Chapter 11: Expenditure Multipliers

Chapter 11: Expenditure Multipliers

Intended Learning Outcomes

  • Explain how expenditure plans are determined when the price level is fixed.

  • Explain how real GDP is determined when the price level is fixed.

  • Explain the expenditure multiplier.

  • Explain the relationship between aggregate expenditure and aggregate demand.

Fixed Prices and Expenditure Plans

Overview of the Keynesian Model

  • Keynesian Model: Describes the economy in the very short run when prices are fixed.

    • Fixed Price Level: 1. The price level is fixed. 2. Aggregate demand determines real GDP.

  • Aggregate Expenditure Plans: What determines aggregate expenditure plans?

Definition of Expenditure Plans

  • Expenditure Plans: The components of aggregate expenditure sum to real GDP.

    • Equation: Y = C + I + G + X - M

    • Where:

      • C = Consumption

      • I = Investment

      • G = Government Expenditure

      • X = Exports

      • M = Imports

  • Influences on Expenditure: Two components of aggregate expenditure (consumption and imports) are influenced by real GDP, reflecting a two-way link between aggregate expenditure and real GDP.

Two-Way Link Between Aggregate Expenditure and Real GDP

  • Relationship Dynamics: Other things remaining the same:

    • An increase in real GDP increases aggregate expenditure.

    • An increase in aggregate expenditure increases real GDP.

Planned Consumption Expenditure

Factors Influencing Consumption Expenditure

  • Disposable Income (YD): Most direct influence on consumption expenditure.

    • Definition: Aggregate income or real GDP minus net taxes.

    • Equation: YD = Y - T

  • **Spending Behavior:

    • Disposable income is either spent on consumption goods and services (C) or saved (S).

    • Relationship: YD = C + S

Consumption and Saving Functions

  • Consumption Function

  • /n: Relationship between consumption expenditure and disposable income.

    • Consumption expenditure is positive even when disposable income is zero (autonomous consumption).

    • Induced consumption occurs when consumption exceeds autonomous consumption as disposable income increases.

Saving Patterns

  • When consumption exceeds disposable income, saving becomes negative (dissaving).

  • When consumption is less than disposable income, savings occur.

Influences on Consumption and Saving

External Factors Affecting Consumption/Saving

  • Other factors influencing consumption and saving include:

    1. The real interest rate.

    2. Wealth.

    3. Expected future income.

  • Changes in these factors can alter autonomous consumption and shift both the consumption function and the saving function.

Marginal Propensities to Consume and Save

Definitions and Calculations

  • Marginal Propensity to Consume (MPC): Fraction of a change in disposable income spent on consumption.

    • Formula: MPC = \frac{\Delta C}{\Delta YD}

    • Where \Delta C = Change in consumption expenditure.

    • Where \Delta YD = Change in disposable income.

  • Marginal Propensity to Save (MPS): Fraction of a change in disposable income that is saved.

    • Formula: MPS = \frac{\Delta S}{\Delta YD}

    • Where \Delta S = Change in savings.

  • Relationship Between MPC and MPS: The sum of the MPC and MPS equals 1:

    • MPC + MPS = 1

Consumption as a Function of Real GDP

Understanding Consumption and GDP Relationships

  • Changes in disposable income occur with changes in real GDP or net taxes.

  • If tax rates are stable, real GDP is the primary influence on disposable income, thus making consumption a function of real GDP.

Import Function

Imports and GDP Influence

  • In the short run, imports in Canada are primarily influenced by Canadian real GDP.

  • Marginal Propensity to Import: Fraction of an increase in real GDP spent on imports.

    • Example: If an increase in real GDP of 100 billion increases imports by 25 billion, then the marginal propensity to import is:

    • \frac{25}{100} = 0.25

Real GDP with a Fixed Price Level

Determinants of Aggregate Demand and Expenditure

  • With a fixed price level, aggregate demand is determined by aggregate expenditure plans, defined as:

    • Aggregate planned expenditure includes:

    • Planned consumption expenditure.

    • Planned investment.

    • Planned government expenditure.

    • Planned exports minus planned imports.

Relationship Between Aggregate Planned Expenditure and Real GDP

  • Aggregate Expenditure Schedule: Lists aggregate expenditure planned at each quantity of real GDP.

  • Aggregate Expenditure Curve: Graphical representation of the aggregate expenditure schedule.

Aggregate Planned Expenditure Overview

Components of Aggregate Expenditure

  • Induced Expenditure: Consumption expenditure minus imports, which change with real GDP.

  • Autonomous Expenditure: Sum of investment, government expenditure, and exports, unaffected by changes in GDP.

Actual Expenditure, Planned Expenditure, and Real GDP

Understanding Equilibrium in Expenditure

  • Actual Aggregate Expenditure: Always equals real GDP.

  • Equilibrium Expenditure: Occurs when aggregate planned expenditure equals real GDP, ensuring no unplanned changes in inventory investment.

Convergence to Equilibrium

  1. Exceeds Real GDP: If aggregate planned expenditure exceeds real GDP, firms experience unplanned reductions in inventories, prompting them to hire and increase production, which raises real GDP.

  2. Less than Real GDP: If aggregate planned expenditure is lower than real GDP, firms encounter unplanned increases in inventories, which compels them to fire workers and decrease output, leading to a reduction in real GDP.

  3. Equals Real GDP: If aggregate planned expenditure equals real GDP, firms maintain current production levels, stabilizing real GDP.

The Multiplier

Understanding the Multiplier Effect

  • Multiplier Concept: A change in autonomous expenditure changes equilibrium expenditure and real GDP, with the alteration in equilibrium exceeding the initial change.

  • Basic Idea: Increases in investment spur further increases in aggregate expenditure and real GDP, resulting in a magnified overall effect.

The Size of the Multiplier

Calculating and Understanding Value

  • Multiplier Calculation: Size equals the change in equilibrium expenditure divided by the change in autonomous expenditure.

    • Multiplier = \frac{\Delta Y}{\Delta A}

  • The slope of the Aggregate Expenditure (AE) curve significantly influences the multiplier's magnitude:

    • Multiplier = \frac{1}{1 - Slope of AE curve}

Factors Influencing Multiplier Size

  • The presence of taxes and imports tends to diminish the size of the multiplier.

The Multiplier Process

Dynamics of Multiplier Action

  • MPC Influence: The MPC determines the magnitude of induced expenditure as aggregate expenditure approaches equilibrium expenditure.

Business Cycle Turning Points

Understanding Peaks and Troughs

  • Economic Fluctuations: Peaks and troughs in the business cycle are often associated with changes in autonomous expenditure, influencing economic performance and confidence in future activities.

Aggregate Expenditure and Aggregate Demand

Relationship Overview

  • Aggregate Expenditure Curve: Illustrates the relationship between aggregate planned expenditure and real GDP, maintaining other influences constant.

  • Aggregate Demand Curve: Relates the quantity of real GDP demanded to the price level, holding all other factors constant.