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Aggregate Expenditure Model

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A model that explains what determines the quantity of real GDP demanded and changes in that quantity at a given price level

*Also known as the Keynesian Model

*Also known as the Keynesian Model

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Aggregate Planned Expenditure

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The sum of the spending plans of households, firms, and governments (autonomous and induced)

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Autonomous Expenditure

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1) Does not respond to changes in real GDP

2) Is seen as the y-intercept on the consumption function

3) Consists of investment, government expenditure on goods and services, exports, and autonomous consumption expenditure

*Investment responds to the real interest rate and expected profits; government expenditures respond to policy priorities; exports depend on global demand

2) Is seen as the y-intercept on the consumption function

3) Consists of investment, government expenditure on goods and services, exports, and autonomous consumption expenditure

*Investment responds to the real interest rate and expected profits; government expenditures respond to policy priorities; exports depend on global demand

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Induced Expenditure

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1) Does respond to changes in real GDP

2) Equals consumption expenditure minus imports

3) Consumption expenditure increases when disposable income increases, which increases aggregate income (real GDP minus net taxes), and increases imports; therefore, an increase in real GDP brings a larger increase in consumption expenditure than in imports, and induced expenditures increase as real GDP increases

2) Equals consumption expenditure minus imports

3) Consumption expenditure increases when disposable income increases, which increases aggregate income (real GDP minus net taxes), and increases imports; therefore, an increase in real GDP brings a larger increase in consumption expenditure than in imports, and induced expenditures increase as real GDP increases

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Consumption Function

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The relationship between consumption expenditure and disposable income, other things remaining the same

*Disposable income is aggregate income (GDP) minus net taxes (taxes - transfers; saving vs. consumption is a tradeoff

*Disposable income is aggregate income (GDP) minus net taxes (taxes - transfers; saving vs. consumption is a tradeoff

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Consumption Plans

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1) As disposable income increases, planned consumption expenditure increases (less than the change in disposable income)

2) The consumption functions uses a 45˚ line for reference; when consumption expenditure exceeds disposable income (above the line) saving is negative, which is called dissaving; when consumption expenditure is less than disposable income (below the line), saving is positive; when consumption expenditure is equal to disposable income (on the line), saving is zero

*When consumption expenditure exceeds disposable income, past savings are used to pay for current consumption (this cannot last forever, but it will occur if disposable income falls temporarily)

2) The consumption functions uses a 45˚ line for reference; when consumption expenditure exceeds disposable income (above the line) saving is negative, which is called dissaving; when consumption expenditure is less than disposable income (below the line), saving is positive; when consumption expenditure is equal to disposable income (on the line), saving is zero

*When consumption expenditure exceeds disposable income, past savings are used to pay for current consumption (this cannot last forever, but it will occur if disposable income falls temporarily)

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Marginal Propensity to Consume (MPC)

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The fraction of a change in disposable income that is spent on consumption (∆ consumption ÷ ∆ disposable income)

*MPC represents the slope of the consumption function

*MPC represents the slope of the consumption function

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Influences on Consumption Expenditure

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1) Real Interest Rate

- When the real interest rate falls, consumption expenditure increases (and saving decreases), and when the real interest rate rises, consumption expenditure decreases (and saving increases)

2) Wealth

- When wealth decreases, consumption expenditure also decreases, and when wealth increases, consumption expenditure also decreases

3) Expected Future Income

- When expected future income decreases, consumption expenditure also decreases, and when expected future income increases, consumption expenditure also decreases

*Increase = shift upward (e.g. stock market boom); Decrease = shift downward (e.g. stock market crash)

- When the real interest rate falls, consumption expenditure increases (and saving decreases), and when the real interest rate rises, consumption expenditure decreases (and saving increases)

2) Wealth

- When wealth decreases, consumption expenditure also decreases, and when wealth increases, consumption expenditure also decreases

3) Expected Future Income

- When expected future income decreases, consumption expenditure also decreases, and when expected future income increases, consumption expenditure also decreases

*Increase = shift upward (e.g. stock market boom); Decrease = shift downward (e.g. stock market crash)

