Expenditure Multipliers: The

Keynesian Model
Chapter 27
Main ideas
After studying this chapter, you will be able to:
•Explain how planned expenditure is determined when the price level is fixed
•Explain and illustrate how real GDP is determined when the price level is fixed
•Calculate the values of the various expenditure components when the price
level is fixed
•Explain, illustrate and calculate the expenditure multiplier when the price
level is fixed
•Explain the relationship between aggregate expenditure and aggregate
demand and explain the multiplier when the price level changes

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Fixed Prices and Planned Expenditure
• Because each firm’s prices are fixed for the economy as a whole:
1. The price level is fixed, and
2. Aggregate demand determines real GDP
• The Keynesian model explains fluctuations in aggregate demand at a fixed
price level by identifying the forces that determine planned expenditure
Planned Expenditure
• Aggregate expenditure has four components: consumption expenditure,
investment, government expenditure on goods and services, and net
exports (exports minus imports)
• Aggregate planned expenditure is equal to the sum of the planned levels of
consumption expenditure, investment, government expenditure on goods
and services and exports minus imports
A Two-Way Link Between Aggregate Expenditure and Real GDP
• There is a two-way link between aggregate expenditure and real GDP:
• An increase in real GDP increases aggregate expenditure, and
• An increase in aggregate expenditure increases real GDP

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Fixed Prices and Planned Expenditure
Consumption and Planned Saving
• Several factors influence planned consumption
expenditure and saving – the more important
ones are:
1. Disposable income
2. Real interest rate
3. Wealth
4. Expected future income
Consumption Expenditure and Saving
• The relationship between consumption expenditure
and disposable income, is called the consumption
function
• The relationship between saving and disposable income is called the saving
function
45° Line
• At each point on this line, consumption expenditure = disposable income
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Fixed Prices and Planned Expenditure
Saving Function
• As disposable income increases, saving increases
Marginal Propensities to Consume and Save
• The marginal propensity to consume (MPC) is the fraction of a change in
disposable income that is spent on consumption
• The marginal propensity to save (MPS) is the fraction of a change in
disposable income that is saved

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Fixed Prices and Planned Expenditure
Slopes and Marginal Propensities
• The slope of the consumption function is the marginal propensity to
consume and the slope of the saving function is the marginal propensity to
save
Consumption as a Function of Real GDP
• Consumption expenditure changes when disposable income changes and
disposable income changes when real GDP changes
Import Function
• South Africa’s real GDP is the main influence on imports in the short run –
an increase in real GDP increases the quantity of South African imports
• The relationship between imports and real GDP is determined by the
marginal propensity to import, which is the fraction of an increase in real
GDP that is spent on imports
• It is calculated as the change in imports divided by the change in real GDP

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Real GDP with a Fixed Price Level
Aggregate Planned Expenditure:
• The relationship between aggregate planned The AE Curve

expenditure and real GDP can be described by

an aggregate expenditure schedule or curve
• The schedule lists aggregate planned
expenditure generated at each level of real
GDP while the curve is a graph of the
aggregate expenditure schedule
• Induced expenditure – consumption
expenditure minus imports
• The sum of investment, government expenditure and exports, which
does not vary with real GDP, is called autonomous expenditure
Actual Expenditure, Planned Expenditure and Real GDP
• Actual aggregate expenditure is always equal to real GDP but aggregate
planned expenditure is not always equal to actual aggregate expenditure
and therefore is not always equal to real GDP – this is because firms can
end up with inventories that are greater or smaller than planned
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Real GDP with a Fixed Price Level
Equilibrium Expenditure
• Equilibrium expenditure is the level of aggregate expenditure that occurs
when aggregate planned expenditure equals real GDP
Convergence to Equilibrium

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The Multiplier
• The amount by which a change in autonomous expenditure is magnified or
multiplied to determine the change in equilibrium expenditure and real GDP
The Basic Idea of the Multiplier
• See figure 27.5
The Multiplier Effect
• The change in autonomous expenditure leads to
an amplified change in equilibrium expenditure
• Equilibrium expenditure increases by more than
the increase in autonomous expenditure
Why is the Multiplier Greater Than 1?
• Because induced expenditure increases – an
increase in autonomous expenditure induces
further increases in expenditure
The Size of the Multiplier
• To calculate the multiplier, we divide the change in equilibrium expenditure
by the change in autonomous expenditure
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The Multiplier
The Multiplier and the Slope of the AE Curve
•The magnitude of the multiplier depends on the slope of the AE curve
Imports and Income Taxes
•Make the multiplier smaller than it
•Otherwise would be
•Imports – the increase in investment
increases real GDP, which in turn
increases consumption expenditure
– but part of the increase in
expenditure is on imported goods
and services.
•Only expenditure on South African-produced goods and services increases
South Africa’s real GDP. The larger the marginal propensity to import, the
smaller is the change in South Africa’s real GDP

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The Multiplier
• Income taxes – The increase in investment increases real GDP. Income tax
payments increase so disposable income increases by less than the
increase in real GDP and consumption expenditure increases by less than it
would if taxes had not changed. The larger the income tax rate, the smaller
is the change in real GDP
• The Multiplier Process

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The Multiplier
Business Cycle Turning Points
• At business cycle turning points, the economy moves from expansion to
recession or from recession to expansion
Adjusting Quantities and Prices
• When firms cannot keep up with sales and their inventories fall below
target, they increase production, but at some point, they raise their prices
Similarly, when firms find unwanted inventories piling up, they decrease
production, but eventually they cut their prices
Aggregate Expenditure and Aggregate Demand
• The aggregate expenditure curve is the relationship between the aggregate
planned expenditure and real GDP
• The aggregate demand curve is the relationship between the aggregate
quantity of goods and services demanded and the price level
Deriving the Aggregate Demand Curve
• When the price level changes, aggregate planned expenditure changes and
the quantity of real GDP demanded changes
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The Multiplier
• The aggregate demand curve slopes downward for two main reasons:
Wealth Effect
• The higher the price level, the smaller is the purchasing power of wealth
Substitution Effects
• For a given expected future price level, a rise in the price level today makes
current goods and services more expensive relative to future goods and
services and results in a delay in purchases – an intertemporal substitution

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The Multiplier
Changes in Aggregate Expenditure and Aggregate Demand
• When any influence on aggregate planned expenditure other than the price
level changes, both the aggregate expenditure curve and the aggregate
demand curve shift

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The Multiplier
Equilibrium Real GDP and the Price Level
An Increase in Aggregate Demand in the Short Run and in the Long
Run

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