GS ECO 2301 CH 12 Aggregate Expenditure and Output in the Short Run

We have seen that consumption spending is divided into three categories:

1. Spending on services, such as medical care, education, and haircuts 2. Spending on nondurable goods, such as food and clothing 3. Spending on durable goods, such as automobiles and furniture Spending on durable goods is most likely to be affected by changes in the interest rate because a high real interest rate increases the cost of spending financed by borrowing. The monthly payment on a four-year car loan will be higher if the real interest rate on the loan is 6 percent than if it is 4 percent.

Summarizing the Multiplier Effect You should note four key points about the multiplier effect:

1. The multiplier effect occurs both when autonomous expenditure increases and when it decreases. For example, with an MPC of 0.75, a decrease in planned investment of $100 billion will lead to a decrease in equilibrium income of $400 billion. 2. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be.Because of the multiplier effect, a decline in spending and production in one sector of the economy can lead to declines in spending and production in many other sectors of the economy. 3. The larger the MPC, the larger the value of the multiplier. This direct relationship between the value of the MPC and the value of the multiplier holds true because the larger the MPC, the larger the change in consumption that takes place after each change in income during the multiplier process. 4. The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that increases in GDP have on imports, inflation, interest rates, and individual income taxes. These effects combine to cause the simple formula to overstate the true value of the multiplier.

The following are the three most important variables that determine the level of net exports:

1. The price level in the United States relative to the price levels in other countries 2 .The growth rate of GDP in the United States relative to the growth rates of GDP in other countries 3. The exchange rate between the dollar and other currencies

2 of 3 : Variables impacting Net Exports : The Growth Rate of GDP in the United States Relative to the Growth Rates of GDP in Other Countries

As GDP increases in the United States, the incomes of households rise, leading them to increase their purchases of goods and services. Most of the additional goods and services purchased with rising incomes are produced in the United States, but some are imported. When incomes rise faster in the United States than in other countries, U.S. consumers' purchases of foreign goods and services increase faster than foreign consumers' purchases of U.S. goods and services. As a result, net exports fall. When incomes in the United States rise more slowly than incomes in other countries, net exports rise.

The table in Figure 12.3 shows hypothetical values for national income (or GDP), net taxes, disposable income, and consumption spending. Notice that national income and disposable income differ by a constant amount, which is equal to net taxes of $1,000 billion. In reality, net taxes are not a constant amount because they are affected by changes in income.

As income rises, net taxes rise because some taxes, such as the personal income tax, increase and some government transfer payments, such as government payments to unemployed workers, fall. Nothing important is affected in our analysis, however, by our simplifying assumption that net taxes are constant.

3 of 3 : Variables impacting Net Exports : The Exchange Rate between the Dollar and Other Currencies

As the value of the U.S. dollar rises, the foreign currency price of U.S. products sold in other countries rises, and the dollar price of foreign products sold in the United States falls. For example, suppose that the exchange rate between the Japanese yen and the U.S. dollar is 100 Japanese yen for 1 U.S. dollar, or ¥100 = $1. At this exchange rate, someone in the United States could buy ¥100 in exchange for $1, or someone in Japan could buy $1 in exchange for ¥100. Leaving aside transportation costs, at this exchange rate, a U.S. product that sells for $1 in the United States will sell for ¥100 in Japan, and a Japanese product that sells for ¥100 in Japan will sell for $1 in the United States. If the exchange rate changes to ¥150 = $1, then the value of the dollar will have risen because it takes more yen to buy $1. At the new exchange rate, the U.S. product that still sells for $1 in the United States will now sell for ¥150 in Japan, reducing the quantity demanded by Japanese consumers. The Japanese product that still sells for ¥100 in Japan will now sell for only $0.67 in the United States, increasing the quantity demanded by U.S. consumers. An increase in the value of the dollar will reduce exports and increase imports, so net exports will fall. A decrease in the value of the dollar will increase exports and reduce imports, so net exports will rise.

Showing a Recession on the 45°-Line Diagram Notice that macroeconomic equilibrium can occur at any point on the 45° line. Ideally, equilibrium will occur at potential GDP. At potential GDP, firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment.

As we have seen, at the natural rate of unemployment, the economy will be at full employment: Everyone in the labor force who wants a job will have one, except those workers who are structurally or frictionally unemployed (see Chapter 9; Section 9.2). However, for equilibrium to occur at potential GDP, planned aggregate expenditure must be high enough. As Figure 12.12 shows, if there is insufficient total spending, equilibrium will occur at a lower level of real GDP. In this situation, many firms will be operating below their normal capacity, and the unemployment rate will be above the natural rate of unemployment.

It is not only investment spending that will have this multiplied effect; any increase in autonomous expenditure will shift up the aggregate expenditure function and lead to a multiplied increase in equilibrium GDP. Autonomous expenditure An expenditure that does not depend on the level of GDP.

