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Copyright © 2006 Pearson Education Canada Expenditure Multipliers PART 8Aggregate Demand and Inflation 23 CHAPTER

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Copyright © 2006 Pearson Education Canada Objectives After studying this chapter, you will able to Explain how expenditure plans and real GDP are determined when the price level is fixed Explain equilibrium expenditure at a fixed price level Explain the expenditure multiplier and how recessions and expansions begin Explain the relationship between aggregate expenditure and aggregate demand and how the multiplier gets smaller as the price level changes

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Copyright © 2006 Pearson Education Canada Economic Amplifier or Shock Absorber? A voice can be a whisper or fill Toronto’s Molson Amphitheatre, depending on the amplification. A limousine with good shock absorbers can ride smoothly over terrible potholes. Investment and exports can fluctuate like the amplified voice, or the terrible potholes; does the economy react like a limousine, smoothing out the bumps, or like an amplifier, magnifying the fluctuations? These are the questions this chapter addresses.

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP The components of aggregate expenditure sum to real GDP. That is, Y = C + I + G + X – M Two of the components of aggregate expenditure, consumption and imports, are influenced by real GDP. So there is a two-way link between aggregate expenditure and real GDP.

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP The two-way link between aggregate expenditure and real GDP: An increase in real GDP increases aggregate expenditure An increase in aggregate expenditure increases real GDP

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP Consumption and Saving Plans Consumption expenditure is influenced by many factors but the most direct one is disposable income. Disposable income is aggregate income or real GDP, Y, minus net taxes, NT. Call disposable income YD. The equation for disposable income is YD = Y – NT

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP Disposable income is either spent on consumption goods and services, C, or saved, S. That is, YD = C + S. The relationship between consumption expenditure and disposable income, other things remaining the same, is the consumption function. The relationship between saving and disposable income, other things remaining the same, is the saving function.

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP Figure 23.1 illustrates the consumption function and the saving function.

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Expenditure Plans and GDP Marginal Propensity to Consume The marginal propensity to consume (MPC) is the fraction of a change in disposable income spent on consumption. It is calculated as the change in consumption expenditure, C, divided by the change in disposable income, YD, that brought it about. That is: MPC = C/ YD

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Copyright © 2006 Pearson Education Canada Figure 23.2(a) shows that the MPC is the slope of the consumption function. Along this consumption function, when disposable income increases by $100 billion, consumption expenditure increases by $75 billion and the MPC is 0.75. Expenditure Plans and GDP

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Expenditure Plans and GDP Marginal Propensity to Save The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved. It is calculated as the change in saving, S, divided by the change in disposable income, YD, that brought it about. That is: MPS = S/ YD

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Copyright © 2006 Pearson Education Canada Figure 23.2(b) shows that the MPS is the slope of the saving function. Along this saving function, when disposable income increases by $100 billion, saving increases by $25 billion and the MPC is 0.25. Expenditure Plans and GDP

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Expenditure Plans and GDP The MPC plus the MPS equals one. To see why, note that, C + S = YD. Divide this equation by YD to obtain, C/ YD + S/ YD = YD/ YD, or MPC + MPS = 1.

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Copyright © 2006 Pearson Education Canada Other Influences on Consumption Expenditure and Saving When an influence other than disposable income changes— the real interest rate, wealth, or expected future income— the consumption function and saving function shift. Figure 23.3 illustrates these effects. Expenditure Plans and GDP

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP The Canadian Consumption Function In 1961, the Canadian consumption function was CF 61. The dots show consumption and disposable income for each year from 1961 to 2004.

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP The consumption function has shifted upward over time because economic growth has created greater wealth and higher expected future income. The assumed MPC in the figure is 0.85.

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Expenditure Plans and GDP Consumption as a Function of Real GDP Disposable income changes when either real GDP changes or when net taxes change. If tax rates don’t change, real GDP is the only influence on disposable income, so consumption expenditure is a function of real GDP. We use this relationship to determine equilibrium expenditure.

