Aggregate Expenditure, Supply, and Demand

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Learning Objectives Upon completion of this unit, students should be able to:

1. Explain the role of consumption. 2. Analyze the effects of government purchases of goods and services. 3. Explain how net exports affect aggregate expenditure. 4. Describe the aggregate demand curve. 5. Analyze shifts of the aggregate supply curve.

Written Lecture Consumption Consumption is a positive function of disposable income. The relationship between U.S. disposable income and consumption has been very stable, especially since World War II. The consumption function shows the relationship between the amount spent on consumption and the level of income, other things constant. Consumption spending increases as disposable income increases; that is, consumption spending and income are directly related. A graph of a consumption function is an upward-sloping line, as shown in Exhibit 3 in the textbook. Economists focus on what happens when disposable income changes. If disposable income increases, some of the additional income will be spent on consumption goods and some will be saved. The proportion of the additional income that is spent on consumption is called the marginal propensity to consume (MPC). That is, the marginal propensity to consume is the change in consumption spending divided by the change in income. Further, the change in income is the cause of the change in consumption spending. Similarly, the marginal propensity to save (MPS) is the change in saving divided by the change in disposable income. Consumption also depends on things other than income. In particular, consumption depends on net wealth, the price level, consumer expectations, and the interest rate. Net wealth is a stock, whereas income is a flow. That is, net wealth is the value of all the assets owned by a household less liabilities and debts owed to others. To increase net wealth, a household must either increase savings or pay off debt. Since an important motive for saving is to increase one's wealth, the greater the wealth, the less the incentive to save and the more the household will spend on consumption. An increase in net wealth causes the consumption function to shift up; a reduction in net wealth causes the consumption function to shift down. Note that in either case the consumption function shifts because of a change in net wealth. A change in income has a different effect: it causes a movement along the consumption function. An increase in the price level makes a household poorer because the purchasing power of the household's savings falls. As a result, the household

Reading Assignments Chapter 9: Aggregate Expenditure Chapter 10: Aggregate Expenditure and Aggregate Demand Chapter 11: Aggregate Supply Supplemental Reading See information below. Learning Activities (Non-Graded) See information below. Key Terms 1. Aggregate

expenditure line 2. Consumption function 3. Expansionary gap 4. Government

purchase function 5. Investment function 6. Long-run aggregate

supply (LRAS) curve 7. Marginal propensity

to consume (MPC) 8. Marginal propensity

to save (MPS) 9. Net export function

10. Net wealth 11. Potential output 12. Recessionary gap

UNIT IV STUDY GUIDE Aggregate Expenditure, Supply, and Demand

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will reduce consumption and increase saving, which generates a downward shift in the consumption function. A change in expectations will also shift the consumption function. Expectations of higher income in the future tend to encourage more consumption today, as do expectations of higher prices in the future. Finally, a change in the market rate of interest will cause the consumption function to shift. If the interest rate falls, savers are rewarded less and generally respond by saving less and consuming more. Keep in mind that a change in disposable income causes a movement along the consumption function, whereas changes in net wealth, in the price level, in expectations, or in the interest rate cause shifts in the consumption function. Investment Investment consists of spending on new factories and equipment, construction of housing, and net increases in inventories. Investment adds to the economy's stock of capital goods and is generally carried out by business firms. Firms engage in investment spending when they believe that the investment will be more profitable than other possible uses of their funds. This will be the case whenever the expected rate of return exceeds the opportunity cost of investing in capital, which is the market rate of interest. The demand for investment funds tends to be a negative function of the interest rate. Investment spending tends to be related to businesses' expectations about future profits rather than to current income. Hence, investment tends to be independent of income, or autonomous. The autonomous investment function can be represented graphically as a horizontal line when disposable income is on the horizontal axis. An increase in the rate of interest will cause the investment function to shift down, and a decrease in the rate of interest will cause the investment function to shift up. A more optimistic business climate causes the investment function to shift up, and a less optimistic business climate causes the investment function to shift down. Government Governments purchase goods and services, borrow money, and collect taxes. Government purchases are assumed to be autonomous, that is, independent of the level of income. Net taxes (taxes - transfer payments) are also assumed to be autonomous. Net Exports Imports are consumer goods just like any other goods. When disposable income increases, Americans buy more of all goods, so spending on imports increases. Hence, imports are a positive function of disposable income. On the other hand, the level of exports is determined by spending in other countries, so exports are autonomous with respect to U.S. disposable income. Combining imports and exports yields net exports, which are inversely related to disposable income, other things being constant. However, usually we will assume net exports are autonomous. Factors held constant along the net export function include domestic and foreign price levels, domestic and foreign interest rates, and the exchange rates between domestic and foreign currencies. Composition of Aggregate Expenditure The composition of aggregate expenditures has changed over the last forty years. The government’s share of it has fallen as defense spending has fallen, and consumption’s share has increased.

