Chapter 11 Expenditure Multipliers

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The AE curve is the relationship between _____ other things remaining the same

Aggregate Planned Expenditure and Real GDP

The multiplier is determined by ____

The slope of the AE curve

Main influence on U.S. imports

U.S. real GDP

*Test* Which two components of Aggregate Planned Expenditure depend on real GDP (they change when income changes)

consumption expenditure imports

*TEST* if Aggregate Planned Expenditure is less than Real GDP, firms ____ production in a response to an unplanned ____ in inventories

decrease; increase

If an income tax is introduced into the economy, the multiplier ____ because _____

decreases; disposable income increases by less than real GDP

*TEST* The multiplier *increases* when the marginal propensity to import ___ or the income tax rate _____

decreases; decreases

Consumption expenditure is determined by

disposable income

Autonomous Expenditure ____ vary with real GDP; Induced Expenditure __ vary with real GDP

does not does

The autonomous tax multiplier is the change in

equilibrium expenditure and real GDP resulting from a change in autonomous taxes / the change in autonomous taxes

*TEST* if Aggregate Planned Expenditure *exceeds* Real GDP, firms ____ production in a response to an unplanned ____ in inventories

increase; decrease

*TEST* The multiplier increases when the marginal propensity to consume ____

increases

As the consumption function shifts upward, Autonomous consumption ________

increases

*TEST* When Real GDP > Aggregate Planned Expenditure, inventories are

increasing (above equilibrium point)

*TEST* When Aggregate Planned Expenditure is greater than real GDP, *actual investment* is ____ than planned investment

less (firms have less than planned inventory)

In Keynesian model of aggregate expenditure, real GDP is determined by

level of aggregate demand

*TEST* Equilibrium Expenditure

level of aggregate expenditure that occurs when *Aggregate Planned Expenditure = Real GDP* **where Aggregate Planned Expenditure intersects 45 degree line on graph**

*Test* Fluctuations in autonomous expenditure bring ___ fluctuations in real GDP opposing equal magnified diminishing

magnified

*TEST* When Aggregate Planned Expenditure is less than real GDP, *actual investment* is ____ than planned investment

more (firms have excess *unplanned* inventory)

*Test* *Sample* An economy has a fixed price​ level, no​ imports, and no income taxes. MPC is 0.8​, and real GDP is ​$250 billion. Businesses increase investment by ​$2 billion. Calculate the multiplier and the change in real GD

multiplier = 5 real GDP increases by $10 billion

*TEST* To calculate the effect of real GDP on imports, we need to know _____

only the Marginal propensity to import (calculation uses GDP, not YD, as denominator)

The slope of the AE curve = MPC when

there are *no* income taxes or imports;

The magnitude of the multiplier depends on the

slope of the AE curve

How to construct the Aggregate Planned Expenditure AE curve

subtract M from C + I + G + X; Expenditure on U.S. - produced goods and services

*Test* *Test* When aggregate planned expenditure is *less than* real GDP, inventories are _____ target, so firms ____ production and inventories return to target level until equilibrium is reached

above; decrease

*TEST* Equilibrium expenditure occurs on the graph where

aggregate planned expenditure equals real GDP equals actual expenditure

When autonomous expenditure increases, aggregate expenditure ___ real GDP _____ and equilibrium expenditure ______

all increase; AE curve shifts up

Aggregate Planned Expenditure is *less than* real GDP on the graph ____ the equilibrium point

ABOVE

An economy has a fixed price​ level, no​ imports, and no income taxes. MPC is 0.8​, and real GDP is ​$100 billion. Businesses increase investment by ​$2 billion. Calculate the new level of real GDP and explain why real GDP increases by more than ​$2 billion. The new level of real GDP is ​____

$110 billion

*TEST* When Actual Expenditure *exceeds* Aggregate Planned Expenditure is the graph above or below equilibrium point

*Above* equilibrium point; (firms have *unplanned inventory* so cut production* ; real GDP decreases)

*TEST* To calculate the effect of real GDP on consumption expenditure, we need to know _____

*BOTH* The Marginal Propensity to Consume MPC *AND* the effect of real GDP on disposable income

*TEST* When Aggregate Planned Expenditure *exceeds* real GDP, is the graph above or below equilibrium point

*Below* equilibrium point; (firms will increase production; real GDP increases)

*TEST* *TEST* *TEST* multiplier vs. MPC in relation to AE curve

*MPC = slope of AE curve* size of multiplier *depends on* slope of AE cuve

What effect does a change in the price level have on the AE curve

*SHIFT* (movement along AD curve)

A change in *autonomous expenditure* that is *not* caused by a change in the price level has what effect on the AD and AE curve

