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 expenditure model and multipliers

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

E4-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

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

E4-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Consumption Schedule A schedule of the income–consumption relationship shows the various amounts households plan or intend to consume at various possible level of disposable income.

E4-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Saving Schedule A schedule of the income–saving relationship shows the various amounts households plan or intend to save at various levels of disposable income.

E4-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Consumption & Saving Schedules Consumption schedule Saving schedule Consumption Saving o C S Disposable Income Dissaving $5 billion Saving $5 billion Dissaving $5 billion

E4-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Consumption and Household Disposable Income 2004–05

E4-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Average Propensity to Consume (APC) The fraction of any total income that is spent on consumption is: APC = Consumption Income

E4-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Average Propensity to Save (APS) That fraction of total income that is saved is: APS = APC + APS = 1 Saving Income

E4-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Marginal Propensity to Consume and the Marginal Propensity to Save

E4-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Shifts in the Consumption & Saving Schedules Consumption Saving o C0C0 S0S0 C S Disposable Income C C1C1 An increase in consumption... S1S1 S Means a decrease in saving

E4-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Shifts in the Consumption & Saving Schedules Consumption Saving o C S C S Disposable Income S S Means an increase in saving A decrease in consumption... C1C1

E4-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Determinants of Investment Two determinants of investment are: The expected rate of net profits that businesses hope to realise from investment spending. The real rate of interest.

E4-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Expected Rate of Net Profit Businesses are motivated by profit. Businesses invest if they expect a net profit from this investment.

E4-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Investment Demand Curve Investment (billions of dollars) Expected rate of net profits and interest rate (per cent)

E4-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Investment (billions of dollars) Real domestic product, GDP (billions of dollars) Autonomous Investment Schedule I I′I′ Induced Investment Schedule The Investment Schedule: Two Possibilities

E4-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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!).

E4-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Volatility of Investment

E4-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Equilibrium Income/GDP The two approaches to determine the equilibrium levels of output and income are: Expenditures–Output approach Leakages–Injections approach.

E4-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Equilibrium GDP: Expenditures–Output Approach Private spending (billions of dollars) 0 45 oC C GDP (billions of dollars) (C + I = GDP) C + I Equilibrium C + I

E4-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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.

E4-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Equilibrium GDP: Leakages–Injections Approach S = I Saving and Investment (billions of dollars) S S Real domestic product, GDP (billions of dollars) –5 I I (S = I = $20) Equilibrium { Unplanned Inventory Decrease At this level of GDP

E4-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Equilibrium GDP: Leakages–Injections Approach S = I Saving and Investment (billions of dollars) S S Real domestic product, GDP (billions of dollars) I I S{S{ } Unplanned Inventory Increase At this level of GDP (S = I = $20) Equilibrium

E4-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-39 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-40 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-41 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Changes in Equilibrium GDP Private spending (billions of dollars) Saving and investment (billions of dollars) o I0I Equilibrium GDP at I 1 level of investment S (C + I ) (C + I ) 1 I1I1 If I increases... Real GDP

E4-42 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Changes in Equilibrium GDP Private spending (billions of dollars) Saving and investment (billions of dollars) o I0I Equilibrium GDP at I 2 level of investment (C + I ) 0 S (C + I ) 2 I2I2 If I decreases... Real GDP

E4-43 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-44 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-45 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-46 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal S2S2 S2S2 The Paradox of Thrift Saving and Investment (billions of dollars) S Real domestic product, GDP (billions of dollars) –5 I I S1S1 S1S1

E4-47 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-48 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Recessionary Gap (cont.) Real GDP (billions of dollars) 0 45 o (C + I ) 0 Full Employment Private spending (billions of dollars) (C + I ) 1 } Recessionary Gap

E4-49 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Inflationary Gap Is the amount by which aggregate spending exceeds that required to achieve full employment Produces an inflationary effect on the economy

E4-50 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Inflationary Gap (cont.) Real GDP (billions of dollars) 0 45 o (C + I) 0 Full Employment Private spending (billions of dollars) (C + I) 1 { Inflationary Gap

E4-51 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-52 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Government Purchases (G) Added to AE Changes to autonomous government expenditure impact equilibrium real GDP through the multiplier

E4-53 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-54 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Government Expenditure and Equilibrium GDP Government spending $20 billion C + I + G 0 45 o C + I Real GDP (billions of dollars) C S C + I + G (billions of dollars) S, I + G (billions of dollars) I Real GDP (billions of dollars) I + G

E4-55 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-56 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal $5 billion decrease in saving SaSa S a + T $20 billion increase in taxes Taxes and Equilibrium GDP C + I + G (billions of dollars) S + T, I + G (billions of dollars) 0 45 o I I + G S $15 billion decrease in consumption C a + I + G C + I + G Real GDP ( $billions ) Real GDP ($ billions)

E4-57 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Fiscal Policy over the Business Cycle Expansionary fiscal policy Increased G Decreased T or both Moves Budget towards a deficit in recessionary times

E4-58 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Fiscal Policy over the Business Cycle (cont.) Contractionary fiscal policy Decreased G Increased T or both Moves Budget towards a surplus in inflationary times

E4-59 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Multiplier and Fiscal Policy If the tax function is of the form T = T LS + MPT(Y ) where MPT = marginal propensity to tax, Multiplier = 1 MPT + MPS (1 – MPT)

E4-60 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-61 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-62 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Exports (X) Level of X depends on foreign countries’ income, not on domestic income Therefore X is an autonomous variable in the model

E4-63 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-64 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Equilibrium GDP with a rise in NX Spending (billions of dollars) 0 45 o Real GDP ($ billions) (C + I + G) (C + I + G + NX) 2 (C + I + G + NX) 0 (C + I + G + NX) 1

E4-65 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal 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

E4-66 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal The Complex Multiplier for an Open Economy The multiplier that arises when all leakages— savings, taxes, and imports—are taken into account: 1 k = [MPT + MPS (1 – MPT) + MPM]

E4-67 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Next Chapter: The economics of growth