One prominent Cambridge economist, John Maynard Keynes, successfully introduced a new school of thought about government intervention. He believed that there can be unemployment but the economy can still find equilibrium. The government, through various expenditures, can fine-tune the economy in order to achieve the desired level of GDP. This theory is the foundation of the famous “Keynesian economics.”

In the last chapter, we discussed how we can measure economic performance. In this chapter, we will see how to manage or control the GDP by using the Keynesian approach. (i.e. aggregate expenditure).

1. COMPONENTS OF AGGREGATE EXPENDITURE

The components of aggregate expenditure (AE) are:

â€¢ Private consumption expenditure (C)

â€¢ Gross investment (I)

â€¢ Government purchases of goods and services (G)

â€¢ Net exports (NX)

## 2. FACTORS AFFECTING CONSUMPTION AND SAVING FUNCTIONS

We cannot spend all our income. The amount we can spend is called “disposable income” which is equal to the sum of aggregate income and transfer payments, less taxes. Every household must decide how to allocate their disposable income between savings and consumption. Similarly, our planned savings is equal to disposable income less planned consumption.

Consumption decision is affected by many factors:

## â€¢

## Real interest rate

Real interest rate represents the opportunity cost of consumption. A dollar spent is a dollar not saved. The interest that could have been earned is forgone.

The higher the real interest rate, all other things being the same, the greater is the households’ opportunity cost of consumption and the greater the amount of saving.

## â€¢ Disposable income

The higher the household’s disposable income, all other things being the same, the greater is its savings.

## â€¢ Wealth

A household’s wealth equals its assets less its debts. The purchasing power of a household’s wealth is the real value of its wealth. It is the quantity of goods and services that the household’s wealth can afford.

The greater the household’s real wealth, all other things being the same, the less its savings.

## â€¢ Expected future income

The lower a household’s expected future income, all other things being the same, the greater is its current saving.

3. CONSUMPTION FUNCTION, MARGINAL PROPENSITY TO CONSUME, AND THE 45o LINE

The relationship between consumption expenditure and disposable income, holding everything constant, is the consumption function. The 45o line contains all points at which consumption expenditure is equal to disposable income.

When the consumption function is above the 45o line, saving is negative (dis-saving).

When the consumption function is below the 45o line, saving is positive.

At the point when the consumption function intersects the 45o line, all disposable income is consumed and saving is zero.

Figure 1 Consumption function

Definition

Marginal propensity to consume (MPC) = Change in consumption expenditure / Change in disposable income

It is equal to the slope of the consumption function.

Figure 2 Marginal propensities to consume and save

Note:

â€¢ Î”C: Change in consumption expenditure

â€¢ Î”YD: Change in disposable income

4. SAVING FUNCTION AND MARGINAL PROPENSITY

TO SAVE

The relationship between saving and disposable income, holding everything constant, is the saving function. The height of the saving function against the X-axis measures saving (or dis-saving) at each level of disposable income.

At the point when the saving function intersects the X-axis, all disposable income is consumed and saving is zero.

Figure 3 Saving function

Definition

## Marginal propensity to save (MPS)

= Change in saving / Change in disposable income

It is equal to the slope of the saving function.

Figure 4 Marginal propensity to save

Note:

â€¢ Î”S: Change in saving

Key Point

As consumption expenditure and savings exhaust disposable income,

## MPC + MPS = 1

5. FACTORS AFFECTING INVESTMENT FUNCTIONS

Investment decisions are influenced by

## â€¢ Expected profit rate

The greater the expected profit rate from making an investment, all other things being the same, the greater is the investment.

Factors affecting expected profit rate include:

(a) the phase of the business cycle, i.e. economic boom or recession

(b) advances in technology

(c) taxes

## â€¢ Interest rates

Definitions

Real interest rate is the net return on capital expected to be earned on money invested in an inflation-free environment.

Nominal interest rate is the gross return on capital expected to be earned in the period of inflation to compensate for the drop in purchasing power of the money invested due to inflation.

The lower the real interest rate, other things being the same, the greater is the investment because the low interest rate reduces the opportunity cost of investment.

Key Point

Nominal interest rate = Real interest rate + Inflation rate

6. FACTORS AFFECTING GOVERNMENT EXPENDITURE

Government expenditure depends on present and past government policy; it also depends on political procedure from political bodies such as the pressure groups.

