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Aggregate Expenditure and Output in the Short Run

CHAPTER

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CHAPTER

Learning Objectives

8.1	The Aggregate Expenditure Model
8.2	Determining the Level of Aggregate Expenditure in the Economy
8.3	Graphing Macroeconomic Equilibrium
8.4	The Multiplier Effect
8.5	The Aggregate Demand Curve
Appendix C: The Algebra of Macroeconomic Equilibrium

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Fluctuating Demand at Tim Hortons

Tim Hortons has seen its sales fall in many of the small Canadian towns where the area’s main employer has shut down or scaled back operations.

When firms have a hard time making sales, they reduce output and sometimes lay off workers. These workers then stop making some purchases.

This is just one example of how some firms that cut production can reduce the total spending, or aggregate expenditure of an economy.

AN INSIDE LOOK on page 244 discusses how a slow economy can hurt Tim Hortons’ sales.

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When Consumer Confidence Falls, Is Your Job at Risk?

Suppose that while taking your degree, you work part time at a local Tim Hortons.

One morning, you read in the local newspaper that consumer confidence in the economy has fallen and, consequently, many households expect their future income to be dramatically less than their current income.

See if you can answer these questions by the end of the chapter:

Should you be concerned about losing your job?

What factors should you consider in deciding how likely your company is to lay you off?

Economics in Your Life

Aggregate expenditure (AE) Total spending in the economy: the sum of consumption, planned investment, government purchases, and net exports.

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Understand how macroeconomic equilibrium is determined in the aggregate expenditure model.

8.1 LEARNING OBJECTIVE

The Aggregate Expenditure Model

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Aggregate expenditure model A macroeconomic model that focuses on the short-run relationship between total spending and real GDP, assuming that the price level is constant.

In any particular year, the level of GDP is determined mainly by the level of aggregate expenditure.

Aggregate Expenditure

In 1936, the British economist John Maynard Keynes published a book, The General Theory of Employment, Interest, and Money, that systematically analyzed the relationship between changes in aggregate expenditure and changes in GDP.

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Keynes identified four components of aggregate expenditure that together equal GDP:

• Consumption (C). This is spending by households on goods and services.

• Planned investment (Ip). This is the planned spending by firms on capital goods such as factories, office buildings, and machines, and by households on new homes.

• Net exports (NX). This is spending by foreign firms and households on goods and services produced in Canada minus spending by Canadian firms and households on goods and services produced in other countries.

• Government purchases (G). This is spending by local, provincial, and federal governments on goods and services, such as the armed forces, bridges and roads, and the salaries of RCMP officers.

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So, we can write

AE = C + Ip + G + NX

Planned aggregate expenditure = Consumption + Planned investment

+ Government purchases + Net exports

Inventories Goods that have been produced but not yet sold.

The Difference between Planned Investment and Actual Investment

Notice that planned investment spending, rather than actual investment spending, is a component of aggregate expenditure.

In this chapter, we will use Ip to represent planned investment.

Actual investment will equal planned investment only when there is no unplanned change in inventories.

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Planned aggregate expenditure = GDP

Macroeconomic Equilibrium

For the economy as a whole, macroeconomic equilibrium occurs where total spending, or aggregate expenditure, equals total production, or GDP:

Getting to Macroeconomic Equilibrium

When aggregate expenditure is greater than GDP, inventories will decline, and GDP and total employment will increase.

When aggregate expenditure is less than GDP, inventories will increase, and GDP and total employment will decrease.

Only when aggregate expenditure equals GDP will the economy be in macroeconomic equilibrium.

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Table 8.1

The Relationship between Planned Aggregate Expenditure and GDP

If . . .	then . . .	and . . .
Planned aggregate expenditure is equal to GDP	inventories don’t change	the economy is in macroeconomic equilibrium.
Planned aggregate expenditure is less than GDP	inventories rise	GDP and employment decrease.
Planned aggregate expenditure is greater than GDP	inventories fall	GDP and employment increase.

When economists forecast that aggregate expenditure is likely to decline and that the economy is headed for a recession, the federal government may implement macroeconomic policies in an attempt to head off the decrease in expenditure and keep the economy from falling into recession.

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Discuss the determinants of the four components of aggregate expenditure and define marginal propensity to consume and marginal propensity to save.

