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2 Aggregate Expenditure & Income A dollar spent (expenditure) Translates directly into a dollar earned (income) Aggregate expenditure components Consumption, C - varies with income Investment, I - autonomous Government purchases, G - autonomous Net exports, (X-M) autonomous 2

3 Aggregate Expenditure & Income Government budget: balanced G = Net taxes AE = C + I + G + (X-M) Aggregate expenditure line Planned spending At each level of real GDP (aggregate output; aggregate income) For a given price level Slope of AE line = MPC 3

4 Aggregate Expenditure & Income Income Expenditure model AE line, given price level 45-degree line Spending = real GDP Aggregate output demanded (real GDP) AE = real GDP 4

5 Aggregate Expenditure & Income If spending > real GDP Decrease inventories Increase Production Employment Income Spending 5

6 Aggregate Expenditure & Income If real GDP > spending Unsold goods: increase inventories Decrease Production Employment Income Spending 6

7 Aggregate expenditure (trillions of dollars) Exhibit 1 Deriving the Real GDP Demanded for a Given Price Level b 45 a e d c C+I+G+(X-M) Real GDP demanded for a given price level is found where aggregate expenditure equals aggregate output that is, where spending equals the amount produced, or real GDP. This occurs at point e, where the aggregate expenditure line intersects the 45- degree line Real GDP (trillions of dollars) 7

8 Simple Spending Multiplier Increased spending: AE line shifts upward Round one Spending > output Unplanned reduction in inventories Expand production Increased income 8

9 Simple Spending Multiplier Increased spending: AE line shifts upward Round two Increased spending and saving Increased output Increased income Round three and beyond Increased spending and saving Increased output Increased income as long as spending exceeds output 9

10 Aggregate expenditure (trillions of dollars) Exhibit 2 Effect of an Increase in Investment on Real GDP Demanded C+I +G+(X-M) f e h j g i e k C+I+G+(X-M) Real GDP (trillions of dollars) The economy is initially at point e, where spending and real GDP equal $14.0 trillion. A $0.1 trillion increase in investment shifts the aggregate expenditure line up vertically by $0.1 trillion from C+I+G+(X-M) to C+I +G+(X-M). Real GDP increases until it equals spending at point e. As a result of the $0.1 trillion increase in investment, real GDP demanded increases by $0.5 trillion, to $14.5 trillion. This analysis assumes a given price level. 10

11 Exhibit 3 Tracking the Rounds of Spending Following a $100 Billion Increase in Investment (billions of dollars) 11

12 Simple Spending Multiplier The larger the MPC The larger the simple spending multiplier Simple spending multiplier Ratio of a change in real GDP demanded To the initial change in spending that brought it about Only consumption varies with income 1 1 MPC 1 MPS 12

13 The Aggregate Demand Curve Each price level Unique AE line Yields a unique real GDP demanded Changing the price level Different real GDP demanded 13

14 The Aggregate Demand Curve Higher price level Decreased C Higher interest rate Decreased I Decreased (X-M) Reduced aggregate spending AE shifts down Decrease real GDP demanded 14

15 The Aggregate Demand Curve Lower price level Increase: C, I, (X-M) Increased aggregate spending AE line shifts up Increase real GDP demanded Aggregate demand curve Various price levels Quantities of real GDP demanded 15

16 Aggregate expenditure (trillions of dollars) Exhibit 4 Changing the Price Level to Find the Aggregate Demand Curve Price level 120 e 45 e e e e e AD AE (P=100) AE (P=110) AE (P=120) Real GDP (trillions of dollars) Real GDP (trillions of dollars) At the initial price level of 110, the aggregate expenditure line is AE, which identifies real GDP demanded of $14.0 trillion. This combination of a price level of 110 and a real GDP demanded of $14.0 trillion determines one combination (point e) on the aggregate demand curve in panel (b). At the higher price level of 120, the aggregate expenditure line shifts down to AE, and real GDP demanded falls to $13.5 trillion. This price-quantity combination is identified as point e in panel (b). At the lower price level of 100, the aggregate expenditure line shifts up to AE, which increases real GDP demanded. This combination is plotted as point e in panel (b). Connecting points e, e, and e in panel (b) yields the downward-sloping aggregate demand curve AD, which shows the inverse relation between the price level and real GDP demanded. 16

