CHAPTER 12 Expenditure Multipliers ECONOMICS 5e Michael Parkin CHAPTER 12 Expenditure Multipliers Chapter 29 in Economics

Learning Objectives Explain how expenditure plans are determined when the price level is fixed Explain how real GDP is determined when the price level is fixed Explain the expenditure multiplier Explain how imports and taxes influence the multiplier

Learning Objectives (cont.) Explain how recessions and expansions begin Explain the relationship between aggregate expenditure and aggregate demand Explain how the multiplier gets smaller as the price level changes

Learning Objectives Explain how expenditure plans are determined when the price level is fixed Explain how real GDP is determined when the price level is fixed Explain the expenditure multiplier Explain how imports and taxes influence the multiplier

Fixed Prices and Expenditure Plans In the very short term, firms’ prices are fixed. The quantities they sell depend on demand, not supply.

Fixed Prices and Expenditure Plans The Aggregate Implications of Fixed Prices 1) Because each firm’s price is fixed, the price level is fixed.

Fixed Prices and Expenditure Plans The Aggregate Implications of Fixed Prices 2) Because demand determines the quantities that each firm sells, aggregate demand determines the aggregate quantity of goods and services sold, which equals GDP.

Fixed Prices and Expenditure Plans The aggregate expenditure model explains fluctuations in aggregate demand by identifying the forces that determine expenditure plans.

Fixed Prices and Expenditure Plans The components of aggregate expenditure are: 1) Consumption expenditure 2) Investment 3) Government purchases of goods and services 4) Net exports (exports minus imports)

Fixed Prices and Expenditure Plans Expenditure Plans (cont.) Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government purchases plus planned exports minus planned imports.

Fixed Prices and Expenditure Plans Expenditure Plans (cont.) In the very short term all are fixed except planned consumption expenditure and planned imports. They depend on the level of GDP.

Fixed Prices and Expenditure Plans A Two-Way Link Between Aggregate Expenditure and GDP (cont.) 1) An increase in real GDP increases aggregate planned expenditure

Fixed Prices and Expenditure Plans A Two-Way Link Between Aggregate Expenditure and GDP (cont.) 2) An increase in aggregate expenditure increases real GDP How does real GDP influence planned consumption expenditure and saving?

Fixed Prices and Expenditure Plans Consumption Function and Saving Function We are going to focus on the relationship between consumption expenditures and disposable income when other factors are constant. The reason: disposable income and consumption expenditures are interrelated.

Fixed Prices and Expenditure Plans The main factors that influence consumption and saving are: 1) Real interest rate 2) Disposable income 3) Purchasing power of net assets 4) Expected future income

Fixed Prices and Expenditure Plans Consumption Function and Saving Function The consumption function shows the relationship between consumption expenditure and disposable income. The saving function shows the relationship between saving and disposable income.

Consumption Function and Saving Function Planned Disposable consumption Planned income expenditure saving (trillions of 1992 dollars per year) a 0 0.75 -0.75 b 1 1.50 -0.50 c 2 2.25 -0.25 d 3 3.00 0 e 4 3.75 0.25 f 5 4.5 0.50 Instructor Notes: The table shows consumption expenditure and saving plans at various levels of disposable income.

Consumption Function and Saving Function 5 a b c d e f Saving 4 (trillions of 1992 dollars/year) Consumption expenditure Dissaving 3 Consumption function 2 Instructor Notes: 1) The graph shows the relationship between consumption expenditure and disposable income (the consumption function). 2) The height of the consumption function measures consumption expenditure at each level of disposable income. 3) Points a through f on the consumption function correspond to the rows of the table. 4) The height of the 45o line measures disposable income. 5) So, along the 45o line, consumption expenditure equals disposable income. 6) When the consumption function is above the 45o line, saving is negative (dissaving occurs). 7) When the consumption function is below the 45o line, saving is positive. 8) At the point where the consumption function intersects the 45o line, all disposable income is consumed and saving is zero. 9) Consumption expenditure that occurs when disposable income is zero is autonomous consumption. 10) Consumption in excess of this is called induced consumption. 1 1 2 3 4 5 Disposable income (trillions of 1992 dollars per year)

Consumption Function and Saving Function Consumption expenditure that occurs when disposable income is zero is autonomous consumption. Consumption in excess of this is called induced consumption.

