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 change in consumption expenditure C,
divided by the change in disposable income, YD.
That is:
MPC = C YD
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 change in saving S, divided by the change
in disposable income, YD.
That is:
MPS = S YD
The marginal propensity to consume plus the marginal propensity to save sum to 1.
You can see this from the following:
C + S = YD
C + S = YD
(C YD) + (S YD) = (YD YD)
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 the marginal propensity to import.
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 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.

Lets 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.
Lets look at this same phenomenon in the figure above.
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 AE1.
Equilibrium is now at $1,400 billion.
In the example weve just studied, the multiplier is 4.

It is calculated as:
Multiplier = Change in equilibrium expenditure
Change in autonomous expenditure
The magnitude of the multiplier depends on the slope of the AE curve.
Lets study this connection:
o Y = real GDP
o N = induced expenditure
o A = autonomous expenditure
o Y=N+A

Because
Y=N+A
You can see that:
Y = N + A
But,
N = Slope of AE curve x Y
So,
Y = Slope of AE curve x Y + A
Rearrange,
Y = Slope of AE curve x Y + A
as
(1- Slope of AE curve) x Y = A
and, rearranging again,
Y = A (1 Slope of AE curve)
The multiplier is:
Y A
which equals
1 (1 Slope of AE curve)

The steeper the aggregate expenditure curve, the larger the multiplier and the flatter the
aggregate expenditure curve, the smaller the multiplier.
The slope of the AE curve that determines the size of the multiplier depends on:
o The MPC
o The marginal tax rate
o The marginal propensity to import

The Multiplier and the Price Level

We use the aggregate demand-aggregate supply model to simultaneously determine real GDP
and the price level.
When the price level changes, aggregate planned expenditure changes and the quantity of real
GDP demanded changes.
The aggregate expenditure curve (AE curve) is the relationship between aggregate planned
expenditure and real GDP, holding all other influences (including the price level) constant.
The aggregate demand curve (AD curve) is the relationship between the quantity of real GDP
demanded and the price level, holding all other influences on spending plans constant.
The quantity of real GDP demanded is equilibrium aggregate planned expenditure.
So, the aggregate demand curve is the relationship between equilibrium aggregate planned
expenditure and the price level.
Lets explore the link between AE and AD further by studying the AE curve and the AD curve.
The figure shows three AE curves and three different levels of equilibrium expenditure.

Focus first on AE0.

With aggregate expenditure curve AE0, equilibrium
expenditure is $1,200 billion.
Along AE0, the price level is constant at 110.
Now suppose the price level rises from 110 to 130.
The AE shifts curve downward to AE1.
With the AE curve shifted downward to AE1,
equilibrium expenditure falls to $1,100 billion.
Now suppose the price level falls from 110 to 90.
The AE curve shifts upward to AE2.
With the AE curve shifted upward to AE2,
equilibrium expenditure rises to $1,300 billion.
A change in the price level shifts the AE curve and
changes equilibrium expenditure, and creates a
movement along the AD curve.
A change in any other influence on aggregate
planned expenditure changes both aggregate
expenditure and aggregate demand and shifts both
curves.
The AE curve shifts upward or downward by the
amount of the change in autonomous expenditure.
The AD curve shifts rightward or leftward by the
amount of the change in autonomous expenditure
multiplied by the multiplier.

Consider what happens in the figures below when investment increases by $100 billion.

The AE curve shifts upward.

Equilibrium expenditure increases by $200 billion.
The multiplier is 2.
A $100 billion increase in investment shifts the AD curve rightward by $200 billion in the bottom
figure.

Lets study some changes in:

o The short run
o The long run
We start by studying the short run.
The equilibrium level of real GDP is initially
equal to $1,200 billion in the figure to the
right.
Now, investment increases and the AE curve
shifts upward from AE0 to AE1.
Equilibrium real GDP increases to $1,400
billion.
The AD curve shifts rightward to AD1.
If the price level remained at 110, equilibrium
real GDP would increase to $1,400 billion.
But the price level does not remain at 110.
There is an upward-sloping SAS curve.
When aggregate demand increases, the price
level rises to 123 and real GDP increases to
$1,330 billion.
As the price level rises toward 123, the AE
curve shifts downward toward AE2.
The new equilibrium is at point C. Now lets study the long run.
Start out at an equilibrium of $1,200 billion, which is potential
GDP.
Now autonomous expenditure increases.
The AE curve shifts upward from AE0 to AE1.
And the AD curve shifts rightward from AD0 to AD1.
The price level rises to 123 and real GDP increases to $1,330
billion.
The AE curve shifts downward to AE2.
But real GDP now exceeds potential GDP.
So the money wage rate begins to rise.
And as the money wage rate rises, the SAS curve begins to shift
leftward.
The price level rises and real GDP decreases.
Eventually, the price level rises to 150 and real GDP returns to
potential GDP of $1,200 billion.
As the new price level rises to 150, the AE curve returns to its
original position, AE0.
In the long run, an increase in autonomous expenditure brings a
temporary increase in real GDP above potential GDP.
It permanently raises the price level.