17 The Aggregate Demand Curve A given price level AE line relationship between Spending plans and income (real GDP) Change in price level Shifts AE line Changes real GDP demanded Movement along AD curve A given price level For changes in spending: shift AD curve 17

18 Price level Aggregate expenditure (trillions of dollars) Exhibit 5 A Shift of the AE Line That Shifts the AD Curve e e e e AD C+I +G+(X-M) C+I+G+(X-M) Real GDP (trillions of dollars) AD (a) Investment increase shifts up the aggregate expenditure line A shift of the aggregate expenditure line at a given price level shifts the aggregate demand curve. In panel (a), an increase in investment of $0.1 trillion, with the price level constant at 110, causes the aggregate expenditure line to increase from C+I+G+(X-M) to C+I +G+(X-M). As a result, real GDP demanded increases from $14.0 trillion to $14.5 trillion. (b) Investment increase shifts aggregate demand rightward In panel (b), the aggregate demand curve has shifted from AD out to AD. At the prevailing price level of 110, real GDP demanded has increased by $0.5 trillion Real GDP (trillions of dollars) 18

19 Exhibit 6 Percentage Changes by Quarter in Real GDP and Consumption Categories During the Four Worst Quarters of the Recession 19

20 Appendix A. Variable net exports revisited Net exports Inversely related to real GDP AE line: smaller slope Marginal propensity to import MPM Fraction of additional $ spent on imports Spending multiplier with variable (X-M) Smaller than simple spending multiplier 1 MPS MPM 20

21 Aggregate expenditure (trillions of dollars) Net exports (trillions of dollars) Exhibit 7 Net Exports and the Aggregate Expenditure Line (a) Variable net export function 0 X-M Real GDP (trillions of dollars) (b) Aggregate expenditure lines with and without net exports C+I+G C+I+G+(X-M) Real GDP (trillions of dollars) In panel (a), net exports, X-M, equal exports minus imports. Net exports are added to consumption, investment, and government purchases in panel (b) to yield C+I+G+(X-M). The addition of net exports has the effect of rotating the spending line about the point where net exports are zero, which occurs in this example where real GDP is $10.0 trillion. 21

22 Appendix A. Variable net exports revisited Change in autonomous spending Change in real GDP demanded Spending multiplier with variable net exports is smaller Change in autonomous spending times the spending multiplier Is smaller 22

23 Aggregate expenditure (trillions of dollars) Exhibit 8 Effect of a Shift of Autonomous Spending on Real GDP Demanded e C+I +G+(X-M) C+I+G+(X-M) e $ Real GDP (trillions of dollars) An increase in investment, other things constant, shifts the spending line up from C+I+G+(X-M) to C+I +G+(X-M), increasing the quantity of real GDP demanded. 23

24 Appendix B. Algebra of income & expenditure Y=C+I+G+(X-M) C= (Y-1.0) MPC=0.8 Y=income; real GDP Autonomous net taxes =$1.0 trillion DI=Y-1.0 C = Y 24

25 Appendix B. Algebra of income & expenditure I = $1.0 trillion G = $1.0 trillion X-M = - $ 0.4 trillion Y= Y Y=2.8 Y=$14.0 trillion 25

26 Appendix B. Algebra of income & expenditure General form C=a+b(Y-NT); b=mpc C=a-bNT+bY Income=Expenditure Y=a-bNT+bY+I+G+(X-M) Y Y' 1 1 b 1 1 b ( a ( a bnt bnt I I G G X X M ) M $1) 26

27 Appendix B. Algebra of income & expenditure Varying net exports Y=C+I+G+(X-M) X-M= (Y-1.0) Y= Y (Y-1.0) Y=$14.0 trillion Y=a+b(Y-NT)+I+G+X-m(Y-NT) Y 1 1 b m ( a bnt I G X mnt) 27