Chapter 11

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.

Disposable Income

Aggregate income or real GDP, Y, minus net taxes, T. Call disposable income YD. So, YD = Y - T. It is either spent on consumption goods and services, C, or saved, S. So, YD = C + S.

Two-Way Link Between Aggregate Expenditure and Real GDP

An increase in real GDP increases aggregate demand and an increase in aggregate expenditure increases real GDP.

Imports and Income Taxes

Both reduce the size of the multiplier

When autonomous expenditure changes, so does equilibrium expenditure and real GDP.

But the change in equilibrium expenditure is larger than the change in autonomous expenditure.

Keynesian Model

Describes the economy in the very short run when prices are fixed. Since the prices are fixed, aggregate demand determines real GDP. (Aggregate Expenditure curve)

Import Function

In the short run, US imports are influenced primarily by US real GDP.

Aggregate Planned Expenditure

Planned consumption expenditure plus planned investment plus planned governement expenditure plus planned exports minus planned imports.

Adjusting Quantities and Prices

Real firms don't hold their prices constant for long. When firms have an unplanned change in inventories, they change production and prices. And the price level changes when firms change prices. The AS-AD model explains the simultaneous determination of real GDP and the price level. The two models are related.

An increase in autonomous expenditure brings an unplanned decrease in inventories.

So firms increase production and real GDP increase to a new equilibrium.

Equilibrium Expenditure

The level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.

Why is the Multiplier Greater Than 1?

The multiplier is greater than 1 because an increase in autonomous expenditure induced further increases in aggregate expenditure.

Aggregate Expenditure Curve

The relationship between aggregate planned expenditure and real GDP, with all other influences on aggregate planned expenditure remaining the same.

The Basic Idea of the Multiplier

And increase in investment (or any component of autonomous expenditure) increase aggregate expenditure and real GDP. The increase in real GDP leads to an increase in induced expenditure. The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP. So real GDP increases by more than the initial increase in autonomous expenditure.

From Above Equilibrium

If real GDP exceeds aggregate planned expenditure, there is an unplanned increase in inventories. To reduce inventories, firms lay off workers and decrease production. Real GDP decreases.

Consumption Expenditure

Influenced by many factors but the most direct one is disposable income.

Aggregate Expenditure Curve (AE)

Is built from its components.

The Size of the Multiplier

Is the change in equilibrium expenditure divided by the change in autonomous expenditure.

Marginal Propensity to Import

The fraction of an increase in real GDP spent on imports. If an increase in real GDP of $1 trillion increases imports by $0.25 trillion, the marginal propensity to import is ).25

Consumption Function

The relationship between consumption expenditure and disposable income, other things remaining the same.

Saving Function

The relationship between saving and disposable income, other tings remaining the same.

Aggregate Demand Curve

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 Slope of the AE Curve

The slope of the AE curve determines the magnitude of the multiplier: Multiplier = 1 / (1 - Slope of AE Curve). If the change in real GDP is DY, the change in autonomous expenditure is DS, and the change in induced expenditure is DN, then Multiplier = DY/DA.

If aggregate planned expenditure equals real GDP

There is no unplanned change in inventories. Firms maintain their current production. Real GDP remains constant.

Business Cycle Turing Points

Turning points in the business cycle - peaks and troughs - occur when autonomous expenditure changes. An increase in autonomous expenditure brings an unplanned decrease in inventories, which triggers an expansion. A decrease in autonomous expenditure brings an unplanned increase in inventories, which triggers a recession.

The money wage rate will continue to rise and the SAS curve will continue to shift leftward

Until real GDP equals potential GDP. In the long run, the multiplier is zero.

When consumption expenditure exceeds disposable income, saving is negative (dissaving).

When consumption expenditure is less than disposable income, there is saving.

Planned consumption expenditure and planned imports are influenced by real GDP.

When real GDP increases, planned consumption expenditure and planned imports increase. Planned investment plus planned government expenditure plus planned exports are not influenced by real GDP.

Deriving the Aggregate Demand Curve

When the price level changes, a wealth effect and substitution effects change aggregate planned expenditure and change the quantity of real GDP demanded.

Real GDP with a Fixed Price Level

When the price level is fixed, aggregate demand is determined by aggregate expenditure plans.

The MPC plus the MPS equal 1

DC + DS = DYD DC/DYD + DS?DYD = DYD/DYD MPC + MPS = 1

Induced Expenditure

Depend on Income

Relationship between Aggregate Planned Expenditure and Real GDP

Described by and aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each level of real GDP.

Consumption as a Function of Real GDP

Disposable income changes when either real GDP changes or net taxes change. If tax rates don't 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 real GDP when the price level is fixed.

Equilibrium occurs at the point at which the AE curve crosses the 45-degree line.

Equilibrium occurs when there are no unplanned change in business inventories.

Marginal Propensity to Consume (MPC)

Fraction of a change in disposable income spent on consumption. It is calculated as the change in consumption expenditure, DC, divided by the change in disposable income, DYD. So, MPC = DC/DYD.

Autonomous Expenditure

Given

From Below Equilibrium

If aggregate planned expenditure exceeds real GDP, there is an unplanned decrease in inventories. To restore inventories, firms hire workers and increase production. Real GDP increases.

When there are no income taxes and no imports, the slope of the AE curve equals the marginal propensity to consume

So the multiplier is, Multiplier = 1 / (1 - MPC) But 1 - MPC = MPS, so the multiplier is also, Multiplier = 1/MPS

Marginal Propensity to Save (MPS)

The Fraction of a change in disposable income that is saved. It is calculated as the change in saving, DS, divided by the change in disposable income, DYD. So, MPS = DS/DYD.

The Multiplier Process

The MPC determines the magnitude of the amount of induced expenditure at each round as aggregate expenditure moves toward equilibrium expenditure.

The Multiplier

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

Equilibrium Real GDP and the Price Level

The effect of an increase in investment in the short run when the price level changes.

Changes in Aggregate Expenditure and Aggregate Demand

The effects of an increase in investment. The AE curve shifts upward and the AD curve shifts rightwards by an amount equal to the change in investment multiplied by the multiplier.