Expenditure Multipliers Notes

Expenditure Multipliers

Learning Outcomes

  • Understand how expenditure plans are formed when the price level is fixed.
  • Explain the determination of real GDP with fixed price levels.
  • Discuss the concept of the expenditure multiplier.
  • Describe the relationship between aggregate expenditure and aggregate demand.

Fixed Prices and Expenditure Plans

  • The Keynesian model addresses the economy's behavior in the very short run with fixed prices.
  • Under fixed pricing:
  • The overall price level remains unchanged.
  • Real GDP is determined by aggregate demand.
  • Components influencing aggregate expenditure:
  • Total Expenditure = Consumption (C) + Investment (I) + Government Spending (G) + Exports (X) - Imports (M)
  • Consumption and imports are sensitive to changes in real GDP.

Two-Way Link Between Aggregate Expenditure and Real GDP

  • An increase in real GDP leads to:
  • Increased aggregate expenditure.
  • Conversely, an increase in aggregate expenditure results in:
  • Higher real GDP.

Planned Consumption Expenditure

  • Consumption (C) is influenced significantly by disposable income (YD).
  • Disposable Income Equation:
    YD = Real GDP (Y) - Net Taxes (T)
  • Consumption/Saving Relationship:
    A change in disposable income YD affects both consumption expenditure (C) and savings (S).
  • YD = C + S

Consumption Function

  • Positive consumption persists even at zero disposable income, termed autonomous consumption.
  • Changes in consumption tied to additional disposable income are referred to as induced consumption.

Other Influences on Consumption and Saving

  1. Real interest rates
  2. Wealth levels
  3. Expected future income
  • These factors affect the consumption function and shift both the consumption and saving functions.

Marginal Propensities to Consume and Save

  • Marginal Propensity to Consume (MPC):
    The fraction of a change in disposable income spent on consumption.
  • Formula: MPC = ∆C / ∆YD
  • Marginal Propensity to Save (MPS):
    The fraction of change in disposable income saved.
  • Formula: MPS = ∆S / ∆YD
  • Key relationship: MPC + MPS = 1.

Consumption and Real GDP

  • Disposable income changes with shifts in real GDP or tax rates.
  • If tax rates are constant, alterations in real GDP solely influence disposable income, thereby affecting consumption.

Import Function

  • Short-term imports in Canada mostly depend on the real GDP.
  • Marginal Propensity to Import (MPI):
    The fraction of an increase in real GDP spent on imports.

Real GDP with a Fixed Price Level

  • With a stable price level, aggregate demand emerges from planned expenditure calculations:
  • Planned Aggregate Expenditure = Planned Consumption + Planned Investment + Planned Government Expenditure + Planned Exports – Planned Imports
  • Planned consumption and imports are responsive to changes in real GDP, while planned investment and government expenditure remain steady.

Aggregate Planned Expenditure and Real GDP

  • An aggregate expenditure schedule reflects the planned expenditure corresponding with various real GDP levels.
  • The aggregate expenditure curve is a graphical representation of this schedule.

Equilibrium Expenditure

  • Actual expenditure equals real GDP; however, actual planned expenditure may differ, leading to potential inventory changes.
  • Equilibrium Expenditure occurs when aggregate planned expenditure matches real GDP.

Convergence to Equilibrium

  • If planned expenditure exceeds real GDP, firms face unplanned inventory drop:
  • Increases in production occur, raising real GDP.
  • If planned expenditure is less than real GDP, firms must reduce inventories:
  • Production decreases, leading to lower real GDP.
  • Equilibrium occurs when expenditure aligns with real GDP, stabilizing production levels.

The Multiplier Effect

  • Adjustments in autonomous expenditure create a larger shift in equilibrium expenditure and real GDP than the initial change.
  • The Multiplier Formula:
    Equilibrium expenditure change = Multiplier * Change in autonomous expenditure.
  • The multiplier effect elucidates how increases in expenditure lead to further increases in induced expenditure and thus real GDP.
  • Why Multiplier > 1? Each increment in autonomous expenditure leads to a cascading increase in overall expenditure.

The Multiplier and Aggregate Demand Curve

  • The slope of the aggregate expenditure curve (AE curve) influences the multiplier’s magnitude:
  • Multiplier Formula: Multiplier = 1 / (1 - Slope of AE curve)
  • Lower taxes or imports increases the multiplier size, while their presence diminishes it.

Business Cycle Impact

  • Peaks and troughs in the business cycle correlate with shifts in autonomous expenditure resulting in unplanned inventory changes leading to economic expansions or recessions.

Long-Run Effects

  • In the long run, the economy adjusts fully, with the multiplier effect dissipating to zero as the economy reaches its potential GDP, accounting for price level changes and wages affecting the short-run aggregate supply curve (SAS curve).