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Copyright © 2006 Pearson Education Canada Expenditure Plans and GDP Import Function In the short run, Canadian imports are influenced primarily by Canadian real GDP. The marginal propensity to import is the fraction of an increase in real GDP spent on imports. In recent years, NAFTA and increased integration in the global economy have increased Canadian imports. Removing the effects of these influences, the Canadian marginal propensity to import is probably about 0.3.

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Copyright © 2006 Pearson Education Canada Equilibrium Expenditure at a Fixed Price Level The Aggregate Implications of Fixed Prices Fixed prices have two implications for the economy as a whole: 1.Because each firm’s price is fixed, the price level is fixed. 2.Because demand determines the quantities that each firm sells, aggregate demand determines the aggregate quantity of goods and services sold, which equals real GDP.

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Copyright © 2006 Pearson Education Canada Equilibrium Expenditure at a Fixed Price Level To understand how real GDP is determined when the price level is fixed, we must understand how aggregate demand is determined. Aggregate demand is determined by aggregate expenditure plans. Aggregate planned expenditure is planned consumption expenditure plus planned investment plus planned government expenditures plus planned exports minus planned imports.

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Copyright © 2006 Pearson Education Canada Equilibrium Expenditure at a Fixed Price Level We’ve seen that planned consumption expenditure and planned imports are influenced by real GDP. When real GDP increases, planned consumption expenditure and planned imports increase. Planned investment plus planned government expenditures plus planned exports are not influenced by real GDP. We’re going to study the aggregate expenditure model that explains how equilibrium expenditure is determined.

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Copyright © 2006 Pearson Education Canada Equilibrium Expenditure at a Fixed Price Level The Aggregate Expenditure Model The relationship between aggregate planned expenditure and real GDP can be described by an aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each level of real GDP. The relationship can also be described by an aggregate expenditure curve, which is a graph of the aggregate expenditure schedule.

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Copyright © 2006 Pearson Education Canada Equilibrium Expenditure at a Fixed Price Level Aggregate Planned Expenditure and Real GDP Figure 23.5 shows how the aggregate expenditure curve is built from its components.

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Equilibrium Expenditure at a Fixed Price Level Consumption expenditure minus imports, which varies with real GDP, is induced expenditure. The sum of investment, government purchases, and exports, which does not vary with GDP, is autonomous expenditure. (Consumption expenditure and imports can have an autonomous component.)

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Copyright © 2006 Pearson Education Canada Equilibrium Expenditure at a Fixed Price Level Actual Expenditure, Planned Expenditure, and Real GDP Actual aggregate expenditure is always equal to real GDP. Aggregate planned expenditure may differ from actual aggregate expenditure because firms can have unplanned changes in inventories. Equilibrium Expenditure Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP.

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Copyright © 2006 Pearson Education Canada Figure 23.6 illustrates equilibrium expenditure. Equilibrium occurs at the point at which the aggregate expenditure curve crosses the 45° line in part (a). Equilibrium occurs when there are no unplanned changes in business inventories in part (b). Equilibrium Expenditure at a Fixed Price Level

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Convergence to Equilibrium Figure 23.6 also illustrates the process of convergence toward equilibrium expenditure. Equilibrium Expenditure at a Fixed Price Level

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Copyright © 2006 Pearson Education Canada If aggregate planned expenditure is greater than real GDP (the AE curve is above the 45° line), an unplanned decrease in inventories induces firms to hire workers and increase production, so real GDP increases. Equilibrium Expenditure at a Fixed Price Level

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If aggregate planned expenditure is less than real GDP (the AE curve is below the 45° line), an unplanned increase in inventories induces firms to fire workers and decrease production, so real GDP decreases. Equilibrium Expenditure at a Fixed Price Level

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If aggregate planned expenditure equals real GDP (the AE curve intersects the 45° line), no unplanned changes in inventories occur, so firms maintain their current production and real GDP remains constant. Equilibrium Expenditure at a Fixed Price Level

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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.