Consumption Function and Saving Function 1 a b c d e f Dissaving Saving (trillions of 1992 dollars per year) 1 3 4 5 Disposable income (trillions of 1992 dollars per year) Instructor Notes: 1) The graph shows the relationship between saving and disposable income (the saving function). 2) The height of the saving function measures saving at each level of disposable income. 3) Points a through f on the saving function correspond to rows of the table. -1

Fixed Prices and Expenditure Plans Marginal Propensities to Consume and Save The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed.

Fixed Prices and Expenditure Plans Marginal Propensities to Consume and Save The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved.

Fixed Prices and Expenditure Plans Marginal Propensities to Consume and Save Example: An increase in disposable income from $3 trillion to $4 trillion increases saving from zero to $0.25 trillion. The $1 trillion increase in disposable income increases saving by $0.25 trillion. The MPS is $0.25 trillion divided by $1 trillion, or 0.25.

Fixed Prices and Expenditure Plans Marginal Propensities to Consume and Save Example: The MPS plus the MPC always equals 1. Therefore, the MPC is 0.75.

Fixed Prices and Expenditure Plans Marginal Propensities to Consume and Save Divide both sides of the equation by the change in disposable income to obtain:

Fixed Prices and Expenditure Plans These two values are the marginal propensity to consume and the marginal propensity to save, so:

Fixed Prices and Expenditure Plans Slopes and Marginal Propensities The slopes of the consumption function and the saving function are the marginal propensities to consume and save.

Marginal Propensities to Consume and Save 45o line 5 a b c d e f MPC= 0.75 Consumption function 4 Consumption expenditure (trillions of 1992 dollars/year) trillion 3 trillion 2 Instructor Notes: 1) The marginal propensity to consume, MPC, is equal to the change in consumption expenditure divided by the change in disposable income, other things remaining the same. 2) It is measured by the slope of the consumption function. 3) In the graph, the MPC is 0.75. 1 1 2 3 4 5 Disposable income (trillions of 1992 dollars per year)

Marginal Propensities to Consume and Save MPS= 0.25 Saving function 1 a b c d e f Saving (trillions of 1992 dollars per year) 1 trillion 3 4 5 Disposable income (trillions of 1992 dollars per year) Instructor Notes: 1) The marginal propensity to save, MPS, is equal to the change ins saving divided by the change in disposable income, other things remaining the same. 2) It is measured by the slope of the saving function. 3) In the graph, the MPS is 0.25. -1

Fixed Prices and Expenditure Plans Other Influences on Consumption Expenditure and Saving Changes in disposable income leads to movements along the consumption function and saving function.

Fixed Prices and Expenditure Plans Other Influences on Consumption Expenditure and Saving A change in any other factor that influences consumption expenditure and saving shifts both the consumption function and the saving function.

Fixed Prices and Expenditure Plans The other factors that change consumption expenditure and saving are: 1) Real interest rates 2) The purchasing power of net assets 3) Expected future income

Shifts in the Consumption and Saving Function CF1 45o line 5 CF0 CF2 4 Consumption expenditure (trillions of 1992 dollars/year) 3 2 Instructor Notes: A rise in the real interest rate or a decrease in either the purchasing power of net assets or expected future income shifts the consumption function downward from CF0 to CF2 and shifts the saving function upward from SF0 to SF2. 1 1 2 3 4 5 Disposable income (trillions of 1992 dollars per year)