In other words, government expenditure is considered autonomous, which is independent of national income (at least in the short run). Over a longer term, government expenditure will, to a certain extent, depend on national income. The higher the level of national income, the higher is the amount of tax revenue that the government receives, and hence the more it can afford to spend.

## 7. FACTORS AFFECTING IMPORT FUNCTION

The marginal propensity to import (MPI) measures the increase in real GDP that is spent on imports.

Definition

## Marginal propensity to import (MPI)

= Change in imports / Change in real GDP

In the short run, import function is determined mainly by real GDP. The greater the real GDP, the larger the quantity of import.

8. AGGREGATE PLANNED EXPENDITURE

## Definition

Aggregate planned expenditure is the expenditure that decision-makers (households, government, firms and foreigners) plan to undertake at various levels of real GDP.

Aggregate planned expenditure equals the sum of planned consumption expenditure, planned investment, planned government purchases of goods and services, and planned exports less planned imports at different levels of real GDP. A schedule of aggregate planned expenditure is produced below.

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An increase in real GDP expands aggregate planned expenditure. An increase in aggregate planned expenditure boosts real GDP. They have a two-way link. However, it is important to note that aggregate planned expenditure is not necessarily equal to real GDP.

## Aggregate planned expenditure

## Real

## GDP

## C

## I

## G

## X

## M

## Aggregate

## Planned

## Expenditure

AE = C + I + G + X – M

0

0

1.5

1.8

1.7

0.0

5.0

7

4.9

1.5

1.8

1.7

1.4

8.5

8

5.6

1.5

1.8

1.7

1.6

9.0

9

6.3

1.5

1.8

1.7

1.8

9.5

10

7.0

1.5

1.8

1.7

2.0

10.0

11

7.7

1.5

1.8

1.7

2.2

10.5

12

8.4

1.5

1.8

1.7

2.4

11.0

Note:

â€¢ C: Consumption expenditure = a + bYd

where a = Autonomous expenditure; b = Marginal propensity to consume; and Yd = Disposable income

â€¢ M: Imports

## Definitions

Autonomous expenditure does not vary with real GDP. I, G and X are assumed to remain fixed at different levels of income. They are assumed to be autonomous.

Induced expenditure varies with different levels of real GDP, e.g. it is a variable part of consumption (C) and imports (M) in an economy.

Adding up the AE components of C, I, G, and X – M, we arrive at the aggregate planned expenditure curve (AE), which describes the aggregate planned expenditure generated at various levels of real GDP.

Figure 5 Aggregate planned expenditure

9. EQUILIBRIUM EXPENDITURE

The 45o line is to represent all the situations where aggregate planned expenditure equals real GDP. Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP. It is where the aggregate planned expenditure (AE) intersects the 45 o line.

Figure 6 Equilibrium expenditure

Below equilibrium, aggregate planned expenditure exceeds real GDP. Above equilibrium, aggregate planned expenditure falls short of real GDP. When aggregate planned expenditure and real GDP are unequal, a process of adjustment toward equilibrium expenditure occurs.

## 10. Adjustments towards Equilibrium

Actual aggregate expenditure is always equal to real GDP. But aggregate planned expenditure is not necessarily equal to actual expenditure and, therefore, is not necessarily equal to real GDP. However, it will set off a series of adjustments which will lead to equilibrium condition.

## â€¢ Case 1: Equilibrium, when planned expenditure equals real GDP

AE curve intersects 45 o line – equilibrium occurs at point d in Figure 6, where real GDP equals aggregate planned expenditure.

## â€¢ Case 2: Below equilibrium, when planned expenditure exceeds real GDP

Suppose the economy is at point b – real GDP is at $2 while aggregate planned expenditure is $4 – aggregate planned expenditure is larger than real GDP. How can real GDP be $2 if people plan to spend $4? The answer is that actual spending is less than planned spending. If real GDP is $2, the value of production is also $2. The only way that people can buy goods and services worth $4 when the value of production is $2 is that firms’ inventories fall by $2.