*SHIFTS* both (*The magnitude of the shift of the AD curve depends on the multiplier and on the change in autonomous expenditure*)

According to Keynesian theory, how does the typical firm change its prices in response to aggregate demand fluctuations

*does not change immediately*

*Test* Possible reasons that the U.S. MPS today is LOWER than it was before 1984 and the MPC is GREATER than it was before 1984

*lower return to saving*

The AD curve is the relationship between ______ other things remaining the same

*quantity* of real GDP demanded and price level

How to calculate the MPC using AE graph

*slope* of AE graph; Change in expenditure / Change in real GDP

If an economy has a fixed price level and no income taxes/imports; The multiplier is 4 The MPC is ____

0.75 ; 1 / (1- *0.75*) = 4

If the slope of the consumption function is 0.9, a $1 trillion increase in disposable income would increase consumption by

0.9 trillion

Calculation for Multiplier when *no* income taxes or imports

1 / (1-MPC) = 1 / MPS

With a fixed price level, the multiplier equals

1 / (1-MPC) or 1 / MPS

Keynesian mode: Because each firm's prices are fixed on any given day, for the economy as a whole

1. *price level* is fixed 2. *Aggregate Demand* determines real GDP

Four most important factors that influence spending and saving plans

1. Disposable income 2. Real interest rate 3. Wealth 4. Expected future income

If investment increases by 100 and the multiplier is 3, the *aggregate demand* curve *shifts right* by ____

300

*****STUDY***** *TEST* *TEST* If autonomous spending is 40 and the slope of the AE curve (aka MPC) is 0.6, the equation for the AE curve is How do we calculate equilibrium expenditure from this?

AE = 40 + 0.6Y set AE = Y , so equilibrium = 100 because 100 = 40 + 0.6 (100)

*TEST* *TEST* *TEST* When the price level rises, how do the Aggregate Expenditure and Aggregate Demand curves change

Aggregate Expenditure *SHIFTS down* *MOVEMENT up* along Aggregate Demand

Relationship between Aggregate Planned Expenditure, Aggregate (*Actual*) Expenditure, and real GDP

Aggregate Expenditure *always* = real GDP Aggregate Planned Expenditure *not always* = real GDP

Induced Expenditure =

Aggregate Expenditure - Autonomous Expenditure

Vocab: Disposable income

Aggregate Income - Taxes + Transfer payments *Aggregate income depends on real GDP, therefore Disposable income depends on real GDP*

Vocab: Aggregate Expenditure Graph

Aggregate Planned Expenditure (y axis) at each given level of real GDP (x axis); Government spending G, Investment I, and Exports X are *constants*: *horizontal lines*; Consumption C and Imports M are *sloped*: dependent on real GDP

When *Actual Expenditure* *exceeds* Aggregate Planned Expenditure, how do real GDP and Aggregate Planned Expenditure compare?

Aggregate Planned Expenditure < real GDP (b/c real GDP always = Actual Expenditure)

Vocab: Balanced budget multiplier

Amount of change in expenditure and real GDP that results from *equal changes* in government expenditure and lump-sum taxes;

*test* Business Investment is a component of ____ Aggregate Expenditure; When is increases, the AE curve _____ and equilibrium expenditure _____

Autonomous; shift up; icnreases

Aggregate Planned Expenditure *exceeds* real GDP ____ the equilibrium point

BELOW

How to calculate Autonomous Consumption Expenditure given YD and C table

C value when YD = 0

*TEST******* Calculation for Multiplier

Change in *equilibrium expenditure* / Change in *autonomous expenditure*

Calculation for Government Expenditure multiplier

Change in equilibrium expenditure and real GDP / change in gov't expenditure

Vocab: Government Expenditure Multiplier

Change in equilibrium expenditure and real GDP resulting from change in government expenditure

How to calculate increase in induced expenditure using autonomous expenditure and equilibrium expenditure

Change in induced = Change in equilibrium - Change in autonomous

*Test* **test* *est* Which components of aggregate expenditure are influenced by real GDP?

Consumption expenditure and imports C and I

*Test* How to calculate *Autonomous Expenditure* given table

Consumption when Real GDP = 0 + Investment + Gov't + Exports + Imports when Real GDP = 0

*Test* *Missed* The​ ______ curve shifts upward by an amount equal to the increases in autonomous expenditure. The​ ______ curve shifts rightward by an amount equal to the increases in autonomous expenditure times the multiplier because the​ ______ at each price level. A. AE​; AD​; AD curve plots aggregate planned expenditure Your answer is not correct.B. AD​; AE​; AE curve plots equilibrium expenditure C. AD​; AE​; AE curve plots aggregate planned expenditure D. AE​; AD​; AD curve plots equilibrium expenditure

D

Choose the correct statement. A.Equilibrium expenditure occurs at the point at which the AE curve intersects the x​-axis. B.Equilibrium expenditure occurs at all points along the AE curve. C.Equilibrium expenditure occurs at all points along the 45degrees line. D.The level of aggregate expenditure that occurs where the AE curve intersects the 45degrees line is equilibrium expenditure

D

Planned saving + Planned consumption =

Disposable income

The height of the 45 degree line on the consumption function graph measures

Disposable income; Where consumption function intersects line, *consumption expenditure = disposable income*

Exports do not depend directly on Real GDP: What do they depend on?