Shifts in the Consumption and Saving Function SF2 1 SF0 Saving (trillions of 1992 dollars per year) SF1 1 2 3 4 5 Instructor Notes: A rise in the real interest rate or a decrease in either the purchasing power of net assets or expected future income shifts the consumption function downward from CF0 to CF2 and shifts the saving function upward from SF0 to SF2. Disposable income (trillions of 1992 dollars per year) -1

The U.S. Consumption Function Instructor Notes: 1) Each blue dot shows consumption expenditure and disposable income for a particular year. 2) The lines CF0 and CF1 are estimates of the U.S. consumption function in 1970 and 1996, respectively. 3) Here, the (assumed) marginal propensity to consume is 0.75.

Fixed Prices and Expenditure Plans Consumption as a Function of Real GDP Consumption changes when disposable income changes. Disposable income changes when either real GDP changes or net taxes change. Instructor Notes: 1) A fall in the real interest rate, an increase in the purchasing power of net assets, or an increase in expected future income increases consumption expenditure and decreases saving. 2) It shifts the consumption function upward from CF0 to CF1 and shifts the saving function downward from SF0 to SF1. 3) A rise in the real interest rate or a decrease in either the purchasing power of net assets or expected future income shifts the consumption function downward from CF0 to CF2 and shifts the saving function upward from SF0 to SF2.

Fixed Prices and Expenditure Plans Consumption as a Function of Real GDP Holding taxes constant, consumption depends not only on disposable income, but also on real GDP. Imports are also influenced by real GDP. Instructor Notes: 1) A fall in the real interest rate, an increase in the purchasing power of net assets, or an increase in expected future income increases consumption expenditure and decreases saving. 2) It shifts the consumption function upward from CF0 to CF1 and shifts the saving function downward from SF0 to SF1. 3) A rise in the real interest rate or a decrease in either the purchasing power of net assets or expected future income shifts the consumption function downward from CF0 to CF2 and shifts the saving function upward from SF0 to SF2.

Fixed Prices and Expenditure Plans Import Function The greater the U.S. real GDP, the larger is the quantity of U.S. imports, other things remaining the same. The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports. Instructor Notes: 1) A fall in the real interest rate, an increase in the purchasing power of net assets, or an increase in expected future income increases consumption expenditure and decreases saving. 2) It shifts the consumption function upward from CF0 to CF1 and shifts the saving function downward from SF0 to SF1. 3) A rise in the real interest rate or a decrease in either the purchasing power of net assets or expected future income shifts the consumption function downward from CF0 to CF2 and shifts the saving function upward from SF0 to SF2.

Learning Objectives Explain how expenditure plans are determined when the price level is fixed Explain how real GDP is determined when the price level is fixed Explain the expenditure multiplier Explain how imports and taxes influence the multiplier

Real GDP with a Fixed Price Level How does aggregate expenditure plans interact to determine real GDP when the price level is fixed?

Real GDP with a Fixed Price Level First, we will study the relationship between aggregate planned expenditure and real GDP. Second, we’ll learn about the key distinction between planned expenditure and actual expenditure.

Real GDP with a Fixed Price Level An aggregate expenditure schedule lists aggregate planned expenditure generated at each level of real GDP. An aggregate expenditure curve is a graph of the aggregate expenditure schedule.