13. Saving function 14. Short-run aggregate

supply (SRAS) curve 15. Simple spending

multiplier

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Appendix: Variable Net Exports Since imports are goods like those produced domestically, Americans buy more imports when their incomes increase. Similarly, foreigners buy more U.S. goods when their incomes increase. Imports to foreigners are U.S. exports, so U.S. exports depend on income levels in other countries rather than on U.S. income. Hence, U.S. exports are not a function of U.S. disposable income; that is, U.S. exports are autonomous. U.S. imports, though, are positively related to U.S. disposable income. Net exports are exports minus imports (X – M). Since exports are autonomous and imports are directly related to disposable income, net exports are inversely related to U.S. disposable income. Aggregate Expenditure and Income The aggregate expenditure at each level of income is the total planned spending, or, according to the chapter's model, the sum of consumption, planned investment spending, government purchases, and net exports. Real GDP is equal to the total output of the economy, which is also equal to the aggregate income generated by production. In equilibrium, aggregate expenditure must equal aggregate income. It is important to note that aggregate income and planned aggregate expenditure are equal only if the economy is in equilibrium, whereas aggregate income and actual total expenditure are equal by definition. For the equilibrium condition to hold, planned consumption expenditures, plus planned investment expenditures, plus government purchases, plus net exports must equal real GDP. When this happens, nobody has an incentive to change his or her actions or plans, and equilibrium is established. Even when we do not have equilibrium, actual total expenditure must equal real GDP because, as the circular flow model indicates, one individual's expenditure is another's income. Exhibit 1 illustrates these concepts. In every row, actual total expenditure equals real GDP, but only in the sixth row does planned aggregate expenditure equal real GDP. Therefore, $10 trillion is the equilibrium level of real GDP demanded. At no other level of GDP does planned aggregate expenditure equal real GDP. For example, consider the second row, where real GDP is $6.0 trillion. Consumption is $4.8 trillion and saving is $0.2 trillion, but planned investment is $0.4 trillion. Planned aggregate expenditure is greater than real GDP. The economy is not producing enough output, so inventories are drawn down, generating an unanticipated inventory adjustment of $0.8 trillion. This yields an actual investment of -$0.4 trillion, not $0.4 trillion; this yields an actual total expenditure level of $6.0 trillion. This is not an equilibrium, since business planned on investing $0.4 trillion but actually disinvested $0.4 trillion. At real GDP of $10.0 trillion, there are no unintended inventory adjustments, so actual investment equals planned investment ($0.4 trillion). Finally, actual total expenditure equals real GDP and also equals (planned) aggregate expenditure. Hence, the equilibrium quantity of real GDP demanded is $10.0 trillion.

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Exhibit 2 presents the information from Exhibit 1 graphically. The 45-degree line shows the points where real GDP equals aggregate expenditure. Point e is the equilibrium point, where real GDP and aggregate expenditure both equal $10.0 trillion. At real GDP of $5.0 trillion, point a indicates planned aggregate expenditure, a´indicates consumption, and a´´ indicates actual total expenditure. The distance between a and a´´ measures the unintended drop in investment of $0.4 trillion. The plans of consumers and business indicate a desire to purchase the amount at point a, but the economy actually spends the amount at point a´´. As long as business responds to the unexpected decline in inventories by increasing production, the economy will expand and eventually arrive at the equilibrium real GDP demanded of $10.0 trillion (point e).

