The big picture marcoeconomics 12e parkin chapter 11

Other Influences on Consumption Expenditure and Saving A change in any other factor influencing consumption and saving besides disposable income such as the real interest rate, wealth, a

T h e B i g P i c t u r e

Where we have been:

Chapter 11 uses the background provided in Chapters 4 and 10 to focus on aggregate expenditure and aggregate demand It builds on the division of GDP

into C + I + G + (X – M) explained in Chapter 4 and then derives the

aggregate demand curve previously used in Chapter 10

Where we are going:

Chapter 11 examines the details of the AS-AD model by focusing on the factors that determine the AD curve The AD curve is important in all the core

short-run macroeconomic chapters The material in this chapter is used in Chapters 12-14 on the business cycle, fiscal policy, and monetary policy

N e w i n t h e Tw e l f t h E d i t i o n

The data in this chapter have been updated to reflect 2014 information The Economics In The News feature reports the BEA statistics for 2014 with economic analysis using the Aggregate Expenditure model The Mathematical Note now includes a short exercise at the end Using data on disposable income and

consumption expenditure, the Worked Problem shows the calculation and effect of the multiplier It also asks the students to use the multiplier to determine the effect an increase in autonomous expenditure has on real GDP To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems

1 1

EXPENDITURE

95

Expenditure Multipliers

components of aggregate expenditure, especially investment

expenditure

Historical background If you want to talk about Keynes and his contribution to

economics, this is probably the best place to do it

The model, now generally called the aggregate expenditure model, presented in this

section is the essence of Keynes General Theory According to Don Patinkin, a leading

historian of economic thought and Keynes scholar, the innovation of the General Theory was to replace price with income (GDP) as the equilibrating variable This version of the

model cannot be found in the General Theory, mainly because Keynes was writing before

the national income accounting system had been developed So he made up his own aggregates, based on employment and a money wage measure of the price level But the

words and equations of the General Theory can be translated readily into the textbook version of the model This version of the model first appeared in The Elements of

Economics, a textbook authored by Lorie Tarshis published in 1947 It was popularized by

Paul Samuelson in the first edition of his celebrated text published in 1948

The main difference between the Keynesian cross model of the 1940s and the aggregate expenditure model of today is that from the 1940s through the mid-1960s, economists believed that the fixed price level assumption was an acceptable (if not exactly accurate) description of reality, so the model was seen as actually determining real GDP, and the multiplier was seen as an empirically relevant phenomenon In contrast, today, we see the

model as part of the aggregate demand story The value of the model today—and it is valuable today and not, as some people claim, eclipsed by the AS-AD model and irrelevant

—is that it explains the multiplier that translates a change in autonomous expenditure into

a shift of the AD curve and it explains the multiplier convergence process that pulls the economy toward the AD curve (When an unintended change in inventories occurs, the economy is of the AD curve but moving toward it.)

I Fixed Prices and Expenditure Plans

The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services As a result, the price level is fixed and so aggregate demand determines real GDP

Expenditure Plans

 Aggregate planned expenditure is equal to planned consumption expenditure

plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports

planned exports are fixed Planned consumption expenditure and planned imports are not fixed, but depend on aggregate income An increase in real GDP increases aggregate expenditure and an increase in aggregate expenditure increases real GDP

Consumption Function and Saving Function

income, wealth, and expected future income Disposable income is aggregate

income minus taxes plus transfer payments The relationship between consumption expenditure and disposable income, other things remaining the same, is called the

consumption function The relationship between saving and disposable income,

other things remaining the same, is called the saving function.

 The figure shows a consumption function.

Along the 45 degree line, consumption

equals disposable income When the

consumption function is above the 45

degree line, there is dissaving When the

consumption function is below the 45

degree line, there is saving

disposable income is zero, $4 trillion in the

figure, is autonomous consumption.

Consumption expenditure in excess of this

amount is induced consumption.

The 45° line Don’t assume that your students immediately understand the 45° line!

