E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate

E4-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Extension Chapter 4

Aggregate expenditure model and multipliers


Learning Objectives• Describe the assumptions underlying the aggregate

expenditures model.• Explain the consumption–income and saving–income

relationships upon which the aggregate expenditures model is based.

• Examine the determinants of the level of investment (firms’ purchases of capital equipment), and analyse the impact of changes in its level on equilibrium real GDP, income and employment.


Learning Objectives (cont.)• Discuss the rationale for the presence of the

multiplier and the multiplier effect.• Apply the aggregate expenditures model to a

discussion of the paradox of thrift.• Examine the difference that may exist between the

equilibrium level of output and that corresponding to the full-employment level of output, allowing discussion of the nature of recessionary and inflationary gaps.


Learning Objectives (cont.)• Analyse the macroeconomic impacts of the

government sector and foreign trade on equilibrium GDP.

• Apply the aggregate expenditures model to explain the concept of the balanced-budget multiplier.


Aggregate Expenditures Model

Assumptions:1. Two sectors, i.e. closed economy with no

government.2. All savings are treated as personal savings.3. Depreciation and net Australian income earned

abroad are zero.4. Businesses make investment decisions.5. Real interest rates influence investment (I).6. All prices are fixed, including wages, i.e.

price-wage inflexibility exists.


Aggregate Expenditures (AE)• Sum of expenditures on consumption (C), investment

(I), government spending (G) and net exports (NX).• Determines the level of output and employment in the

economy.


Consumption and Savings• Both consumption and savings level are determined

by household disposable income (DI).• Households consume most of their DI.• DI that is not consumed is called savings.


Consumption ScheduleA schedule of the income–consumption relationship• shows the various amounts households plan or

intend to consume at various possible level of disposable income.


Saving ScheduleA schedule of the income–saving relationship• shows the various amounts households plan or

intend to save at various levels of disposable income.


425410405400

375

Consumption & Saving Schedules

Consumptionschedule

Savingschedule

Co

nsu

mp

tio

nS

avin

g

0

045

o

C

S

Disposable Income

Disposable Income370 390 410 430 450

370 390 410 430 450

Dissaving $5 billion

Saving $5 billion

Saving $5 billionDissaving $5 billion


Consumption and Household Disposable Income 2004–05


Average Propensity to Consume (APC)

• The fraction of any total income that is spent on consumption is:

APC =Consumption

Income


Average Propensity to Save (APS)• That fraction of total income that is saved is:

APS =

APC + APS = 1

Saving

Income


Marginal Propensity to Consume• That fraction of each additional dollar of income that

is consumed is:

MPC =

• Represented as the slope of the consumption schedule.

Change in consumption

Change in income


Marginal Propensity to Save• That fraction of each additional dollar of income that

is saved is:

MPS =

• Represented as the slope of the saving schedule.• Therefore MPC + MPS = 1

Change in saving

Change in income


The Marginal Propensity to Consume and the Marginal Propensity to Save


Non-Income Determinants of Consumption and Savings• wealth• price level• expectations• consumer indebtedness• taxation.• Changes in these determinants cause a shift (up

or down) of the curves.


Shifts in the Consumption & Saving Schedules

Co

ns

um

pti

on

Sa

vin

g

0

0 45o

C0

S0

C

S

Disposable Income

Disposable Income

C

C1

Anincrease in

consumption...

S1

S

Meansa decreasein saving


Shifts in the Consumption & Saving Schedules

Co

ns

um

pti

on

Sa

vin

g

0

0 45o

C

S

C

S

Disposable Income

Disposable Income

S

S

Meansan increase

in saving

Adecrease in

consumption...

C1


Determinants of InvestmentTwo determinants of investment are:• The expected rate of net profits that businesses hope

to realise from investment spending.• The real rate of interest.


Expected Rate of Net Profit• Businesses are motivated by profit.• Businesses invest if they expect a net profit from this

investment.


Real Rate of Interest• The inflation-adjusted cost associated with borrowing

money.• Equals nominal interest rate minus the inflation rate.• Investment projects will only be undertaken if net

expected profit rate exceeds real interest rate.


Investment Demand Curve• shows graphically the investment–interest rate

relationship• shows cumulative levels of investment at possible

levels of investment at some point in time.


Investment Demand Curve

Investment (billions of dollars)

Exp

ect

ed

ra

te o

f ne

t pro

fits

and

inte

rest

rat

e (p

er c

ent

)

16

14

12

10

8

6

4

2

05 10 15 20 25 30 35 40


Shifts in Investment Demand

Other determinants of investment are:• acquisition, operation and maintenance costs• business taxes• technological change• business expectations• stock of capital goods on hand• expectations.

Changes in these factors shift the investment demand curve.


Investment and Income• An autonomous investment is

– the desired level of investment based upon long-term profit expectations

• An induced investment is– the level of investment induced by the current level of

income.