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But firms have target levels for inventories. When inventories fall below those targets, firms increase production to restore inventories to their target levels. To restore their inventories, firms hire additional labour and increase production. In this case, firms will increase production to replenish their inventories. Real GDP rises by $2 to $4. But again, aggregate planned expenditure exceeds real GDP. When real GDP is $4, aggregate planned expenditure is $5 (point c). Again, inventories fall, but this time by less than before. With real GDP of $4 and planned expenditure of $4.5, inventories fall by only $0.5. Again, firms hire additional labour and production increases; real GDP rises further.

This process that inventories fall when planned expenditure exceeds income and production rises to replenish the unplanned inventory reduction ends when real GDP has reached $6. At this level of real GDP (point d), equilibrium is obtained.

## â€¢ Case 3: Above equilibrium, when real GDP exceeds planned expenditure

Suppose real GDP is $10. At this level, aggregate planned expenditure is $8 (point f), $2 less than real GDP. With aggregate planned expenditure less than real GDP, inventories rise by $2 which is unplanned additions to inventories. With unsold inventories on their hands, firms cut back on production and real GDP falls. If they cut back production by the amount of the unplanned increase in inventories, real GDP falls by $1 to $9. At that level of real GDP, aggregate planned expenditure is $7.5. Again, there is an unplanned increase in inventories, but it is only one half of the previous increase (point e). Again, firms will cut back production and lay off more workers. Real GDP continues to fall as unplanned inventories exist. Real GDP decreases until it reaches its equilibrium level of $6 (point d) as in Figure 6.

10.1 Conclusion

If real GDP is below equilibrium, aggregate planned expenditure exceeds real GDP. Inventories will fall. Firms increase production to restore their inventories, and real GDP rises.

If real GDP is above equilibrium, aggregate planned expenditure is less than real GDP. Inventories will increase. Unsold inventories prompt firms to cut back production, and real GDP falls.

If real GDP equals aggregate planned expenditure, there are no unplanned inventory changes and no changes in firms’ output plans. In this situation, real GDP comes to equilibrium.

11. EXPENDITURE MULTIPLIER

The planned expenditure can generate income to all sectors of the economy, and income in turn will generate another cycle of expenditure. Such income expenditure relationship forms the backbone of the Keynesian model. The government can increase public expenditure to stimulate GDP. We find that the initial autonomous spending can have a multiplication effect on the resultant GDP.

Definition

The multiplier is the magnitude by which a change in autonomous expenditure leads to change in equilibrium expenditure.

11.1 Changes In Autonomous Expenditure

The AE curve will shift if any of the components of AE (e.g. I, G and/or X) changes.

Multiplier = Change in equilibrium expenditure / Change in autonomous expenditure

The following figure illustrates such shifting and the effect on equilibrium.

Figure 7 The multiplier

11.2 Why Is The Expenditure Multiplier Greater Than One?

It is greater than one because of the additions of induced expenditure. An increase in autonomous expenditure results in further increases in induced expenditure. An example is produced below:

Example 1

## Expenditure multiplier

## Expenditure

## Round

## Increase In Expenditure

## Cumulative Increase

## In Real GDP

1

500

500

2

375

875

3

281

1,156

Autonomous expenditure (e.g. I, G and/or X) increases in Round 1 by $500. Real GDP increases by the same amount. Each additional dollar of real GDP leads to an additional $0.75 of induced expenditure on consumption.

Therefore, in Round 2, the $500 increase in real GDP leads to a further increase in induced expenditure of $375. At the end of Round two, real GDP has increased by $875.

Again, the extra $375 of real GDP leads to a further increase in induced expenditure of $281 in Round 3. The process goes on and on until real GDP increases to $2,000.

To conclude, the increase in $500 autonomous expenditure has a four-time multiplier effect to increase real GDP to $2,000.

Figure 8 The multiplier process

11.3 Slope Of Aggregate Expenditure Curve And Multiplier

The slope of the aggregate planned expenditure curve determines the effect of an increase in real GDP on induced expenditure. The steeper the slope, the higher will be the expenditure multiplier.

In the above example, marginal propensity to consume (0.75) is the slope of the aggregate planned expenditure curve and therefore the multiplier is four.

Figure 9 The multiplier and slope of the AE curve

11.4 Multiplier, MPC And MPS

In Example 1, it is the marginal propensity to consume that determines the magnitude of the multiplier effect. The larger the MPC, the larger is the multiplier.

