repeats.

So real GDP increases by more than the initial increase in autonomous expenditure.

Multiplier -- caveats
Can we get something for nothing? No. Changes in expenditure can only produce changes in output real GDP if we have the capacity to produce more. So we will only get full multiplier effects if we start with spare capacity that is, with actual real GDP less than potential GDP. The Keynesian model originates from a condition of massive involuntary unemployment and spare capacity. If we are already at or above potential GDP [full employment], increases in aggregate expenditure will likely produce more price change than output change [in terms of dollars, aggregate expenditure must always equal measured real GDP because of the circular flow and our accounting definitions].

The Multiplier
Figure 10.7 illustrates the multiplier. The Multiplier Effect The amplified change in real GDP that follows an increase in autonomous expenditure is the multiplier effect.

The Multiplier
When autonomous expenditure increases, inventories make an unplanned decrease, so firms increase production and real GDP increases to a new equilibrium.

The Multiplier
Why Is the Multiplier Greater than 1?

The multiplier is greater than 1 because an increase in autonomous expenditure induces further increases in expenditure.
The Size of the Multiplier The size of the multiplier is the change in equilibrium expenditure divided by the change in autonomous expenditure that brought it about.

The Multiplier
The Multiplier and the Marginal Propensities to Consume and Save Ignoring imports and income taxes, the marginal propensity to consume determines the magnitude of the multiplier. The multiplier equals 1/(1 MPC) or, alternatively [with no taxes or foreign trade], 1/MPS. More generally, the multiplier is one over one minus the marginal propensity to spend out of real GDP on domestically-produced output.

The Multiplier
Figure 10.8 illustrates the multiplier process and shows how the MPC determines the magnitude of the amount of induced expenditure at each round as aggregate expenditure moves toward equilibrium expenditure.

The Multiplier
Imports and Income Taxes

Income taxes and imports both reduce the size of the multiplier.
Including income taxes and imports, the multiplier equals 1/(1 slope of the AE curve) or 1/(1 the marginal propensity to spend out of real GDP on domestically produced output [real GDP]).

The Multiplier
Figure 10.9 shows the relation between the multiplier and the slope of the AE curve. In part (a) the slope of the AE curve is 0.75 and the multiplier is 4.

The Multiplier

In part (b) the slope of the AE curve is 0.5 and the multiplier is 2.

The Multiplier
Business Cycle Turning Points

Turning points in the business cycle peaks and troughs often occur when autonomous expenditure changes.
An increase in autonomous expenditure can bring an unplanned decrease in inventories, which may trigger an expansion. A decrease in autonomous expenditure can bring an unplanned increase in inventories, which may trigger a recession.

The Multiplier and the Price Level

In the equilibrium expenditure model, the price level is constant. But real firms dont hold their prices constant for long. When they have an unplanned change in inventories, they may change both production and prices. And the output price level changes when firms change prices. The aggregate supply-aggregate demand model explains the simultaneous determination of real GDP and the price level. The two models are related.

The Multiplier and the Price Level

Aggregate Expenditure and Aggregate Demand

The aggregate expenditure curve is the relationship between aggregate planned expenditure and real GDP, with all other influences on aggregate planned expenditure remaining the same.
The aggregate demand curve is the relationship between the quantity of real GDP demanded and the price level, with all other influences on aggregate demand remaining the same.

The Multiplier and the Price Level

So far, we built the multiplier on the assumption the price level was fixed. But, the basic accounting identities on which the multiplier idea is based are always true, whether prices are fixed or variable. So, in money terms, the multiplier always works. However, the change in money GDP is split between a change in output [real GDP] and a change in the output price level [inflation]. How that split turns out between real output and prices depends in part on where we start, that is where actual GDP is compared to potential GDP, and therefore whether there is spare capacity and how much.

The Multiplier and the Price Level

Aggregate Expenditure and the Price Level

When the output price level changes, a wealth effect and substitution effect change aggregate planned expenditure and change the quantity of real GDP demanded.
Figure 10.10 on the next slide illustrates the effects of a change in the output price level on the AE curve, equilibrium expenditure, and the quantity of real GDP demanded.

The Multiplier and the Price Level

In Figure 10.10(a), a rise in the output price level from 110 to 130 shifts the AE curve from AE0 downward to AE1 and decreases the equilibrium level of real output from $10 trillion to $9 trillion.

The Multiplier and the Price Level

In Figure 10.10(b), the same rise in the output price level that lowers equilibrium expenditure, brings a movement along the AD curve to point A.

The Multiplier and the Price Level

A fall in the output price level from 110 to 90 shifts the AE curve from AE0 upward to AE2 and increases equilibrium real GDP from $10 trillion to $11 trillion.

The Multiplier and the Price Level

The same fall in the output price level that raises equilibrium expenditure brings a movement along the AD curve to point C.

The Multiplier and the Price Level

Points A, B, and C on the AD curve correspond to the equilibrium expenditure points A, B, and C at the intersection of the AE curve and the 45 line.

The Multiplier and the Price Level

Figure 10.11 illustrates the effects of an increase in autonomous expenditure.
An increase in autonomous expenditure shifts the aggregate expenditure curve upward and shifts the aggregate demand curve rightward by the multiplied increase in equilibrium expenditure.

The Multiplier and the Price Level

Equilibrium Real GDP and the Price Level Figure 10.12 shows the effect of an increase in investment in the short run when the output price level changes and the economy moves along its SAS curve.

The Multiplier and the Price Level

The increase in investment shifts the AE curve upward and shifts the AD curve rightward. With no change in the output price level real GDP would increase to $12 trillion at point B.

The Multiplier and the Price Level

But the output price level rises and the rise in the output price level decreases aggregate planned expenditure and lowers the multiplier effect on real GDP.

The Multiplier and the Price Level

The AD curve shifts rightward by the amount of the multiplier effect but equilibrium real GDP increases by less than this amount because of the rise in the output price level.

The Multiplier and the Price Level

Real GDP increases from $10 trillion to $11.3 trillion, instead of to $12 trillion as it does with a fixed output price level.

The Multiplier and the Price Level

Figure 10.13 illustrates the long-run effects of an increase in autonomous expenditure at full employment.

The Multiplier and the Price Level

If the increase in autonomous expenditure takes real GDP above potential GDP,
the money wage rate rises, the SAS curve shifts leftward, and real GDP decreases until it is back at potential real GDP. The long-run multiplier is zero; capacity LAS -- depends on K, L, and T.