8.2 LEARNING OBJECTIVE

Determining the Level of Aggregate Expenditure in the Economy

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Expenditure Category	Real Expenditure (billions of 2007 dollars)
Consumption	$924.18
Planned investment	327.80
Government purchases	415.23
Net exports	−45.06

Table 8.2

Components of Aggregate Expenditure, 2012

Each component is measured in real terms, meaning that it is corrected for inflation by being measured in billions of 2007 dollars.

Net exports were negative because in 2012 indicating a trade deficit (Canada imported more goods and services than it exported).

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Figure 8.1

Real Consumption

Consumption follows a smooth, upward trend, interrupted only infrequently by brief recessions.

Consumption

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The following are the five most important variables that determine the level of consumption:

Current disposable income

Household wealth

Expected future income

The price level

The interest rate

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Current Disposable Income Disposable income is the income remaining to households after they have paid the personal income tax and received government transfer payments.

Household Wealth A household’s wealth is the value of its assets minus the value of its liabilities.

A recent estimate of the effect of changes in wealth on consumption spending indicates that, for every permanent $1 increase in household wealth, consumption spending will increase by between 4 and 5 cents per year.

Expected Future Income Most people prefer to keep their consumption fairly stable from year to year, even if their income fluctuates significantly.

Current income explains current consumption well only when it is not unusually high or unusually low compared with expected future income.

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The Price Level The price level measures the average prices of goods and services in the economy.

Changes in the price level affect consumption mainly through their effect on the real value of household wealth.

The Interest Rate Recall that the nominal interest rate is the stated interest rate on a loan or a financial investment, corrected for the effect of inflation by the real interest rate, which is the nominal interest rate minus the inflation rate.

Consumption spending depends on the real interest rate because households are concerned with the payments they will make or receive after the effects of inflation are taken into account.

Changes in the interest rate affect spending on durable goods more than they affect spending on services and nondurable goods because a high real interest rate increases the cost of spending financed by borrowing.

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Figure 8.2

The Relationship between Consumption and Income, 1981–2012

The Consumption Function

Panel (a) shows the relationship between consumption and income.

The points represent combinations of real consumption spending and real disposable income for the years 1981 to 2012.

In panel (b), we draw a straight line through the points from panel (a).

The line, which represents the relationship between consumption and disposable income, is called the consumption function.

The slope of the consumption function is the marginal propensity to consume.

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Consumption function The relationship between consumption spending and disposable income.

Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

Because changes in consumption depend on changes in disposable income, we can say that consumption is a function of disposable income.

Using the Greek letter delta, ∆, to represent “change in,” C to represent consumption spending, and YD to represent disposable income, we can write the expression for the MPC as follows:

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For example, between 2011 and 2012, consumption spending increased by $ $31.4 billion, while disposable income increased by $39 billion.

The marginal propensity to consume was, therefore:

The value for the MPC tells us that households spent 80 cents out of every additional dollar of income.

Change in consumption = Change in disposable income × MPC

We can also use the MPC to determine how much consumption will change as income changes:

With an MPC of 0.80, a $10 billion increase in disposable income will increase consumption by $10 billion × 0.80, or $8 billion.

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The Relationship between Consumption and National Income

Since the differences between GDP and national income are small and can be ignored without affecting our analysis, we will use these terms interchangeably.

Disposable income is equal to national income plus government transfer payments minus taxes.

Taxes minus government transfer payments are referred to as net taxes, so:

Disposable income = National income − Net taxes

We can rearrange the equation like this:

National income = GDP = Disposable income + Net taxes

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Figure 8.3

The Relationship between Consumption and National Income

Because national income differs from disposable income only by net taxes—which, for simplicity, we assume are constant—

we can graph the consumption function using national income rather than disposable income.

We can also calculate the MPC,

which is the slope of the consumption function,

using either the change in national income or the change in disposable income and always get the same value.

The slope of the consumption function between point A and point B is equal to the change in consumption—$1,500 billion—

divided by the change in national income—$2,000 billion—or 0.75.

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If we calculate the slope of the line in Figure 12.3 between points A and B, we get a result that will not change whether we use the values for national income or the values for disposable income.

Using the corresponding values for disposable income from the table:

National income and disposable income differ by a constant amount, so changes in the two numbers always give us the same value.

