Lecture Macroeconomics - Chapter 8: Building the aggregate expenditure model

Chapter 8 - Building the aggregate expenditure model. In this chapter you will learn: The factors that determine consumption expenditure and saving, the factors that determine investment spending, how equilibrium GDP is determined in a closed economy without a government sector, about the effects of the multiplier on changes in equilibrium GDP,…

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 1

Building the Aggregate

Expenditure Model

Chapter 8

SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

In this chapter you will learn

The factors that determine consumption

expenditure and saving

The factors that determine investment

spending

How equilibrium GDP is determined in a

closed economy without a government

sector

About the effects of the multiplier on

changes in equilibrium GDP

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 3

In this chapter you will learn

How international trade affects

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 5

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 7

Tools of the AE Model

the amount of goods & services

produced & therefore the level of

employment depend directly on the

level of aggregate expenditures

(total spending)

assume excess production capacity

& unemployed labour

price level is constant

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 9

Consumption & Saving

The Consumption Schedule

The Saving Schedule

S = DI - C

Consumption & Saving

APC = consumption

income APS = saving

income

MPC = change in consumption

change in income MPS = change in saving

change in income

APC + APS = 1

MPC + MPS = 1 MPC + MPS = 1

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 11

(1)

GDP

(=DI)

(2) C

(3) S (1)-(2)

(4) APC (2)/(1)

(5) APS (3)/(1)

(6) MPC

)

(7) MPS

375/370 = 1.01 1.01

1.00 99 98 97 96 95 94 93

-5/370 = -.01 -.01

.00 01 02 03 04 05 06 07

15/20= 75 75

.75 75 75 75 75 75 75 75

5/20 = 25 .25

.25 25 25 25 25 25 25 25

Table 8-1

Saving schedule

Disposable Income

Disposable Income

SAVING

SAVING DISSAVING

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 13

45 o

C

C1

An increase in consumption

A decrease

45 o

C

C2

A decrease in consumption

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 17

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 19

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

The Real Interest Rate

Investment Demand Curve

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 21

Investment (billions of dollars)

Investment demand curve

5 10 15 20 25 30 35 40

ID

Figure 8-5

Shifts in the ID Curve

Acquisition, Maintenance &

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 23

Investment Schedule

the relationship between

investment & GDP (DI)

assume planned investment is

independent of the level of current

disposable income or real output

Investment (billions of dollars)

Investment demand curve

5 10 15 20 25 30 35 40

ID

Figure 8-7a

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 25

Figure 8-7b

Ig

Fluctuations of Investment

Durability of Capital & the

Variability of Expectations

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 27

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

Equilibrium GDP

The equilibrium output is that

output the production of which

creates total spending just

sufficient to purchase that output

No overproduction

No draw down of inventories

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 29

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 31

unplanned inventory change is the difference between production &

AE

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 33

down, production will

increase

when inventories run

down, production will

increase

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 35

employment

s

tendency of output

employment

s

tendency of output

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 37

employment

s

tendency of output

370 390 410 430 450 470 490 510 530

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 39

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

Other Features of Equilibrium GDP

Savings equals Planned

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 41

Other Features of Equilibrium GDP

No Unplanned Changes in

Inventories

investment

inventories are considered, investment & savings are always equal, at any level of GDP

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 43

Changes in Equilibrium GDP &

the Multiplier

a $5 billion increase of investment

will shift the AE schedule upward

billion to $490 billion (an increase of

more than $5 billion)

illustrated…

Figure 8-9

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 45

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 47

The Multiplier Effect

in spending

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 49

The Multiplier Effect

spending generates income

change in income will cause both

consumption & saving to change

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 51

(1) income

(2) C (MPC=.75)

(3) S (MPS=.25)

(1) income

(2) C (MPC=.75)

(3) S (MPS=.25)

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 53

(1) income

(2) C (MPC=.75)

(3) S (MPS=.25)

(1) income

(2) C (MPC=.75)

(3) S (MPS=.25)

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 55

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 57

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

International Trade & Equilibrium

Output

Net Exports & Aggregate

Expenditures

production, income & employment

services produced abroad

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 59

Determinants of Net Exports

if GDP in other countries is growing,

demand for our exports will increase

our imports are dependent on our own

GDP

both imports & exports are affected by

the exchange rate

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 61

Open-Economy Multiplier

spending on imports is another

leakage

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 63

The impact of net exports on equilibrium GDP

Equilibrium GDP is unchanged

Net Exports & Equilibrium GDP

figures chosen in the example have

a neutral effect on equilibrium GDP

not necessarily the case

illustrated…

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 65

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 67

Net Exports & Equilibrium GDP

A decline in net exports decreases

aggregate expenditures & reduces

GDP

A rise in net exports increases

aggregate expenditures &

increases GDP

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 69

International Economic Linkages

Prosperity Abroad

Tariffs

Exchange Rates

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 71

Adding the Public Sector

Adding the Public Sector

increases in public spending shift

the AE schedule upward & result in

higher equilibrium GDP

G=$4 0

Impact of $40 billion in government

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 75

Taxation & Equilibrium GDP

suppose government imposes a

lump-sum tax of $40 billion

Disposable income decreases because of the

tax

Investment

& exports

are unchanged

Government spending is unchanged

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 83

GDP (billions of dollars)

510 550

470

$40 billion lump sum personal taxes

net effect: a reduction of $20 billion in AE

470

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 85

Balanced Budget Multiplier

equal increases in G & T increase

equilibrium GDP

government spending has a direct

impact on AE

taxes affect AE indirectly through DI

the balanced budget multiplier is 1

Balanced Budget Multiplier

increase G by $40 billion

increase T by $40 billion

equilibrium AE increases by $40

billion

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 87

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP

Equilibrium vs Full-Employment

GDP

equilibrium GDP may or may not

provide full employment

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 89

Real GDP (billions of dollars)

Recessionary gap — When aggregate expenditures are inadequate to bring about full employment

Real GDP (billions of dollars)

Recessionary Gap = $20 billion

Recessionary gap — When aggregate expenditures are inadequate to bring about full employment

Figure 8-16

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 91

Inflationary gap — When aggregate expenditures are greater than the full employment level causing demand-pull inflation

Figure 8-16

Inflationary gap — When aggregate expenditures are greater than the full employment level causing demand-pull inflation

Inflationary Gap = $20 billion

20

Figure 8-16

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 93

Applications of the Model

The End of the Japanese Growth

“Miracle”

Limitations of the Model

The model does not show

price-level changes

The model does not deal with

cost-push inflation

© 2002 McGraw-Hill Ryerson Ltd Macroeconomics, Chapter 8 95

Chapter 8 Topics

Simplifications

Tools of the Aggregate Expenditures Model

Consumption & Saving

Investment

Equilibrium GDP

Other Features of Equilibrium GDP

Changes in Equilibrium GDP & the Multiplier

International Trade & Equilibrium Output

Adding the Public Sector

Equilibrium vs Full-Employment GDP