Autonomous expenditure does not depend on the level of GDP. In the aggregate expenditure model we have been using, planned investment spending, government spending, and net exports are all autonomous expenditures. Consumption has both an autonomous component, which does not depend on the level of GDP, and a nonautonomous—or induced—component, which does depend on the level of GDP. For example, if households decide to spend more of their incomes—and save less—at every level of income, there will be an autonomous increase in consumption spending, and the aggregate expenditure function will shift up. If, however, real GDP increases and households increase their consumption spending, as indicated by the consumption function, there will be a movement up along the aggregate expenditure function, and the increase in consumption spending will be nonautonomous.

We can also use the MPC to determine how much consumption will change as income changes. To see this relationship, we rewrite the expression for the MPC:

Change in consumption = Change in disposable income × MPC. For example, with an MPC of 0.95, a $10 billion increase in disposable income will increase consumption by $10 billion × 0.95, or $9.5 billion.

Keynes identified four components of aggregate expenditure that together equal GDP (these are the same four components we discussed in Chapter 8, Section 8.1):

Consumption (C). Spending by households on goods and services, such as automobiles and haircuts. Planned investment (I). Planned spending by firms on capital goods, such as factories, office buildings, and machine tools, and on research and development, and spending by households and firms on new houses. Government purchases (G). Spending by local, state, and federal governments on goods and services, such as aircraft carriers, bridges, and the salaries of FBI agents. Net exports (NX). Spending by foreign firms and households on goods and services produced in the United States minus spending by U.S. firms and households on goods and services produced in other countries. AE = C + I + G + NX

3 of 5 : Consumption : Expected Future Income

Consumption depends in part on expected future income. Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly. Some salespeople, for example, earn most of their income from commissions, which are fixed percentages of the prices of the products they sell. A salesperson might have a high income in some years and a much lower income in other years. Most people in this situation keep their consumption steady and do not increase it during good years and then drastically cut it back during slower years. If we looked only at the current income of someone in this situation, we might have difficulty estimating the person's current consumption. Instead, we need to take into account the person's expected future income. We can conclude that current income explains current consumption well but only when current income is not unusually high or unusually low compared with expected future income.

2 of 5 : Consumption : Household Wealth

Consumption depends in part on the wealth of households. A household's wealth is the value of its assets minus the value of its liabilities. Recall that an asset is anything of value owned by a person or a firm, and a liability is anything owed by a person or a firm (see Chapter 6, Section 6.3). A household's assets include its home, stock and bond holdings, and bank accounts. A household's liabilities include any loans that it owes. A household with $10 million in wealth is likely to spend more than a household with $10,000 in wealth, even if both households have the same disposable income. Therefore, when the wealth of households increases, consumption should increase, and when the wealth of households decreases, consumption should decrease. Shares of stock are an important category of household wealth. When stock prices increase, household wealth will increase, and so should consumption. Economists who have studied the determinants of consumption have concluded that permanent increases in wealth have a larger impact than temporary increases. One estimate of the effect of changes in wealth on consumption spending indicates that, for every permanent $1 increase in household wealth, consumption spending will increase by between 4 and 5 cents per year.

To better understand how macroeconomic equilibrium is determined in the aggregate expenditure model, we look more closely at the components of aggregate expenditure. Table 12.2 lists the four components of aggregate expenditure for 2016. The components are measured in real terms, which means that their values are corrected for inflation by being measured in billions of 2009 dollars.

Consumption is clearly the largest component of aggregate expenditure. Investment and government purchases are of roughly similar size. Net exports was negative because in 2016, as in most other years since the early 1970s, the United States imported more goods and services than it exported. Next, we consider the variables that determine each of the four components of aggregate expenditure.

We can use a 45°-line diagram to illustrate the multiplier effect working in reverse during these years. The economy was at potential real GDP in 1929, before the declines in aggregate expenditure began.

Declining consumption, planned investment, and net exports shifted the aggregate expenditure function down from AE1929 to AE1933, reducing equilibrium real GDP from $1,057 billion in 1929 to $778 billion in 1933. The depth and length of this economic downturn led to its being labeled the Great Depression. Real GDP did not regain its 1929 level until 1936, and a growing labor force meant that the unemployment rate did not return to its 1929 level until 1942, after the United States entered World War II.

Government Purchases Total government purchases include all spending by federal, local, and state governments for goods and services. Recall that government purchases do not include transfer payments, such as Social Security payments by the federal government or pension payments by local governments to retired police officers and firefighters, because the government does not receive a good or service in return (see Chapter 8, Section 8.1).

Figure 12.6 shows levels of real government purchases from 1979 through the first quarter of 2017. Government purchases grew steadily for most of this period, with the exception of the early 1990s and the period following the end of the recession of 2007-2009. During the early 1990s, Congress and Presidents George H. W. Bush and Bill Clinton enacted a series of spending reductions after they became concerned that spending by the federal government was growing much faster than tax receipts. As a result, real government purchases declined for three years beginning in 1992. Contributing to the slow growth of government purchases during the 1990s was the end of the Cold War between the United States and the Soviet Union in 1989.

