Aggregate Expenditure
Outline
•Components of aggregate expenditure
•Planned and unplanned expenditure
•The consumption function
•Imports and GDP
•Equilibrium expenditure
•The expenditure multiplier
Components of Aggregate
Expenditure
Recall from Chapter 5 that aggregate expenditure
for final goods and services equals the sum of
•Consumption expenditure, C
•Investment, I
•Government purchases of goods and services, G
•Net exports, NX
Thus:
Aggregate expenditure = C + I + G + NX
Planned and Unplanned
Expenditures
Aggregate expenditure aggregate
income and real GDP. But
aggregate planned expenditure
might not equal real GDP
because firms can end up with
larger or smaller inventories than
they had intended.
Aesop’s Bottles B.C. 400
Investment Plans
Planned spending on buildings, equipment,
and tools
20,000 drachmas
Planned inventory investment
0 drachmas
Value of inventories on Dec. 31, 401 B. C.
11,000 drachmas
Value of inventories on Dec. 31, 400 B.C.
13,500 drachmas
Unplanned inventory investment in 400 B.C. 2,500 drachmas
Actual investment in 400 B.C.
22,500 drachmas
Autonomous versus induced
Expenditure
•Autonomous expenditure: The components of
aggregate expenditure that do not change when
real GDP changes.
•Induced expenditure: The components of
aggregate expenditure that change when real GDP
changes.
The Consumption Function
The consumption function
shows the relationship
between consumption
expenditure and disposable
income, holding all other
influences on influences on
household spending
behavior constant.
What is disposable income?
•Disposable income is aggregate income (GDP)
minus net taxes
•Net taxes are taxes paid to government minus
transfer payments received from government.
Disp osable Income and Consumptio n in th e U.S., 1959-99
7000
www.bea.gov
6000
1991
5000
4000
3000
2000
1000
1000
2000
3000
4000
5000
6000
Disp osable Income (billions o f 1996 dollar s)
7000
450 line
Consumption (trillions of 1996 dollars)
Saving
F
Consumption
function
E
D
6.0
Dissaving C
Saving is
zero
B
2.0 A
2.0
6.0
10.0
Disposable income (trillions of 1996 dollars)
(trillions of 1996 dollars)
Disposable income
Planned Consumption
Expenditure
0
2.0
4.0
6.0
8.0
10.0
1.5
3.0
4.5
6.0
7.5
9.0
A
B
C
D
E
F
Notice that autonomous
consumption is given by
point A. This is planned
consumption expenditure
when disposable income is
zero ($1.5 trillion). This
spending must be financed
by past saving or by
borrowing
Marginal Propensity to
Consume (MPC)
The marginal propensity to consume (MPC) is the
fraction of the change in disposable income that is
spent on consumption. That is:
MPC =
Change in consumption expenditure
Change in disposable income
Notice that when disposable income increases from $6 to
$8 trillion, consumption expenditure changes from $6.0 to
$7.5 trillion. Thus we have:
$1.5trillion
MPC 
 0.75
$2.0trillion
Consumption (trillions of 1996 dollars)
MPC gives the slope of the
consumption function
Consumption
function
E
7.5
6.0
D
rise
K
run
rise EK $1.5trillion
Slope  MPC 


 0.75
run KD $2.0trillion
0
6.0
8.0
Disposable income (trillions of 1996 dollars)
Disposable
income
+
(Expected) real
interest rate
The buying power
of net assets
Expected future
disposable income
+
+
Real
Consumption
Spending
Consumption (trillions of 1996 dollars)
Shifts of the consumption
function
CF
1
CF0
CF2
CF0 to CF1
•Decrease in
the real interest
rate.
•Buying power
of net assets
increases.
•Rise in
expected future
disposable
income.
0
Disposable income (trillions of 1996 dollars)
Falling interest rates have
stimulated consumer
spending recently
Complete Exercise #1
on p. 394
Imports and GDP
Imports are a component
of induced expenditure.
Imports depend partly on
the health of the
domestic economy.
Marginal Propensity to
import (MPI)
The marginal propensity to import (MPI) is the
fraction of the change in disposable income that is
spent on imports . That is:
MPI =
Change imports
Change in disposable income
Suppose that, ceteris paribus, when disposable income
increases from $2 trillion, imports increase by $0.3 trillion.
Thus we have:
$0.3trillion
MPI 
 0.15
$2.0trillion
Aggregate Expenditure and
Real GDP
Planned Expenditures
[Y]
[C]
[I]
[G]
[X]
[M]
[AE = C + I + G +X - M]
(trillions of 1996 dollars)
A
0.00
0.00
2.00 1.00 1.50 0.00
4.50
B
3.00
2.25
2.00 1.00 1.50 0.75
6.00
C
6.00
4.50
2.00 1.00 1.50 1.50
7.50
D
9.00
6.75
2.00 1.00 1.50 2.25
9.00
E 12.00
9.00
2.00 1.00 1.50 3.00
10.50
F 15.00 11.25 2.00 1.00 1.50 3.75
12.00
Note: Y is real GDP
I+G+C+X
Agg. Exp. (billions of 1996 dollars)
imports
AE
D
Consumption
expenditure
C
4.5
I+G+X
A
3
0
I+G
I
9
GDP (Billions of 1996 dollars)
Real
GDP
Aggregate
Unplanned
planned
inventory
expenditure
change
(trillions of 1996 dollars)
A
0.0
0.0
-4.5
B
3.0
3.0
-3.0
C
6.0
6.0
-1.5
D
9.0
9.0
0.0
E
12.0
12.0
1.5
F
15.0
15.0
3.0
AE (trillions of 1996 dollars)
12
AE
J
F
D
9
B
6
K
450
0
3
9
15
GDP (trillions of 1996 dollars)
•AE > GDP by vertical distance B-K
•Plans of producing and spending units do not
coincide
•Unplanned inventory investment = - $3 trillion
•Tendency for firms (on average) to step up the
pace of production and offer more employment
• GDP > AE by vertical distance J-F
•Plans of producing and spending units do not
coincide
•Unplanned inventory investment =$3 trillion
•Tendency for firms (on average) to scale back
the on production and offer less employment
•AE = GDP
•Plans of producing and spending units coincide.
•Unplanned inventory investment = 0
• No tendency for firms (on average) to step up
the pace of production and offer more
employment. Nor is there a tendency for firms to
scale back on production and offer less
employment.
Say’s Law1
•“Supply creates its own demand.”
•By producing goods and services,
firms create a total demand for goods
and services equal to what they have
produced.
Say’s law apparently
rules out the
possibility of a
widespread glut of
goods.
1 J.B.
Say. Treatise on Political Economy, 1903.
Say’s law implies that full-employment
equilibrium is the normal state of
affairs
AE
C + I + G + NX
AE touches
the 450 line at
potential GDP
Full employment
GDP
GDP
General (Keynesian) Case:
Underemployment Equilibrium
AE
A
C + I + G + NX
H
Y*
Full employment
GDP
GDP
•Assume the economy is in equilibrium
when real GDP = $3 trillon.
•What would happen if, other things
being equal, planned investment (I)
increased by $0.5 trillion?
How did a $0.5 trillion
change in I bring about
a $2 trillion change in
GDP?
AE
AE2
2
AE1
1
5
I
4.5
GDP
450
0
9.0
11.0
GDP
It’s a bird
It’s a plane
No, it’s the multiplier
effect!
The expenditure multiplier
The multiplier is 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.
Change in equilibrium expenditure
Multiplier =
Change in autonomous expenditure
Thus in our case the multiplier is given by:
Y
$2trillion
Multiplier 

