 Fixed Prices and Expenditure Plans

 Real GDP with a Fixed Price Level

1
Fixed Prices and Expenditure Plans
 Keynesian model describes the economy in the
very short run when prices are fixed.
 Because each firm’s price is fixed, for the
economy as a whole:
 1. The price level is fixed.
 2. Aggregate demand determines real GDP.
 What determines aggregate expenditure plans?

2
Fixed Prices and Expenditure Plans
 Expenditure Plans
 The components of aggregate expenditure sum to
real GDP.
 That is,
Y=C+I+G+X–M
 Two of the components of aggregate expenditure,
consumption and imports, are influenced by real
GDP.
 So there is a two-way link between aggregate
expenditure and real GDP.
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Fixed Prices and Expenditure Plans
 Two-Way link Between Aggregate
Expenditure and Real GDP
 Other things remaining the same,
 An increase in real GDP increases aggregate
expenditure.
 An increase in aggregate expenditure increases
real GDP.

4
Fixed Prices and Expenditure Plans
 Consumption and Saving Plans
 Consumption expenditure is influenced by
many factors but the most direct one is
disposable income.
 Disposable income is aggregate income or real
GDP, Y, minus net taxes, T.
 Call disposable income YD.
 The equation for disposable income is
 YD = Y – T

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Fixed Prices and Expenditure Plans
 Disposable income is either spent on consumption
goods and services, C, or saved, S.
 That is,
 YD = C + S.
 The relationship between consumption expenditure
and disposable income, other things remaining the
same, is the consumption function.
 The relationship between saving and disposable
income, other things remaining the same, is the
saving function.

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Fixed Prices …
Figure 27.1 illustrates the
consumption function …

and the saving function.

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

When consumption
expenditure is less than
disposable income, there
is saving.
Fixed Prices and Expenditure Plans
 Marginal Propensity to Consume
 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, DC, divided by the change in
disposable income, DYD, that brought it about.
 That is,
 MPC = DC ÷ DYD

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Fixed Prices and Expenditure Plans
 Figure 27.2(a) shows
that the MPC is the
slope of the
consumption function.
 Along this
consumption function,
when disposable
income increases by
$200 billion,
consumption
expenditure increases
by $150 billion.
 The MPC is 0.75.
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Fixed Prices and Expenditure Plans
 Marginal Propensity to Save
 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, DS,
divided by the change in disposable income,
DYD, that brought it about.
 That is,
 MPS = DS ÷ DYD

10
Fixed Prices and Expenditure Plans
 Figure 27.2(b) shows
that the MPS is the
slope of the saving
function.
 Along this saving
function, when
disposable income
increases by $200
billion, saving
increases by
$50 billion.
 The MPS is 0.25.

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Fixed Prices and Expenditure Plans
 The MPC plus the MPS equals 1.
 To see why, note that,
 DC + DS = DYD.
 Divide this equation by DYD to obtain,
 DC/DYD + DS/DYD = DYD/DYD
 or
 MPC + MPS = 1.

12
Fixed Prices and Expenditure Plans
 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.

13
Fixed Prices and Expenditure Plans
 Import Function
 In the short run, Canadian imports are
influenced primarily by Canadian real GDP.
 The marginal propensity to import is the
fraction of an increase in real GDP spent on
imports.
 If $100 billion increase in real GDP increases
imports by $25 billion, then the marginal
propensity to import is about 0.25.

14
Real GDP with a Fixed Price Level
 When the price level is fixed, aggregate demand
is determined by aggregate expenditure plans.
 Aggregate planned expenditure is planned
consumption expenditure plus planned
investment plus planned government
expenditure plus planned exports minus planned
imports.

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Real GDP with a Fixed Price Level
 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.
 We’re going to study the aggregate expenditure
model that explains how real GDP is determined
when the price level is fixed.

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Real GDP with a Fixed Price Level
 The Aggregate Expenditure Model
 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.

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Real GDP with a Fixed Price Level

18
Real GDP with a Fixed Price Level
 Aggregate
Planned
Expenditure
 Figure 27.3
shows how the
aggregate
expenditure
curve (AE) is
built from its
components.

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Real GDP with a Fixed Price Level

 Consumption expenditure minus imports,

20
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.
 Equilibrium Expenditure
 Equilibrium expenditure is the level of aggregate
expenditure that occurs when aggregate planned
expenditure equals real GDP.
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Real GDP with a
Fixed Price Level
 Figure 27.4 illustrates
equilibrium expenditure.
 Equilibrium occurs at
the point at which the
aggregate expenditure
curve crosses the 45° line
in part (a).
 Equilibrium occurs when
there are no unplanned
changes in business
inventories in part (b).

22
Real GDP with a
Fixed Price Level
 Convergence to
Equilibrium
 If aggregate planned
expenditure exceeds real
GDP (the AE curve is
above the 45° line), …
 there is an unplanned
short fall of inventories.
 To restore inventories,
firms hire workers and
increase production.
 Real GDP increases.

23
Real GDP with a
Fixed Price Level
 If aggregate planned
expenditure is less than
real GDP (the AE curve
is below the 45° line), …
 there is an unplanned
excess of inventories.
 To reduce inventories,
firms fire workers and
decrease production.
 Real GDP decreases.

24
Real GDP with a
Fixed Price Level
 If aggregate planned
expenditure equals
real GDP (the AE
curve intersects the
45° line), …
 there is no unplanned
change in inventories.
 So firms maintain
their current
production.
 Real GDP remains
constant.

