1 ECON203 Principles of Macroeconomics Topic: Expenditure Multipliers: The Keynesian Model Dr. Mazharul Islam 9W/10/2013

2 EXPENDITURE PLANS AND REAL GDP –From the circular flow of expenditure and income, aggregate expenditure is the sum of Consumption expenditure, C Investment, I Government expenditure on goods and services, G Net exports, NX ( = difference between spending on imports and receipts from exports (Balance of Payments) –Aggregate expenditure = C + I + G + NX. Dr. Mazharul Islam

3 EXPENDITURE PLANS AND REAL GDP Aggregate planned expenditure might not equal real GDP because firms might end up with more or less inventories than planned. Aggregate planned expenditure is planned consumption expenditure plus planned investment plus planned government expenditure plus planned exports minus planned imports. Dr. Mazharul Islam

4 EXPENDITURE PLANS AND REAL GDP Dr. Mazharul Islam The Consumption Function –Consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same. –Disposable income is aggregate income (GDP) minus net taxes. –Net taxes are taxes paid to the government minus transfer payments received from the government.

5 Dr. Mazharul Islam Dissaving Point on Consumption Function line ABCDEF Disposable income Planned Consumption Expenditure Consumption (trillions of dollars) A F E 6.0 D Saving is zero B C Saving 45 0 line

6 Consumption Function Dr. Mazharul Islam Along the 45° line, consumption expenditure equals disposable income.. When the consumption function is above the 45° line, saving is negative (dissaving occurs). When the consumption function is below the 45° line, saving is positive. At the point where the consumption function intersects the 45° line, all disposable income is consumed and saving is zero.

7 Dr. Mazharul Islam MPC onsume –Marginal propensity to consume (MPC) is the fraction of a change in disposable income that is spent on consumption. 7 MPC = Change in consumption expenditure Change in disposable income Example : Notice that when disposable income increases from $6 to $8 trillion, consumption expenditure changes from $6.0 to $7.5 trillion. Then:

8 Dr. Mazharul Islam Real Consumption Spending Disposable income (Expected) real interest rate Wealth Expected future disposable income Other Influences on Consumption

9 Dr. Mazharul Islam –A change in disposable income leads to a change in consumption expenditure and a movement along the consumption function. –A change in any other influence on planned consumption shifts the consumption function. –For example, When the real interest rate decreases, or wealth increases, or expected future income increases, consumption expenditure increases.

10 Dr. Mazharul Islam Shifts of the consumption function Consumption (trillions of 1996 dollars)Disposable income (trillions of 1996 dollars) CF 0 CF 2 CF 1 1. Consumption expenditure increases and the consumption function shifts upward if The real interest rate falls Wealth increases Expected future income increases 2. Consumption expenditure decreases and the consumption function shifts downward if The real interest rate rises Wealth decreases Expected future income decreases

11 Dr. Mazharul Islam Consumption and Saving Since there are only two places income can go: consumption or saving. The fraction of additional income that is not consumed is the fraction saved. The fraction of a change in income that is saved is called the marginal propensity to save (MPS). Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore,Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore,

12 Dr. Mazharul Islam Equilibrium Expenditure Using aggregate expenditure model (which is called the Keynesian model), we can determine equilibrium in the economy when aggregate planned expenditure equals real GDP- the price level being constant.

Dr. Mazharul Islam Planned Expenditures [Y][C][I][G][X][M][AE = C + I + G +X - M] trillions of 1996 dollars A B C D E F Note: Y is real GDP Aggregate expenditure is the sum of Consumption expenditure (C), Investment (I), Government expenditure (G), Net export (NX) [Export (X) minus Import (M)] 13

14 EQUILIBRIUM EXPENDITURE –Equilibrium expenditure is the level of aggregate expenditure when aggregate planned expenditure equals real GDP. –Equilibrium expenditure equals the real GDP at which the AE curve intersects the 45 line. –In macroeconomics, equilibrium in the goods market is the point at which planned aggregate expenditure is equal to aggregate output

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16 Dr. Mazharul Islam EQUILIBRIUM EXPENDITURE 1.When aggregate planned expenditure exceeds real GDP, an unplanned decrease in inventories occurs. 2.When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs. 3.When aggregate planned expenditure equals real GDP, there are no unplanned inventories and real GDP remains at equilibrium expenditure

17 Dr. Mazharul Islam –When aggregate planned expenditure is less than real GDP, firms cut production. Real GDP decreases. –When real GDP decreases, aggregate planned expenditure decreases. But real GDP decreases by more than planned expenditure, so eventually the gap between planned expenditure and actual expenditure closes. Vice a Versa

18 Dr. Mazharul Islam The Multiplier An autonomous change in aggregate spending leads to a chain reaction in which the change in real GDP is equal to the multiplier times the initial change in aggregate spending.

19 Dr. Mazharul Islam The Multiplier 19. The size of the multiplier, 1/(1 − MPC), depends on the marginal propensity to consume, : the larger the MPC, the larger the change in real GDP for any given autonomous increase in aggregate spending.,., or Marginal Propensity to Save MPS = 1-MPC

20 Dr. Mazharul Islam 20 THE EXPENDITURE MULTIPLIER The Basic Idea of the Multiplier –The initial increase in investment brings an even bigger increase in aggregate expenditure because it encourages an increase in consumption expenditure. –The multiplier determines the amount of the increase in aggregate expenditure that results from an increase in investment or another component of autonomous expenditure.

21 Dr. Mazharul Islam A $0.5 trillion increase in investment shifts the AE curve upward by $0.5 trillion from AE 0 to AE Equilibrium expenditure increases by $2 trillion from $9 trillion to $11 trillion. 3. The increase in equilibrium expenditure is 4 times the increase in investment, so the multiplier is 4 THE EXPENDITURE MULTIPLIER

22 Dr. Mazharul Islam 22 THE AD CURVE AND EQUILIBRIUM –The AE curve is the relationship between aggregate planned expenditure and real GDP when all other influences on expenditure plans remain the same. –The AD curve is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same.

23 Dr. Mazharul Islam 23 when the price level changes, the AE curve shifts. –When the price level changes, other things remaining the same, aggregate planned expenditure changes and equilibrium expenditure changes. –Aggregate planned expenditure changes because a change in the price level changes the buying power of net assets, the real interest rate, and the real prices of exports and imports.

24 Dr. Mazharul Islam 24 When the price level rises to 130, the AE curve shifts downward to AE 2. The quantity of real GDP demanded at the price level of 130 is $9 trillion—a movement along the AD curve to point A. Equilibrium expenditure decreases to $9 trillion at point A. THE AD CURVE AND EQUILIBRIUM 24

25 Now it’s over for today. Do you have any question? Dr. Mazharul Islam