Aggregate Planned Expenditure Consumption Government planned Real GDP expenditure Investment purchases Exports Imports expenditure (Y) (C) (I) (G) (X) (M) (AE=C+I+G+X–M) (trillions of 1992 dollars) a 0 0.75 0.5 0.55 1.2 0.0 3 b 2 2.25 0.5 0.55 1.2 0.5 4 c 4 3.75 0.5 0.55 1.2 1.0 5 d 6 5.25 0.5 0.55 1.2 1.5 6 e 8 6.75 0.5 0.55 1.2 2.0 7 f 10 8.25 0.5 0.55 1.2 2.5 8 Instructor Notes: 1) The aggregate expenditure schedule shows the relationship between aggregate planned expenditure and real GDP. 2) Aggregate planned expenditure is the sum of planned consumption expenditure, investment, government purchases of goods and services, and exports minus imports. 3) For example, in row b of the table, when real GDP is $2 trillion, planned consumption expenditure is $2.25 trillion, planned investment is $0.5 trillion, planned government purchases of goods and services are $0.55 trillion, planned exports are $1.2 trillion, and planned imports are $0.5 trillion. 4) Thus when real GDP is $2 trillion, aggregate planned expenditure is $4 trillion (($2.25 + $0.5 + $0.55 + $1.2 - $0.5). 5) The schedule shows that aggregate planned expenditure increases as real GDP increases.

Aggregate Planned Expenditure I + G + X + C 10 Imports AE a b c d e f 8 Aggregate planned expenditure (trillions of 1992 dollars/year) 6 Consumption expenditure 4 Instructor Notes: 1) This relationship is graphed as the aggregate expenditure curve AE, the line af. 2) The components of aggregate expenditure that increases with real GDP are consumption expenditure and imports. 3) The other components--investment, government purchases, and exports--do not vary with real GDP. I + G + X 2 I + G I 2 4 6 8 10 Real GDP (trillions of 1992 dollars per year)

Aggregate Planned Expenditure and Real GDP Induced expenditure is the sum of the components of aggregate expenditure that vary with real GDP. Autonomous expenditure is the sum of the components of aggregate expenditure that are not influenced by real GDP.

Aggregate Planned Expenditure and Real GDP Actual Expenditure, Planned Expenditure, and Real GDP Actual aggregate expenditure is always equal to real GDP However, aggregate planned expenditure is not necessarily equal to actual aggregate expenditure and therefore is not necessarily equal to real GDP.

Aggregate Planned Expenditure and Real GDP Actual Expenditure, Planned Expenditure, and Real GDP Actual and planned expenditure sometimes differ because firms might end up with more inventories than planned or with less inventories than planned.

Aggregate Planned Expenditure and Real GDP Equilibrium Expenditure Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. When aggregate planned expenditure and actual aggregate expenditure are unequal, a process of convergence toward equilibrium expenditure occurs.

Aggregate Planned Expenditure and Real GDP Convergence to Equilibrium When actual and planned expenditure are unequal, unplanned changes in business inventories (investment) occur. GDP either increases or decreases until actual expenditures equal planned expenditures.

Equilibrium Expenditure Aggregate planned Unplanned Real GDP expenditure inventory change (Y) (AE) (Y-AE) (trillions of 1992 dollars) a 0 3 –3 b 2 4 –2 c 4 5 –1 d 6 6 0 e 8 7 1 f 10 8 2 Instructor Notes: 1) This table shows expenditure plans at different levels of real GDP. 2) When real GDP is $6 trillion, aggregate planned expenditure equals real GDP.

Equilibrium Expenditure 45o line Real GDP exceeds planned expenditure 10.0 8.0 Aggregate planned expenditure (trillions of 1992 dollars/year) f e d 6.0 Equilibrium expenditure b c 4.0 Instructor Notes: The graph illustrates equilibrium expenditure, which occurs when aggregate planned expenditure equal real GDP at the intersection of the 45o line and the AE curve. Planned expenditure exceeds real GDP a 2.0 2 4 6 8 10 Real GDP (trillions of 1992 dollars per year)

Equilibrium Expenditure Unplanned inventory investment Unplanned increase in inventories 4.0 f 2.0 Unplanned decrease in inventories e (trillions of 1992 dollars per year) Unplanned inventory change d 2 4 6 8 10 Real GDP (trillions of 1992 dollars per year) c Instructor Notes: 1) The graph shows the forces that bring about equilibrium expenditure. 2) When aggregate planned expenditure exceeds real GDP, inventories decrease--for example, point b in both parts of the figure. 3) Firms increase production, and real GDP increases. 4) When aggregate planned expenditure is less than real GDP, inventories increase--for example, point f in both of these graphs. 5) Firms decrease production, and real GDP decreases. 6) When aggregate planned expenditure equals real GDP, there are no unplanned inventory changes and real GDP remains constant at equilibrium expenditure. –2.0 b a –4.0