4
I $0.5trillion
Chain of causation
When firms increase investment by $0.5
trillion, sales revenues at investment goods
manufacturers (Boeing, Westinghouse,
Cincinnati Milacron) will increase by $0.5
trillion
The $0.5 trillion in revenue will be distributed as
factor payments to those supplying resources
necessary to produce capital goods—hence the
change in spending generates $0.5 trillion in
income in the first round.
Now households have $1,000 in additional income.
What do they do with it? Their spending will increase
by the MPC times the change in income—that is:
C = .75  $0.5 trillion = $0.375 trillion Hence,
households spend $375 billion and save $125billion
But the story does not end here, since
McDonalds’s, Disney, Kraft, American Airlines,
and Amheiser Busch, etc. will see their sales
increase by $375 billion, and will distribute $375
billion in wages, salaries, rental income, and
profits to those who supplied resources
necessary to produce the additional consumer
goods.
Those who earned additional income in
consumer goods industries will now
increase their spending. By how much?
C = .75  $375 = $281.85.
This will result in additional production
and factor payments. Spending will
then increase. And so on. And so on.
Why is the multiplier greater
than 1?
As we see from the
preceding illustration, a
change in autonomous
expenditure (in this
case, I) induces a
change in consumption
expenditure.
The Multiplier and the MPC
We will now illustrate why the magnitude of the
multiplier depends on the MPC. For the moment,
assume no imports, exports, or taxes. Thus:
Y  C  Y
[1]
Where:
C  MPC  Y
[2]
Now substitute [2] into [1] to obtain:
Y  MPC  C  I
[1]
Now solve for Y
(1  MPC )  Y  I
[4]
Now rearrange [4]
1
Y 
I
(1  MPC )
[5]
Divide both sides of [5] by I to obtain the
multiplier
Multiplier 
Y
1
1
1



4
I (1  MPC ) (1  0.75) 0.25
The expenditure
multiplier
You can see from the
math that the size of the
multiplier is positively
linked to the MPC. The
higher the MPC, the
greater the “induced”
expenditure resulting from
a change in autonomous
expenditure
Taxes, Imports, and the
Multiplier
Once we allow for imports
and taxes, the multiplier
depends not only on the
MPC, but also on the
marginal propensity to
import (MPI) and the
marginal tax rate (MTR)
Marginal Tax Rate (MTR)
The marginal tax rate (MTR) is the fraction of the
change in real GDP that is paid income taxes. That
is:
MTR =
Change in tax payments
Change in real GDP
Suppose that, ceteris paribus, when real GDP increases by
$0.5 trillion, tax payments increase by $0.05 trillion. Thus we
have:
$0.05trillion
MTR 
 0.1
$0.5trillion
The “real” expenditure
multiplier
The multiplier is given by
Multiplier 
Y
1

I (1  Slope of AE curve)
The slope of the AE curve is given by:
Slope of AE curve = MPC – (MPI + MTR)
Thus the multiplier can be written as:
Multiplier 
Y
1

I 1  MPC  MPI  MTR
In this case, MPC = 0.75;
MPI = 0.15; MTR = 0.1
AE
Slope = 0.5
AE2
2
AE1
1
5
Multiplier 
I
Y $1.0 trillion

2
I $0.5 trillion
4.5
Y
450
0
9.0
10.0
GDP