Using the values for national income:

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National income = Consumption + Saving + Taxes

Change in national income = Change in consumption + Change in saving + Change in taxes

Y = C + S + T

Income, Consumption, and Saving

and

To simplify, we can assume that taxes are always a constant amount, in which case ∆T = 0, so the following is also true:

For the economy as a whole, we can write the following:

When national income increases, there must be some combination of an increase in consumption, an increase in saving, and an increase in taxes:

Using symbols, where Y represents national income (and GDP), C represents consumption, S represents saving, and T represents taxes, we can write the following:

∆Y = ∆C + ∆S + ∆T

∆Y = ∆C + ∆S

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Marginal propensity to save (MPS) The amount by which saving changes when disposable income changes.

or,

1 = MPC + MPS

We can measure the MPS as the change in saving divided by the change in disposable income, again safely ignoring the difference between national income and disposable income.

If we divide the last equation on the previous slide by the change in income, ∆Y, we get an equation that shows the relationship between the marginal propensity to consume and the marginal propensity to save:

This equation tells us that when taxes are constant, the marginal propensity to

consume plus the marginal propensity to save must always equal 1 because additional income not consumed must instead be saved.

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Figure 8.4

Real Investment

Planned Investment

Investment is subject to larger changes than is consumption. Investment declined significantly

during the recessions of 1981–1982, 1991, and 2008–2009.

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The four most important variables that determine the level of investment are:

Expectations of future profits

Interest rate

Taxes

Cash flow

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Expectations of Future Profits Investment goods are long lived.

The optimism or pessimism of firms about the economy is an important determinant of investment spending.

Interest Rate Borrowing takes the form of issuing corporate bonds or receiving loans from banks.

Because households and firms are interested in the cost of borrowing after taking into account the effects of inflation, investment spending depends on the real interest rate.

Holding the other factors that affect investment spending constant, there is an inverse relationship between the real interest rate and investment spending:

A higher real interest rate results in less investment spending, and a lower real interest rate results in more investment spending.

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Taxes Firms focus on the profits that remain after they have paid taxes.

The federal government imposes a corporate income tax on the profits corporations earn, which affects the after-tax profitability of investment spending.

Investment tax incentives provide firms with tax reductions to increase their spending on new investment goods.

Cash flow The difference between the cash revenues received by a firm and the cash spending by the firm.

Profit contributes the most to cash flow, which excludes noncash spending.

The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment.

Cash Flow Most firms use their own funds to finance spending.

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Figure 8.5

Real Government Purchases

Government Purchases

Government purchases grew steadily for most of the 1981–2012 period. However, in the mid-1990s, concern about the federal budget deficit caused real government purchases to fall from 1992 to 1997. Real government purchases also grew slowly in 2011 and 2012, a period during which the federal

government focused on reducing the deficit

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We can calculate net exports by taking the value of spending by foreign firms and households on goods and services produced in the United States and subtracting the value of spending by U.S. firms and households on goods and services produced in other countries.

Net Exports

Total government purchases include all spending by federal, local, and state governments for goods and services, excluding transfer payments by the federal government or pension payments by local governments because the government does not receive from these a good or service in return.

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Figure 8.6

Real Net Exports

Net exports were positive for most of the period between 1981 and 2012. Net exports

have usually increased when the American economy is booming and decreased when

the United States enters a recession.

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The following are the three most important variables that determine the level of net exports:

The price level in Canada relative to the price levels in other countries

The growth rate of GDP in Canada relative to other countries

The exchange rate between the Canadian dollar and other currencies

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The Growth Rate of GDP in Canada Relative to the Growth Rates of GDP in Other Countries When incomes rise faster in Canada than in other countries, Canadian consumers’ purchases of foreign goods and services increase faster than foreign consumers’ purchases of Canadian goods and services, decreasing net exports.

When incomes in Canada rise more slowly than incomes in other countries, net exports rise.

The Exchange Rate between the Dollar and Other Currencies As the value of the Canadian dollar rises, the foreign currency price of Canadian products sold in other countries rises, and the dollar price of foreign products sold in Canada falls, so net exports will fall.

Conversely, a decrease in the value of the dollar will increase net exports.

The Price Level in Canada Relative to the Price Levels in Other Countries A slower increase in the Canadian price level than the price levels in other countries increases the demand for Canadian products relative to the demand for foreign products, increasing net exports.

The reverse happens during periods when the inflation rate in the United States is higher than the inflation rates in other countries.

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LO8.2

Use a 45°-line diagram to illustrate macroeconomic equilibrium.

