Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited Aggregate Expenditure CHAPTER SIX

© 2004 McGraw–Hill Ryerson Limited Distinguish between autonomous and induced expenditures Understand the concept of expenditures equilibrium Explain what factors can affect spending and how they can affect income Describe how small changes in spending have a large effect on national income See the significance of the Keynesian revolution This Chapter Will Enable You to:

© 2004 McGraw–Hill Ryerson Limited Quick review/definitions GDP = national income = Y AE = aggregate expenditure = Question: does AE always equal Y? C + I + G + Xn

© 2004 McGraw–Hill Ryerson Limited The Expenditure Model (I) Autonomous spending –The portion of total spending that is independent of the level of income Induced spending –The portion of spending that depends on the level of income Aggregate expenditures = autonomous + induced

© 2004 McGraw–Hill Ryerson Limited The Expenditure Model (II) Marginal propensity to expend –The ratio of the change in aggregate expenditure that results from a change in income Marginal leakage rate –The rate of change of leakages that result from a change in income MPE =  aggregate expenditures /  income MLR =  total leakages /  income MLR = 1 - MPE

© 2004 McGraw–Hill Ryerson Limited The Tax Function and Disposable Income It shows the relationship between taxes and income –Marginal tax rate The ratio of the change in taxation as a result of a change in income To calculate it, you divide the change in taxes by the change in income –Disposable income It is national income minus taxes (Y - T) Total taxes = autonomous taxes + induced taxes

© 2004 McGraw–Hill Ryerson Limited The Consumption Function Autonomous consumption –The portion of consumer spending that is independent of the level of income Induced consumption –The portion of consumer spending that is dependent on the level of income Marginal propensity to consume –The ratio of the change in consumption to the corresponding change in income MPC =  consumption /  income

© 2004 McGraw–Hill Ryerson Limited The Saving Function S = Yd – C Yd = C + S Marginal propensity to save (MPS) –The change in savings as a result of a change in disposable income or national income MPS =  saving /  income

© 2004 McGraw–Hill Ryerson Limited The Consumption Function As disposable income rises, consumption also rises The slope of the consumption function is the MPC As disposable income rises, consumption also rises The slope of the consumption function is the MPC Income C C Autonomous consumption

© 2004 McGraw–Hill Ryerson Limited The Saving Function S Income S The slope of the saving function is the MPS The slope of the saving function is the MPS

© 2004 McGraw–Hill Ryerson Limited The Investment and Government Spending Functions I & G Income I G NOTE: Model assumes that both Investment and Government spending functions are autonomous Figure 6.2

© 2004 McGraw–Hill Ryerson Limited Exports, Imports and the Net Export Function Net Exports –It is assumed that exports are autonomous whereas imports are directly related to national income –Marginal propensity to import (MPM) The change in imports as a result of a change in national income –Balance of trade The value of a country’s export of goods and services less the value of imports MPM =  imports (IM) /  income (Y)

© 2004 McGraw–Hill Ryerson Limited Expenditure Equilibrium …is that level of income (and production) at which there is neither a surplus nor a shortage of goods and unplanned investment is zero Unplanned investment: the amount of unintended build-up or run-down of business inventories (= Y-AE)

© 2004 McGraw–Hill Ryerson Limited The Aggregate Expenditure Function The slope of the aggregate expenditure function is the MPE It is equal to the slope of the consumption function (MPC) minus the slope of the net export function (MPM) The slope of the aggregate expenditure function is the MPE It is equal to the slope of the consumption function (MPC) minus the slope of the net export function (MPM) AE Income AE C Xn Figure 6.4

© 2004 McGraw–Hill Ryerson Limited Expenditure Equilibrium (Graph) AE Y AE=Y G + I + X T + S + IM Y Shortage Surplus Figure 6.5

© 2004 McGraw–Hill Ryerson Limited The Net Export Function X, IM X N =X-IM X IM Income Trade + - Figure 6.3

© 2004 McGraw–Hill Ryerson Limited From Income to Disposable Income Disposable income –It is national income minus total taxes (Y - T) Total taxes = autonomous taxes + induced taxes Marginal tax rate –The ratio of the change in taxation as a result of a change in income MTR =  taxes /  income