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Imports and Real GDP

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Because an increase in real GDP is also an increase in income, as income increases, people increase their expenditures on most goods and services, including imported goods/services

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Marginal Propensity to Import (MPI)

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The fraction of an increase in real GDP that is spent on imports ( ∆ imports ÷ ∆ real GDP)

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Graphing Aggregate Expenditure

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Schedule/graph of the relationship between aggregate planned expenditure and real GDP

*Composed of C + I + G + X - M; I, G, and X will remain constant with changes in real GDP

*Composed of C + I + G + X - M; I, G, and X will remain constant with changes in real GDP

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Equilibrium Expenditure

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Occurs when aggregate planned expenditure equals real GDP (at the intersection with the 45˚ line)

* If real GDP is less than the point on the 45˚ line, aggregate planned expenditure exceeds real GDP; if real GDP is greater than the point on the 45˚ line, aggregate planned expenditure is less than real GDP

Y = C + I + G

* If real GDP is less than the point on the 45˚ line, aggregate planned expenditure exceeds real GDP; if real GDP is greater than the point on the 45˚ line, aggregate planned expenditure is less than real GDP

Y = C + I + G

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Convergence to Equilibrium

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1) When real GDP is below equilibrium, and aggregate planned expenditure exceeds real GDP, firms experience an unplanned decrease in inventories equal to the difference between real GDP and equilibrium (investment) so they increase production

2) When real GDP is above equilibrium, and aggregate planned expenditure is below real GDP, firms experience an unplanned pileup of inventories equal to the difference between real GDP and equilibrium (investment) so they cut production

*There are no unplanned inventory changes at equilibrium

2) When real GDP is above equilibrium, and aggregate planned expenditure is below real GDP, firms experience an unplanned pileup of inventories equal to the difference between real GDP and equilibrium (investment) so they cut production

*There are no unplanned inventory changes at equilibrium

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Say's Law

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Jean-Baptiste Say wrote the Treatise on Political Economy and claimed that supply creates its own demand (i.e. the real wage rate adjusts to ensure that the quantity of labor demanded equals the quantity of labor supplied and real GDP equals potential GDP)

*Saving equals income minus consumption expenditure; equilibrium real interest rate ensures that consumption expenditure plus investment exactly equals potential GDP

*Saving equals income minus consumption expenditure; equilibrium real interest rate ensures that consumption expenditure plus investment exactly equals potential GDP

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Keynes' Principle of Effective Demand

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John Maynard Keynes disagreed with Say and said that effective demand determines real GDP

*If businesses spend less on new capital than the amount that people save, equilibrium expenditure will be less than potential GDP (leading to indefinite unemployment)

*If businesses spend less on new capital than the amount that people save, equilibrium expenditure will be less than potential GDP (leading to indefinite unemployment)

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Expenditure Multiplier

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Determines the amount by which a change in any component of autonomous expenditure is magnified to determine the change in equilibrium expenditure and real GDP that it generates

*Increase in investment increases real GDP, which increases disposable income and consumption expenditure which adds to the increase in investment

*Equilibrium expenditure is when aggregate planned expenditure equals real GDP

*Increase in investment increases real GDP, which increases disposable income and consumption expenditure which adds to the increase in investment

*Equilibrium expenditure is when aggregate planned expenditure equals real GDP

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Size of the Multiplier

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1) Multiplier = ∆ equilibrium expenditure ÷ ∆ autonomous expenditure

2) Multiplier = ∆Y ÷ ∆I

*Multiplier is greater than one because an increase in autonomous expenditure induces further increases in aggregate expenditure (induced expenditure increases)

- Investment = jobs = income = expenditure = income...

2) Multiplier = ∆Y ÷ ∆I

*Multiplier is greater than one because an increase in autonomous expenditure induces further increases in aggregate expenditure (induced expenditure increases)

- Investment = jobs = income = expenditure = income...

