Chapter 10 Aggregate Expenditure and Aggregate Demand

 

I.                    Aggregate Expenditure and Income

 

In the model we have developed, GDP = AGGREGATE INCOME.

 

The aggregate demand curve (AD) tells us, at each price level, how much aggregate output will be demanded.

 

A.     EXAMPLE: Assume that the price level = 130. The following data tells us, at each level of aggregate income (REAL GDP - Y), how much will be spent.

 

 

Real GDP (Y)

Net Taxes (NT)

Disposable Income

(Y-NT)

Consumption - C

Savings

(S)

Planned Investment (I)

Government Purchases (G)

Net Exports (X-M)

Planned Aggregate Expenditure (AE)

Unintended Change in Inventory (Y-AE)

7.0

1.0

6.0

5.7

0.3

0.6

1.0

-0.1

7.2

-0.2

7.5

1.0

6.5

6.1

0.4

0.6

1.0

-0.1

7.6

-0.1

8.0

1.0

7.0

6.5

0.5

0.6

1.0

-0.1

8.0

0.0

8.5

1.0

7.5

6.9

0.6

0.6

1.0

-0.1

8.4

+0.1

9.0

1.0

8.0

7.3

0.7

0.6

1.0

-0.1

8.8

+0.2

 

What is the Marginal Propensity to consume in this economy?

 

 

 

 

What is the Marginal Propensity to save in this economy?

 

 

 

 

Which variables are considered autonomous of aggregate income?

 

 

 

 

 

When is planned investment equal to actual investment in this economy?

 

 

 

 

 

Planned Aggregate Expenditure = C + I (Planned) + G + X - M

(Amount that households, firms, government, and the rest of the world plans to spend on U.S. output)

 

 

B.     Income-Expenditure Model

 

Aggregate Expenditure Line -- a relationship showing, for a given price level, planned spending at each level of income, i.e. total C + I (Planned) + G + X - M at each level of aggregate income.

 

Graph:

 

 

Where the 45 degree line crosses the Aggregate Expenditure Line, aggregate output (real GDP) is equal to the amount people plan to spend on U.S. output. At the current price level, this is the aggregate output demanded.

 

 

C.     What happens when output and planned spending are different?

 

 

II.                Deriving the Aggregate Demand Curve

 

Up to this point, we have assumed that the price level is constant at 130. What happens to the quantity of aggregate output demanded if the price level changes?

 

 

A.     What if the price level increases? (140)

 

-         Consumption changes.

 

 

-         Planned investment changes.

 

 

Graph:

 

B.     What if the price level decreases? (120)

 

-         Consumption changes.

 

 

-         Investment changes.

 

 

 

III.             The Spending Multiplier

 

A.     How do changes in autonomous spending affect real GDP demanded?

 

Example: Suppose that firms become more optimistic. We learned in chapter 9 that they will increase their planned investment spending. Suppose firms increase their planned investment spending by $.1 trillion dollars. How does that change affect real GDP demanded?

 

 

How much does real GDP demanded change? Think about the circular flow of income, and suppose that the MPC in this country is 4/5. What happens when I increases by $.1 trillion.

 

1.      At our original output level (Real GDP = $8.0 trillion), planned spending is greater than output, so inventories fall (by $.1 trillion). In response, firms increase output by $.1 trillion.

2.      This increase in output translates directly to an increase in income to households. If NT do not change, then DI increases by $.1 trillion. Households spend $.1 trillion * MPC = $.08 trillion more than they did before.

3.      At $8.1 trillion in real GDP, planned spending is still greater than output by $.08 trillion, so firms increase their output by $.08 trillion.

4.      This increase in output translates directly to an increase in income to households. Households spend $.08 * MPC = $.064 more than they did before.

5.      Now spending is $.064 greater than output. This continues until the change in consumer spending is too small to measure.

 

Mathematically, the change in real GDP demanded from the increase in investment of $.1 trillion is written as:

                        $.1 trillion (1 + 4/5 + (4/5)2 + (4/5)3 +…)

 

The infinite series can be solved so that

 

D Real GDP demanded = $.1 trillion (1/(1-4/5)) = $.5 trillion

 

We can depict what occurred in our example graphically.

 

GRAPH:

 

 

B.     The Simple Spending Multiplier

 

(1/(1-4/5)) is the simple spending multiplier in our example. In general, the multiplier is 1/(1-MPC).

 

 

Simple Spending Multiplier - The ratio of a change in real GDP demanded to the initial change in expenditure that brought it about.

 

 

D Real GDP demanded = D autonomous spending (planned AE) * simple spending multiplier

(in equilibrium)              (initial change)

 

 

Practice Problems:

 

1.      Suppose that currently real GDP is $7.0 trillion and the MPC for our economy is 2/3. Depict graphically and explain what will happen in our economy if autonomous spending (I, G, C, or (X-M)) increases by $.8 trillion.

 

 

2.      Suppose that currently real GDP is $8.0 trillion and MPC for our economy is .8. If the government wants to increase real GDP demanded to $10.0 trillion, how much do they have to increase autonomous government spending? Depict what occurs graphically.