Key Point

## Multiplier = 1 / (1 – MPC)

Alternatively, since marginal propensity to save (MPS) = 1 – MPC, the above expression can also be stated as:

## Multiplier = 1 / MPS

Chapter Review

â€¢ The components of aggregate expenditure (AE) are private consumption expenditure

(C); gross investment (I); government purchases of goods and services (G);

and net exports (NX).

â€¢ The 45o line contains all points at which consumption expenditure is equal to disposable income.

â€¢ The height of saving function against the X-axis measures saving (or dis-saving) at each level of disposable income.

â€¢ Equilibrium expenditure occurs when aggregate planned expenditure equals real GDP.

What You Need To Know

â€¢ Marginal propensity to consume (MPC): Change in consumption expenditure / Change in disposable income. It is equal to the slope of the consumption function.

â€¢ Marginal propensity to save (MPS): Change in saving / Change in disposable income. It is equal to the slope of the saving function.

â€¢ Real interest rate: Net return on capital expected to be earned on money invested in an inflation-free environment.

â€¢ Nominal interest rate: Gross return on capital expected to be earned in the period of inflation to compensate for the drop in purchasing power of the money invested due to inflation. Equal to real interest rate + inflation rate.

â€¢ Aggregate planned expenditure is the expenditure that decision-makers (households, government, firms and foreigners) plan to undertake at various levels of real GDP.

â€¢ Autonomous expenditure: Expenditure that does not vary with real GDP.

â€¢ Induced expenditure: Expenditure that varies with different levels of real GDP

â€¢ Multiplier: The magnitude by which a change in autonomous expenditure leads to change

in equilibrium expenditure.

Work Them Out

1. Disposable income is

A income minus saving

B income minus net taxes

C income plus transfer payments minus consumption expenditure

D total income divided by the price level

2. The slope of the consumption function is

A less than the slope of the 45° line but not equal to zero

B greater than the slope of the 45° line

C equal to the slope of the 45° line

D equal to zero

3. Saving rather than dis-saving occurs at any level of disposable income at which

A the consumption function is above the 45° line

B the consumption function intersects the saving/income curve

C the consumption function is below the 45° line

D autonomous consumption is positive

4. If consumption expenditures for a household increase from $1,000 to $1,300 when disposable income rises from $1,000 to $2,000, the marginal propensity to consume is

A 0.8

B 0.5

C 0.3

D 0.2

5. If an increase in a household’s disposable income from $10,000 to $13,000 boosts its consumption expenditure from $8,000 to $9,000, the

A household is dis-saving

B slope of the consumption function is 0.3

C slope of the consumption function is 0.5

D slope of the consumption function is 1,000

6. The slope of the aggregate expenditure curve equals the change in

A planned expenditure divided by the change in real GDP

B autonomous expenditure divided by the change in real GDP

C government expenditure divided by the change in real GDP

D real GDP divided by the change in planned expenditure

7. Expenditure that does NOT rely on real GDP is called

A spurious expenditure

B equilibrium expenditure

C induced expenditure

D autonomous expenditure

8. If real GDP is $2 billion and planned aggregate expenditure is $2.25 billion, inventories will

A be depleted and output will increase

B be depleted and output will decrease

C pile up and output will decrease

D pile up and output will increase

9. Suppose there are no taxes or imports and MPC = 0.4, the multiplier is

A 2.5

B 3

C 6

D 0.33

10. Suppose that MPC = 0.8 and there are no taxes or imports. Then a $100 increase in autonomous spending causes equilibrium expenditure to

A decrease by $500

B increase by $500

C decrease by $800

D increase by $800

## SHORT QUESTIONS

1. Explain the difference between real and nominal interest rate.

2. Explain how an economy could achieve equilibrium if now

## (a) aggregate planned expenditure exceeds real GDP.

(b) real GDP exceeds aggregate planned expenditure.

## ESSAY QUESTIONS

You are given the following information about the economy of Fantasy Island:

## Disposable Income

## (Millions Of Dollars Per Year)

## Consumption Expenditure

## (Millions Of Dollars Per Year)

0

100

100

150

200

200

300

250

400

300

Calculate Fantasy Island’s:

## marginal propensity to consume.

## saving at each level of disposable income.

## marginal propensity to save.

The equilibrium level of income is $500 when C = $50 + 0.80Yd and I = $50. Now, imagine some outside forces change the spending equations so that now it becomes

C = $30 + 0.80 Yd and I = $70.