ECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
Chapter 10
“Aggregate Expenditures”
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
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Learning Objectives
1. Summarize the perspective of
Keynesian and Keynesian economics.
2. Illustrate the income-expenditure.
3. Explain the adjustment process to an
expenditure equilibrium.
4. Describe how new spending can have a
ripple effect throughout the economy.
©2004 Prentice Hall Publishing
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Learning Objectives
5. Distinguish the types of multipliers in the
Keynesian model.
6. Graph the relationship of the incomeexpenditure model to aggregate demand.
7. (E&A) Compare economic analyses of the
Great Depression.
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10.1
“IN THE LONG RUN, WE ARE ALL DEAD”
Keynes chose to ignore long-run tendencies
toward full employment.
In his view the problems of unemployment could
be solved only if people and government would
buy more goods and services.
Consumption spending is 70% of GDP, and it
motivates investment spending.
The Keynesian model is based around
understanding how much spending is likely to
occur at different levels of spending, and how
government can influence that spending to ensure
full employment.
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10.2
THE INCOME-EXPENDITURE
MODEL
“One person’s spending is another
person’s income.”
Aggregate National Income
=
Aggregate National Output
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The Income –Expenditure Model
The aggregate expenditures function tells
what the economy’s planned spending
will be at each level of real GDP.
There will be only one GDP that does
match up planned spending and actual
spending.
That GDP occurs at the expenditure
equilibrium, where the AE function and
the 45-degree line intersect.
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Expenditures
The Income –Expenditure Model
#2 The 4-degree line
shows expenditures by repeating to the
vertical axis the real
GDP listed on the horizontal axis.
#3 At the equilibrium
value of GDP, actual
spending equals planned
$10
trillion.
spending
Aggregate
Expenditure
Function
#1 The aggregate
expenditure function
shows how much the
economy plans to
spend at each possible
GDP
$5 trillion
$10
trillion
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45o: Spending=production
Real GDP
(income)
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Components of Aggregate
Expenditures
Spending can be divided into two types:
Autonomous spending: spending that
would occur even if people had no income.
Induced spending: spending that depends
upon income.
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Components of Aggregate
Expenditures
Autonomous spending includes both
investments and goods.
Draw upon previous wealth and savings.
College students with no earnings drawing
down their parents bank accounts to pay for
room and board at school.
Graphically, autonomous spending is a
positive amount that shows up as a
horizontal line.
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Components of Aggregate
Expenditures
 Since induced spending is entirely
dependent upon income, graphically it
starts at zero starts at zero and GDP rises
from there.
 When autonomous spending and induced
spending are added together, the result is
an aggregate expenditure function that has
both a positive vertical intercept, and a
positive slope.
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Aggregate Expenditures
Aggregates
expenditures includes
both autonomous
and induced
spending.
Expenditures
$10 trillion
Aggregate
Expenditure
Function
Induced spending
$5 trillion
Autonomous
spending
0
$10
trillion
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Real GDP
(income)
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Components of Aggregate
Expenditures
o The components of aggregate expenditures
are merely the components of GDP.
GDP = C + I + G + (X-M)
o The consumption function because of
autonomous spending has a positive
vertical intercept.
o From there, it slopes upward because of
the marginal propensity to consume (mpc).
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MPC and MPS
o The marginal propensity to consume
(MPC) is the fraction of additional
income that people spend.
o The marginal propensity to save (MPS) is
the fraction of additional income that
people save.
MPC + MPS = 1
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The Aggregate Expenditures
Function
• Investment and government purchases
are of roughly comparable size.
• If planned government purchases and
investment spending are assumed to be
completely autonomous, they will be
constant as GDP changes.
• For this reason, the slope of the AE
function and the consumption function
are the same.
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Modeling the Expenditure
Equilibrium
When the economy is not at equilibrium,
actual GDP and planned spending differ.
Unintended inventory changes show up
as the difference between planned and
actual investment.
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Modeling the Expenditure
Equilibrium
Expenditure equilibrium:
aggregate expenditures = actual GDP
where
Aggregate expenditures: consumption + planned investment
government + net exports
and
GDP = consumption + actual investment
+ government +net exports
which
implies
Expenditure equilibrium:
planned investment = actual investment
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Modeling the Expenditure Equilibrium
#2 A progression of inventory
buildups less production
leads to
the expenditures equilibrium
here.
#1 if the economy
starts here
Output decreases
but at a decreasing rate.
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45o: Spending=production
Aggregate
Expenditure
Function
Real GDP
(income)
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10.3
CHANGING THE EXPENDITURE
EQUILIBRIUM
When there are changes in autonomous
spending, the changes are magnified by the
multiplier effect.
Adding autonomous spending causes a higher
GDP, which causes more induced spending.
That’s because money that one person spends
autonomously adds to income of others, which in
turn induces them to buy more output.
At each stage in this cycle, however, some income
is saved, thus eventually bringing the cycle to a
halt.
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The Multiplier Effect
Expenditures
The multiplier effect causes a small
increase in autonomous expenditures to
have a much larger effect on GDP.
The expenditure
equilibrium moves
higher
Increase in
autonomous
expenditures
Increase in GDP
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Aggregate
expenditure
function
Real GDP
(income)
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The Multiplier Effect
The strength of the multiplier effect
depends upon the proportion of income
that is devoted to consumption.
To the extent that people save their
incomes, savings represents a leakage out
of the multiplier process.