8.3 LEARNING OBJECTIVE

Graphing Macroeconomic Equilibrium

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Figure 8.7

An Example of a 45°-Line Diagram

The 45° line shows all the points that are equal distances from both axes.

Points such as A and B, at which the quantity produced equals the quantity sold, are on the 45° line.

Points such as C, at which the quantity sold is greater than the quantity produced, lie above the line.

Points such as D, at which the quantity sold is less than the quantity produced, lie below the line.

The 45°-line diagram is sometimes referred to as the Keynesian cross because it is based on the analysis of John Maynard Keynes.

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Figure 8.8

The Relationship between Planned Aggregate Expenditure and GDP on a 45°-Line Diagram

Every point of macroeconomic equilibrium is on the 45° line, where planned aggregate expenditure equals GDP.

At points above the line, planned aggregate expenditure is greater than GDP.

At points below the line, planned aggregate expenditure is less than GDP.

Although all points of macroeconomic equilibrium must lie along the 45° line,

only one of these points will represent the actual level of equilibrium real GDP during any particular year, given the actual level of planned real expenditure.

The aggregate expenditure function shows us the amount of planned aggregate expenditure that will occur at every level of national income, or GDP.

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Figure 8.9

Macroeconomic Equilibrium on the 45°-Line Diagram

Macroeconomic equilibrium occurs where the aggregate expenditure (AE) line crosses the 45° line.

The lowest upward-sloping line, C, represents the consumption function.

The quantities of planned investment, government purchases, and net exports are constant because we assumed that the variables they depend on are constant.

So, the total of planned aggregate expenditure at any level of GDP is the amount of consumption at that level of GDP plus the sum of the constant amounts of planned investment, government purchases, and net exports.

We successively add each component of spending to the consumption function line to arrive at the line representing aggregate expenditure.

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Figure 8.10

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs where the AE line crosses the 45° line.

In this case, that occurs at GDP of $10 trillion.

If GDP is less than $10 trillion, the corresponding point on the AE line is above the 45° line, planned aggregate expenditure is greater than total production, firms will experience an unplanned decrease in inventories, and GDP will increase.

If GDP is greater than $10 trillion, the corresponding point on the AE line is below the 45° line, planned aggregate expenditure is less than total production, firms will experience an unplanned increase in inventories, and GDP will decrease.

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Showing a Recession on the 45°-Line Diagram

Macroeconomic equilibrium can occur at any point on the 45° line.

Ideally, we would like equilibrium to occur at potential GDP.

At potential GDP, firms will be operating at their normal level of capacity, and the economy will be at the natural rate of unemployment.

At the natural rate of unemployment, the economy will be at full employment: Everyone in the labor force who wants a job will have one, except the structurally and frictionally unemployed.

For equilibrium to occur at the level of potential GDP, planned aggregate expenditure must be high enough.

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Figure 8.11

Showing a Recession on the 45°-Line Diagram

When the aggregate expenditure line intersects the 45° line at a level of GDP below potential GDP, the economy is in recession.

The figure shows that potential GDP is $2 trillion,

but because planned aggregate expenditure is too low, the equilibrium level of GDP is only $1.6 trillion,

where the AE line intersects the 45° line.

As a result, some firms will be operating below their normal capacity, and unemployment will be above the natural rate of unemployment.

We can measure the shortfall in planned aggregate expenditure as the vertical distance between the AE line and the 45° line at the level of potential GDP.

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Whenever planned aggregate expenditure is less than real GDP, some firms will experience unplanned increases in inventories.

If firms do not cut back their production promptly when spending declines, they will accumulate inventories.

Firms will have to sell their excess inventories before they can return to producing at normal levels, even if spending has already returned to normal levels.

The Important Role of Inventories

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A Numerical Example of Macroeconomic Equilibrium

Real GDP (Y)	Consumption (C)	Planned Investment (Ip)	Government Purchases (G)	Net Exports (NX)	Planned Aggregate Expenditure (AE)	Unplanned Change in Inventories	Real GDP Will …
$800	$740	$125	$125	− $30	$960	−$160	increase
1200	1060	125	125	−30	1280	−80	Increase
1600	1380	125	125	−30	1600	0	be in equilibrium
2000	1700	125	125	−30	1920	80	decrease
2400	2020	125	125	−30	2240	160	decrease
Note: The values are in billions of 2007 dollars

Table 8.3

Macroeconomic Equilibrium

We can capture some key features contained in the quantitative models that economic forecasters use by looking at several hypothetical combinations of real GDP and planned aggregate expenditure.