Net Exports Net exports equal exports minus imports. We can calculate net exports by taking the value of spending by foreign firms and households on goods and services produced in the United States and subtracting the value of spending by U.S. firms and households on goods and services produced in other countries.

Figure 12.7 illustrates movements in real net exports from 1979 through the first quarter of 2017. During nearly all these years, the United States imported more goods and services than it exported, so net exports were negative. Net exports usually increase when the U.S. economy is in a recession and fall when the U.S. economy is in an expansion.

Figure 12.9 is similar to Figure 12.8 except that it measures real national income, or real GDP (Y), on the horizontal axis and planned real aggregate expenditure (AE) on the vertical axis. Because macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP, we know that all points of macroeconomic equilibrium must lie along the 45° line.

For all points above the 45° line, planned aggregate expenditure will be greater than GDP. For all points below the 45° line, planned aggregate expenditure will be less than GDP.

Don't Confuse Aggregate Expenditure with Consumption Spending Macroeconomic equilibrium occurs where planned aggregate expenditure equals GDP. But remember that planned aggregate expenditure equals the sum of consumption spending, planned investment spending, government purchases, and net exports, not consumption spending alone.

If GDP were equal to consumption, the economy would not be in equilibrium. Planned investment plus government purchases plus net exports will always be a positive number. Therefore, if consumption were equal to GDP, aggregate expenditure would have to be greater than GDP. In that case, inventories would be decreasing, and GDP would be increasing; GDP would not be in equilibrium.

The Important Role of Inventories Whenever planned aggregate expenditure is less than real GDP, some firms will experience unplanned increases in inventories. If firms do not cut back their production promptly when spending declines, they will accumulate inventories.

If firms accumulate excess inventories, then even if spending quickly returns to its normal level, firms will have to sell their excess inventories before they can return to producing at normal levels. For example, more than half of the sharp 5.4 percent annual rate of decline in real GDP during the first quarter of 2009 resulted from firms cutting production as they sold off unintended accumulations of inventories.

1 of 3 : Variables impacting Net Exports : The price level in the United States relative to the price levels in other countries

If inflation in the United States is lower than inflation in other countries, prices of U.S. products increase more slowly than the prices of products in other countries. This slower increase in the U.S. price level increases the demand for U.S. products relative to the demand for foreign products. So, U.S. exports increase and U.S. imports decrease, which increases net exports. The reverse happens during periods when the inflation rate in the United States is higher than the inflation rates in other countries: U.S. exports decrease and U.S. imports increase, which decreases net exports.

Now suppose that aggregate expenditure is less than GDP. With spending being less than production, many businesses will sell fewer goods and services than they had expected to sell, so their inventories will increase.

If the decrease in sales is affecting not just refrigerators but also many other goods and services, GDP and total employment will begin to decrease. Falling sales followed by reductions in production and employment occurred at many firms during 2008. In summary, when aggregate expenditure is less than GDP, inventories will increase, and GDP and total employment will decrease.

Although our discussion in this section has concentrated on the components of investment that represent spending by businesses, household purchases of new homes are an important part of investment spending. As the following graph shows, spending on residential construction rose rapidly in the period just before the recession of 2007-2009, declined dramatically during the recession, and recovered only slowly thereafter.

In 2017, spending on residential construction remained 30 percent below its 2005 peak, despite the U.S. population having grown by more than 10 percent during that time. The slow recovery in spending on residential construction is one reason the recovery from the recession was weaker than most previous recoveries.

Table 12.1 The Relationship between Aggregate Expenditure and GDP

Increases and decreases in aggregate expenditure cause the year-to-year changes we see in GDP. Economists devote considerable time and energy to forecasting what will happen to each component of aggregate expenditure. If economists forecast that aggregate expenditure will decline in the future, that is equivalent to forecasting that GDP will decline and that the economy will enter a recession.

1 of 4 : Factors of planned investment : Expectations of future profitability

Investment goods, such as factories, office buildings, and machinery and equipment, are long-lived. A firm is unlikely to build a new factory unless it is optimistic that the demand for its product will remain strong for at least several years. When the economy moves into a recession, many firms postpone buying investment goods even if the demand for their own product is strong because they are afraid that the recession may become worse. During an expansion, some firms may become optimistic and begin to increase spending on investment goods even before the demand for their own product has increased. The key point is that the optimism or pessimism of firms is an important determinant of investment spending. Residential construction is included in investment spending. Since 1990, residential construction has averaged about 30 percent of total investment spending. But the swings in residential construction have been quite substantial, ranging from a high of 34 percent of investment spending at the height of the housing boom in 2005 down to 17 percent in 2011. The sharp decline in spending on residential construction beginning in 2006 helped to cause the 2007-2009 recession and contributed to its severity.

We defined the marginal propensity to consume (MPC) as the change in consumption divided by the change in disposable income, which is the slope of the consumption function.

It should not be surprising that we get the same result in either case. National income and disposable income differ by a constant amount, so changes in the two numbers always give us the same value, as shown in the last two columns of the table in Figure 12.3. Therefore, we can graph the consumption function using national income rather than using disposable income. We can also calculate the MPC by using either the change in national income or the change in disposable income and always get the same value.