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Copyright © 2006 Pearson Education Canada The Multiplier The Basic Idea of the Multiplier An increase in investment (or any other component of autonomous expenditure) increases aggregate expenditure and real GDP and the increase in real GDP leads to an increase in induced expenditure. The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP. So real GDP increases by more than the initial increase in autonomous expenditure.

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Copyright © 2006 Pearson Education Canada The Multiplier Figure 23.7 illustrates the multiplier. The amplified change in real GDP that follows an increase in autonomous expenditure is the multiplier effect.

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Copyright © 2006 Pearson Education Canada The Multiplier When autonomous expenditure increases, inventories make an unplanned decrease, so firms increase production and real GDP increases to a new equilibrium.

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The Multiplier Why Is the Multiplier Greater than 1? The multiplier is greater than 1 because an increase in autonomous expenditure induces further increases in expenditure. The Size of the Multiplier The size of the multiplier is the change in equilibrium expenditure divided by the change in autonomous expenditure.

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Copyright © 2006 Pearson Education Canada The Multiplier The Multiplier and the Slope of the AE Curve The slope of the AE curve determines the magnitude of the multiplier: Multiplier = 1 ÷ (1 – Slope of AE curve)

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Copyright © 2006 Pearson Education Canada The Multiplier To see why the multiplier = 1 ÷ (1 – Slope of AE curve), begin with the fact that: Y = N + A But Slope of AE curve = N ÷ Y so, N = Slope of AE curve x Y and Y = Slope of AE curve x Y + A

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Copyright © 2006 Pearson Education Canada The Multiplier Because Y = Slope of AE curve x Y + A you can see that 1 Slope of AE curve) x Y = A and Y = A ÷ 1 Slope of AE curve)

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Copyright © 2006 Pearson Education Canada The Multiplier The multiplier is Y ÷ A So, divide both sides of Y = A ÷ 1 Slope of AE curve) by A to obtain Y ÷ A = 1 ÷ 1 Slope of AE curve)

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Copyright © 2006 Pearson Education Canada The Multiplier With the numbers in Figure 23.7, the slope of the AE curve is 0.75, so the multiplier is Y ÷ A = 1 ÷ 1 0.75) = 1 ÷ 0.25) = 4. When there are no income taxes and no imports, the slope of the AE curve equals the marginal propensity to consume, so the multiplier is Multiplier = 1 ÷ 1 MPC). But 1 – MPC = MPS, so the multiplier is also Multiplier = 1 ÷ MPS.

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Copyright © 2006 Pearson Education Canada The Multiplier Figure 23.8 illustrates the multiplier process and shows how the MPC determines the magnitude of the amount of induced expenditure at each round as aggregate expenditure moves toward equilibrium expenditure.

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The Multiplier Math ∆Y = ∆I + b∆I + b 2 ∆I + b 3 ∆I + b 4 ∆I + b 5 ∆I + …. (where b = slope of AE curve). Multiply by b to obtain b∆Y = b∆I + b 2 ∆I + b 3 ∆I + b 4 ∆I + b 5 ∆I + …. b n approaches zero as n becomes large so b (n + 1) also approaches zero. Subtract the second equation from the first to obtain ∆Y – b∆Y = ∆I, or (1 – b) ∆Y = ∆I, so that ∆Y = ∆I/(1 – b).

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Copyright © 2006 Pearson Education Canada The Multiplier Imports and Income Taxes Income taxes and imports both reduce the size of the multiplier. Figure 23.9 shows how. In part (a) with no taxes or imports, the slope of the AE curve is 0.75 and the multiplier is 4.

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The Multiplier In part (b), with taxes and imports, the slope of the AE curve is 0.5 and the multiplier is 2.