Learning Objectives Explain how expenditure plans are determined when the price level is fixed Explain how real GDP is determined when the price level is fixed Explain the expenditure multiplier Explain how imports and taxes influence the multiplier

The Multiplier A fall in real interest rates, a wave of innovation, or an increase in the demand for U.S. exports will lead to an increase in autonomous expenditure.

The Multiplier The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.

The Multiplier The Basic Idea of the Multiplier Suppose that investment increases. This means that aggregate expenditure and real GDP increases. Disposable income increases. Consumption expenditures increase.

The Multiplier The Basic Idea of the Multiplier Aggregate expenditure increases again. Real GDP, disposable income, and consumption expenditure increase more. The initial increase in investment brings an even bigger increase in aggregate expenditure because it induces an increase in consumption expenditure.

The Multiplier Aggregate planned expenditure Real GDP Original New (Y) (AE0) (AE1) (trillions of 1992 dollars) 5 a 5.25 a' 5.75 6 b 6.00 b' 6.50 7 c 6.75 c' 7.25 8 d 7.50 d' 8.00 9 e 8.25 e' 8.75

The Multiplier AE1 9 AE0 8 7 6 5 5 6 7 8 9 Aggregate expenditure b' c' d' 45o line 9 e' AE0 Aggregate expenditure (trillions of 1992 dollars) 8 e A $0.5 trillion increase in investment... d 7 c 6 b …increases real GDP by $2 trillion Instructor Notes: 1) Equilibrium expenditure increase by $2 trillion, from $6 trillion to $8 trillion. 2) The increase in equilibrium expenditure is 4 times the increase in autonomous expenditure, so the multiplier is 4. a 5 5 6 7 8 9 Real GDP (trillions of 1992 dollars)

The Multiplier The Size of the Multiplier The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure that it generates.

The Multiplier The multiplier is (from the table shown earlier): Change in equilibrium expenditure Change in autonomous expenditure = = 4 $2 trillion $0.5 trillion

The Multiplier The Multiplier and the Marginal Propensity to Consume and Save The larger the marginal propensity to consume, the larger the multiplier.

The Multiplier A change in real GDP equals the change in consumption expenditure plus the change in investment:

The Multiplier But the change in consumption expenditure is determined by the change in real GDP and the marginal propensity to consume:

I Y MPC    ) ( The Multiplier Substituting in the previous equation we get: I Y MPC    ) (

The Multiplier Solving for we get:

The Multiplier Dividing both sides of this equation by we get:

The Multiplier Using this formula, with MPC = 0.75, the multiplier is:

The Multiplier Process 2.0 1.5 1.0 0.5 Instructor Notes: 1) Autonomous expenditure increases in round 1 by $0.5 trillion. 2) As a result, real GDP increases by the same amount. 3) With a marginal propensity to consume of 0.75, each additional dollar of real GDP induces an additional 0.75 of a dollar of aggregate expenditure. 4) The round 1 increase in real GDP induces an increase in consumption expenditure of $0.375 trillion in round 2. 5) At the end of round 2, real GDP has increased by $0.875 trillion. 6) The extra $0.375 trillion of real GDP in round 2 induces a further increase in consumption expenditure of $0.281 trillion in round 3. 7) Real GDP increases yet further to $1.156 trillion. 8) This process continues with real GDP increasing by ever smaller amounts. 9) When the process comes to an end, real GDP has increased by a total of $2 trillion. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Expenditure round Increase in current round Cumulative increase from previous rounds