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Describe the multiplier effect and use the multiplier formula to calculate changes in equilibrium GDP.

8.4 LEARNING OBJECTIVE

The Multiplier Effect

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Figure 8.12

The Multiplier Effect

The economy begins at point A , at which

equilibrium real GDP is $1.6 trillion. An $80 billion increase in planned investment shifts up aggregate expenditure from AE 1 to AE 2 . The new equilibrium is at point B , where real GDP is $2 trillion, which is potential real GDP. Because of the multiplier effect, an $80 billion increase in investment results in a $400 billion increase in equilibrium real

GDP.

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Autonomous expenditure An expenditure that does not depend on the level of GDP.

Multiplier The increase in equilibrium real GDP divided by the increase in autonomous expenditure.

Multiplier effect The process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

The increase in planned investment spending has had a multiplied effect on equilibrium real GDP.

It is not only investment spending that will have this multiplied effect; any increase in autonomous expenditure will shift up the aggregate expenditure function and lead to a multiplied increase in equilibrium GDP.

In the aggregate expenditure model we have been using, planned investment spending, government spending, and net exports are all autonomous expenditures, but consumption actually has both an autonomous component and a nonautonomous—or induced—component, which does depend on the level of GDP.

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Table 8.4

The Multiplier Effect in Action

	Additional Autonomous Expenditure	Additional Induced Expenditure (C)	Total Additional Expenditure = Total Additional GDP
Round 1	$80 billion	$0	$80.00 billion
Round 2	0	64.00 billion	144.00 billion
Round 3	0	51.20 billion	195.20 billion
Round 4	0	40.96 billion	236.16 billion
Round 5	0	32.77 billion	268.93 billion
. . .	. . .		. . .
Round 10	0	10.74 billion	357.05 billion
. . .	. . .		. . .
Round 20	0	1.15 billion	395.39 billion
.	.	.	.
Round n	0	0	400.00 billion

By thinking of the multiplier effect occurring in rounds of spending, we can summarize how changes in GDP and spending caused by the initial $80 billion increase in investment will result in equilibrium GDP rising by $400 billion.

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Eventually, the process will be finished, although we cannot say precisely how many spending rounds it will take, so we simply label the last round n rather than give it a specific number.

We can calculate the value of the multiplier in our example by dividing the increase in equilibrium real GDP by the increase in autonomous expenditure:

With a multiplier of 5, each increase in autonomous expenditure of $1 will result in an increase in equilibrium GDP of $5.

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A Formula for the Multiplier

During the multiplier process, each round of increases in consumption is smaller than the previous, so eventually, the increases will come to an end, and we will have a new macroeconomic equilibrium.

We can show that the total in Table 8.4 will be $400 billion when we add all the increases in GDP by first writing out the total change in equilibrium GDP:

The total change in equilibrium real GDP equals the initial increase in planned investment spending = $80 billion

Plus the first induced increase in consumption = MPC × $80 billion

Plus the second induced increase in consumption = MPC × (MPC × $80 billion)

= MPC2 × $100 billion

Plus the third induced increase in consumption = MPC × (MPC2 × $80 billion)

= MPC3 × $80 billion

Plus the fourth induced increase in consumption = MPC × (MPC3 × $80 billion)

= MPC4 × $80 billion

And so on …

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Or:

where the ellipsis (. . .) indicates that the expression contains an infinite number of similar terms.

If we factor out the $80 billion from each expression, we have:

The expression in parentheses sums to

In this case, the MPC is equal to 0.8. So, we can now calculate that the change in equilibrium GDP = 80billion × [1/(1 − 0.8)] = 80 billion × 5 = $400 billion.

We have also derived a general formula for the multiplier:

In this case, the multiplier is 1/(1 − 0.8), or 5, so a $80 billion increase in planned investment spending results in a $400 billion increase in equilibrium GDP.

Total change in GDP = $80 billion + MPC × $80 billion + MPC2

× $80 billion + MPC3 × $80 billion + MPC4 × $80 billion + …)

Total change in GDP = $80 billion × (1 + MPC + MPC2 + MPC3 + MPC4 + …)

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Summarizing the Multiplier Effect

1. The multiplier effect occurs both when autonomous expenditure increases and when it decreases. For example, with an MPC of 0.8, a decrease in planned investment of $80 billion will lead to a decrease in equilibrium income of $400 billion.

