Chapter 21
AGGREGATE EXPENDITURE
and
EQUILIBRIUM OUTPUT
Mrs. Eskra
AE Model:
John Maynard Keynes
Keynes’ model
considers all spending
in the economy
(consumer, business,
and government
spending).
Y* = Current level of
production (real GDP)
Y axis: AE (C+I+G)
X axis: Real GDP
45 degree line: shows
where these two are equal.
AE: At Full Employment
Y* = Current level of
production (real GDP)
It’s WHERE WE ARE.
FE = Level of spending
that would get us to full
employment.
It’s WHERE WE WANT TO BE!
On this graph, you can see that we are in equilibrium
at full employment.
This means that unemployment is right around 5%.
AE: Below Full Employment
(Recession)
Y* = Current level of
production (real GDP)
It’s WHERE WE ARE.
FE = Level of spending
that would get us to full
employment.
It’s WHERE WE WANT TO BE!
On this graph, you can see that we are in equilibrium below full
employment.
This means that people are not spending enough money for our
economy to be fully employed.
Unemployment is greater than 5%, and we are in a recession.
AE: Beyond Full Employment
(Inflation)
Y* = Current level of
production (real GDP)
It’s WHERE WE ARE.
FE = Level of spending
that would get us to full
employment.
It’s WHERE WE WANT TO BE!
On this graph, you can see that we are in equilibrium beyond full
employment.
This means that people are spending too much money too quickly,
and our economy is “overheated.”
Unemployment is temporarily less than 5%, and we are
experiencing inflation.
Expansionary Fiscal Policy:
Multiplier Effect
Y=C+I+G
• If the government increases spending, this
could have a multiplied effect by encouraging
greater consumer and business spending (C & I
as well).
– Say I get hired as government employee as a result
of increased spending.
– I now have money to go out and spend in
restaurants, on vacations, etc.
– Those places of business will now have more
money to pay their workers, and those workers will
in turn have more money to spend elsewhere!
Expansionary Fiscal Policy:
Multiplier Effect
Y=C+I+G
• How much will the multiplied effect be?
– It really depends on how much I am going to
spend versus save my new income.
– If I save it all, I will create no multiplied effect
in the economy.
– The more I spend, the greater the multiplied
effect.
Multiplier Effect:
Consumption Multiplier
• Here’s how we find the potential multiplied
effect:
Consumption Multiplier = 1/(1-MPC)
MPC = consumers’ marginal propensity to
consume (% of all income that is being spent in
the economy).
Multiplier Effect:
Consumption Multiplier
• Say the government wants to increase GDP.
They spend $10 billion on new programs.
The MPC is 0.75. What overall effect will
this have on the economy?
– What does this MPC of .75 tell us?
Economy-wide: People will spend 75%
of additional income they receive.
Individual: If I make an additional $100 this
paycheck, I will spend $75 of it and save $25.
Multiplier Effect:
Consumption Multiplier
• Say the government wants to increase GDP.
They spend $10 billion on new programs.
The MPC is 0.75. What overall effect will
this have on the economy?
– Consumption Multiplier = 1/(1-MPC)
Multiplier = 1/.25 = 4
If government spending increases by $10
billion, then this could generate an additional
$40 billion in economic activity (Y).
Multiplier Effect:
Taxation Multiplier
• If the government cuts taxes by $10 billion,
now we have to look at the impact this will
have on consumption.
– It will increase consumption by MPC x amount
of tax benefit:
.75 x $10 billion = $7.5 billion
increase in consumption
$7.5 billion x 4 (multiplier) = $30 billion
increase in economic activity as a result of a $10
billion tax cut.
Multiplier Effect:
Taxation Multiplier
• Here’s how we find the potential multiplied
effect when the government changes taxes:
Taxation Multiplier = -MPC/ MPS
MPC = .75, so MPS = .25 and the multiplier = -3
$-10 billion x -3 (multiplier) = $30 billion
increase in economic activity as a result of a $10
billion tax cut.