2 AE (Aggregate Expenditure) Concepttotal expenditure in the economy which is equal to the sum of C, I, G and NX.Autonomous vs. induced expenditureAutonomous: spending not influenced by the level of real GDP (e.g., I, G, X)Induced: spending affected by the level of real GDP (e.g., C)Planned vs. unplannedActual expenditure = planned plus unplanned expenditure = real GDP
3 AE (Aggregate Expenditure) Continued Distinction between AE and ADAE : relationship between planned aggregate expenditure and real GDPAD: relationship between real GDP demanded and the price level
4 Consumption Expenditure Induced expenditureConsumption function: relationship between consumption expenditure and disposable income (consumption depends on disposable income)MPC (marginal propensity to consume): the fraction of the change in disposable income that is spent on consumptionMPC = Δ C / Δ Disposable IncomeMPC for the US economy is .87Other variables that affect (shift) consumptionReal interest rate, purchasing power of money, expected future disposable income
5 Other Expenditures Imports Exports Investment Government purchase Induced expenditure (imports depend on the level of real GDP)Marginal propensity to import = Δ imports / Δ real GDPExportsAutonomous expenditureInvestmentGovernment purchase
6 Equilibrium Expenditure The level of aggregate expenditure that occurs when planned aggregate expenditure equals real GDPIf AE > real GDP Unplanned decrease in inventories production increase back to equilibrium levelIf AE < real GDP Unplanned increase in inventories production decrease back to equilibrium level
7 Expenditure Multiplier You thought it is over with the multiplier with the 2nd test, but not yet.What is it?The magnitude by which real GDP (= equilibrium expenditure) changes from a change in autonomous expenditureΔ real GDP / Δ autonomous expenditureFormulaExpenditure multiplier = 1/ (1-MPC)
8 Expenditure Multiplier Continued How to obtain the formulaAssuming no government and no foreign sector, Δ Y = Δ C + Δ IΔ C can be expressed as MPC * Δ Y.So, Δ Y = MPC * Δ Y + Δ IBy rearranging, Δ Y – MPC * Δ Y = Δ I or (1-MPC) Δ Y = Δ ITherefore, Δ Y / Δ I = 1 / (1-MPC)Actual multiplier is smaller than theoretically predicted because of imports and income taxes.