2. The multiplier effect makes the economy more sensitive to changes in autonomous expenditure than it would otherwise be. Because of the multiplier effect, a decline in spending and production in one sector of the economy can lead to declines in spending and production in many other sectors of the economy.

3. The larger the MPC, the larger the value of the multiplier. This direct relationship between the value of the MPC and the value of the multiplier holds true because the larger the MPC, the more additional consumption takes place after each rise in income during the multiplier process.

4. The formula for the multiplier, 1/(1 − MPC), is oversimplified because it ignores some real-world complications, such as the effect that increases in GDP have on imports, inflation, interest rates, and individual income taxes. These effects combine to cause the simple formula to overstate the true value of the multiplier.

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Using the Multiplier Formula

Solved Problem 8.2

Use the information in the table to answer the following questions:

Real GDP (Y)	Consumption (C)	Planned Investment (Ip)	Government Purchases (G)	Net Exports (NX)
$800	$690	$100	$100	−$50
900	770	100	100	−50
1000	850	100	100	−50
1100	930	100	100	−50
1200	1010	100	100	−50
Note: The values are in billions of 2007 dollars.

a. What is the equilibrium level of real GDP?

b. What is the MPC?

c. If government purchases increase by $20 billion, what will be the new equilibrium level of real GDP?

Use the multiplier formula to determine your answer.

Solving the Problem

Step 1: Review the chapter material.

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Using the Multiplier Formula

Solved Problem 8.2

Step 2: Determine equilibrium GDP.

We can find macroeconomic equilibrium by calculating the level of planned aggregate expenditure for each level of real GDP.

Step 3: Calculate the MPC.

In this example:

Use the information in the table to answer the following questions:

Real GDP (Y)	Consumption (C)	Planned Investment (Ip)	Government Purchases (G)	Net Exports (NX)
$800	$690	$100	$100	−$50
900	770	100	100	−50
1000	850	100	100	−50
1100	930	100	100	−50
1200	1010	100	100	−50
Note: The values are in billions of 2007 dollars.

Planned Aggregate Expenditure (AE)

$840

920

1000

1080

1160

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Using the Multiplier Formula

Solved Problem 8.2

So:

Change in equilibrium real GDP = Change in autonomous expenditure × 5

Or:

Change in equilibrium real GDP = $20 billion × 5 = $100 billion

Therefore:

New level of equilibrium GDP = $1000 billion + $100 billion

= $1100 billion

Your Turn: Test your understanding by doing related problem 4.2 on page 249 at the end of this chapter.

Step 4: Use the multiplier formula to calculate the new equilibrium level of real GDP.

We could find the new level of equilibrium real GDP by constructing a new table with government purchases increased from $1,000 billion to $1,200 billion.

But the multiplier allows us to calculate the answer directly.

In this case:

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The Paradox of Thrift

In discussing the aggregate expenditure model, John Maynard Keynes argued that if many households decide at the same time to increase their saving and reduce their spending, they may make themselves worse off by causing aggregate expenditure to fall, thereby pushing the economy into a recession.

The lower incomes in the recession might mean that total saving does not increase, despite the attempts by many individuals to increase their own saving.

Keynes referred to this outcome as the paradox of thrift because what appears to be something favorable to the long-run performance of the economy might be counterproductive in the short run.

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Understand the relationship between the aggregate demand curve and aggregate expenditure.

8.5 LEARNING OBJECTIVE

The Aggregate Demand Curve

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Increases in the price level cause aggregate expenditure to fall, and decreases in the price level cause aggregate expenditure to rise.

There are three main reasons for this inverse relationship between changes in the price level and changes in aggregate expenditure:

A rising price level decreases consumption by decreasing the real value of household wealth; a falling price level has the reverse effect.

If the price level in Canada rises relative to the price levels in other countries, Canadian exports will become relatively more expensive, and foreign imports will become relatively less expensive, causing net exports to fall.

A falling price level in Canada has the reverse effect.

When prices rise, firms and households need more money to finance buying and selling. If the central bank (the Bank of Canada) does not increase the money supply, the result will be an increase in the interest rate, which causes investment spending to fall. A falling price level has the reverse effect: Other things being equal, interest rates will fall, and investment spending will rise.