Formulas for MPC / MPS

MPC = ΔC / ΔY = Δ Consumption / Δ GPD (National Income) MPS = ΔS / ΔY = Δ Savings / Δ Δ GPD (National Income)

4 of 4 : Factors of planned investment : Cash Flow

Many firms do not borrow to finance spending on new factories, machinery, and equipment. Instead, they use their own funds. Cash flow is the difference between the cash revenues received by a firm and the cash spending by the firm. Neither noncash receipts nor noncash spending is included in cash flow. For example, tax laws allow firms to count the depreciation of worn-out or obsolete machinery and equipment as a cost, even if new machinery and equipment have not actually been purchased. Because this is noncash spending, firms do not include it when calculating cash flow. The largest contributor to cash flow is profit. The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment. During periods of recession, many firms experience reduced profits, which in turn reduces their ability to finance spending on new factories or machinery and equipment.

Income, Consumption, and Saving To complete our discussion of consumption, we can look briefly at the relationships among income, consumption, and saving. Households spend their income, save it, or use it to pay taxes. For the economy as a whole, we can write the following:

National income = = Consumption + Saving +T axes. When national income increases, there must be some combination of an increase in consumption, an increase in saving, and an increase in taxes: Change in national income = = Change in consumption + Change in saving + Change in taxes Using symbols, where Y represents national income (and GDP), C represents consumption, S represents saving, and T represents taxes, we can write the following: Y = C + S + T and: ΔY = ΔC +ΔS + ΔT

The business cycle involves the interaction of many economic variables. A simple model called the aggregate expenditure model can help us understand the relationships among some of these variables.

Recall that GDP is the value of all the final goods and services produced in an economy during a period of time, typically one year. Real GDP corrects nominal GDP for the effects of inflation.

4 of 5 : Consumption : The Price Level

Recall that the price level measures the average prices of goods and services in the economy (see Chapter 9, Section 9.4). Changes in the price level affect consumption. It is tempting to think that an increase in prices will reduce consumption by making goods and services less affordable. In fact, the effect of an increase in the price of one product on the quantity demanded of that product is different from the effect of an increase in the price level on total spending by households on goods and services. Changes in the price level affect consumption mainly through their effect on household wealth. An increase in the price level will result in a decrease in the real value of household wealth. For example, if you have $2,000 in a checking account, the higher the price level, the fewer goods and services you can buy with your money. Therefore, as the price level rises, the real value of your wealth declines, and so will your consumption, at least a little. Conversely, if the price level falls—which happens rarely in the United States—the real value of your $2,000 increases, and your consumption will also increase.

We can now incorporate the effect of a change in the price level into the basic aggregate expenditure model, in which equilibrium real GDP is determined by the intersection of the aggregate expenditure (AE) line and the 45° line.

Remember that we measure the price level as an index number with a value of 100 in the base year. If the price level rises from, say, 100 to 103, consumption, planned investment, and net exports will all fall, causing the AE line to shift down in the 45°-line diagram. The AE line shifts down because with higher prices, less spending will occur in the economy at every level of GDP. Panel (a) of Figure 12.14 shows that the downward shift of the AE line results in a lower level of equilibrium real GDP.

Figure 12.10 shows the aggregate expenditure function on the 45°-line diagram. The lowest upward-sloping line, C, represents the consumption function, as shown in Figure 12.2, panel (b). The quantities of planned investment, government purchases, and net exports are constant because we assumed that the variables they depend on are constant.

So, the level of planned aggregate expenditure at any level of GDP is the amount of consumption spending at that level of GDP plus the sum of the constant amounts of planned investment, government purchases, and net exports. In Figure 12.10, we add each component of spending successively to the consumption function line to arrive at the line representing planned aggregate expenditure (AE). The C+I line is higher than the C line by the constant amount of planned investment; the C+I+G line is higher than the C+I line by the constant amount of government purchases; and the C+I+G+NX line is higher than the C+I+G line by the constant amount of NX. (In many years, however, NX is negative, which would cause the C+I+G+NX line to be below the C+I+G line.) The C+I+G+NX line shows all four components of expenditure and is the aggregate expenditure (AE) function. At the point where the AE line crosses the 45° line, planned aggregate expenditure is equal to GDP, and the economy is in macroeconomic equilibrium.

2 of 4 : Factors of planned investment : The Interest Rate

Some business investment is financed by borrowing, as firms issue corporate bonds or receive loans from banks. Households also borrow to finance most of their spending on new homes. The higher the interest rate, the more expensive it is for firms and households to borrow. Because households and firms are interested in the cost of borrowing after taking into account the effects of inflation, investment spending depends on the real interest rate. Therefore, holding constant the other factors that affect investment spending, there is an inverse relationship between the real interest rate and investment spending: A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending. The ability of households to borrow money at very low real interest rates helps explain the rapid increase in spending on residential construction from 2002 to 2006.

