28 EXPENDITURE
MULTIPLIERS
After studying this chapter, you will be able to:
Explain how expenditure plans are determined when
the price level is fixed
Explain how real GDP is determined when the price
level is fixed
Explain the expenditure multiplier
Explain the relationship between aggregate
expenditure and aggregate demand
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Fixed Prices and Expenditure Plans
The 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?
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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.
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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, YD, 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.
Figure 28.1 illustrates the consumption function and the
saving function.
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Fixed Prices and Expenditure Plans
When consumption expenditure
exceeds disposable income,
saving is negative (dissaving).
When consumption expenditure is
less than disposable income, there
is saving.
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Fixed Prices and Expenditure Plans
Marginal Propensities to Consume and Save
The marginal propensity to consume (MPC) is the
fraction of a change in disposable income spent on
consumption.
It is calculated as the change in consumption expenditure,
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 28.2(a) shows that
the MPC is the slope of the
consumption function.
When disposable income
increases by $2 trillion, …
consumption expenditure
increases by $1.5 trillion.
The MPC is 0.75.
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Fixed Prices and Expenditure Plans
The marginal propensity to save (MPS) is the fraction of
a change in disposable income that is saved.
It is calculated as the change in saving, DS, divided by the
change in disposable income, DYD, that brought it about.
That is,
MPS = DS ÷ DYD.
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Fixed Prices and Expenditure Plans
Figure 28.2(b) shows that
the MPS is the slope of the
saving function.
When disposable income
increases by $2 trillion, …
saving increases by
$0.5 trillion.
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.
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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.
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Fixed Prices and Expenditure Plans
Import Function
In the short run, U.S. imports are influenced primarily by
U.S. real GDP.
The marginal propensity to import is 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 0.25.
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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.
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Real GDP with a Fixed Price Level
Aggregate Planned Expenditure
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
Figure 28.3 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, which varies with
real GDP, is induced expenditure.
The sum of investment, government expenditure, and
exports, which does not vary with GDP, is autonomous
expenditure.
(Consumption expenditure and imports can have an
autonomous component.)
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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 28.4 illustrates
equilibrium expenditure.
Equilibrium occurs at the point
at which the AE curve crosses
the 45° line in part (a).
Equilibrium occurs when there
are no unplanned changes in
business inventories in part (b).
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Real GDP with a Fixed Price Level
Convergence to Equilibrium
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.
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Real GDP with a Fixed Price Level
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.
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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.
And firms maintain their current
production.
Real GDP remains constant.
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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.
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.
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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 28.5 illustrates
the multiplier.
An increase in
autonomous expenditure
brings an unplanned
decrease in 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.
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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).
Now replace DN in the first equation
DY = (Slope of AE curve x DY) + DA.
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The Multiplier
DY = (Slope of AE curve x DY) + DA
Re-arrange as
(1 - Slope of AE curve) x DY = DA
and
DY = DA ÷ (1 - Slope of AE curve).
Multiplier = DY ÷ DA
So Multiplier = 1 ÷ (1 - Slope of AE curve)
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The Multiplier
With the numbers in Figure 28.5:
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.
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The Multiplier
Imports and Income
Taxes
Both imports and income
taxes reduce the size of
the multiplier.
Figure 28.6 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
Imports and Income
Taxes
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
The Multiplier Process
Figure 28.7 illustrates
the multiplier process.
The MPC determines
the amount of induced
expenditure at each
round (green bar) as
aggregate expenditure
moves toward
equilibrium expenditure.
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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
unplanned decrease in inventories, which triggers an
expansion.
A decrease in autonomous expenditure brings an
unplanned increase in inventories, which triggers a
recession.
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The Multiplier and the Price Level
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.
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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.
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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 28.8 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.
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The Multiplier and
the Price Level
In Figure 28.8(a), a rise in
price level from 110 to 130 …
shifts the AE curve from AE0
downward to AE1 and …
decreases the equilibrium
expenditure from
$20 trillion to $19 trillion.
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The Multiplier and
the Price Level
In Figure 28.8(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.
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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
$20 trillion to $21 trillion.
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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.
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The Multiplier and
the Price Level
Points A, B, and C on the
AD curve correspond to the
equilibrium expenditure
points A, B, and C at the
intersection of the AE curve
and the 45° line.
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The Multiplier and
the Price Level
Changes in Aggregate
Expenditure and Aggregate
Demand
Figure 28.9 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 28.10 shows the
effect of an increase in
investment in the short run
when the price level
changes.
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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 $22 trillion 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 $21.3 trillion…
As the price level rises, real
GDP increases along the
SAS curve to $21.3 trillion.
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 28.11 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 GDP.
In the long run, the
multiplier is zero.
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