Module 14 Notes: Aggregate Expenditure Multiplier

aggregate expenditure equals the sum of-

consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports, NX.

Autonomous expenditure does not respond to-

changes in real GDP and induced expenditure does respond to changes in real GDP.

Consumption plans are influenced by many factors other than disposable income. The more important influences are

• Real interest rate

• Wealth

• Expected future income

Many factors influence U.S. imports, but in the short run, one factor dominates:

U.S. real GDP.

When autonomous expenditure (investment, government expenditure, or exports) increases-

aggregate expenditure and real GDP also increase.

The change in equilibrium expenditure also equals-

the change in real GDP

The marginal tax rate determines-

the extent to which income tax payments change when real GDP changes.

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 the price level falls, other things remaining the same, aggregate planned expenditure increases and equilibrium expenditure increases. The reason is that a change in the price level changes the-

buying power of money, the real interest rate, and the real prices of exports and imports 

Autonomous expenditure is

the sum of the components of aggregate expenditure that real GDP does not influence directly.

 Induced expenditure is

the sum of the components of aggregate expenditure that real GDP influences.

Consumption expenditure varies with

disposable income and real GDP and depends on the marginal propensity to consume.

 Imports vary with real GDP and

depend on the marginal propensity to import.

 Actual aggregate expenditure equals real GDP, but when aggregate planned expenditure differs from real GDP-

firms have unplanned inventory changes.

 If aggregate planned expenditure exceeds real GDP _________________. If real GDP exceeds aggregate planned expenditure, _______________.

firms increase production and real GDP increases;  firms decrease production and real GDP decreases.

Real GDP changes until-

aggregate planned expenditure equals real GDP.

When autonomous expenditure changes, equilibrium expenditure changes by a larger amount:

There is a multiplier

 The multiplier is greater than 1 because

a change in autonomous expenditure changes induced expenditure.

 The larger the marginal propensity to consume-

the larger is the multiplier.

 The AD curve is

the relationship between the quantity of real GDP demanded and the price level when n all other influences on expenditure plans remain the same.

The quantity of real GDP demanded on the AD curve is

the equilibrium real GDP when aggregate planned expenditure equals real GDP.

From the circular flow of expenditure and income aggregate expenditure is the sum of-

Consumption expenditure, C

Investment, I

Government expenditure on goods & services, G

Net Exports, NX

Aggregate expenditure =

C+ I + G + NX

Aggregate planned expenditure is-

sum of the spending plans of households, firms, & governments

planned consumption expenditure, plus planned investment, plus planned government expenditure, plus planned exports, minus planned imports

sum of induced expenditure and autonomous expenditure

We divide aggregate expenditure plans into-

Autonomous expenditure & Induced expenditure

Autonomous expenditure is

the components of aggregate expenditure that do not change when real GDP changes

Autonomous expenditure equals

investment, plus government expenditure, plus exports, plus the components of consumption expenditure and imports that are not influenced by real GDP. 

Induced expenditure is

the components of aggregate expenditure that change real GDP changes

Induced expenditure =

consumption expenditure minus imports (excluding the elements of consumption expenditure and imports that are part of autonomous expenditure).

Consumption function is

the relationship between consumption expenditure and disposable income, other things remaining the same

Disposable income is-

aggregate income (GDP) minus net taxes.

Net taxes are

taxes paid to the government minus transfer payments received from the government.

The Marginal propensity to consume (MPC) is

the fraction of a change in disposable income that is spent on consumption.

MPC =

Change in consumption expenditure/ change in disposable income.

The other influences on consumption plans are:

The real interest rate

Wealth

Expected future income

When the real interest rate falls,

consumption expenditure increases and saving decreases

When the real interest rate rises,

consumption decreases and saving increases

When wealth or expected future income increases,

consumption expenditure increases

When wealth or expected future income decreases,

consumption expenditure decreases

Consumption expenditure increases when

disposable income increases

Disposable income = aggregate income— real GDP — minus net taxes,

so disposable income and consumption expenditure increase when real GDP increases

We use this link between consumption expenditure and real GDP to-

determine equilibrium expenditure

Investment, government expenditure, and exports, which are

components of autonomous expenditure, are the same at all levels of real GDP.

A higher level of GDP brings

higher levels of consumption expenditure and imports

To find aggregate planned expenditure, AE, we the planned levels of

C, I, G, and X and subtract M

For example if real GDP is $16 trillion, aggregate planned expenditure is equal to

($12.00 + $3.50 + $2.50 + $4.00 - $4.00) trillion, which = $18.00

The aggregate planned expenditure curve, or AE curve is

a graph of aggregate planned expenditure of each level of real GDP

Equilibrium expenditure is

the level of aggregate expenditure when aggregate planned expenditure = real GDP

Equilibrium expenditure = the real GDP at which

the AE curve intersects the 45 degree line

At equilibrium expenditure, production plans and spending plans-

agree, and there is no reason to change production or spending

But when aggregate planned expenditure and actual aggregate expenditure are

unequal, production plans and spending plans are misaligned, and a process of convergence toward equilibrium expenditure occurs

When aggregate planned expenditure is less than real GDP

firms cut production. Real GDP decreases

When GDP decreases -

aggregate planned expenditure decreases

But real GDP decreases by more than planned expenditure

so eventually the gap between planned expenditure and actual expenditure closes.

