Aggregate Expenditure

and Aggregate Demand

CHAPTER

25

© 2003 South-Western/Thomson Learning

1
 Aggregate Expenditure and Income
Here we build on the income-
consumption connection to uncover the
tie between income and total spending

Assumptions
No capital depreciation
No business saving
Each dollar spent on production translates
directly into a dollar of aggregate income 
GDP equals aggregate income
Investment, government purchases, and net
exports are autonomous  independent of
the level of income

2
Components of Aggregate Expenditure

To develop the aggregate demand

curve, we begin by asking how
much aggregate output would be
demanded at a given price level

Our objective is to analyze the

relationship between aggregate
spending in the economy and
aggregate income, or real GDP

3
 Aggregate Expenditures
Aggregate expenditures equals the
amount that households, firms,
governments, and the rest of the
world plan to spend on U.S. output
at each level of real GDP
Consumption, C
Planned investment, I
Government purchases, G
Net exports, X – M
Consumption is the only spending
component that varies with the level of
real GDP
4
 Exhibit 1: Table for Real GDP With Net Taxes and
Government Purchases (trillions of dollars)
Planned Unintended
Aggregate Inventory
Real Net Disposable Planned Government Net Expenditur Adjustment
GDP Taxes Income Consumption Saving Investment Purchases Exports e (Y-AE)
(Y) (NT) (Y-NT) (C) (S) (I) (G) (X-M) (AE) (10)=(1)-
(1) (2) (3)=(1)-2) (4) (5) (6) (7) (8) (9) (9)

9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02

9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1
10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0

10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1

11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2

Suppose the price level in the economy is 130  30% higher than in the base year
First column lists a range of possible levels of real GDP symbolized by Y
When we subtract net taxes, column (2), we get disposable income in column (3)
Households only have two possible uses for disposable income
Consumption, MPC assumed to be 4/5
Saving, MPS assumed to be 1/5 5
 Planned Unintended
Aggregate Inventory
Real Net Disposable Planned Government Net Expenditur Adjustment
GDP Taxes Income Consumption Saving Investment Purchases Exports e (Y-AE)
(Y) (NT) (Y-NT) (C) (S) (I) (G) (X-M) (AE) (10)=(1)-
(1) (2) (3)=(1)-2) (4) (5) (6) (7) (8) (9) (9)

9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02
9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1
10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0

10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1

11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2

Columns (6), (7), and (8) list the injections into the circular flow: planned investment,
government purchases and net exports.
Government purchases equals net taxes  government’s budget is balanced
The final column lists any unplanned inventory adjustment which equals real GDP minus
planned aggregate expenditures
When the amount people plan to spend equals the amount produced, there are no
unplanned inventory adjustments. In our example, this occurs where planned aggregate
expenditures and real GDP equal 10.0 6
 Exhibit 1: Table for Real GDP With Net Taxes and
Government Purchases (trillions of dollars)
Planned Unintended
Aggregate Inventory
Real Net Disposable Planned Government Net Expenditure Adjustment
GDP Taxes Income Consumption Saving Investment Purchases Exports (AE) (Y-AE)
(Y) (NT) (Y-NT) (C) (S) (I) (G) (X-M) (9) (10)=(1)-
(1) (2) (3)=(1)-2) (4) (5) (6) (7) (8) (9)

9.0 1.0 8.0 7.5 0.5 0.8 1.0 -0.1 9.5 -.02
9.5 1.0 8.5 7.9 0.6 0.8 1.0 -0.1 9.6 -0.1
10.0 1.0 9.0 8.3 0.7 0.8 1.0 -0.1 10.0 0.0

10.5 1.0 9.5 8.7 0.8 0.8 1.0 -0.1 10.4 +0.1

11.0 1.0 10.0 9.1 0.9 0.8 1.0 -0.1 10.8 +0.2

If, however, real GDP is $9.0 trillion

Planned aggregate expenditure is $9.2 trillion  firms must reduce inventories to make up the
shortfall in output
When the amount produced exceeds planned spending, firms get stuck with unsold goods which
become unplanned increases in inventories
For example, if real GDP is $11.0 trillion, planned aggregate expenditure is only $10.8 trillion
 $0.2 million in output remains unsold  firms respond by reducing output and do so until
they produce the amount that people want to buy 7
 Exhibit 2: Deriving Aggregate Output
This graph is often called the income-expenditure model. The aggregate
expenditure line reflects the sum of consumption, investment, government
purchases, and net exports

C + I + G + (X – M)
Aggregate expenditure
(trillions of dollars)

e Planned aggregate expenditure

10.0
is measured on the vertical
axis. Real GDP, measured on
the horizontal axis, can be
viewed in two ways: 1) the
value of aggregate output ,and
2) as the aggregate income
generated by that level of
45º
output for a given price level
0 10.0

Real GDP
8
(trillions of dollars)
 Exhibit 2: Deriving Aggregate Output
The special feature of the 45-
degree line is that it identifies all
points where planned expenditure
equals real GDP.
C + I + G + (X – M)
Aggregate expenditure
(trillions of dollars)

e
10.0
Aggregate output demanded at
any given price level occurs where
real GDP equals planned
aggregate expenditure, at point e

45º

0 10.0
Real GDP
(trillions of dollars)
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 Exhibit 2: Deriving Aggregate Output

C + I + G + (X – M) Consider what happens when real

GDP is initially less than $10.0
trillion, say $9.0 trillion. Planned
aggregate expenditures of $9.2
trillion (point b) exceed real GDP:
Aggregate expenditure

planned expenditures exceed the

(trillions of dollars)

amount that firms produce.