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Figure 8.13

The Effect of a Change in the Price Level on Real GDP

In panel (a), an increase in the price level results in declining consumption, planned investment, and net exports and causes the aggregate expenditure line to shift down from AE1 to AE2. As a result, equilibrium real GDP declines from $2 trillion to $1.6 trillion.

In panel (b), a decrease in the price level results in rising consumption, planned investment, and net exports and causes the aggregate expenditure line to shift up from AE1 to AE2.

As a result, equilibrium real GDP increases from $1.6 trillion to $2 trillion.

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LO8.5

Figure 8.14

The Aggregate Demand Curve

The aggregate demand (AD) curve shows the relationship between the price level and the level of planned aggregate expenditure in the economy.

When the price level is 105,

real GDP is $2 trillion.

An increase in the price level to 120 causes consumption, investment, and net exports to fall,

which reduces real GDP to $1.6 trillion.

Aggregate demand (AD) curve A curve that shows the relationship between the price level and the level of planned aggregate expenditure in the economy, holding constant all other factors that affect aggregate expenditure.

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LO8.5

When Consumer Confidence Falls, Is Your Job at Risk?

At the beginning of this chapter, we asked you to suppose that you work part time at a local Tim Hortons.

You have learned that consumer confidence in the economy has fallen and that many households expect their future income to be dramatically less than their current income.

Should you be concerned about losing your job?

If consumers expect their future incomes to decline, they will cut their consumption spending, Consumption spending is about 63 percent of

total expenditure in the economy.

So if the decline in consumer confidence is correct in forecasting

the decline in consumption, then aggregate expenditure and real GDP are likely to decline as well. If the economy moves into a recession, spending at Tim Hortons is likely to fall; this could reduce your location’s sales and possibly cost you a job.

Economics in Your Life

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The Algebra of Macroeconomic Equilibrium

Appendix C

Apply the algebra of macroeconomic equilibrium.

LEARNING OBJECTIVE

Graphs help us understand economic change qualitatively.

When we write an economic model using equations, we make it easier to make quantitative estimates.

An econometric model is an economic model written in the form of equations, where each equation has been statistically estimated, using methods similar to the methods used in estimating demand curves.

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Appendix C

The following equations are based on the example shown in Table 8.3.

Y stands for real GDP, and the numbers (with the exception of the MPC) represent billions of dollars.

1. C = 100 + 0.8Y

2. Ip = 125

3. G = 125

4. NX = −30

5. Y = C + Ip + G + NX

Consumption function

Planned investment function

Government spending function

Net export function

Equilibrium condition

The parameters of the functions—such as the value of autonomous consumption and the value of the MPC in the consumption function—would be estimated statistically, using data on the values of each variable over

a period of years.

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LO App C

In this model, GDP is in equilibrium when it equals planned aggregate expenditure.

Equation 5—the equilibrium condition—shows us how to calculate equilibrium in the model: We need to substitute equations 1 through 4 into equation 5.

Doing so gives us the following:

Y = 100 + 0.8Y + 125 + 125 − 30

We need to solve this expression for Y to find equilibrium GDP.

The first step is to subtract 0.8Y from both sides of the equation:

Y − 0.8Y = 100 + 125 + 125 − 30

Then, we solve for Y:

0.2Y = 320

Or:

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LO App C

To make this result more general, we can replace particular values with general values represented by letters:

Consumption function

Planned investment function

Government spending function

Net export function

Equilibrium condition

For example, represents autonomous consumption, which had a value of 100 in our original example.

The letters with bars over them represent fixed, or autonomous, values.

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LO App C

Solving now for equilibrium, we get

Remember that 1/(1 − MPC) is the multiplier, and all four variables in the numerator of the equation represent autonomous expenditure.

Therefore, an alternative expression for equilibrium GDP is:

Equilibrium GDP = Autonomous expenditure × Multiplier

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LO App C

MPC

income

disposable

Change

consumptio

Change

billion

$39

billion

$31.4

billion

000

billion

000

billion

750

billion

250

billion

000

billion

000

billion

750

billion

250

billion

400

spending

investment

Change

GDP

real

Change

MPC

expenditur

autonomous

Change

GDP

real

equilibriu

Change

Multiplier

MPC

billion

$1000

billion

$800

MPC

Multiplier

MPC

1600

320

)

(

MPC

)

(

MPC

)

(

MPC

)

(

MPC