Inve

stm

ent

(bil

lio

ns

of

do

llar

s)

Real domestic product, GDP (billions of dollars)

60

40

20

0370 390 410 450 430 450 490 510

AutonomousInvestment Schedule

II′

InducedInvestment Schedule

The Investment Schedule: Two Possibilities


Instability of Investment• Consumption (especially non-durables) is relatively

stable BUT• investment is unstable: Why?

– durable and therefore postponable purchases– irregularity of innovation– profit variability– variable expectations (consider the new global competitive

environment!).


The Volatility of Investment


Equilibrium Income/GDPThe two approaches to determine the equilibrium levels

of output and income are:

• Expenditures–Output approach• Leakages–Injections approach.


Expenditures–Output Approach• Utilises the relationship between AE and income.• In a two-sector economy, AE = C + I.• Equilibrium occurs where the total output (measured

by GDP) and aggregate expenditures (C + I ) for a two sector economy are equal.


Equilibrium GDP:Expenditures–Output Approach

Pri

vate

sp

end

ing

(bill

ion

s o

f d

olla

rs)

045

o

CC

C

GDP (billions of dollars)

370 390 410 430 450 470 490 510

(C + I = GDP) C + I

C + I

Equilibrium

C + I


Leakages–Injections Approach• This approach utilises the relationship between

leakages and injections back to the expenditure flow.• Two sectors: S = I at all levels I = total investment.• At equilibrium: S = planned investment.


Equilibrium GDP:Leakages–Injections Approach

S = I S

avi

ng

an

d In

ves

tmen

t(b

illio

ns

of

do

llars

)

S

S


370 390 410 430 450 470 490 510 530 550

60

40

20

0

–5

I I

(S = I = $20)

Equilibrium

{

UnplannedInventoryDecrease

At this levelof GDP


Equilibrium GDP:Leakages–Injections Approach

S = I S

avi

ng

an

d In

ves

tmen

t(b

illio

ns

of

do

llars

)

S

S


370 390 410 430 450 470 490 510 530 550

60

40

20

0

-5

I IS{}

UnplannedInventoryIncrease

At this levelof GDP

(S = I = $20)Equilibrium


Planned vs Unplanned Investment• Investment has two components:

– Planned investment as determined by investment demand schedule

– Unplanned investment is unintended changes in the level of inventories

– Actual investment = sum of planned and unplanned investment

• At equilibrium: Unplanned investment = zero


Achieving Equilibrium• Difference in savings and planned investment causes • Mismatching of production and spending causes • Revision of production plans by firms until equilibrium

is once again re-established• The level of GDP would be stable only where savings

and planned investment are equal


Changes in Equilibrium GDP• GDP is seldom stable. It is characterised by cyclical

fluctuations• Changes in investment schedule or the saving-

consumption schedule will lead to changes in equilibrium GDP

• Investment expenditures are generally less stable due to changes in the expected rate of net profit


Autonomous Expenditure Changes• Shifts in the AE curve due to changes in

autonomous expenditure– result in new equilibrium levels of output (GDP)– how much output changes by depends on the

size of the expenditure multiplier


Expenditure Multiplier• A change in autonomous expenditure results in a

change in equilibrium income that is a multiple of the initial change

• The multiplier is defined as the ratio of the change in GDP arising from a change in autonomous spending


Changes in Equilibrium GDP

Pri

va

te s

pe

nd

ing

(b

illi

on

s o

f d

oll

ars

)S

av

ing

an

d i

nv

es

tme

nt

(bil

lio

ns

of

do

lla

rs)

0

045

o

510510

490490

470470

450450

430430

2020I0

390 450 470 490 510390 450 470 490 510

Equilibrium GDPat I1 level of investment

S

(C + I ) 0

390 450 470 490 510390 450 470 490 510

(C + I ) 1

I1

If I increases...

Real GDP

Real GDP


Changes in Equilibrium GDP

Pri

vate

sp

end

ing

(b

illio

ns

of

do

llars

)

Sav

ing

an

d in

vest

men

t(b

illio

ns

of

do

llars

)

0

045

o

510510

490490

470470

450450

430430

2020 I0

430 450 470 490 510430 450 470 490 510

Equilibrium GDPat I2 level of investment

(C + I ) 0

S

430 450 470 490 510430 450 470 490 510

(C + I ) 2

I2

If I decreases...