Spend a bit of time explaining how to “read” it Fundamentally, it shows all points where x

= y This line happens to be a 45° line when the scales along the x-axis and the y- axis are the same Then point out that the horizontal distance to a point along the x-axis equals the vertical distance from that point to the 45° line So at all points along the 45° line, x = y If you wish, you can go on to show the students how the x = y line changes its appearance if

we stretch or squeeze the scale on the y-axis holding the scale on the x-axis constant Emphasize that x and y can be anything In the figure above, x is disposable income and y

is consumption expenditure; in the figure below, x is real GDP and y is aggregate planned

expenditure

Marginal Propensities to Consume and Save

consumption function, which is 0.67 in the figure

income that is saved, S/YD The MPS is the slope of the saving function

Marginal propensities The text defines the MPC and MPS, and shows that they sum to

one because disposable income can only be consumed or saved Students generally relate

to percentages better, so you can explain it as percent but stress that we use the decimal number for analytical purposes

Other Influences on Consumption Expenditure and Saving

A change in any other factor influencing consumption and saving besides disposable

income (such as the real interest rate, wealth, and expected future income) shifts the consumption function and the saving function An increase in wealth or expected future income and a decrease in the real interest rate increases consumption—and shifts the consumption function upward—and decreases saving—and shifts the saving function downward

wealth have shifted the consumption function upward

Consumption as a Function of Real GDP and the Import Function

changes, so consumption also is a function of real GDP We use this observation

when we derive the aggregate expenditure function

GDP, so do imports The marginal propensity to import is the fraction of an

increase in real GDP that is spent on imports

II Real GDP with a Fixed Price Level

Real

GDP

(Y)

Consumpti on expenditur e

(C)

Investme nt

(I)

Governme nt expenditur e

(G)

Export s

(X)

Import s

(M)

Aggregate planned expenditure

(AE=C+I+G+X

M)

(trillions of 2009 dollars)

Aggregate Planned Expenditure and Real GDP

sum of planned consumption expenditure

plus planned investment plus planned

government expenditure on goods and

services plus planned exports minus

planned imports The above table shows

the calculation of an aggregate planned

expenditure schedule The figure shows the

resulting AE curve.

vary with real GDP and are induced

expenditure The sum of investment,

government expenditures, and exports do

not vary with real GDP and are

autonomous expenditure Consumption

expenditure and imports also have an

autonomous component

sell what they plan to, in which case they have unplanned inventory investment For instance, a car that is manufactured but not immediately sold is part of that firm’s

actual inventory investment regardless of whether the firm planned to add it to

inventory or not

Equilibrium Expenditure and Convergence to the Equilibrium

 Equilibrium expenditure is the level of aggregate expenditure that occurs when

aggregate planned expenditure equals real GDP In the figure, equilibrium

expenditure is $12 trillion

For example, if real GDP exceeds aggregate planned expenditure, firms find their

inventories are increasing more than planned The unplanned inventory

accumulation leads firms to cut production so that real GDP decreases, which

decreases aggregate planned expenditures Real GDP still exceeds aggregate

planned expenditure, but by less than before The process continues until real GDP equals aggregate planned expenditure so that there is no unplanned inventory accumulation

III The Multiplier

magnified or multiplied to determine the change in equilibrium expenditure and real GDP

investment, additional changes in aggregate expenditure are set in motion Because

of the feedback between real GDP and consumption expenditure, the total change in real GDP is larger than the initial change in autonomous expenditure

expenditure

Work through an example of a change in government spending Suppose there are no taxes, no imports, no exports and the MPC is 0.9 If the government purchases $5 billion of weapons from Nuc’s-R-US, what happens to that spending? Nuc’s has to pay all of its

employees, subcontractors and material suppliers among other costs These costs to Nuc’s

turn into income (Y) for others (remind your students of the circular flow) These other

people are going to consume 90 percent of that income, $45 billion, at stores such as JCPenney Now JCPenney must pay its costs, which again turns into other people’s income,

of which 90 percent again gets spent again ($40.5 billion) and so on and so on and so on…

Explain to the students that we have a short-cut to explain this iterative process and

(1  MPC) × G

Why is the Multiplier Greater Than 1?

