Chapter Twenty Seven – Expenditure multiplier Keynesian
Investment and exports fluctuate like the volume of Céline Dion’s voice in a concert and the surface of a
potholed road. But how does the economy react to those fluctuations? Does it behave like an amplifier,
blowing up the fluctuations and spreading them out to affect the many millions of participants in an
economic concert? Or does it react like a limousine, absorbing the shocks and providing a smooth ride
for the economy’s passengers?
Fixed prices and expenditure plans
Keynesian model describes the economy in the very short run when prices are fixed. Because each firm’s
price is fixed, for the economy as a whole: The price level is fixed and the aggregate demand determines
real GDP. What determines aggregate expenditure plans?
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, change when income changes so they
depend on real GDP. So there is a two-way link between aggregate expenditure and real GDP. Other
things remaining the same, an increase in real GDP increases aggregate expenditure. An increase in
aggregate expenditure increases real GDP.
Consumption expenditure is influenced by many factors (Disposable income, Real interest rate, Wealth,
Expected future income) but the most direct one is disposable income. Disposable income is aggregate
income minus taxes plus transfer payments. Aggregate income equals real GDP, so disposable income
depends on real GDP. Call disposable income YD. The equation for disposable income is YD = Y – T.
Disposable income, YD, 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. The figure illustrates the consumption function and
the saving function. When consumption expenditure exceeds disposable income, saving is negative
(dissaving). When consumption expenditure is less than disposable income, there is saving. 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 expnC, divided by the change in
disposable income YD, that brought it about. That is,MC ÷ YD. The figure shows that the
MPC is the slope of the consumption function. Along this consumption function, when disposable
income increases by $200 billion, consumption expenditure increases by $150 billion. The MPC is 0.75.
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 svS, divided by the change in disposable iYD, that
brought it about. That is, MS ÷ YD. The saving figure shows that the MPS is the slope of the
saving function. Along this saving function, when disposable income increases by $200 billion, saving
increases by $50 billion. The MPC is 0.25. The MPC plus the MPS equals 1. To see whC +ote that,
S = YD. Divide this equationbYD to obtai,C/ YD + S/ YD = YD/ YD or MPC + MPS =
Consumption as a function of real GDP - Disposable income changes when either real GDP changes or
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 real GDP
when the price level is fixed.
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. If an increase
in real GDP of $100 billion increases imports by $25 billion, the marginal propensity to import is 0.25. Real GDP with a fixed price level
When the price level is fixed, aggregate demand is determined by aggregate expenditure plans.
Aggregate planned expenditure is planned consumption expenditure plus planned investment plus
planned government expenditure plus planned exports minus planned imports. 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
expenditure plus planned exports are not influenced by real GDP.
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. The figure shows how
the aggregate expenditure curve (AE) is built from its
components. Consumption expenditure minus imports,
which varies with real GDP, is induced expenditure.
The sum of investment, government expenditure, and
exports, which does not vary with GDP, is autonomous
expenditure. (Consumption expenditure and imports
can have an autonomous component).
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 is the level of aggregate expenditure that occurs when aggregate planned
expenditure equals real GDP. Figure a illustrates equilibrium expenditure. Equilibrium occurs at the
point at which the aggregate expenditure curve crosses the 45° line. Equilibrium occurs when there are
no unplanned changes in business inventories in part b. Convergence to equilibrium - If aggregate planned expenditure exceeds real GDP (the AE curve is above
the 45° line), there is an unplanned decrease in inventories. To restore inventories, firms hire workers
and increase production. Real GDP increases. If aggregate planned expenditure is less than real GDP (the
AE curve is below the 45° line