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CHAPTER 27

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Department
Economics
Course
EC140
Professor
Matthew Smith
Semester
Winter

Description
EC140 Chapter 27-Expenditure Multipliers: The Keynesian Model Week 2 Fixed Prices and Expenditure Plans -In the Keynesian model, all firms are like the grocery store: They set their prices and sell the quantities their customers are willing to buy -If they persistently sell a greater quantity than they plan to and have inventories piling up, they eventually cut their prices and vice versa -On any given day, their prices are fixed and the quantities they sell depend on demand, not supply -Because  each  firm’s  prices  are  fixed,  for  the  economy  as  a  whole 1. The price level is fixed, and 2. Aggregate demand determines real GDP Expenditure Plans -Aggregate expenditure has four components: consumption expenditure, investment, government expenditure on goods and services, and net exports -Aggregate planned expenditure is equal to the sum of the planned levels of consumption expenditure, investment, government expenditure on goods and services, and exports minus imports. A Two-Way Link Between Aggregate Expenditure and Real GDP The two way link is: -an increase in real GDP increases aggregate expenditure, and -an increase in aggregate expenditure increases real GDP Consumption and Saving Plans -Several factors influence consumption expenditure and saving plans. The most important are: -Disposable income -Real interest rate -Wealth -Expected future income -Disposable income is aggregate income minus taxes plus transfer payments Consumption Expenditure and Saving -Households can only spend their disposable income on consumption or save it, so planned consumption expenditure plus planned saving always equals disposable income -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 Consumption Function -The y-axis measures consumption expenditure, and the x-axis measures disposable income -The autonomous consumption is the amount of consumption expenditure that would take place in the short run even if people had no current income -Consumption expenditure in excess of this amount is called induced consumption which is the consumption expenditure that is induced by an increase in disposable income 45° Line -The height of this measures disposable income EC140 Chapter 27-Expenditure Multipliers: The Keynesian Model Week 2 -At each point on this line, consumption expenditure equals disposable income Saving Function -As disposable income increases, saving increases -Notice that when consumption expenditure exceeds disposable income in part (a), saving is negative, called dissaving, in part (b) Marginal Propensities to Consume and Save -The Marginal propensity to consume (MPC) is the fraction of a change in disposable income that is spent on consumptions MPC = change in consumer expenditure (C) change in disposable income (YD) -The Marginal Propensity to Save (MPS) is the fraction of a change in disposable income that is saved. MPS = change in savings (S) change in disposable income (YD) -Because an increase in disposable income is either spent on consumption or saved, the marginal propensity to consume plus the marginal propensity to save = 1 Change in consumer expenditure + change in savings = change in disposable income Slopes and Marginal Propensities -The slope of the consumption function is the marginal propensity to consume, and the slope of the saving function is the marginal propensity to save EC140 Chapter 27-Expenditure Multipliers: The Keynesian Model Week 2 Consumption as a Function of Real GDP -Consumption expenditure changes when disposable income changes and disposable income changes when real GDP changes -Consumption expenditure depends not only on disposable income but also on real GDP Import Function -Of the many influenced on Canadian imports in the short run, Canadian real GDP is the main influence. -An increase in Canadian real GDP increases the quantity of Canadian imports -The marginal propensity to import is 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, other things remaining the same Real GDP with a Fixed Price Level -The aggregate expenditure schedule lists aggregate planned expenditure generated at each level of real GDP -The aggregate expenditure curve is a graph of the aggregate expenditure schedule Aggregate Planned Expenditure -To calculate aggregate planned expenditure at a given real GDP, we add the expenditure components together -Real GDP is shown on the x-axis and aggregate planned expenditure is shown on the y-axis -Consumption expenditure is the vertical gap between the lines labelled I+G+X and I+G+X+C -Aggregate expenditure is expenditure on Canadian-produced goods and services -Consumption expenditure minus imports, which varies with real GDP, is called induced expenditure -The sum of investment, government expenditure, and exports, which does not vary with real GDP, is called autonomous expenditure -Consumption expenditure and imports can also have an autonomous component – a component that does not vary with real GDP -The aggregate expenditure curve summarizes the relationship between aggregate planned expenditure and real GDP EC140 Chapter 27-Expenditure Multipliers: The Keynesian Model Week 2 Actual Expenditure, Planned Expenditure, and Real GDP -Actual aggregate expenditure is always equal to real GDP -But aggregate planned expenditure is not always equal to actual aggregate expenditure and therefore is not always equal to real GDP -They differ because firms can end up with inventories that are greater or smaller than planned -People carry out their consumption expenditure plans, the government implements its planned expenditure on goods and services, and net exports as planned. Firms carry out their plans to purchase new buildings, plants and equipment. -But,  one  component  of  investment  is  the  change  in  firm’s  inventories -If aggregate planned expenditure exceeds real GDP, firms sell more than they planned to sell and end up with inventories being too low 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 towards equilibrium expenditure occurs -Throughout this process, real GDP adjusts EC140 Chapter 27-Expenditure Multipliers: The Keynesian Model Week 2 Convergence to Equilibrium From Below Equilibrium -Firms have inventory targets based on their sales -When inventories fall below target, firms increase production to restore inventories to the target level -To increase inventories, firms hire additional labour and increase production -When firms hire additional labour and production increases; real GDP increases yet further -Refer to figure above From Above Equilibrium -As long as actual expenditure exceeds planned expenditure, inventories rise and production decreases Quick Summary -When the price level is fixed, real GDP is determined by equilibrium expenditure -Unplanned changes in inventories and the production response they generate bring a convergence towards equilibrium expenditure The Multiplier -Investment and exports can change for many reasons -When autonomous expenditure increases (Ex. a wave of innovation) , aggregate expenditure increases and so does equilibrium expenditure are real GDP -The increase in real GDP is larger than the change in autonomous expenditure -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 Basic Idea of the Multiplier -Suppose investment increases. The additional expenditure by businesses means that aggregate expenditure and real GDP increase -The increase in real GDP increases disposable income, and with no income taxes, real GDP and disposable EC140 Chapter 27-Expenditure Multipliers: The Keynesian Model Week 2 income increase by the same amount -The increase in disposable income brings an increase in consumption expenditure -The increased consumption expenditure adds even more to aggregate expenditure -Real GDP and disposable income
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