Real GDP

Real GDP


The Multiplier Effect• A change in autonomous spending gives rise to a

larger change in GDP• The multiplier effect arises because initial increase in

aggregate expenditure will induce successive rounds of increased expenditure

• The multiplier = Changes in real GDP/Changes in I


Multiplier and Marginal Propensities• A relationship exists between the MPS (the

amount of leakage) and the multiplier• Multiplier = 1/MPS = 1/(1 – MPC)• The simple multiplier is defined as 1/MPS, when

the leakage in the economy is only saving


S, I & the Paradox of Thrift• Paradox of thrift:

– If society attempts to save more, it may end up actually saving the same amount or even less, as a result of the multiple decline in equilibrium GDP caused by the withdrawal of aggregate expenditure

• For savings to be beneficial it must be matched by injection, especially I


S2

S2

The Paradox of Thrift

Sa

vin

g a

nd

Inv

estm

ent

(bill

ion

s o

f d

olla

rs)

S


370 390 410 430 450 470 490 510

60

40

20

0

–5

I I

S1

S1


Recessionary Gap• The amount by which aggregate expenditures are

deficient to that required to generate the full employment level of GDP

• Produces a concretionary impact upon the economy


Recessionary Gap (cont.)

Real GDP (billions of dollars)

045

o

470 490 510470 490 510

(C + I )0

Full Employment

Pri

vate

sp

end

ing

(b

illi

on

s o

f d

oll

ars)

(C + I )1

} RecessionaryGap


Inflationary Gap• Is the amount by which aggregate spending exceeds

that required to achieve full employment• Produces an inflationary effect on the economy


Inflationary Gap (cont.)


045

o

470 490 510470 490 510

(C + I)0

Full Employment

Pri

vate

spen

din

g (

bil

lio

ns

of

do

llar

s)

(C + I)1

{{

InflationaryGap


Discretionary Fiscal Policy• Deliberate manipulation of taxes (T ) and spending (G

) by government for the purpose of altering real GDP and employment, controlling inflation and stimulating economic growth


Government Purchases (G)• Added to AE• Changes to autonomous government expenditure

impact equilibrium real GDP through the multiplier


Three-Sector Economy Equilibrium

• Aggregate expenditure = C + I + G = real GDP

and• S = I + G

where• C is after-tax consumption• S is after-tax saving


Government Expenditure and Equilibrium GDP

Governmentspending$20 billion

C + I + G

0 45o

4040

2020

00

470 510 550470 510 550

C + I


470 510 550470 510 550

C

S

C

+ I

+

G(b

illi

on

s o

f d

oll

ars)

S, I

+ G

(bill

ion

s o

f d

olla

rs)

I


I + G


Taxes and Equilibrium GDP• Taxes are assumed to be lump-sum

– A tax that collects the same amount at each level of GDP

• Reduces levels of both saving and consumption• How much S and C are affected depends on the

MPC and MPS


$5 billion decreasein saving

SaSa + T

$20 billion increasein taxes

Taxes and Equilibrium GDP

C +

I +

G(b

illi

on

s o

f d

oll

ars)

S +

T, I

+ G

(bill

ion

s o

f d

olla

rs)

045

o

4040

2020

00

490 550490 550

II + G

S

490 550490 550

$15 billiondecrease in

consumptionCa + I + G

C + I + G

Real GDP ( $billions )

Real GDP ($ billions)


Fiscal Policy over the Business CycleExpansionary fiscal policy• Increased G• Decreased T• or both• Moves Budget towards a deficit in recessionary

times


Fiscal Policy over the Business Cycle (cont.)Contractionary fiscal policy• Decreased G• Increased T• or both• Moves Budget towards a surplus in inflationary

times


The Multiplier and Fiscal Policy

If the tax function is of the form

T = TLS + MPT(Y )

where MPT = marginal propensity to tax ,

Multiplier = 1

MPT + MPS (1 – MPT)


Balanced-Budget Multiplier• The effect of an equal increase (or decrease) of both

the level of government expenditure and taxation• Increases (decreases) the level of equilibrium GDP

by exactly the amount of the increase (or decrease) in G and T

• Thus, equal increases in G and T are expansionary


Foreign Trade and Equilibrium GDP• Exports (X ) and imports (M ) are introduced into

the model• Net exports (NX) = X – M• AE = C + I + G + NX


Exports (X)

• Level of X depends on foreign countries’ income, not

on domestic income

• Therefore X is an autonomous variable in the model


Imports (M)

• Level of M is dependent on domestic income or GDP

• Given autonomous exports, a rise in imports due to a

rise in income results in a fall in NX


Equilibrium GDP with a rise in NX

Sp

end

ing

(b

illio

ns

of

do

llars

)

045

o Real GDP ($ billions)

510510

490490

470470

450450

450 470 490 510 530450 470 490 510 530

(C + I + G)

(C + I + G + NX)2

(C + I + G + NX)0

(C + I + G + NX)1


Open-Economy Multiplier• The introduction of foreign trade reduces:

– the expenditure multiplier– the slope of the AE curve

• The open-economy multiplier = 1/[MPS + MPM],

if taxes are lump sum with

no marginal propensity to tax

MPM is the marginal propensity to Import


The Complex Multiplier for an Open Economy• The multiplier that arises when all leakages—

savings, taxes, and imports—are taken into account:

1k = [MPT + MPS (1 – MPT) + MPM]


Next Chapter:

The economics of growth

Documents

E4-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Extension Chapter 4 Aggregate