25
The Multiplier
 The multiplier is the amount by which a
change in autonomous expenditure is
magnified or multiplied to determine the
change in equilibrium expenditure and real
GDP.

26
The Multiplier
 The Basic Idea of the Multiplier
 An increase in investment (or any other component
of autonomous expenditure) increases 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.

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The Multiplier
 Figure 27.5
illustrates the
multiplier.
 An increase in
autonomous
expenditure brings
an unplanned short
fall of inventories.
 So firms increase
production and real
GDP increases to a
new equilibrium.

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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 aggregate expenditure.
 The Size of the Multiplier
 The size of the multiplier is the change in
equilibrium expenditure divided by the change in
autonomous expenditure.

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The Multiplier
 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 DA, and the change
in induced expenditure is DN, then
 Multiplier = DY ÷ DA
The Multiplier
 To see why the multiplier = 1 ÷ (1 – Slope of AE
curve), begin with the fact that:
 DY = DN + DA
 But
 Slope of AE curve = DN ÷ DY
 so,
 DN = (Slope of AE curve x DY)
 and
 DY = (Slope of AE curve x DY) + DA
The Multiplier
 Because
 DY = (Slope of AE curve x DY) + DA
 you can see that
 (1 - Slope of AE curve) x DY = DA
 and
 DY = DA ÷ (1 - Slope of AE curve)
The Multiplier
 The multiplier is
 DY ÷ DA
 So, divide both sides of
 DY = DA ÷ (1 - Slope of AE curve)
 by DA to obtain
 DY ÷ DA = 1 ÷ (1 - Slope of AE curve)
The Multiplier
 With the numbers in Figure 27.5 (AE increases by 75
for real GDP’s increase of 100), the slope of the AE
curve is 0.75, so the multiplier is
 DY ÷ DA = 1 ÷ (1 - 0.75) = 1 ÷ (0.25) = 4.
 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.
The Multiplier
 Imports and Income
Taxes
 Both imports and
income taxes reduce
the size of the
multiplier.
 Figure 27.6 shows
how.
 In part (a) with no
taxes or imports, the
slope of the AE curve
is 0.75 and the
multiplier is 4.

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The Multiplier

 In part (b),
with taxes and
imports, the
slope of the AE
curve is 0.5 and
the multiplier
is 2.

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The Multiplier
 Business Cycle Turning Points
 Turning points in the business cycle—peaks and
troughs—occur when autonomous expenditure
changes.
 An increase in autonomous expenditure brings an
short fall of unplanned inventories, which triggers
an expansion.
 A decrease in autonomous expenditure brings an
excess of unplanned inventories, which triggers a
recession.

37
The Multiplier and the Price Level
 Adjusting Quantities and Prices
 Real firms don’t hold their prices constant for
long.
 When firms have a change in unplanned
inventories, they change productions and prices.
 The aggregate supply-aggregate demand model
explains the simultaneous determination of real
GDP and the price level.

38
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.

39
The Multiplier and the Price Level
 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.
 Figure 27.8 on the next slide illustrates the effects
of a change in the price level on the AE curve,
equilibrium expenditure, and the quantity of real
GDP demanded.

40
The Multiplier and
the Price Level
 In Figure 27.8(a), a rise in
price level from 110 to 130 …
 shifts the AE curve from
AE0 downward to AE1 and
 decreases equilibrium
expenditure from
$1,200 billion to $1,100
billion.

41
The Multiplier and
the Price Level
 In Figure 27.8(b),
the same rise in the
price level that
lowers equilibrium
expenditure …
 brings a movement
along the AD curve
from point B to
point A.

42
The Multiplier and
the Price Level
 A fall in price level from
110 to 90 …
 shifts the AE curve from
AE0 upward to AE2 and
 increases equilibrium
expenditure from
$1,200 billion to $1,300
billion.

43
The Multiplier and
the Price Level
 The same fall in the
price level that
increases equilibrium
expenditure …
 brings a movement
along the AD curve
from point B to point
C.

44
The Multiplier and
the Price Level
 Changes in Aggregate
Expenditure and Shifts in
Aggregate Demand
 Figure 27.9 illustrates the
effects of an increase in
investment.
 The AE curve shifts upward
…
 …and the AD curve shifts
rightward …
 by an amount equal to the
change in investment
multiplied by the multiplier.
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The Multiplier and
the Price Level
 Equilibrium Real GDP
and the Price Level
 Figure 27.10 shows the
effect of an increase in
investment in the short
run when the price
level changes and the
economy moves along
its SAS curve.

46
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 price level, real
GDP would increase
to $1,400 billion at
point B.

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The Multiplier and
the Price Level
 But the price level rises. The
AE curve shifts downward….
 Equilibrium expenditure
decreases to $1,330 billion.
 As the price level rises, real
GDP increases along the
SAS curve to $1,330 billion.
 The multiplier in the short
run is smaller than when the
price level is fixed.

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The Multiplier and
the Price Level
 Figure 27.11
illustrates the
long-run effects.
 At point C in part
(b), there is an
inflationary gap.
 The money wage
rate starts to rise
and the SAS
curve starts to
shift leftward.

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The Multiplier and
the Price Level
 The money wage rate
will continue to rise
and the SAS curve
will continue to shift
leftward, until real
GDP equals potential
real GDP.
 In the long run, the
multiplier is zero.

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