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Multiplier and MPC

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*Ignoring imports and income taxes, the magnitude of the multiplier depends on the marginal propensity to consume

∆Y = ∆C + ∆I

With no income taxes, ∆C = MPC x ∆Y

∆Y = MPC x ∆Y + ∆I

(1-MPC) x ∆Y = ∆I

∆Y = 1/(1-MPC) x ∆I

Multiplier = ∆Y/∆I = 1/(1-MPC)

The greater the marginal propensity to consume, the larger is the multiplier

∆Y = ∆C + ∆I

With no income taxes, ∆C = MPC x ∆Y

∆Y = MPC x ∆Y + ∆I

(1-MPC) x ∆Y = ∆I

∆Y = 1/(1-MPC) x ∆I

Multiplier = ∆Y/∆I = 1/(1-MPC)

The greater the marginal propensity to consume, the larger is the multiplier

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The Multiplier, Imports, and Income Taxes

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1) When an increase in investment increases consumption and real GDP, part of the increase in expenditure is on imports, not U.S. produced goods and services (does not increase real GDP)

*The larger the marginal propensity to import, the smaller is the multiplier

2) When an increase in investment increases real GDP, income tax payments increase so disposable income increases by less than the increase in real GDP, which means that consumption expenditure increases by less than it would if income taxes had not been changes

*The larger the marginal propensity to import, the smaller is the multiplier

2) When an increase in investment increases real GDP, income tax payments increase so disposable income increases by less than the increase in real GDP, which means that consumption expenditure increases by less than it would if income taxes had not been changes

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Marginal Tax Rate

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The fraction of a change in real GDP that is paid in income taxes; the larger the marginal tax rate, the smaller are the changes in disposable income and real GDP that result from a given change in autonomous expenditure

*Marginal propensity to import, marginal tax rate, and marginal propensity to consume determine the multiplier, and combine to determine the MPC

*Marginal propensity to import, marginal tax rate, and marginal propensity to consume determine the multiplier, and combine to determine the MPC

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Business Cycle Turning Points

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1) When an expansion is triggered by an increase in autonomous expenditure, aggregate planned expenditure exceeds real GDP; firms' inventories take an unplanned dive, so production is increased, which brings higher incomes- the multiplier process restores equilibrium

2) When a recession is triggered by a decrease in autonomous expenditure, real GDP exceeds aggregate planned expenditure; firms' inventories pile up, so production is cut, which brings lower income- the multiplier process restores equilibrium

2) When a recession is triggered by a decrease in autonomous expenditure, real GDP exceeds aggregate planned expenditure; firms' inventories pile up, so production is cut, which brings lower income- the multiplier process restores equilibrium

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Magnitude of the Government Expenditure Multiplier

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1) Christina Romer (Chair of the President's Council of Economic Advisors (estimated the multiplier at 1.6)

2) Robert Barro (Harvard) found the multiplier to be 0.8 due to crowding out effects (decreased real GDP)

3) John Taylor (Stanford) says that crowding out gets more severe as time passes, so the multiplier gets smaller and smaller every year

2) Robert Barro (Harvard) found the multiplier to be 0.8 due to crowding out effects (decreased real GDP)

3) John Taylor (Stanford) says that crowding out gets more severe as time passes, so the multiplier gets smaller and smaller every year

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Deriving the AD Curve from Equilibrium Expenditure

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1) AE curve is the relationship between aggregate planned expenditure and real GDP when all other influences on expenditure plans remain the same (a movement along the AE curve arises from a change in real GDP)

2) AD curve is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same (a movement along the AD curve arises from a change in the price level)

3) When the price level rises, other things remaining the same, aggregate planned expenditure decreases, and equilibrium expenditure decreases (shifts AE downward)

4) When the price level falls, other things remaining the same, aggregate planned expenditure increases, and equilibrium expenditure increases (shifts AE upward)

*Movement along one curve causes a shift of the other

2) AD curve is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same (a movement along the AD curve arises from a change in the price level)

3) When the price level rises, other things remaining the same, aggregate planned expenditure decreases, and equilibrium expenditure decreases (shifts AE downward)

4) When the price level falls, other things remaining the same, aggregate planned expenditure increases, and equilibrium expenditure increases (shifts AE upward)

*Movement along one curve causes a shift of the other