Events in the World Economy Prices of foreign-produced goods/service Exchange rates

*TEST* *VERY IMPORTANT* How can actual expenditure and planned expenditure differ?

Firms end up with inventories that are greater or smaller than planned; *if Aggregate Planned Expenditure < Real GDP, firms *SELL LESS* than they planned to sell* = *UNPLANNED INVENTORIES* *if Aggregate Planned Expenditure > Real GDP, = firms have *SMALLER INVENTORIES* than planned

*Test* If real GDP increases by 2 million and potential GDP increases by $3 million and the Marginal Propensity to Import is 0.2, by how much do imports change?

Increase by $400,000; 2 million (0.2) ; use only real GDP

Two way link between Aggregate Expenditure and real GDP

Increase in real GDP = increase in agg. expenditure Increase in aggregate expenditure = increase in real GDP

*TEST* *TEST* *TEST* Induced Expenditure vs. Autonomous Expenditure

Induced: sum of components that *vary* with real GDP: Consumption Expenditure - Imports Autonomous Expenditure: the sum of components that *do not vary* with Real GDP: Investment + Govt Exp + Exports + (Consumption when GDP = 0) - (Imports when GDP = 0)

MPC and MPS equations

MPC + MPS = 1 (ΔC/ΔYD)+ (ΔS/ΔYD) = 1 ΔC+ ΔS = ΔYD

Calculation for MPC

MPC = (Change in consumption C $) / (Change in Disposable income YD$)

*Test* *Easy Review* In an​ economy, when disposable income increases from​ $400 to​ $500, consumption expenditure increases from ​$450 billion to ​$525. Calculate the marginal propensity to​ consume, the change in​ saving, and the marginal propensity to save.

MPC = 0.75 (525-450) / (500-400) MPS = 0.25 (-25 - (-50)) / (500-400)

the *slope* of the AE curve changes when _____ A *shift* of the AE curve happens when _____

MPC changes; *tax rates* or government spending* changes

Calculation for Marginal Propensity to Import

MPI = Change in imports / Change in real GDP

Calculation for MPS

MPS = (Change in saving S $) / (Change in disposable income YD $)

_____ determines the change in consumption expenditure brought about by a change in disposable income

Marginal Propensity to Consume MPC

The slope of the AE curve is influenced by ______

Marginal Propensity to consume Marginal Propensity to Import Income tax rate

*Test* *Sample* An economy has a fixed price​ level, no​ imports, and no income taxes. MPC is 0.9​, and real GDP is ​$150 billion. Businesses increase investment by ​$5 billion. Calculate the new level of real GDP and explain why real GDP increases by more than ​$5 billion.

New GDP = 200 billion: 100 billion + 10 (5 billion)

Aggregate Planned Expenditure depends on _____

Real GDP

Imports are determined by _____

Real GDP

What factors bring *shifts* up or down of the consumption and savings function

Real interest Rate Wealth

What do the slope of the consumption and saving function tell

Slope of consumption function *IS THE MPC* Slope of savings function *IS THE MPS* (y axis = consumption $, saving $, x axis = disposable income $)

*TEST* Difference between Aggregate Expenditure and Aggregate Demand curves

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

Vocab: Induced consumption

The amount of consumption expenditure in excess of autonomous consumption; consumption expenditure that is induced by an increase in disposable income

For a given increase in aggregate​ demand, the steeper the slope of the​ short-run aggregate supply​ curve, the​ ______ is the increase in the price level and the​ ______ is the multiplier effect on real GDP in the short run.

The steeper the slope of the short-run aggregate supply curve, the *larger* is the increase in the price level and the *smaller* is the multiplier effect on real GDP.