Because we assume prices will
e remain constant, firms will
10.0
reduce inventories. But
unplanned inventory reductions
b cannot continue indefinitely;
9.2
9.0 a firms will increase employment
 increasing income 
increasing consumer spending.
This process will continue until
45º planned spending equals real
GDP at point e
0 9.0 10.0
Real GDP
(trillions of dollars)
10
 Exhibit 2: Deriving Aggregate Output

When aggregate
expenditures exceed real
GDP - for example at
d $11.0 - planned spending
Aggregate expenditure

11.0 (point c on the AE line)

10.8
(trillions of dollars)

c falls short of production

C + I + G + (X – M)
(point d). Since real GDP
e
10.0 exceeds the amount people
want to spend, unsold
goods accumulate. Rather
than allow inventories to
pile up indefinitely, firms
reduce production, which
reduces employment and
45º income.

0 10.0 11.0
Real GDP
(trillions of dollars)
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 Simple Spending Multiplier
If we continue to assume that the
price level remains unchanged, we
can trace the effects of changes in
planned spending on aggregate
output demanded

The key point is that like a stone

thrown into a still pond, the effect of
any shift in planned spending ripples
through the economy, generating
changes in aggregate output that
may far exceed the initial shift in
planned spending
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 Exhibit 3: Effect of an Increase In Autonomous
Investment on Real GDP Demanded
Assume that we begin at
Aggregate expenditure (trillions of dollars)

equilibrium at point e
e´ and that firms become
10.5
more optimistic about
C+I´+G+(X-M) future prospects. As a
result they increase their
planned investment,
10.1
a from I to I'.
10.0 e C+I+G+(X-M)
In our example,
investment is assumed to
0.1 have increased by $0.1
trillion per year. What is
45º important to note is that
real GDP increased by
0 10.0 10.5 $0.5 trillion.
Real GDP
(trillions of dollars)
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 Exhibit 3: Autonomous Increase In Investment

Round 1: The upward shift

of the AE line means that at
Aggregate expenditure (trillions of dollars)

C + I + G + (X – M) the initial real GDP level of

e' $10.0 trillion, planned
10.5
C + I' + G + (X – M) spending now exceeds output
by $0.1 trillion: e  a
f Initially, inventories may be
c g reduced, prompting firms to
a d expand production: a  b
10.1
b
10.0 e
e  b shows the first round
0.1 in the multiplier process.
Those who receive this
45º additional income spend
some of it and save the rest,
0 10.0 10.1 10.5
laying the basis for round
Real GDP
two of spending and income.
(trillions of dollars)
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 Exhibit 3: Autonomous Increase In Investment

Round Two. Given a MPC of

0.8, those who receive the
additional income of $100
Aggregate expenditure (trillions of dollars)

C + I + G + (X – M)
e' billion as income will spend a
10.5 total of $80 billion,shown by the
C + I' + G + (X – M) move from point b  c. Firms
respond by increasing their
f
output by $80 billion: c  d.
c g
a d
10.1
b Round Three and Beyond. This
10.0 e increase of $80 becomes income to
resource suppliers. Based on the
MPC, we know that four-fifths
0.1
($64 billion) will be spent: f  g.
So long as planned spending
45º exceeds output, production will
increase, thereby creating more
0 10.0 10.1 10.5 income, which will generate still
Real GDP more spending
(trillions of dollars)
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 Exhibit 4: Summary of the Multiplier Effect
New Spending Cumulative New Saving Cumulative
Round This Round New Spending This Round New Saving
1 100 100 - -
2 80 180 20 20
3 64 244 16 36
10 13.4 446.3 3.35 86.6
∞ 0 500 0 100
8

Exhibit 4 summarizes the multiplier process, showing the first

three rounds, round ten, and the cumulative effect of all
rounds
The new spending generated in each round is shown in the
second column and the accumulation of new spending
appears in the third column
Total new spending after 10 rounds sums to $446.3 billion
But calculating the exact total would require us to work
through an infinite series of rounds
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 Simple Spending Multiplier
The cumulative spending resulting from an
infinite series of rounds equals
1 / (1 – MPC) which in our example where the
MPC was 0.8  1 / 0.2  5

Thus, the initial increase in planned

investment of $100 billion will eventually
boost real GDP by 5 times this $100 billion,
or $500 billion

Simple Spending Multiplier =1/(1–MPC)

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 Simple Spending Multiplier
The multiplier depends on the value
of the MPC