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The Multiplier Business Cycle Turning Points Turning points in the business cycle—peaks and troughs—occur when autonomous expenditure changes. An increase in autonomous expenditure brings an unplanned decrease in inventories, which triggers an expansion. A decrease in autonomous expenditure brings an unplanned increase in inventories, which triggers a recession.

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Copyright © 2006 Pearson Education Canada The Multiplier and the Price Level In the equilibrium expenditure model, the price level is constant. But real firms don’t hold their prices constant for long. When they have an unplanned change in inventories, they change production and prices. And the price level changes when firms change prices. The aggregate supply-aggregate demand model explains the simultaneous determination of real GDP and the price level. The two models are related.

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Copyright © 2006 Pearson Education Canada The Multiplier and the Price Level Aggregate Expenditure and Aggregate Demand The aggregate expenditure curve is the relationship between aggregate planned expenditure and real GDP, with all other influences on aggregate planned expenditure remaining the same. The aggregate demand curve is the relationship between the quantity of real GDP demanded and the price level, with all other influences on aggregate demand remaining the same.

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Copyright © 2006 Pearson Education Canada The Multiplier and the Price Level Aggregate Expenditure and the Price Level When the price level changes, a wealth effect and substitution effect change aggregate planned expenditure and change the quantity of real GDP demanded. Figure 23.10 on the next slide illustrates the effects of a change in the price level on the AE curve, equilibrium expenditure, and the quantity of real GDP demanded.

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Copyright © 2006 Pearson Education Canada The Multiplier and the Price Level In Figure 23.10(a), a rise in price level from 110 to 130 … Shifts the AE curve from AE 0 downward to AE 1 and … Decreases the equilibrium expenditure from $1,000 billion to $900 billion.

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Copyright © 2006 Pearson Education Canada The Multiplier and the Price Level In Figure 23.10(b), the same rise in the price level that lowers equilibrium expenditure brings a movement along the AD curve to point A.

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The Multiplier and the Price Level A fall in price level from 110 to 90 … Shifts the AE curve from AE 0 upward to AE 2 and… Increases equilibrium expenditure from $1,000 billion to $1,100 billion.

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Copyright © 2006 Pearson Education Canada The Multiplier and the Price Level The same fall in the price level that increases equilibrium expenditure brings a movement along the AD curve to point C.

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The Multiplier and the Price Level Points A, B, and C on the AD curve correspond to the equilibrium expenditure points A, B, and C at the intersection of the AE curve and the 45° line.

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The Multiplier and the Price Level Figure 23.11 illustrates the effects of an increase in autonomous expenditure. An increase in autonomous expenditure shifts the AE curve upward … …and shifts the AD curve rightward by the multiplied increase in equilibrium expenditure.

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The Multiplier and the Price Level Equilibrium Real GDP and the Price Level Figure 23.12 shows the effect of an increase in investment in the short run when the price level changes and the economy moves along its SAS curve.

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The Multiplier and the Price Level The increase in investment shifts the AE curve upward and shifts the AD curve rightward. With no change in the price level, real GDP would increase to $1,200 billion at point B.

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The Multiplier and the Price Level But the price level rises. The AE curve shifts downward…. Reduces equilibrium expenditure … Equilibrium real GDP decreases along the AD curve. The multiplier effect is smaller than when the price level is fixed.

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The Multiplier and the Price Level Real GDP increases from $1,000 billion from $1,130 billion, instead of to $1,200 billion as it does with a fixed price level.

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The Multiplier and the Price Level Figure 23.13 illustrates the long-run effects of an increase in autonomous expenditure at full employment.

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Copyright © 2006 Pearson Education Canada The Multiplier and the Price Level If the increase in autonomous expenditure takes real GDP above potential GDP and there is an inflationary gap. The money wage rate rises, the SAS curve shifts leftward, and real GDP decreases until it is back at potential real GDP. In the long run, the multiplier is zero.

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