A negative value for savings means that
there is dissaving – spending out of
existing savings.
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Spending Depends upon the Marginal
Propensity to Consume (mpc):
Income
$0
$1,000
$2,000
$3,000
$4,000
$5,000
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Spending
$1,000
$1,600
$2,200
$2,800
$3,400
$4,000
Savings
-$1,000
-$600
-$200
$200
$600
$1,000
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The Expenditure Multiplier
Expenditure multiplier = 1/mps
or
1/(1-MPC)
 Autonomous spending x 1/mps
=
 Expenditure equilibrium
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The Multiplier Effect
The multiplier is multiplied by a change
in autonomous spending to reveal the
change in equilibrium GDP.
There must be some idle resources for the
multiplier effect to occur.
Keynesian multiplier analysis assumes a
constant price level.
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Recession and Inflation within the
Income-Expenditure Model
 If the expenditure equilibrium lies below fullemployment GDP, it is called an unemployment
equilibrium.
 Along with the unemployment equilibrium
comes an output gap, in which actual GDP falls
below full-employment GDP.
At an unemployment equilibrium, there is to
little spending for the economy to achieve
full employment GDP.
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Recession and Inflation within the
Income-Expenditure Model
 If the expenditure equilibrium lies below fullemployment GDP, it is called an unemployment
equilibrium. The shortfall
in spending equilibrium
 Along with the unemployment
called
a
comes an output is
gap,
in which
actual GDP falls
recessionary
gap.
below full-employment
GDP.
At an unemployment equilibrium, there is to
little spending for the economy to achieve
full employment GDP.
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Recession and Inflation within the
Income-Expenditure Model
If the expenditure equilibrium occurs past
the full-employment GDP, multiplier
analysis does not apply, because inflation
will not allow it to stay there.
This possibility is referred to as an
inflationary gap, which is the excess of the
aggregate expenditure function above that
consistent with a full employment
equilibrium.
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Making Policy with Multipliers
• Keynesian analysis suggest that govern can use
taxes to stimulate the economy.
• However people might save some of their
higher after tax income rather than spend it.
The tax multiplier, which is the expansionary, or
contractionary effect of a tax cut, or increase
would be less than the multiplier by the amount
of the initial round of spending.
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Making Policy with Multipliers
Tax Multiplier = -mpc/(1-mpc)
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Balanced Budget Multiplier
• Keynesians view extra government
spending as the most effective policy to
cure a recession.
• The balanced-budget multiplier combines
the expenditure multiplier for an increase
in government spending and the tax
multiplier because taxes would increase
to finance that spending.
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Making Policy with Multipliers
Balanced Budget Multiplier =
1/(1-mpc) – mpc/(1-mpc)=
(1-mpc)/(1-mpc)=1
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10.4 AGGREGATE DEMAND
Price Level
Expenditures
45o: Spending=production
Aggregate Expenditures
with lower price level P1
Aggregate Expenditures
with higher price level P2
Actual Real GDP (income)
P2
P1
Aggregate Demand
GDP2
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GDP1
Real GDP
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10.5 EXPLORE & APPLY
The Great Depression
 The 1920’s era of prosperity peaked in early
1929.
 A few months later the stock market
crashed.
 The Great Depression began and did not end
for over a decade.
 Keynesian aggregate expenditure analysis can
be used to describe the depression and the
policy action to correct it.
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Terms Along the Way
income-expenditures
model
aggregate
expenditures
aggregate
expenditures
function
expenditure
equilibrium
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autonomous
spending
induced spending
consumption
function
marginal propensity
to consume
marginal propensity
to save
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Terms Along the Way
multiplier effect
expenditure
multiplier
unemployment
equilibrium
output gap
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recessionary gap
inflationary gap
tax multiplier
balanced budget
multiplier
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Test Yourself
1. John Maynard Keynes offered a long-run
perspective on the macro-economy in the general
theory.
a.
b.
c.
d.
If you had no income you could still engage in induced
spending.
The marginal propensity to consume must be 1 or less.
An expenditure equilibrium occurs where the aggregate
expenditure function intersects the vertical axis.
An injection of new autonomous spending will leave
equilibrium real GDP unchanged when the marginal
propensity to save equals 0.5.
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Test Yourself
2. Suppose actual spending equals planned
a.
b.
c.
d.
spending. Then we can say
the economy is at an expenditure
equilibrium.
real GDP is the most it can possibly be.
autonomous spending equals zero.
aggregate demand has shifted to the left.
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Test Yourself
3. In the income expenditures model the
45-degree line shows
a. the amount of autonomous spending.
b. the amount of induced spending.
c. the expenditure multiplier.
d. that the economy’s expenditures are
actually the same as its output. .
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Test Yourself
4. Aggregate expenditures include all of
the following except
a. consumption.
b. planned investment.
c. net exports.
d. unintended changes in business
inventories.
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Test Yourself
5. The marginal propensity to consume equals
a. the fraction of their total income that people
consume.
b. the fraction of additional income that people
consume.
c. the fraction of their savings that people plan
to spend within the next year.
d. one in most cases..
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Test Yourself
6. The paradox of thrift, if true suggest
that people should
a. save more.
b. spend more.
c. vote more often.
d. spend the same amount of money, but
spend it more wisely.
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The End!
Next Chapter 11
“Fiscal Policy in
Action"
©2004 Prentice Hall Publishing
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