(McEachern, W. A., 2012)

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The Simple Spending Multiplier Suppose we are at equilibrium in Exhibit 2. If businesses decide to change investment spending, then adjustments must be made by all participants in the economy until a new equilibrium is achieved. We can determine what these changes will be as long as we know the MPC. Suppose planned investment increases by $0.1 trillion, to $0.5 trillion. At the previous equilibrium level of real GDP demanded of $10.0 trillion, we have an excess demand for goods, since aggregate expenditure now equals $10.1 trillion instead of $10.0 trillion. There is an unintended reduction of inventories of $0.1 trillion. Those businesses that face excess demand for their output will increase production and hire more productive inputs. The payments to the productive inputs are income, which the input owners spend. That is, income increases by the amount of the extra payments to resource owners, and these individuals increase both consumption spending and saving. By how much do they increase consumption? Since the MPC is 0.8, consumption spending increases by $80 for every $100 in extra income. This is not the end, though. The extra consumption spending provides income to those who produce and sell the extra consumption goods. The higher incomes of these individuals lead them to increase their own consumption spending, increasing income for other people, and another round of increased consumption spending and income occurs. Where does it end? It ends when the extra $0.1 trillion of investment spending increases income to the point where saving increases by $0.1 trillion. Since the MPS is 0.2, every extra $100 of income generates an extra $20 of saving. For saving to increase by $0.1 trillion, income must increase by $0.5 trillion. That is, real GDP must increase from $10.0 trillion to $10.5 trillion for saving to increase from $1.0 trillion to $1.1 trillion. Exhibit 3 illustrates these changes. The C + I + NX curve is the same as in Exhibit 2, and point e is the original equilibrium. The increase in planned investment spending causes the C + I + NX curve to shift up to C + I´+ NX. The distance from e to f is $100. The extra investment spending is income to others and generates increased consumption spending, as described. The new equilibrium is e´, where real GDP and aggregate expenditure are equal at $3,500. (McEachern, W. A., 2012)

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The multiplier is a number that indicates the number of times by which the change in the quantity of real GDP demanded exceeds the change in planned investment spending. In the previous case, the multiplier is equal to 5, since real GDP increased by $0.5 trillion after planned investment spending increased by $0.1 trillion. There is a relation between the multiplier and the MPS, as the previous discussion suggests. Since income must increase enough to allow saving to increase by an amount equal to the increase in planned investment, the multiplier equals 1/MPS. In the previous case, the multiplier equals 1/0.2 = 5. Further, MPS = 1 – MPC, so the multiplier also equals 1/(1 – MPC). The multiplier can also be used to calculate the change in real GDP demanded that follows a decrease in planned investment spending or autonomous changes in consumption spending and saving. Deriving the Aggregate Demand Curve In the last chapter we saw how changes in the price level shift the consumption function: increases in the price level lower the consumption function, and decreases in the price level raise the consumption function. The aggregate demand curve illustrates the relationship between the price level and real GDP demanded. Exhibit 4 in the textbook derives the aggregate demand curve. Changes in the price level cause the consumption function, the investment function, and net exports to shift, which causes the aggregate expenditure function to shift. Hence, there is a different equilibrium level of real GDP demanded for each price level. The aggregate demand curve is found by relating the equilibrium level of real GDP demanded with the appropriate price level. Be sure that you understand how the aggregate demand curve is derived. Autonomous changes in consumption, investment, government purchases, or net exports induce shifts in the aggregate demand curve. An increase in planned investment spending shifts the aggregate expenditure curve upward, which generates a new, higher real GDP demanded. Since the increase in planned investment does not imply a change in the price level, the higher real GDP demanded is associated with the same price level as before. That is, as a result of the increase in planned investment spending, the aggregate demand curve shifts to the right by an amount equal to the multiplier times the change in planned investment spending. Appendix A: Variable Net Exports The textbook treats net exports as autonomous, but spending on imports actually is directly related to the level of income. When disposable income increases, consumption spending increases, and part of this increased spending is on imports. Since exports are autonomous, an increase in disposable income causes increased imports and decreased net exports. In this model, with net exports inversely related to the level of income, the new aggregate expenditure function is flatter than the domestic function. Further, the multiplier is lower, since imports increase with income and imports are a leakage from the circular flow. The new multiplier equals 1/(MPS + MPM), where MPM equals the marginal propensity to import. Appendix B: Algebra of Private-Sector Demand The aggregate expenditure function can be derived algebraically. The consumption function has two components: an autonomous component (that is, consumption that occurs when income equals zero) and an induced component (that is, consumption that depends on the level of income). Hence, we have C = a + b(Y - NT), where a is the autonomous component and b is the marginal propensity to consume. Investment spending is autonomous, so it is constant at level I. Government purchases are also autonomous, so they are

