14.1
Expenditure Plans and Real GDP
Expenditure Plans
 Aggregate expenditure equals consumption expenditure plus investment plus government
expenditures on goods and services plus exports minus imports, or C + I + G + NX.
 Aggregate planned expenditure is equal to planned consumption expenditure plus
planned investment plus planned government expenditures on goods and services plus
planned exports minus planned imports.
 The components of aggregate expenditure that do not change when real GDP changes are
called autonomous expenditure. The components of aggregate expenditure that change
when real GDP changes are called induced expenditure.
The Consumption Function
 The consumption function is the
relationship between consumption
expenditure and disposable income,
other things remaining the same.
Disposable income is aggregate income
minus taxes plus transfer payments.
 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.
 The consumption expenditure when
disposable income is zero, $4 trillion in
the figure, is autonomous consumption.
Consumption expenditure in excess of this amount is induced consumption.
Marginal Propensity to Consume
 The marginal propensity to consume (MPC ) is the fraction of a change in disposable
income that is consumed. The MPC is equal to
Change in consumption expenditure
Change in disposable income
.
The
MPC is slope of the consumption function, which is 0.67 in the previous figure.
Other Influences on Consumption Expenditure
 A change in the real interest rate, wealth, or expected future income shifts the
consumption function.
o An increase in wealth, an increase in expected future income, or a decrease in the
real interest rate increase consumption and shift the consumption function
upward.
o When the consumption function shifts in it means that there will be more
consumption expenditure for a given amount of disposable income.
Representations of the Consumption function
The consumption function can also be represented in a table or as an equation
Disposable
Income
Aggregate
Consumption
0
4
8
12
16
20
4
6.67
9.33
12
14.67
17.33
2
The corresponding equation in CF = 4 + 3(disposable income)
2
Where 4 equals the autonomous expenditure and 3 equals the Marginal Propensity to Consume.
The general consumer function equation is CF = a + 𝑏(disposable income)
Where a equals the autonomous expenditure and 𝑏 equals the Marginal Propensity to Consume.
Marginal Propensity to Save
 The marginal propensity to save (MPS ) is the fraction of a change in disposable
Change in Savings
income that is saved. The MPS is equal to
.
Change in disposable income
Aggregate savings = disposable income – aggregate consumption
Aggregate
Savings
Disposable
Income
Aggregate
Consumption
0
4
8
12
16
4
6.67
9.33
12
14.67
-4
-2.67
-1.33
0
1.33
20
17.33
2.67
1
The savings function is then SF= -4 + 3(disposable income)
1
Where 4 equals the autonomous expenditure and 3 equals the Marginal Propensity to Save.
Because we assume that all disposable income is saved or consumed,
The MPC +MPS =1
Imports and GDP
 Imports depend on U.S. real GDP. The marginal propensity to import is the fraction of
an increase in real GDP that is spent on imports and is equal to
14.2
Change in imports
Change in real GDP
.
Equilibrium Expenditure
Aggregate planned
Real Consumption
Government
expenditure
GDP expenditure Investment expenditures Exports Imports (AE=C+I+G+XM)
(Y )
(C )
(I )
(G )
(X )
(M )
(trillions of 2005 dollars)
11.0
12.0
13.0
6.2
7.1
8.0
2.0
2.0
2.0
3.0
3.0
3.0
1.0
1.0
1.0
0.8
0.9
1.0
11.4
12.2
13.0
14.0
8.9
2.0
3.0
1.0
1.1
13.8
Aggregate Planned Expenditure and Real GDP
 Aggregate planned expenditure, AE, is the
sum of planned consumption expenditure plus
planned investment plus planned government
expenditures on goods and services plus
planned exports minus planned imports. The
table above shows the calculation of an
aggregate planned expenditure schedule. The
figure shows the resulting AE curve.

I, G, and X, are autonomous because they do
not depend on the current level of real GDP.
o Investment is based on the real interest
rate and expectations of profit
o government expenditure is based on a
political process.
o Exports depend on foreign income,
not on domestic real GDP
Equilibrium Expenditure
 Equilibrium expenditure is the level of aggregate expenditure that occurs when
aggregate planned expenditure equals real GDP. In the figure, equilibrium expenditure is
$13 trillion.
o The 45° line is where AE = Real GDP and we have equilibrium expenditure.
o Actual expenditures can differ from planned expenditures because firms do not
always 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 inventory investment regardless of whether it was planned or
not.
 Real GDP levels to the left of the intersection point of the
aggregate planned expenditure curve and the 45° line involve an
unplanned inventory decrease.
o This means that businesses and households are drawing
down on the inventories left over from the previous year.
That is, the economy is consuming part or all of last year’s
output that went unsold.