Vocab: Aggregate Planned Expenditure

The sum of the *planned* levels of consumption expenditure investment government expenditure on goods/services exports - imports

*Test* A reason for the difference in MPS values for the US and China may be _____

U.S. consumers are more confident about the future (U.S. MPS < China MPS)

The level of disposable income at which all disposable income is consumed is ____ on the consumption function graph

Where the consumption function *intersects the 45 degree line*

You observe that unplanned inventories are increasing. You predict that there will be​ _______.

a recession

*Test* *Test* *Test* When aggregate planned expenditure is *greater than* real GDP, inventories are _____ target, so firms ____ production and inventories return to target level until equilibrium is reached

below target; increase

When expenditure increase, the AE curve shifts by the ____ and the AD curve shifts by the ____ Why?

change in autonomous expenditure; change in autonomous expenditure *times the multiplier* b/c *the AD curve plots EQUILIBRIUM EXPENDITURE*

What two variables of expenditure vary with real GDP? What are these called?

consumption expenditure and imports; Induced expenditure

**TEST* If Real GDP *and* Aggregate Expenditure are *less* than *equilibrium expenditure*, firm's inventories

decrease (so they increase production and real GDP increases)

Initially, when autonomous expenditure increases, aggregate planned expenditure ______ real GDP. As a result, inventories _______. How do firms respond?

exceeds; decrease Firms respond by increasing production so as to restore their inventories to the target level. As production increases, so does real GDP. With a higher level of real GDP, *induced* expenditure increases

When the price level is fixed, ______ determine real GDP

expenditure plans

*Test* *Review* Equilibrium Expenditure comes about because firms adjust their _____ in response to unplanned changes in ______

firms adjust *production* in response to unplanned changes in *inventory*

*TEST* When Aggregate Planned Expenditure *exceeds* real GDP and firms have *less inventory* than planned, what happens

firms hire more labor and *increase* production to increase inventory real GDP *increases* until equilibrium

*Test* the Multiplier mater because we can use it to determine by how much we should change autonomous expenditure to _____

increase real GDP by a given amount

Real GDP increases by more than $5 billion because an increase in investment

induced an increase in consumption expenditure

*Test* Real GDP increases by more than autonomous expenditure because the _____ increases

induced consumption expenditure

Examples of increases in autonomous expenditure

innovation = rise in *expected future profits* economic boom in other countries

*TEST* As long as *Actual Expenditure* exceeds *Planned Expenditure*, inventories _____ and firms ____ production

inventories *rise* (unplanned inventories) firms *cut* production until real GDP = agg planned expenditure at equilibrium point

What three variables of expenditure *do not* vary with real GDP? What are these called?

investment, govt expenditure, exports *autonomous* expenditure

Investment does not depend directly on Real GDP: What does it depend on?

real interest rate expected profit

Vocab: Consumption Function

relationship between consumption expenditure (y axis) and *Disposable Income* (x axis) all other factors *remaining the same*

*****TEST*** Relationship between slope of the AE curve and expenditure multiplier

slope of AE curve = MPC multiplier = 1/MPS MPC + MPS = 1

Imports and income taxes make the size of the multiplier ____

smaller

*TEST* Vocab: Multiplier

the amount by which a change in *AUTONOMOUS* expenditure is multiplied to determine the resulting change in *equilibrium expenditure* and *real GDP*

Vocab: Autonomous Consumption

the amount of consumption expenditure that would take place in the short run even if people had no current disposable income

*Test* Vocab: Marginal Propensity to Save

the fraction of a *change* in disposable income that is saved

*Test* Vocab: Marginal Propensity to Consume

the fraction of a *change* in disposable income that is spent on consumption

*Test* Marginal Propensity to Import

the fraction of an increase in real GDP that is spent on imports; change in imports brought about by a change in real GDP

When autonomous expenditure increases, *equilibrium expenditure* increases by

the sum of the increase in autonomous expenditure + increase in induced expenditure

True/False: Planned consumption expenditure + Planned saving *always* = Disposable income

true

*TEST* *IMPORTANT* *REVIEW* If real GDP *and* aggregate expenditure are *less than* equilibrium expenditure, there is an unplanned ____ in inventories; so firms ___ production and real GDP ____

unplanned *decrease*; (counter-intuitive) firms *increase* production, real GDP *increases*

*TEST* *IMPORTANT* When Real GDP and Aggregate Expenditure are *greater* than equilibrium expenditure, there is an unplanned _____ in inventories; firms ____ production and real GDP ___

unplanned *increase* (counter-intuitive); firms *decrease* production real GDP *decreases*

The long-run multiplier =

zero

Calculation for *change in induced expenditure*

ΔN = Slope of AE curve × ΔY

Calculation for slope of the AE curve

ΔN÷ΔY Change in induced exp / change in real GDP

Calculation for Multiplier

ΔY / ΔA : change in real GDP/change in autonomous expenditure = 1 / (1−Slope of AE curve) aka 1/MPS

Calculation for change in Real GDP

ΔY=ΔN+ΔA Change in real GDP = change in induced expenditure + change in autonomous expenditure


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