An increase in autonomous expenditure increases real GDP and the increase in real GDP induces an additional increase in aggregate expenditure (primarily an increase in

consumption expenditure) Each additional increase in aggregate expenditure increases real GDP further, leading to yet further increases in aggregate expenditure The process converges because the increase in aggregate expenditure is smaller at each step of the process

The Multiplier and the Marginal Propensities to Consume and Save

induced expenditures, and A is autonomous expenditure The slope of the AE curve

= N÷Y, so N = (slope of AE curve) Y Using this equality in the previous

1  slope of the AE curve  A This last result shows that the multiplier

equals 1

1  slope of the AE curve In the previous figure, the slope of the AE curve is

0.8, so the multiplier is 5.0

1  MPCor, equivalently,

1

MPS.

equivalently, the larger the MPS, the smaller the increase in expenditure at each

step of the multiplier process and so the smaller the multiplier

The basic idea and practice Students need quite a lot of practice using multipliers One

good problem involves working out the effects on consumption as well as on GDP of a

change in investment (when the price level is fixed) The best way to present this problem

to the students seems to be sequentially Begin by giving them the data necessary to

deduce how real GDP changes from an increase in investment Tell them there is no foreign trade, so that there are no exports or imports, and no income taxes Tell them that the

marginal propensity to consume is b (pick any valid number you like), and that investment

computed the change in GDP, ask them what the change in consumption expenditure is

Review their attempts to answer this question as follows: The change in GDP, Y, is given

by the equation:

Y = C + I Given I from the initial statement of the problem and Y from the first set of

calculations, the students can readily calculate C Focusing the students’ attention on the

change in consumption is important because it reinforces the point that a change in

autonomous expenditure (investment in this example) leads to an induced change in

consumption expenditure and that this increase in consumption expenditure is the source

of the multiplier

An Economics in Action detail analyzes the multiplier in the Great Depression The analysis concludes that the multiplier during that episode in history equaled 1.6

The Efect of Imports and Income Taxes on the Multiplier; Business Cycle Turning

Points

production will be smaller at each step of the multiplier process and so the multiplier

is smaller

unplanned inventories The buildup in inventories sets the multiplier process in

motion that decreases aggregate expenditure and real GDP so that a recession

follows

depletion of inventories The depletion in inventories sets the multiplier process in

motion and an expansion follows

The idea that prices are fixed, even in the very short run, is controversial in economics

However, the fact that changes in inventories have long been a good leading indicator of

business cycles is less controversial

IV The Multiplier and the Price Level

In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices But eventually they also change prices To study

the determination of the price level and real GDP the AS-AD model must be used The AD curve is related to the AE curve.

The Aggregate Expenditure Curve and the Aggregate Demand Curve

GDP, all other influences (such as the price level) remaining the same The AD curve

is the relationship between the aggregate quantity of goods and services demanded

and the price level When the price level changes, the AE curve shifts and there is a movement along the AD curve.

consumers’ real wealth, which decreases their consumption expenditures

expensive relative to the future (an intertemporal substitution effect) It also makes U.S goods and services more expensive relative to imports (an

international substitution effect)

The multiplier and the price level: Emphasize the key point of this section: That the AE model and the multiplier tell us how far the AD curve shifts when autonomous expenditure changes It is through the multiplier process that expenditure and GDP respond to

unplanned changes in inventories I like to draw out the model with AE curve on top and the AD and AS curves on the bottom Then:

level constant

Ask the students, “Will the economy get the full change in Y?” They will see that in that the upward sloping SAS curve means that there is an increase in the price level, lowering the

multiplier effect

AE curve).