Real GDP levels to the right of the intersection point of the
aggregate planned expenditure curve and the 45° line involve an
unplanned inventory increase.
o This means that businesses and households are increasing
their inventories by more than they expected.
Convergence to Equilibrium
 If aggregate expenditure does not equal its equilibrium, there are forces that lead to
convergence. 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.
o You should know how to solve for the equilibrium expenditure using a table or
graph.
14.3
Expenditure Multipliers
The Basic Idea of the Multiplier
 The multiplier is the amount by which a change in any component of autonomous
expenditure is magnified or multiplied to determine the change that it generates in
equilibrium expenditure and real GDP.
 An increase in investment increases real GDP, which increases disposable income and
consumption expenditure. The increase in consumption expenditure adds to the increase
in investment and a multiplier determines the magnitude of the resulting increase in
aggregate expenditure.
The Size of the Multiplier
Change in equilibrium expenditure

The multiplier equals

If there are no imports or income taxes, the multiplier equals


Change in autonomous expenditure
.
1
.
1  MPC
o You should know how to derive this equation
The size of the multiplier depends on the MPC. The smaller the MPC, the smaller the
increase in expenditure at each step of the multiplier process and so the smaller the
multiplier.
You should know how to determine the multiplier from the aggregate planned
expenditure table if you are given information about the size of the change in investment.
You should also be able to derive the new Aggregate Expenditure column if given
information on the size of the multiplier and information about the size of the change in
investment.
The Multiplier, Imports and Income Taxes
 Imports and income taxes both mean that the increase in expenditure on domestic
production will be smaller at each step of the multiplier process and so the multiplier is
smaller. The larger the marginal propensity to import, the smaller is the multiplier.
 The marginal tax rate is the fraction of a change in real GDP that is paid in income
taxes – the change in tax payments divided by the change in real GDP. 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.
 When imports and income taxes are included, the multiplier equals
1
.
1  slope of the AE curve

When the multiplier is smaller, it means that the magnitude of the impact of investment on
real GDP will be smaller.
Business Cycle Turning Points


An unexpected decrease in autonomous expenditure is signaled by a buildup of
unplanned inventories. The buildup in inventories sets the multiplier process in motion
that decreases aggregate expenditure and real GDP so that a recession follows.
An unexpected increase in autonomous expenditure is signaled by an unwanted depletion
of inventories. The depletion in inventories sets the multiplier process in motion and an
expansion follows.
The multiplier is just a representation of the relationship between autonomous
spending and real GDP.
For example, Amazon is constructing a new headquarters downtown. (This is an
increase in investment)This will increase the disposable income of the
construction workers who are building the headquarters. Since we assume that
the Marginal Propensity to consume is between 0 and 1, the construction
workers will increase their consumption as a result of the increase disposable
income. Suppose that construction workers all buy their lunches out while
working on the project because they have more income. This would increase the
revenue of local restaurants in the area, which increase the disposable income of
the workers and the owners. Since the marginal propensity to consume is
between 0 and 1, these people will also increase consumption as a result of the
increase in disposable income. Therefore the initial increase in investment, also
increased the consumption of the construction workers and
restaurant workers in the local area. These purchases will then create even more
consumption. All the added consumption expenditure makes the multiplier larger
than 1.

The magnitude of the change is limited by the size of the marginal
propensity to consume.
 landscaping haha and that person pays his employees and they pay for
gas/supplies and those employees pay for lunch etc...that initial $500
becomes wayyyy more when you think about how much money is being
spent as a result.
Paradox of Thrift
 What happens if households become concerned about the future and want to save more
today to prepare for hard times tomorrow?
o To increase savings they will reduce consumption.
 Drop in spending leads to a drop in income
 GDP will decrease because of the drop in consumption.
o Since investment= savings and investment does not change, savings will remain
constant.
o Real GDP will decrease, causing the recession that people were worried about,
but savings will not change.
 Paradox because when a society tries to save more income drops but there
is no increase in savings.
 Paradox is resolved if we allow desired investment to change with desired savings.
Multiplier in reality
 We are using a very simplified picture of the economy.
o Assumed that investment is exogenous(not true in reality because it depends on
the interest rates)
o Ignored role of government, financial markets and the rest of the world in the
macroeconomy
o Ignored the fact that part of an expansion is likely to take to form of increased
prices instead of only increases in output.
 In reality the multiplier is about 1.4
14.4
The AD Curve and Equilibrium Expenditure
Difference between the Aggregate Demand curve and the Aggregate Expenditure Curve
 It is important to remember that these curves do not mean the same thing, but
they are closely related.
o
The aggregate expenditure model is a fixed price model that
examines how aggregate expenditure depends on disposable
income.

As a result, the AE curve shifts due to a change in the price
level, which is not on either axes of the AE graph.
o The aggregate demand curve, however, is a variable price model
that examines how aggregate demand depends on the price
level.

For the AD curve, a change in the price level leads to a
movement along the curve because the price level is on the
vertical axis. .
Deriving the AD Curve from Equilibrium Expenditure

The AE curve is the relationship between aggregate planned expenditures and real 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. The AD curve is derived from the AE model.

A rise in the price level decreases aggregate planned expenditure. So, as shown in the
figure to the left, a rise in the price level from 120 to 140 decreases aggregate planned
expenditure and shifts the AE curve downward from AE0 to AE1. In the figure,

equilibrium expenditure decreases to $12 trillion.
The diagram to the right shows that when the price level rises from 120 to 140, there is a
movement along the AD curve from point a to point b. The aggregate quantity of real
GDP demanded decreases from $14 trillion (which is the initial equilibrium expenditure
in the AE diagram to the left) to $12 trillion (which is the new equilibrium expenditure
along AE1 in the AE diagram to the left).