Learning Objectives Explain how expenditure plans are determined when the price level is fixed Explain how real GDP is determined when the price level is fixed Explain the expenditure multiplier Explain how imports and taxes influence the multiplier

The Multiplier Process Imports and Income Taxes The marginal propensity to import and the marginal tax rate also affects the multiplier. Imports and income taxes reduce the multiplier. Instructor Notes: 1) Autonomous expenditure increases in round 1 by $0.5 trillion. 2) As a result, real GDP increases by the same amount. 3) With a marginal propensity to consume of 0.75, each additional dollar of real GDP induces an additional 0.75 of a dollar of aggregate expenditure. 4) The round 1 increase in real GDP induces an increase in consumption expenditure of $0.375 trillion in round 2. 5) At the end of round 2, real GDP has increased by $0.875 trillion. 6) The extra $0.375 trillion of real GDP in round 2 induces a further increase in consumption expenditure of $0.281 trillion in round 3. 7) Real GDP increases yet further to $1.156 trillion. 8) This process continues with real GDP increasing by ever smaller amounts. 9) When the process comes to an end, real GDP has increased by a total of $2 trillion.

The Multiplier and the Slope of the AE Curve 45o line 9 AE0 b 8 Aggregate expenditure (trillions of 1992 dollars) 7 When the slope of the AE curve is 0.75, the multiplier is 6 Instructor Notes: 1) Imports and income taxes make the AE curve less steep and reduce the value of the multiplier. 2) In the graph, with no imports and income taxes, the slope of the AE curve is 0.75 (the marginal propensity to consume) and the multiplier is 4. 5 5 6 7 8 9 Real GDP (trillions of 1992 dollars)

The Multiplier and the Slope of the AE Curve 45o line 9 Aggregate expenditure (trillions of 1992 dollars) AE1 8 AE0 7 When the slope of the AE curve is 0.50, the multiplier is 6 Instructor Notes: 1) With imports and income taxes, the slope of the AE curve is less than the marginal propensity to consume. 2) The slope of the AE curve is 0.5. 3) In this case, the multiplier is 2. 5 5 6 7 8 9 Real GDP (trillions of 1992 dollars)

Learning Objectives (cont.) Explain how recessions and expansions begin Explain the relationship between aggregate expenditure and aggregate demand Explain how the multiplier gets smaller as the price level changes

The Multiplier Business Cycle Turning Points An Expansion Begins An expansion is triggered by an increase in autonomous expenditure that increases aggregate planned expenditure. At the trough of the business cycle, aggregate planned expenditure exceeds real GDP.

The Multiplier Business Cycle Turning Points An Expansion Begins Business inventories take an unplanned dive. Production increases and incomes increase. The multiplier effect causes the expansion to gain speed.

The Multiplier Business Cycle Turning Points A Recession Begins A recession is triggered by an decrease in autonomous expenditure that decreases aggregate planned expenditure. At the peak of the business cycle, real GDP exceeds aggregate planned expenditure.

The Multiplier Business Cycle Turning Points A Recession Begins Unplanned inventories begin to increase. Production decreases and incomes decrease. The multiplier effect causes the recession to take hold.

The Multiplier Business Cycle Turning Points The Next U.S. Recession? The U.S. economy has been in a business cycle expansion since 1991. Inventories began to increase in 1994, but they were planned increases. Recessions will occur — predicting them far in advance with any accuracy is virtually impossible.

Learning Objectives (cont.) Explain how recessions and expansions begin Explain the relationship between aggregate expenditure and aggregate demand Explain how the multiplier gets smaller as the price level changes

The Multiplier and the Price Level When firms inventories fall below the desired level, they increase production. At some point, they also increase their prices. When firms inventories are above the desired level, they decrease production. Eventually, they cut their prices.

The Multiplier and the Price Level We will use the aggregate supply-aggregate demand model to study the determination of real GDP and the price level.

The Multiplier and the Price Level We must understand the distinction between the aggregate expenditure and aggregate demand. Furthermore, we must understand the distinction between their corresponding curves.