Now ask them, “How big is the multiplier in the long run?” You should be able to get a few

to mumble “Zero”

So, tell them the conclusion: There is no multiplier in the long run! If the long run is not so

long, then it is questionable to increase G in order to increase Y Students appreciate

learning about the tension in economics surrounding this issue since it relates well with politics too

The mechanics of the relationship between the AE and AD curves Students need a

lot of help and clear explanation of the mechanics of the link between these two curves Here’s what to stress:

1 The AE curve shows how aggregate planned expenditure depends on real GDP (through

the effects of disposable income), other things remaining the same

2 The AD curve shows how equilibrium aggregate expenditure depends on the price level,

other things remaining the same

The next two points are really hard for students:

3 A change in the price level changes autonomous expenditure, which shifts the AE

curve, generates a new level of equilibrium expenditure, and creates a new point on the

AD curve.

4 A change in autonomous expenditure at a given price level shifts the AE curve,

generates a new level of equilibrium expenditure, and shifts the AD curve by an

amount equal to the change in autonomous expenditure multiplied by the multiplier

 The wealth effect and the substitution effects show that a rise in the price level

decreases consumption expenditure So, as shown in the figure below to the left, a

rise in the price level from 120 to 140 decreases aggregate planned expenditure and

shifts the AE curve downward from AE 0 to AE1 In the figure, equilibrium expenditure decreases to $14 trillion

140, there is a movement along the AD curve from point a to point b The aggregate

quantity of real GDP demanded decreases from $16 trillion (which is the initial

equilibrium expenditure in the AE diagram to the left) to $14 trillion (which is the

new equilibrium expenditure along AE1 in the AE diagram to the left)

AD curve also shifts For instance, an increase in autonomous expenditures shifts the

AE curve upward and increases equilibrium expenditure by a multiplied amount In

this case, the AD curve shifts rightward and the amount of the rightward shift is

equal to the increase in equilibrium expenditure

expenditure increases so that the AD

curve shifts rightward The multiplied

increase in autonomous expenditure has

created a $2 trillion increase in

equilibrium expenditure, so the AD curve

shifts rightward by $2 trillion (which

equals the length of the double headed

arrow) from AD0 to AD1

Equilibrium Real GDP and the Price Level

aggregate supply determine the

equilibrium price level and real GDP

raises the price level and increases real GDP In the figure to the right, the

increase in aggregate demand and rightward shift of the aggregate demand

curve from AD0 to AD1 creates a movement from point a to point b so that the

price level rises from 120 to 130 and real GDP increases from $13 trillion to $14 trillion

 The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate

planned expenditure In terms of the AE curve, the increase in the price level shifts the AE curve downward

 Because the actual increase in real GDP is less than the initial increase in

equilibrium expenditure, the multiplier is smaller once price level effects are taken into account The more that the price level changes (that is, the steeper

the SAS curve), the smaller the multiplier in the short run.

the money wage rate rises, which decreases the short-run aggregate supply and

shifts the SAS curve leftward The economy moves along the AD curve so that the

price level rises and real GDP decreases

shift in the SAS curve is not illustrated in order to simplify the figure.) The price

level rises from 130 to 140 and real GDP decreases from $14 trillion back to potential GDP of $13 trillion

expenditure In terms of the AE curve, the AE curve shifts downward and

eventually returns to its initial level As a result, the long-run multiplier is equal

to zero

It is important to emphasize that the aggregate expenditure model is not without

connection to the AS-AD model Point out to the students that the AE model provides the underpinnings for the AD curve in the AS-AD model used throughout macroeconomics That is, the students can now understand why the AD curve shifts, why it is downward sloping, and why changes in the price level lead to movements along the AD curve.

It may be a good time to remind students that, just as the Keynesian AE model provides underpinnings for the AD curve, the labor market/aggregate production function model

discussed in Chapter 6 provides underpinnings for the long-run aggregate supply curve Thus, the mechanics of the model have not changed, but the students now have a deeper understanding of the forces behind those mechanics

The Economics in the News section studies expenditure changes in the 2014 expansion It analyzes the growth during the second quarter in terms of the aggregate expenditure model It focuses on which changes in autonomous expenditure were responsible for

increasing aggregate expenditure and hence real GDP