Households saved very little of their income in the mid-2000s but increased their saving markedly in late 2008 and 2009. The personal saving rate is saving by households as a percentage of disposable personal income. By mid-2009, the personal saving rate had increased to 6 percent.

Some economists argued that this increase in saving contributed to the recession and weak recovery by reducing consumption spending. Other economists are skeptical of the reasoning behind the paradox of thrift. An increase in saving, by increasing the supply of loanable funds, should lower the real interest rate and increase the level of investment spending (see Chapter 10, Section 10.2). This increase in investment spending might offset some or all of the decline in consumption spending attributable to increased saving. Economists continue to debate the short-run effects of an increase in saving.

A Numerical Example of Macroeconomic Equilibrium In forecasting real GDP, economists rely on quantitative models of the economy. We can increase our understanding of the causes of changes in real GDP by considering a simple numerical example of macroeconomic equilibrium. Although simplified, this example captures some of the key features contained in the quantitative models that economic forecasters use.

Table 12.3 shows several hypothetical combinations of real GDP and planned aggregate expenditure. The first column lists real GDP. The next four columns list levels of the four components of planned aggregate expenditure that occur at the corresponding level of real GDP. We assume that planned investment, government purchases, and net exports do not change as GDP changes. Because consumption depends on GDP, it increases as GDP increases.

3 of 4 : Factors of planned investment : Taxes

Taxes affect the level of investment spending. Firms focus on the profits that remain after they have paid taxes. The federal government imposes a corporate income tax on the profits corporations earn, including profits from the new buildings, equipment, and other investment goods they purchase. A reduction in the corporate income tax increases the after-tax profitability of investment spending. An increase in the corporate income tax decreases the after-tax profitability of investment spending. Investment tax incentives increase investment spending. An investment tax incentive provides firms with a tax reduction when they buy new investment goods.

5 of 5 : Consumption : The Interest Rate

The Interest Rate Finally, consumption depends on the interest rate. When the interest rate is high, the reward for saving is increased, and households are likely to save more and spend less. Recall the distinction between the nominal interest rate and the real interest rate (see Chapter 9, Section 9.6): • The nominal interest rate is the stated interest rate on a loan or a financial investment such as a bond. • The real interest rate corrects the nominal interest rate for the effect of inflation and is equal to the nominal interest rate minus the inflation rate. Because households are concerned with the payments they will make or receive after the effects of inflation are taken into account, consumption spending depends on the real interest rate.

The Increasing Importance of Software and the Declining Importance of Hardware In recent years, most businesses have increased their use of information technology in a variety of ways, including expanding their presence on the Internet, especially by using social media apps such as Twitter, Snapchat, and Facebook; designing company apps; and providing employees with tablets and smartphones. As Figure 12.5 shows, though, the focus of many businesses on information technology is not reflected in spending on computers.

The blue line shows that in 2017, business spending on computers had grown by less than 10 percent from its level at the beginning of the 2007-2009 recession. Total business spending on software, in contrast, has grown rapidly and in 2017, it was nearly 50 percent higher than its peak at the beginning of the recession. A key reason for this change in business investment spending is that over time, the frontier of developments in information technology has shifted away from equipment— particularly computers and servers—and toward software, such as apps used on smartphones and tablets and artificial intelligence programs that, among other uses, help guide business and investing decisions.

The ratio of the increase in equilibrium real GDP to the increase in autonomous expenditure is called the multiplier.

The change in equilibrium real GDP divided by the change in autonomous expenditure.

The Consumption Function Panel (a) in Figure 12.2 plots the relationship between consumption and disposable income during the years 1970 to 2016. In panel (b), we draw a straight line through the points representing consumption and disposable income.

The fact that most of the points lie almost on the line shows the close relationship between consumption and disposable income. Because changes in consumption depend on changes in disposable income, we can say that consumption is a function of disposable income. The relationship between consumption spending and disposable income illustrated in panel (b) of Figure 12.2 is called the consumption function.

When the aggregate expenditure line intersects the 45° line at a level of GDP below potential GDP, the economy is in recession.

The figure shows that potential GDP is $10 trillion, but because planned aggregate expenditure is too low, the equilibrium level of GDP is only $9.8 trillion, where the AE line intersects the 45° line. As a result, some firms will be operating below their normal capacity, and unemployment will be above the natural rate of unemployment. We can measure the shortfall in planned aggregate expenditure as the vertical distance between the AE line and the 45° line at the level of potential GDP.

Table 12.4 summarizes how changes in GDP and spending caused by the initial $100 billion increase in investment will result in equilibrium GDP rising by $400 billion. We can think of the multiplier effect occurring in rounds of spending. In round 1, there is an increase of $100 billion in autonomous expenditure—the $100 billion in planned investment spending in our example—which causes GDP to rise by $100 billion. In round 2, induced expenditure rises by $75 billion (which equals the $100 billion increase in real GDP in round 1 multiplied by the MPC). The $75 billion in induced expenditure in round 2 causes a $75 billion increase in real GDP, which leads to a $56 billion increase in induced expenditure in round 3, and so on.

