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# Ec1022_Chapter+27.pdf

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School
Department
Economics
Course
Economics 1022A/B
Professor
Jeannie Gillmore
Semester
Fall

Description
Chapter 27 Expenditure Multipliers Fixed Prices and Expenditure Plans • Several factors influence consumption expenditure and saving. • The most direct influence is disposable income, which is real GDP or aggregate income minus net taxes (taxes minus transfer payments). • Planned consumption expenditure plus planned saving equals disposable income. • The greater the disposable income, the greater is consumption expenditure and the greater is saving. • The relationship between consumption expenditure and disposable income, other things remaining the same, is called the consumption function. • The relationship between saving and disposable income, other things remaining the same, is called the saving function. • The extent to which a change in disposable income changes consumption expenditure depends on the marginal propensity to consume. • The marginal propensity to consume(MPC) is the fraction of a change in disposable income that is consumed. • The marginal propensity to consume is calculated as the changein consumption expenditure ΔC, divided by the change in disposable income, ΔYD. • That is: MPC = ΔC ÷ ΔYD • The extent to which a change in disposable income changes saving depends on the marginal propensity to save. • The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved. • The marginal propensity to save is calculated as the changein saving ΔS, divided by the change in disposable income, ΔYD. • That is: MPS = ΔS ÷ ΔYD • The marginal propensity to consume plus the marginal propensity to save sum to 1. • You can see this from the following: C + S = YD ΔC + ΔS = ΔYD (ΔC ÷ ΔYD) + (ΔS ÷ ΔYD) = (ΔYD ÷ ΔYD) MPC + MPS = 1 • The figure below shows the MPC as the slope of the consumption function. • MPC is \$150 billion ÷ \$200 billion = 0.75. • The figure below shows the MPS as the slope of the saving function. • MPS is \$50 billion ÷ \$200 billion = 0.25. The relationship between imports and real GDP is determined by themarginal propensity to import. • The marginal propensity to importis the fraction of an increase in real GDP that is spent on imports. • It is calculated as the change in imports divided by the change in real GDP that brought it about, other things remaining the same. Real GDP with a Fixed Price Level • Aggregate planned expenditure equals planned consumption expenditure plus planned investment plus planned government expenditures plus planned exports minus planned imports. • The table sets out an aggregate expenditure schedule, together with the components of aggregate planned expenditure. • The figure shows the AE curve. • It is made up from the consumption function minus the import function plus I, G, and X. • The AE curve can be thought of as two parts: o Autonomous expenditure o Induced expenditure • Autonomous expenditure is the sum of investment, government expenditures, and exports, which does not vary with real GDP. • Induced expenditure is consumption expenditure minus imports, which varies with real GDP. • Actual aggregate expenditure is always equal to real GDP. • Aggregate planned expenditure is not necessarily equal to real GDP. • Planned expenditure can depart from real GDP because of unplanned changes in inventories. • Equilibrium expenditure is in the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. • The figure shows equilibrium expenditure. • The AE curve shows aggregate planned expenditure at each level of real GDP. • The 45-degree line shows actual aggregate expenditure at each level of real GDP. • Only at point D is actual aggregate expenditure equal to aggregate planned expenditure. • So, \$1,200 billion is equilibrium real GDP. • Below \$1,200 billion, aggregate planned expenditure exceeds real GDP. • Above \$1,200 billion, aggregate planned expenditure is less than real GDP. • The bottom figure shows the unplanned inventory changes that bring a convergence to equilibrium expenditure. • Below \$1,200 billion, aggregate planned expenditure exceeds real GDP, so inventories fall below their target levels. • Firms increase production. • Real GDP increases. • Above \$1,200 billion, aggregate planned expenditure is less than real GDP, so inventories rise above their target levels. • Firms decrease production. • Real GDP decreases. • At \$1,200 billion, aggregate planned expenditure equals real GDP, so inventories remain at their target levels. • Firms do not change production. • Real GDP remains constant. The Multiplier • A change in expenditure generates a change in income. • The change in income induces a change in consumption expenditure. • The change in consumption expenditure increases income further. • Where does the process end? • 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. • Let’s look at the table of an AE schedule. • By studying the schedule, you can work out the equilibrium of real GDP (Y) and aggregate expenditure, AE. • The equilibrium is \$1,200 billion, the level at which aggregate planned expenditure equals real GDP. • Now suppose that aggregate planned expenditure increases \$50 billion. • We must make a new AE schedule. • Now what is the equilibrium? • Again, you can work it out from the schedule. • Equilibrium expenditure has now increased to \$1,400 billion, an increase of \$200 billion. • But aggregate planned expenditure increased by only \$50 billion. • The additional \$150 billion is induced expenditure and results from the multiplier. • Let’s look at this same phenomenon in the figureabove. • Initially, equilibrium is at \$1,200 billion. • When aggregate planned expenditure increases, the AE curve shifts upward. • Here, the AE curve shifts upward by \$50 billion. • The new AE curve is AE 1 • Equilibrium is now at \$1,400 billion. • In the example we’ve just studied, the multiplier is 4. • It is calculated as: Multiplier = Change in equilibrium expenditure Change in autonomous expenditure
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