30.1
Expenditure Plans and Real GDP
The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and
services. As a result, the price level is fixed and so aggregate demand determines 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.
In the very short term, planned investment, planned government expenditures, and planned
exports are fixed. Planned consumption expenditure and planned imports are not fixed, but
depend on aggregate income. An increase in real GDP increases aggregate expenditure and an
increase in aggregate expenditure increases real GDP.
Autonomous Expenditure and Induced Expenditure

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, $2 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
is the fraction of a change in disposable
that is consumed. The MPC is equal to
(MPC )
income
Change in consumption expenditure
Change in disposable income
. The MPC is slope
of the consumption function, which is 0.67 in the figure.
Other Influences on Consumption


A change in disposable income leads to a movement along the consumption function.
A change in the real interest rate, the buying power of net assets, or expected future disposable income
shifts the consumption function. An increase in the buying power of net assets or expected future
disposable income and a decrease in the real interest rate increases consumption and shifts the
consumption function upward.
Imports and Real GDP

Imports depend on U.S. real GDP. The marginal propensity to import is the fraction of an
Change in imports
increase in real GDP that is spent on imports and is equal to
.
Change in real GDP
30.2
Real
GDP
(Y )
Equilibrium Expenditure
Consumption
expenditure
(C )
Investment
(I )
Government
expenditures
(G )
Exports
(X )
Imports
(M )
Aggregate
planned
expenditure
(AE=C+I+G+XM)
(trillions of 2000 dollars)
8.0
4.2
2.0
2.0
1.0
0.8
8.4
9.0
5.1
2.0
2.0
1.0
0.9
9.2
10.0
6.0
2.0
2.0
1.0
1.0
10.0
11.0
6.9
2.0
2.0
1.0
1.1
10.8
Aggregate Planned Expenditure and Real GDP

Aggregate planned expenditure, AE, is
sum of planned consumption
expenditure plus planned investment
planned government expenditures on
and services plus planned exports
minus planned imports. The table above
shows the calculation of an aggregate
planned expenditure schedule. The
shows the resulting AE curve.
the
plus
goods
figure
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 $10 trillion.
Convergence to Equilibrium

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.

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.
30.3
The Expenditure Multiplier
The Basic Idea of the Multiplier



The multiplier is the amount by which a change in autonomous expenditure is magnified or
multiplied to determine the change in equilibrium expenditure and real GDP.
The multiplier exists because a change in autonomous expenditure creates a change in disposable
income, which leads to additional changes in induced expenditure and disposable income.
The multiplier effect operates for a decrease as well as an increase in autonomous 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
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.
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.
1
When imports and income taxes are included, the multiplier equals
. In
1  slope of the AE curve
the previous figure, the slope of the AE curve is 0.8, so the multiplier equals 5.0.
It is interesting to note that the volatility of real GDP has declined in recent years (since 1984 to be
precise). One question is whether this decline is the result of a smaller multiplier or simply a lack of large
changes in autonomous expenditure (referred to as “shocks” by economists). No consensus has been
reached, although some economists including James Stock and Mark Watson have argued that the
reduction is more the consequence of smaller shocks rather than a decrease in the size of the multiplier.
Business Cycle Turing 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.
30.3
The Expenditure Multiplier
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 $9 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 $11 trillion (which is the initial equilibrium expenditure in the AE
diagram to the left) to $9 trillion (which is the new equilibrium expenditure along AE1 in the AE
diagram to the left).