The final column adds up the total increases in expenditure, which equal the total increase in GDP. In each round, the additional induced expenditure becomes smaller because the MPC is less than 1. By round 10, additional induced expenditure is only $8 billion, and the total increase in GDP from the beginning of the process is $377 billion. By round 19, the process is almost complete: Additional induced expenditure is only about $1 billion, and the total increase in GDP is $398 billion. Eventually, the process will be finished, although we cannot say precisely how many spending rounds it will take, so we simply label the last round n rather than give it a specific number. We can calculate the value of the multiplier in our example by dividing the increase in equilibrium real GDP by the increase in autonomous expenditure: ΔY / ΔI = Change in real GDP / Change in investment spending = $400 billion / $100 billion = 4. With a multiplier of 4, each increase in autonomous expenditure of $1 will result in an increase in equilibrium GDP of $4.

1 of 5 : Consumption : Current disposable income

The most important determinant of consumption is the current disposable income of households. Recall that disposable income is the income remaining to households after they have paid the personal income tax and received government transfer payments, such as Social Security payments (see Chapter 8, Section 8.4). The main reason for the general upward trend in consumption shown in Figure 12.1 is that disposable income has followed a similar upward trend.

A Formula for the Multiplier Table 12.4 shows that during the multiplier process, each round of increases in consumption is smaller than in the previous round, so eventually, the increases will come to an end, and we will have a new macroeconomic equilibrium. But how do we know that when we add all the increases in GDP, the total will be $400 billion? We can verify this result by first writing out the total change in equilibrium GDP:

The total change in equilibrium real GDP equals the initial increase in planned investment spending = $100 billion Plus the first induced increase in consumption = MPC × $100 billion Plus the second induced increase in consumption = MPC × (MPC ×$100 billion) =MPC2 × $100 billion Plus the third induced increase in consumption = MPC × (MPC2×$100 billion) =MPC3× $100 billion Plus the fourth induced increase in consumption = MPC × (MPC3 × $100 billion) =MPC4 × $100 billion and so on ... Total change in GDP = $100 billion×(1 + MPC + MPC2 + MPC3 + MPC4 +...) Mathematicians have shown that an expression like the one in the parentheses sums to: 1 / 1 − MPC Multiplier = Change in equilibrium real GDP / Change in autonomous expenditure = 1 / 1 − MPC = In this case, the multiplier is 1/(1 − 0.75), or 4, which means that for each additional $1 of autonomous spending, equilibrium GDP will increase by $4

Consumption Figure 12.1 shows movements in real consumption from 1979 through the first quarter of 2017. Notice that consumption follows a smooth, upward trend. Only during periods of recession does the growth in consumption decline.

These are the five most important variables that determine the level of consumption: 1. Current disposable income 2. Household wealth 3. Expected future income 4. The price level 5. The interest rate

Planned Investment Figure 12.4 shows movements in real investment spending from 1979 through the first quarter of 2017. Notice that, unlike consumption, investment does not follow a smooth, upward trend. Investment declined significantly during the recessions of 1980, 1981-1982, 1990-1991, 2001, and 2007-2009.

These are the four most important variables that determine the level of investment: 1. Expectations of future profitability 2 .The interest rate 3. Taxes 4. Cash flow

We saw earlier in the chapter that macroeconomic equilibrium occurs when GDP is equal to aggregate expenditure. We can use a graph called the 45°-line diagram to illustrate macroeconomic equilibrium. (The 45°-line diagram is also sometimes called the Keynesian cross because it is based on the analysis of John Maynard Keynes.)

To become familiar with this diagram, consider Figure 12.8, which is a 45°-line diagram that shows the relationship between the quantity of Pepsi sold (on the vertical axis) and the quantity of Pepsi produced (on the horizontal axis). The 45° line shows all the points that are equal distances from both axes. Points such as A and B, at which the quantity produced equals the quantity sold, are on the 45° line. Points such as C, at which the quantity sold is greater than the quantity produced, lie above the line. Points such as D, at which the quantity sold is less than the quantity produced, lie below the line.

The 45° line shows many potential points of macroeconomic equilibrium. During any particular year, only one of these points will represent the actual level of equilibrium real GDP, given the actual level of planned real expenditure.

To determine this point, we need to draw a line on the graph to represent the aggregate expenditure function, which shows the amount of planned aggregate expenditure that will occur at every level of national income, or GDP.

The slope of the consumption function, which is equal to the change in consumption divided by the change in disposable income, is called the marginal propensity to consume (MPC).

Using the Greek letter delta, Δ, to represent "change in," C to represent consumption spending, and YD to represent disposable income, we can write the expression for the MPC as follows: For example, between 2015 and 2016, consumption spending increased by $308 billion, while disposable income increased by $324 billion. The marginal propensity to consume was, therefore: ΔC / ΔYD = $308 billion / $324 billion = 0.95. This value for the MPC tells us that households in 2016 spent 95 percent of the increase in their disposable income.

