ECN 111 Chapter 15 Lecture Notes

15.1 Expenditure Plans and Real GDP A. The Economy at Full Employment At full employment, GDP equals potential GDP and is determined by real factors. Changes in the quantity of money change only the price level, but they have no effect on potential GDP. Away from potential GDP, real and monetary factors interact to determine real GDP. B. Departures from Full Employment Away from full employment, fluctuations in aggregate supply and aggregate demand bring fluctuations around full employment. C. Fixed Price Level The aggregate expenditure model tells us about the forces that determine the quantity of real GDP demanded at any given price level. D. Planned and Unplanned Expenditures Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government purchases plus planned exports minus planned imports. If aggregate planned expenditure equals real GDP, the change in firms’ inventories is the planned change. If aggregate planned expenditure exceeds real GDP, firms’ inventories are smaller than planned; if aggregate planned expenditure is less than real GDP, firms’ inventories are larger than planned. E. Autonomous Expenditure and Induced Expenditure The components of aggregate expenditure that do not change when real GDP changes are called autonomous expenditure. The components of aggregate expenditure that change when real GDP changes are called induced expenditure. F. The Consumption Function The consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same. 1. Consumption Plans For households and the economy as a whole, as disposable income increases, planned consumption expenditure increases. 2. Marginal propensity to consume (MPC) is the fraction of a change in disposable income that is spent on consumption. The marginal propensity to consume is equal to C h a n ge i n c o n s u m p t i on e x p e n d i t u re . C h a n ge i n d i s p o s a b l ei n c o m e 3. Other Influences on Consumption a. A movement along the consumption function results from a change in disposable income. b. Shifts in the consumption function result from changes in the real interest rate, the buying power of net assets, and expected future disposable income. G. Imports and GDP The major factor that influences U.S. imports is U.S. real GDP. An increase in real GDP is also an increase in income and, as income increases, consumers increase their expenditure on most goods and services, including imports. a. The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports—the change in imports divided by the change in real GDP. 15.2 Equilibrium Expenditure A. Aggregate Planned Expenditure and Real GDP Aggregate planned expenditure is the sum of planned consumption expenditure, investment, government purchases of goods and services, and exports minus imports. B. Equilibrium Expenditure Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. C. Convergence to Equilibrium When aggregate planned expenditure and actual aggregate expenditure are unequal, production plans and spending plans are inconsistent, and a process of convergence toward equilibrium expenditure occurs. 1. If aggregate planned expenditure exceeds real GDP, inventories decrease below their target levels. Firms increase their production to build up their inventories and GDP increases. 2. If aggregate planned expenditure is less than real GDP, inventories increase above their target levels. Firms decrease their production to reduce their inventories and GDP decreases. 15.3 The Expenditure Multiplier A. The Basic Idea of the Multiplier The multiplier is the amount by which a change in any component of autonomous expenditure is magnified or multiplied to determine the change that it generates in equilibrium expenditure and real GDP. 1. The multiplier exists because a change in autonomous expenditure creates a change in disposable income, which leads to additional changes in induced expenditure and disposable income. B. The Size of the Multiplier C h a n ge i n e q u i l i b r i um e x p e n d i t u re Multiplier = . C h a n ge i n a u t o n o m o u se x p e n d i t u re C. Why is the Multiplier Greater Than 1? The multiplier is greater than 1 because an increase in autonomous expenditure induces further increases in aggregate expenditure—induced expenditure increases. D. The Multiplier and the MPC The greater the marginal propensity to consume, the larger is the multiplier. Ignoring the effects of 1 imports and income taxes, the multiplier equals . ( 1  MPC ) E. Imports and Income Taxes The larger is the marginal propensity to import and the larger is the marginal tax rate (the fraction of a change in real GDP that is paid in income taxes), the smaller is the multiplier. 1. The general formula for the multiplier is 1 Multiplier = . ( 1  S l o p e o f AE c u r v e) F. Business-Cycle Turning Points The forces that bring business-cycle turning points are the swings in autonomous expenditure such as investment and exports. The mechanism that gives momentum to the economy's new direction is the multiplier. 15.4 The AD Curve and Equilibrium Expenditure A. Deriving the AD Curve from Equilibrium Expenditure. The AD curve can be derived from the aggregate expenditure model. 1. An increase in the price level decreases aggregate expenditure. 2. The decrease in aggregate expenditure is reflected in a downward shift in the AE curve. 3. The decrease in aggregate expenditure leads to a decrease in equilibrium expenditure. 4. Plotting the higher price level against the lower level of equilibrium expenditure creates a point on the aggregate demand (AD) curve. 5. Because a higher price level results in a lower quantity of real GDP demanded, the AD curve is downward sloping.