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constant at level G. When net exports are treated as autonomous, net exports are constant at level X - M. Since Y = C + I + G +(X - M), we can substitute the individual functions into this equation and get:

Y = a - bNT + bY + I + G + (X - M)

Y = [1/(1 - b)](a - bNT + I + G + X - M)

When exports vary with the level of income, we substitute m(Y - NT) for m, where m is the marginal propensity to import. The equilibrium level of real GDP can be found as above:

Y = a + bNT + I + G + X + mNT + (b - m)Y or

Y = [1/(1 – b + m)](a + I + G + X + mNT) The term (a - b NT + I + G + X + mNT) represents autonomous spending and 1/(1 – b + m) is the multiplier. Aggregate Supply in the Short Run Workers and other resource owners make decisions concerning how much of their resources to supply for a particular time period on the basis of expected real wages or prices. But wages and prices are always stated in dollar terms, i.e., as nominal wages and prices. Often nominal resource prices, including wages paid to labor, are set for a given time period by explicit or implicit contracts. If the actual price level differs from the expected price level on which the contracts are based, resource owners will not receive the real return that they expected. If the actual price level is greater than expected, the real wage falls as the nominal wage remains constant; the opposite occurs if the actual price level is less than expected. Some resource prices adjust more quickly than others. Some workers may agree to twelve-month contracts, others may agree to six-month contracts, and still others may not agree to contracts at all. Similarly, one electric utility may agree to long-term contracts with coal suppliers; others may rely on spot markets. Prices set by contracts tend to be more stable than those set in spot markets. Consequently, when the actual price level exceeds the expected price level, some resource prices adjust quickly while others remain constant for a while. Production costs rise more slowly than product prices, on average, because of the stability of some resource prices. If a firm's product price increases at the same rate as the average level of prices, expanding output increases the firm's profit because the extra cost of producing an additional unit of output rises more slowly than the extra revenue received from an additional unit of output. Hence, the firm has an incentive to increase production in the short run when the actual price level rises above the expected price level reflected in long-term contracts. When the actual price level falls below the expected price level, costs do not fall as quickly as product prices. Again, the relative stability of some resource prices is the reason costs do not change at the same rate as the price level. Firms respond to the lower profitability by curtailing production and laying off some resources. We have seen that firms increase output when the price level is higher than had been expected and decrease output when the price level is lower than had been expected. What happens when the actual price level equals the expected price level reflected in long-term contracts? When expectations about prices