We begin the discussion with Figure 12.13, which illustrates the effect of an increase in planned investment spending.

We assume that the economy starts in equilibrium at point A, at which real GDP is $9.6 trillion. Firms then become more optimistic about the future profitability of investment and increase spending on factories, machinery, and equipment by $100 billion. This increase in investment spending shifts the AE line up by $100 billion, from AE1 to AE2. The new equilibrium occurs at point B, at which real GDP is $10.0 trillion, which equals potential real GDP. The economy begins at point A, at which equilibrium real GDP is $9.6 trillion. A $100 billion increase in planned investment shifts up the aggregate expenditure function from AE1 to AE2. The new equilibrium is at point B, where real GDP is $10.0 trillion, which is potential real GDP. Because of the multiplier effect, a $100 billion increase in investment results in a $400 billion increase in equilibrium real GDP.

We have already seen that the marginal propensity to consume equals the change in consumption divided by the change in income. We can define the marginal propensity to save (MPS) as the amount by which saving changes when disposable income changes.

We can measure the MPS as the change in saving divided by the change in disposable income. In calculating the MPS, as in calculating the MPC, we can safely ignore the difference between national income and disposable income. If we divide the previous equation by the change in income, ΔY, we get an equation that shows the relationship between the marginal propensity to consume and the marginal propensity to save: ΔY/ΔY=ΔC/ΔY + ΔS/ΔY, or: 1 = MPC + MPS. This equation tells us that when taxes are constant, the marginal propensity to consume plus the marginal propensity to save must always equal 1. They must add up to 1 because part of any increase in income is consumed, and whatever remains must be saved.

Notice that planned investment spending, rather than actual investment spending, is a component of aggregate expenditure.

We can resolve this puzzle by first remembering that goods that have been produced but have not yet been sold are referred to as inventories. Changes in inventories are included as part of investment spending, along with spending on machinery, equipment, office buildings, research and development, and factories. We assume that the amount businesses plan to spend on machinery and office buildings is equal to the amount they actually spend, but the amount businesses plan to spend on inventories may be different from the amount they actually spend. In other words, changes in inventories depend on sales of goods, which firms cannot always forecast with perfect accuracy.

There are three main reasons for this inverse relationship between changes in the price level and changes in aggregate expenditure.

We discussed the first two reasons in Section 12.2 when considering the factors that determine consumption and net exports: 1. A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect. 2. If the price level in the United States rises relative to the price levels in other countries, U.S. exports will become relatively more expensive, and foreign imports will become relatively less expensive, causing net exports to fall. A falling price level in the United States has the reverse effect. 3. When prices rise, firms and households need more money to finance buying and selling. If the central bank (the Federal Reserve in the United States) does not increase the money supply, the result will be an increase in the interest rate. In Chapter 15, Section 15.2, we will analyze in more detail why the interest rate increases. As we discussed in Section 12.2, at a higher interest rate, investment spending falls as firms decrease their borrowing to build new factories or to install new machinery and equipment and households decrease their borrowing to buy new houses. A falling price level has the reverse effect: Other things being equal, interest rates will fall, and investment spending will rise.

So far, we have seen that aggregate expenditure determines real GDP in the short run, and we have seen how the economy adjusts if it is not in equilibrium.

We have also seen that whenever aggregate expenditure changes, there will be a new level of equilibrium real GDP. In this section, we will look more closely at the effects of a change in aggregate expenditure on equilibrium real GDP.

Figure 12.11 makes the relationship between planned aggregate expenditure and GDP clearer by showing only the 45° line and the AE line. The figure shows that the AE line intersects the 45° line at a level of real GDP of $10 trillion. Therefore, $10 trillion represents the equilibrium level of real GDP. To see why, consider the situation in which real GDP is only $8 trillion. By moving vertically from $8 trillion on the horizontal axis up to the AE line, we see that planned aggregate expenditure is greater than $8 trillion at this level of real GDP.

Whenever total spending is greater than total production, firms' inventories will fall. The fall in inventories is equal to the vertical distance between the AE line, which shows the level of total spending, and the 45° line, which shows the $8 trillion of total production. Unplanned declines in inventories lead firms to increase their production. As real GDP increases from $8 trillion, so will total income and, therefore, consumption. The economy will move up the AE line as consumption increases. The gap between total spending and total production will fall, but as long as the AE line is above the 45° line, inventories will continue to decline, and firms will continue to expand production. When real GDP rises to $10 trillion, inventories stop falling, and the economy will be in macroeconomic equilibrium.