The Multiplier and the Price Level The aggregate expenditure curve illustrates the relationship between the aggregate planned expenditure and real GDP. The aggregate demand curve illustrates the relationship between aggregate demand and the price level. Let's look at how these are related

The Multiplier and the Price Level Aggregate Expenditure and the Price Level The aggregate demand curve is downward sloping for two main reasons 1) Wealth effect 2) Substitution effects

Aggregate Demand 9 AE2 8 AE1 AE0 7 6 5 5 6 7 8 9 Effect of decrease in price level 45o line 9 AE2 c 8 AE1 Aggregate planned expenditure (trillions of 1992 dollars) AE0 7 b Effect of increase in price level 6 a Instructor Notes: 1) A change in the price level shifts the AE curve and results in a movement along the AD curve. 2) When the price level is 110, the AE curve is AE0 , and equilibrium expenditure is $7 trillion at point b. 3) When the price level rises to 130, the AE curve is AE1, and equilibrium expenditure is $6 trillion at point a. 4) When the price level falls to 980, the AE curve is AE2 , and equilibrium expenditure is $8 trillion at point c. 5) Points a, b, and c on the AD curve in the second graph correspond to the equilibrium expenditure points a, b, and c in the first. 5 5 6 7 8 9 Real GDP (trillions of 1992 dollars)

Aggregate Demand AD 140 Effect of increase in price level a (GDP deflator, 1992 = 100) Price level 130 120 Effect of decrease in price level b 110 100 Instructor Notes: 1) A change in the price level shifts the AE curve and results in a movement along the AD curve. 2) When the price level is 110, the AE curve is AE0 , and equilibrium expenditure is $7 trillion at point b. 3) When the price level rises to 130, the AE curve is AE1, and equilibrium expenditure is $6 trillion at point a. 4) When the price level falls to 980, the AE curve is AE2 , and equilibrium expenditure is $8 trillion at point c. 5) Points a, b, and c on the AD curve in the second graph correspond to the equilibrium expenditure points a, b, and c in the first. c 90 5 6 7 8 9 Real GDP (trillions of 1992 dollars)

A Change in Aggregate Demand 45o line A $1 trillion increase in investment increases aggregate planned expenditure... 10 AE1 Aggregate planned expenditure (trillions of 1992 dollars) b 9 AE0 8 Instructor Notes: 1) The price level is 110. 2) When the aggregated expenditure curve is AE0 , the aggregate demand curve is AD0. 3) An increase in autonomous expenditure shifts the AE curve upward to AE1. 4) In the new equilibrium, real GDP is $9 trillion (at b). 7 a 7 8 9 10 Real GDP (trillions of 1992 dollars)

A Change in Aggregate Demand …and increases aggregate demand. The multiplier in this example is 2. AD1 140 (GDP deflator, 1992 = 100) Price level 130 120 b 110 a 100 Instructor Notes: 1) An increase in autonomous expenditure shifts the AE curve upward to AE1. 2) In the new equilibrium, real GDP is $9 trillion (at b). 3) Because the quantity of real GDP demanded at a price level of 110 increases to $9 trillion, the AD curve shifts rightward to AD1 . AD0 90 7 8 9 10 Real GDP (trillions of 1992 dollars)

A Change in Aggregate Demand Summary 1) If some factor other that a change in the price level increases autonomous expenditure, the AE curve shifts upward and the AD curve shifts rightward. 2) The size of the AD curve shift depends on the change in autonomous expenditure and the multiplier.

Learning Objectives (cont.) Explain how recessions and expansions begin Explain the relationship between aggregate expenditure and aggregate demand Explain how the multiplier gets smaller as the price level changes

The Multiplier and the Price Level An Increase in Aggregate Demand in the Short Run When price level effects are taken into account, an increase in investment still has a multiplier effect on real GDP, but the effect is smaller than it would be if the price level were fixed.