Specifically, the larger the fraction of

an increase in income that is spent
each round, the larger the spending
multiplier  the larger the MPC, the
larger the simple multiplier
With an MPC of 0.8, the multiplier is 5
With an MPC of 0.9, the multiplier is 10
With an MPC of 0.75, the multiplier is 4

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 Simple Spending Multiplier

Recall from previous discussions

that the MPC and the MPS must
add up to 1

Therefore, we can define the simple

spending multiplier in terms of the
MPS as follows:

Simple spending multiplier = 1 /

MPS
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 Simple Spending Multiplier
In our example, the multiplier
process started because of an
increase in investment

The same impact would occur if any

one of the components of
aggregate expenditures changed

Finally, if the higher level of

planned investment is not
sustained in future years, real GDP
would fall back and the multiplier
process would work in reverse
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 Deriving the Aggregate Demand Curve
Thus far we have used the aggregate
expenditure line to determine real GDP
demanded for a given price level

What happens to the aggregate

expenditure line if the price level
changes

As will be seen, for each price level

there is a specific aggregate
expenditure line which yields a unique
real GDP demanded  by altering the
price level, we can derive the
aggregate demand curve
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 A Higher Price Level
What is the effect of a higher price level
on the economy’s aggregate expenditure
line and, in turn, on real GDP demanded?

A higher price level

reduces consumption because it reduces the
real value of dollar-denominated assets held
by households
increases the market rate of interest which
reduces investment
makes U.S. goods relatively more expensive
abroad  imports rise and exports fall

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 Exhibit 5: Income-Expenditure and Aggregate Demand

Aggregate expenditure
(trillions of dollars)
AE (P = 130)

e
In panel (a), the AE
function intersects the 45
degree line at point e to (a) Income-expenditure model
yield $10.0 trillion in real
GDP demanded. 45°

0 10.0 Real GDP (trillions of dollars)

Panel (b) shows more

directly the link between
140
real GDP demanded and the
price level. When the price
Price level

e
level is 130, real GDP 130

demanded is $10.0 trillion.

This combination of price (b) Aggregate demand curve
level and real GDP is
identified by point e on the
aggregate demand curve.
0 10.0 Real GDP (trillions of dollars)
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 Exhibit 5: Income-Expenditure and Aggregate Demand

Aggregate expenditure
(trillions of dollars)
AE" (P = 120)
If the price level increases to 140?
e" AE (P = 130)

It reduces consumption, AE' (P = 140)

investment, and net exports, as e

reflected in panel (a) by the

downward shift from AE to AE' e' (a) Income-
As a result of the decrease in expenditure
planned spending, real GDP
45° model
demanded declines from e  e' 0 9.5 10.0 10.5 Real GDP (trillions of dollars)

If the price level declines to120?

140 e'
It increases consumption,
Price level

planned investment, and net e

130
exports, as reflected panel (a) by
the upward shift in the spending (b) Aggregate
e"
line from AE to AE" 120 demand curve
The increase in planned spending at AD
each income level increases real GDP
demanded increases from e  e" 0 9.5 10.0 10.5 Real GDP (trillions of dollars)
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 Aggregate Demand and Expenditures
The aggregate expenditure line and
the aggregate demand curve portray
real output from different perspectives

The aggregate expenditure line shows, for

a given price level, how planned spending
relates to the level of real GDP in the
economy

The aggregate demand curve shows, for

various price levels, the quantities of real
GDP demanded

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 Multiplier and Aggregate Demand
Suppose we return to the situation
where the price level is assumed to be
constant

What we want to do now is trace

through the effects of a shift in any of
the components of spending on
aggregate demand, while assuming
that the price level does not change,
e.g., we want to look at the multiplier
and shifts in aggregate demand

26
 Exhibit 6: Shifts

Aggregate expenditure (trillions of dollars)

C + I' + G + (X – M)
C + I + G + (X – M)

At a price level of 130, the e'

aggregate expenditure line
0.1
intersects the 45 degree line at
point e in panel (a), and yields
e (a) Income-
expenditure
point e on the aggregate demand
model
curve in panel (b) 45º

When one component of 0 10.0 10.5 Real GDP (trillions of dollars)

aggregate expenditure increases,
the AE function shifts upward.
Because the price level is
assumed constant, the aggregate
e e´
demand curve shifts from AD to 130 (b) Aggregate
AD' and the new point of demand curve
equilibrium is shown as e' in both
Price level

panels. AD'
AD
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0 10.0 10.5 Real GDP (trillions of dollars)
 Limitations of the Multiplier
Our discussion of the simple spending
multiplier exaggerates the actual effect
we might expect from a given shift in
the aggregate expenditure line
We have assumed that the price level
remains constant. However, as we will see
later, once we incorporate aggregate supply
into the analysis, changes in the price level
reduce the impact of the multiplier
Leakages such as higher income taxes and
increased spending on imports all reduce the
size of the multiplier
The spending multiplier takes time to work
itself out  the process does not occur
instantly
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