During some years, total spending in the economy, or aggregate expenditure (AE)

and total production of goods and services increase by the same amount. In this case, most firms will sell about as much as they expected to sell, and they probably will not increase or decrease production or the number of workers they hire. During other years, total spending in the economy increases more than the production of goods and services. In those years, firms will increase production and hire more workers. But there are times, such as 2008 and early 2009, when total spending does not increase as much as total production. As a result, firms cut back on production and lay off workers, and the economy moves into a recession. Total spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

When aggregate expenditure is greater than GDP, the total amount of spending in the economy is

greater than the total amount of production. With spending being greater than production, many businesses will sell more goods and services than they had expected to sell. For example, the manager of a Home Depot store might like to keep 50 refrigerators in stock to give customers the opportunity to see a variety of different sizes and models. If sales are unexpectedly high, the store may have only 20 refrigerators in stock. In that case, the store will have an unplanned decrease in inventories: Its inventory of refrigerators will decline by 30. In summary, when aggregate expenditure is greater than GDP, inventories will decline, and GDP and total employment will increase.

When demand for a product increases, firms usually respond by increasing production, but they are also likely to

increase prices. Similarly, when demand falls, production falls, but prices may also fall. We would expect, then, that an increase or a decrease in aggregate expenditure would affect not just real GDP but also the price level. Will a change in the price level, in turn, affect the components of aggregate expenditure? In fact, increases in the price level cause aggregate expenditure to fall, and decreases in the price level cause aggregate expenditure to rise.

When economists forecast that aggregate expenditure is likely to decline and that the economy is headed for a recession, the federal government may implement

macroeconomic policies in an attempt to head off the decrease in expenditure and keep the economy from falling into a recession. We will discuss these macroeconomic policies in Chapters 15 and 16.

Changes in GDP have a much greater effect on consumption than on

planned investment, government purchases, or net exports. For simplicity, we assume that changes in GDP have no effect on planned investment, government purchases, or net exports. We also assume that the other variables that determine planned investment, government purchases, and net exports all remain constant, as do the variables other than GDP that affect consumption. For example, we assume that a firm's level of planned investment at the beginning of the year will not change during the year, even if the level of GDP changes.

The Paradox of Thrift We have seen that an increase in saving can increase the rate of economic growth in the long run by providing funds for investment (see Chapters 10 and 11). But in the short run, if households

save more of their income and spend less of it, aggregate expenditure and real GDP will decline. In discussing the aggregate expenditure model, John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession. The lower incomes in the recession might mean that total saving does not increase, despite the attempts by many individuals to increase their own saving. Keynes called this outcome the paradox of thrift because what appears to be something favorable to the long-run performance of the economy might be counterproductive in the short run.

Macroeconomic equilibrium is similar to microeconomic equilibrium. In microeconomics,

the apple market occurs when the quantity of apples demanded equals the quantity of apples supplied. When the apple market is in equilibrium, the quantity of apples produced and sold will not change unless the demand for apples or the supply of apples changes. For the economy as a whole, macroeconomic equilibrium occurs when total spending, or aggregate expenditure, equals total production, or GDP: Aggregate expenditure = GDP. To simplify the analysis of macroeconomic equilibrium, we assume that the economy is not growing. If we assume that the economy is not growing, then equilibrium GDP will not change unless aggregate expenditure changes.

We have seen that consumption spending by households depends on disposable income. We now shift our focus slightly to the similar relationship that exists between consumption spending and GDP. We make this shift because we are interested in using the aggregate expenditure model to explain changes in real GDP rather than changes in disposable income. The first step in examining the relationship between consumption and GDP is to recall that

the differences between GDP and national income are small and can be ignored without affecting our analysis (see Chapter 8, Section 8.4). In fact, in this and the following chapters, we will use the terms GDP and national income interchangeably. Also recall that disposable income is equal to national income plus government transfer payments minus taxes. Taxes minus government transfer payments are called net taxes. So, we can write the following: Disposable income = National income − Net taxes. We can rearrange the equation like this: National income = GDP = Disposable income + Net taxes.

Notice that the value of the multiplier depends on the value of the MPC. In particular

the larger the value of the MPC, the larger the value of the multiplier. For example, if the MPC were 0.9 instead of 0.75, the value of the multiplier would increase from 4 to 1/(1 − 0.9) = 10.

The series of induced increases in consumption spending that results from an initial increase in autonomous expenditure is called

the multiplier effect. The multiplier effect occurs because an initial increase in autonomous expenditure sets off a series of increases in real GDP. Multiplier effect The process by which a change in autonomous expenditure leads to a larger change in real GDP.

The aggregate expenditure model focuses on

the short-run relationship between total spending and real GDP. An important assumption of the model is that the price level is constant. In Chapter 13, we will develop a more complete model of the business cycle that relaxes the assumption of constant prices. The key idea of the aggregate expenditure model is that in any particular year, the level of GDP is determined mainly by the level of aggregate expenditure.

For the economy as a whole, we can say that actual investment spending will be greater than planned investment spending when

there is an unplanned increase in inventories. Actual investment spending will be less than planned investment spending when there is an unplanned decrease in inventories. Therefore, actual investment will equal planned investment only when there is no unplanned change in inventories. In this chapter, we will use I to represent planned investment. We will also assume that the government data on investment spending compiled by the U.S. Bureau of Economic Analysis represents planned investment spending. This assumption is a simplification, however, because the government collects data on actual investment spending, which equals planned investment spending only when unplanned changes in inventories are zero.