When aggregate planned expenditure exceeds real GDP

firms increase production. Real GDP increases.

But Real GDP increases by more than

the increase in planned expenditure

Eventually the gap between ____________ and __________ is closed.

planned expenditure, actual expenditure

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 that it generates.

A change in autonomous expenditure brings a larger change in aggregate in aggregate expenditure because-

it induces a change in consumption expenditure.

The magnitude of the multiplier is influenced by the

marginal propensity to consume — the MPC

The change in real GDP (△ Y) equals the change in

consumption expenditure (△ C) plus the change in investment (△I)

Step 1: △ Y = △ C + △ I but the change in consumption expenditure is determined by the change in-

Step 1: Real GDP and the marginal propensity to consume.

Step 2: △ C = MPC x △ Y  But the change in consumption expenditure is determined by the change in 

 Step 2: real GDP and the marginal propensity to consume.

Step 3: To get △ Y =

MPC x △ Y + △I

Step 4: (1- MPC) x △ Y =

 △I

Step 5: △ Y =

 △I/ (1-MPC)

Step 6: △ Y /△I =

1/(1-MPC)

So when the MPC is 0.75, the multiplier is

△ Y /△I =  1/(1-0.75) = 1/0.25 = 4

Imports and income taxes make the

multiplier smaller

Imports make the multiplier smaller because

only expenditure on U.S. -made goods and services increases U.S. real GDP

Income taxes make the multiplier smaller because

when real GDP increases, income tax payments increase and disposable income increases by less than the increase in real GDP.

The marginal propensity to consume, the marginal propensity to import, and the marginal tax rate-

determine the multiplier

Their combined influences determines the

slope of the AE curve

The general formula for the multiplier is

△Y/△I = 1/(1- Slope of AE curve)

The AE curve is

the relationship between aggregate planned expenditure & real GDP all other influences on expenditure plans remain the same

A movement along the AE curve arises-

from a change in real GDP

The AD curve is

the relationship between quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same

A movement along the AD curve arises from

a change in the price level

Equilibrium expenditure depends on

the price level

When the price level changes, other things remaining the same, ______ ______ changes and _____ ______ changes.

aggregate planned, equilibrium expenditure

Aggregate planned expenditure changes because

a change in the price level changes the buying power of net assets, the real interest rate, and the real prices of exports and imports

When the price level changes-

the AE curve shifts

Formula: Marginal propensity to import =

change in imports/ change in real GDP

Formula: Multiplier =

change in equilibrium expenditure/ change in autonomous expenditure

General formula for the multiplier is

Multiplier = △Y/△I = 1/ (1 - Slope of AE curve)

marginal propensity to import

the fraction of an increase in real GDP that is spent on imports.

Equilibrium expenditure

occurs when aggregate ​planned expenditure equals​ real G​DP.

Aggregate planned expenditure is the sum of planned _____. 

D. consumption expenditure, investment, government expenditure, and exports minus imports

The consumption function is the relationship between consumption expenditure and _____, other things remaining the same. 

A. disposable income 

If disposable income increases from $4 trillion to $7 trillion, consumption expenditure increases from $3.5 trillion to $5.5 trillion, and nothing else changes, the marginal propensity to consume is _____. 

C. 0.67 

If real GDP increases by $2 million and potential GDP increases by $3 million and the marginal propensity to import is 0.2, by how much do imports change?

 A. Imports increase by $400,000 

Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate _____ equals _____. 

C. planned expenditure; real GDP

A multiplier is the amount by which a change in any component of _____ is magnified or multiplied to determine the change in _____ and _____ that it generates.

B. autonomous expenditure; equilibrium expenditure; real GDP 

The marginal tax rate is the fraction of a change in _____ that is paid in _____ - the change in _____ divided by the change in _____.

C. real GDP; income taxes; tax payments; real GDP 

The consumption function shows how an increase in _____- influences ______. 

C. disposable income; consumption expenditure

The marginal propensity to consume tells us by how much           changes when           changes.

D. consumption expenditure; disposable income

The components of induced expenditure are           .

A. consumption expenditure, government expenditure, and exports

The aggregate planned expenditure curve           increases.

A. slopes upward because induced expenditure increases as income

If real GDP           planned expenditure, the economy converges to equilibrium expenditure because inventories            and firms increase production.

C. is less than; are run down

The multiplier equals ______ divided by ______

B. 1; (1 - Slope of the AE curve)