© 2004 McGraw–Hill Ryerson Limited Where Income Goes MPC = (1 – MTR) x MPC D MPC D =  consumption /  disposable income MPE = MPC - MPM

© 2004 McGraw–Hill Ryerson Limited Autonomous and Induced Spending (I) Y AE Y=AE AE  Spending (effect)  Income (cause) Figure 6.7A

© 2004 McGraw–Hill Ryerson Limited Autonomous and Induced Spending (II) Y AE Y=AE AE  Autonomous spending (cause)  Level of Spending (effect) Figure 6.7B

© 2004 McGraw–Hill Ryerson Limited A Change in Autonomous Consumption Changes in wealth –Wealth effect The effect of a change in wealth on consumption spending Changes in the price level –Real-balances effect The effect that a change in the value of real balances has on consumption spending. The value of real balances is affected by changing price levels Changes in the age of consumer durables Changes in consumer expectations

© 2004 McGraw–Hill Ryerson Limited A Change in Investment Interest rates Purchase price, installation, maintenance and operating costs of capital goods The age of capital goods Business expectations Government regulations

© 2004 McGraw–Hill Ryerson Limited A Change in Government Spending Tax revenues Interest rates Social and cultural standards Voters’ expectation Budget philosophies Political considerations

© 2004 McGraw–Hill Ryerson Limited A Change in Autonomous Net Exports Comparative price levels The value of exchange rates –Exchange rates The value of a country’s currency in relation to foreign currencies Income levels abroad

© 2004 McGraw–Hill Ryerson Limited The Model’s Algebra Assume: C = Y D and T = Y C = Y I = 250 G = 400 X N = 100 – 0.1 Y

© 2004 McGraw–Hill Ryerson Limited The Multiplier (I) The effect on income of a change in autonomous spending The value of the multiplier depends on the MPE In general, a one dollar increase in autonomous spending will lead to more than a dollar increase in income

© 2004 McGraw–Hill Ryerson Limited The Multiplier (II) AE Income AE 2 AE 1 Y=AE Shortages cause result Figure 6.8

© 2004 McGraw–Hill Ryerson Limited The Multiplier (III) An increase in investment will lead to an increase in income, which will in turn lead to an increase in consumption Multiplier =  income /  autonomous expenditures Multiplier = 1 / (1 – MPE) or 1 / MLR or 1 / MPC - MPM The higher the MPE, the higher the multiplier.

© 2004 McGraw–Hill Ryerson Limited The Model’s Algebra Assume: C = Y I = 250 G = 400 X N = 100 – 0.1 Y Then… AE = Y = C + I + G + X N = Y – 0.1Y 0.5Y = 800 Y = 1600

© 2004 McGraw–Hill Ryerson Limited Summing up (I) Income will increase if one of the following increases: –Autonomous consumption –Investment –Exports –Government spending Income will increase if one of the following decreases: –Autonomous taxes –Autonomous imports

© 2004 McGraw–Hill Ryerson Limited Summing up (II) The value of the multiplier will increase if any of the following decreases: –Marginal propensity to save (MPS or MPS D ) –Marginal tax rate –Marginal propensity to import

© 2004 McGraw–Hill Ryerson Limited A Look at Keynesian Revolution The Great Depression and the low employment equilibrium due to shortage in purchasing power Keynes’ prescription: that the government borrow and spend, increasing autonomous expenditures and boosting incomes (and therefore purchasing power and consumption)

© 2004 McGraw–Hill Ryerson Limited Derivation of the Aggregate Demand Curve AE2 AE1 AE3 AE Y1Y2 Y3 Y P2 P1 P3 AD

© 2004 McGraw–Hill Ryerson Limited A change in expenditure can be autonomous or induced Expenditures are in equilibrium when they equal income and there is no unplanned investment Many factors can affect spending and therefore income. Can you list and explain them? Describe how small changes in spending have a large effect on national income Summarized the significance of the Keynesian revolution Chapter Summary: What to Study and Remember