The Multiplier and the Price Level An Increase in Aggregate Demand in the Short Run The steeper the slope of the short-run aggregate supply curve, the larger is the increase in the price level and the smaller is the multiplier effect on real GDP.

The Multiplier in the Short Run An increase in investment increases aggregate planned expenditure... 45o line 10 AE1 Aggregate planned expenditure (trillions of 1992 dollars) AE2 b 9 AE0 8.6 c 8 …but the price level rises, which decreases aggregate planned expenditure Instructor Notes: 1) An increase in investment shifts the AE curve from AE0 to AE1 and shifts the AD curve from AD0 to AD1. 2) The price level does not remain at 110 but rises, and the higher price level shifts the AE curve downward from AE1 to AE2. 3) The economy moves to point c in both graphs. 4) In the short run when prices are flexible, the multiplier effect is smaller than when the price level is fixed. 7 a 7 8 8.6 9 10 Real GDP (trillions of 1992 dollars)

The Multiplier in the Short Run AD1 140 130 SAS (GDP deflator, 1992 = 100) Price level c 116 An increase in investment increases aggregate planned expenditure... b 110 a 100 Instructor Notes: 1) An increase in investment shifts the AE curve from AE0 to AE1 and shifts the AD curve from AD0 to AD1. 2) The price level does not remain at 110 but rises, and the higher price level shifts the AE curve downward from AE1 to AE2. 3) The economy moves to point c in both graphs. 4) In the short run when prices are flexible, the multiplier effect is smaller than when the price level is fixed. …but the price level rises, which decreases aggregate planned expenditure 90 AD0 7 8 8.6 9 10 Real GDP (trillions of 1992 dollars)

The Multiplier and the Price Level An Increase in Aggregate Demand in the Long Run In the long run, an increase in aggregate demand leaves real GDP unchanged but increases the price level. In the long run, the multiplier is zero.

The Multiplier in the Long Run 45o line AE1 b 9 AE2 c Aggregate planned expenditure (trillions of 1992 dollars) 8 AE0 a' 7 a Instructor Notes: 1) In the long run, the money wage rate rises, the SAS curve shifts to SAS1, the AE curve shifts back to AE0. the price level rises, and real GDP falls. 2) The economy moves to point a', and in the long run, the multiplier is zero. 6 6 7 8 9 Real GDP (trillions of 1992 dollars)

The Multiplier in the Long Run 45o line 9 Aggregate planned expenditure (trillions of 1992 dollars) 8 AE0 a' 7 a Instructor Notes: 1) In the long run, the money wage rate rises, the SAS curve shifts to SAS1, the AE curve shifts back to AE0. the price level rises, and real GDP falls. 2) The economy moves to point a', and in the long run, the multiplier is zero. 6 6 7 8 9 Real GDP (trillions of 1992 dollars)

The Multiplier in the Long Run LAS SAS1 150 AD1 a' 140 130 Price level (GDP deflator) SAS0 c 116 b 110 a 100 Instructor Notes: 1) In the long run, the money wage rate rises, the SAS curve shifts to SAS1, the AE curve shifts back to AE0. the price level rises, and real GDP falls. 2) The economy moves to point a', and in the long run, the multiplier is zero. 90 AD0 6 7 8 8.6 9 Real GDP (trillions of 1992 dollars)

Review A change in the price level shifts the AE curve and brings a movement along the AD curve. A change in autonomous expenditure that is not caused by a change in the price level shifts both the AE curve and the AD curve, and the multiplier determines the magnitude of the shift in the AD curve.

Review In the short run, the increase in real GDP that results from an increase in autonomous expenditure is smaller than the increase in aggregate demand. In the long run, an increase in aggregate demand leaves real GDP unchanged but increases the price level. In the long run, the multiplier is zero.

The Algebra of the Multiplier

The Algebra of the Multiplier

The Algebra of the Multiplier

The End