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prove correct, economic agents have no reason to change their actions. If all households and firms find their expectations about prices are correct, then the output decisions of firms and the resource-supply and consumption decisions of households are correct. There are no surprises, and the economic actors will continue doing the same thing until something fundamental changes, such as tastes or technology. Since all resource owners and all firms continue doing what they have been doing, output remains constant until a fundamental change occurs. Hence, the output level in this situation is the natural level of output. This output level is often called the potential output, or the full- employment level of output. The unemployment rate that prevails when the potential output is being produced is called the natural rate of unemployment. Because firms expand production when the actual price level exceeds the expected price level, actual output exceeds potential output and the actual rate of unemployment is less than the natural rate of unemployment. Such a situation cannot last for a long time because higher prices mean that some resource owners are earning less in real terms than they expected. These resource owners will try to negotiate higher payments at their next opportunity, which will increase production costs, reduce profits, and encourage firms to reduce output. This process will stop when actual output again equals potential output. Similarly, when the actual price level is less than expected, firms' profitability falls, so they reduce output below potential output and unemployment rises above the natural rate. When they can renegotiate resource prices to reflect the actual state of the economy, then their resource costs will adjust to reflect the lower actual price level, they will again increase production, and aggregate output will equal potential output. The changes in output that result when actual prices differ from the expected prices reflected in long-term contracts are short-run changes. Once the economic actors learn the true state of the economy and have time to adjust their behavior, output becomes equal to potential output. In the short run, there is a positive relationship between the price level and the quantity of aggregate output supplied. At prices greater than expected prices, actual output exceeds potential output; at prices lower than expected prices, actual output falls below potential output. The short-run aggregate supply curve slopes upward and is defined for a given contract period reflecting a given expected price level. If expectations about prices change, the short-run aggregate supply curve shifts. From the Short Run to the Long Run The short-run aggregate supply curve is relevant only as long as some resource prices remain fixed. As these resource prices respond in the long run to new situations, the short-run aggregate supply curve shifts. As a result, the economy returns to the potential output and the natural rate of unemployment. In Exhibit 1, potential output is $5 trillion and the expected price level is 100.

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Suppose the short-run aggregate supply curve is SRAS100´, which intersects the aggregate demand curve (AD) at e´. Hence, actual output is $6.0 trillion, and there is an expansionary gap of $6.0 – 5.0 = $1.0 trillion. The actual price level is 120, which is greater than the expected price level of 100. The output, $6.0 trillion, cannot be sustained for long because it exceeds the potential output. Nothing fundamental to the economy has changed; instead, output has increased because people's expectations have not been realized. Economic actors negotiate higher resource prices in the long run, firms curtail production, and the short-run aggregate supply curve shifts to the left, to SRAS130. New long-term contracts reflect the expected price level of 130. The new long-run equilibrium is at e, with output of $5.0 trillion and an actual price level of 130. A similar adjustment process occurs when the actual price level is lower than expected, only in that case the short-run aggregate supply curve shifts to the right as a result of the pressures created by a contractionary gap. Whenever the economy is in long-run equilibrium—that is, whenever the actual price level equals the expected price level reflected in long-term contracts— the real GDP is equal to the potential output. That is, the long-run aggregate supply curve is vertical at the potential output. This potential GDP is consistent with any price level as long as all resource prices adjust to the actual price level. Potential output depends on the supply of resources in the economy, the state of technology, and the institutional structure of the economic system. The long- run supply curve is vertical at the potential output. The location of the short-run aggregate supply curve depends on the expected price level. Shifts of the Aggregate Supply Curve Potential output is determined by real factors in the economy—factors such as the quantity and quality of the resources available to the economy and the state of technology. Potential output will change only when one of these factors changes. An increase in the labor force, the discovery of new sources of raw materials, an increase in education levels of the population, and technological change are events that can cause potential output to increase. Both the long- run and the short-run aggregate supply curves will shift when potential output

(McEachern, W. A., 2012)

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changes. The short-run aggregate supply curve also can shift without a change in potential output. The short-run aggregate supply curve shifts in response to supply shocks—unexpected events that affect the supply of a resource, often only temporarily. For example, a severe hailstorm may reduce the supply of wheat, thus affecting the supply of bread in the economy. This type of supply shock does not reduce the economy's output permanently, since wheat production can return to normal levels the next year. Supplemental Reading Click here to access a PDF of the Chapter 9 Presentation. Click here to access a PDF of the Chapter 10 Presentation. Click here to access a PDF of the Chapter 11 Presentation. Learning Activities (Non-Graded) Video Click on the following link to watch a video on The Stock Market and Labor Force Participation: http://www.swlearning.com/economics/abcvideos/WNT02071501.html Click on the following link to watch a video on Can Tax Policy Encourage Saving? http://www.swlearning.com/economics/abcvideos/GMA05111901.html Click on the following link to watch a video on Core Inflation and Fed Policy: http://www.swlearning.com/economics/abcvideos/TMG02111901.html Non-graded learning activities are provided to aid students in their course of study. This is a non-graded activity, so you do not have to submit it.