Consumption Expenditure
Fixed Prices and Expenditure Plans
Keynesian model describes the economy in the very short
run when prices are fixed.
Because each firm’s price is fixed, for the economy as a
whole:
1. The price level is fixed.
2. Aggregate demand determines real GDP.
What determines aggregate expenditure plans?
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Fixed Prices and Expenditure Plans
Expenditure Plans
The components of aggregate expenditure sum to real
GDP.
That is,
Y=C+I+G+X–M
Two of the components of aggregate expenditure,
consumption and imports, are influenced by real GDP.
So there is a two-way link between aggregate expenditure
and real GDP.
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Fixed Prices and Expenditure Plans
Two-Way link Between Aggregate Expenditure and Real
GDP
Other things remaining the same,
An increase in real GDP increases aggregate expenditure.
An increase in aggregate expenditure increases real GDP.
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Fixed Prices and Expenditure Plans
Consumption and Saving Plans
Consumption expenditure is influenced by many factors
but the most direct one is disposable income.
Disposable income is aggregate income or real GDP, Y,
minus net taxes, T.
Call disposable income YD.
The equation for disposable income is
YD = Y – T
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Fixed Prices and Expenditure Plans
Disposable income, YD, is either spent on consumption
goods and services, C, or saved, S.
That is, YD = C + S.
The relationship between consumption expenditure and
disposable income, other things remaining the same, is
the consumption function.
The relationship between saving and disposable income,
other things remaining the same, is the saving function.
Figure 11.1 illustrates the consumption function and the
saving function.
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but2
When consumption
expenditure exceeds
disposable income, saving
is negative (dissaving).
When consumption
expenditure is less than
disposable income, there
is saving.
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Fixed Prices and Expenditure Plans
Marginal Propensities to Consume and Save
The marginal propensity to consume (MPC) is the
fraction of a change in disposable income spent on
consumption.
It is calculated as the change in consumption expenditure,
C, divided by the change in disposable income, YD, that
brought it about.
That is, MPC = C ÷ YD
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Fixed Prices and Expenditure Plans but2
Figure 11.2(a) shows that the MPC is the slope of the
consumption function.
When disposable income increases by $2 trillion,
consumption expenditure increases by $1.5 trillion.
The MPC is 0.75.
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Fixed Prices and Expenditure Plans
The marginal propensity to save (MPS) is the fraction of
a change in disposable income that is saved.
It is calculated as the change in saving, S, divided by the
change in disposable income, YD, that brought it about.
That is,
MPS = S ÷ YD
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Fixed Prices and Expenditure Plans but2
Figure 11.2(b) shows that the MPS is the slope of the
saving function.
When disposable income increases by $2 trillion,
saving increases by $0.5 trillion.
The MPC is 0.25.
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Fixed Prices and Expenditure Plans
The MPC plus the MPS equals 1.
To see why, note that,
C + S = YD.
Divide this equation by YD to obtain,
C/YD + S/YD = YD/YD
or
MPC + MPS = 1.
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Fixed Prices and Expenditure Plans
Consumption as a Function of Real GDP
Disposable income changes when either real GDP
changes or net taxes change.
If tax rates don’t change, real GDP is the only influence on
disposable income, so consumption expenditure is a
function of real GDP.
We use this relationship to determine real GDP when the
price level is fixed.
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Fixed Prices and Expenditure Plans
Import Function
In the short run, U.S. imports are influenced primarily by
U.S. real GDP.
The marginal propensity to import is the fraction of an
increase in real GDP spent on imports.
If an increase in real GDP of $1 trillion increases imports
by $0.25 trillion, the marginal propensity to import is 0.25.
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Real GDP with a Fixed Price Level
When the price level is fixed, aggregate demand is
determined by aggregate expenditure plans.
Aggregate planned expenditure is planned consumption
expenditure plus planned investment plus planned
government expenditure plus planned exports minus
planned imports.
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Real GDP with a Fixed Price Level
Planned consumption expenditure and planned imports
are influenced by real GDP.
When real GDP increases, planned consumption
expenditure and planned imports increase.
Planned investment plus planned government expenditure
plus planned exports are not influenced by real GDP.
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Real GDP with a Fixed Price Level
Aggregate Planned Expenditure
The relationship between aggregate planned expenditure
and real GDP can be described by an aggregate
expenditure schedule, which lists the level of aggregate
expenditure planned at each level of real GDP.
The relationship can also be described by an aggregate
expenditure curve, which is a graph of the aggregate
expenditure schedule.
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Real GDP with a Fixed Price Level but2
Figure 11.3 shows how
the aggregate
expenditure curve (AE)
is built from its
components.
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Real GDP with a Fixed Price Level
Consumption expenditure minus imports, which varies
with real GDP, is induced expenditure.
The sum of investment, government expenditure, and
exports, which does not vary with GDP, is autonomous
expenditure.
(Consumption expenditure and imports can have an
autonomous component.)
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Real GDP with a Fixed Price Level
Actual Expenditure, Planned Expenditure, and
Real GDP
Actual aggregate expenditure is always equal to real GDP.
Aggregate planned expenditure may differ from actual
aggregate expenditure because firms can have unplanned
changes in inventories.
Equilibrium Expenditure
Equilibrium expenditure is the level of aggregate
expenditure that occurs when aggregate planned
expenditure equals real GDP.
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Real GDP with a Fixed Price Level but2
Figure 11.4 illustrates
equilibrium expenditure.
Equilibrium occurs at the
point at which the AE
curve crosses the 45° line
in part (a).
Equilibrium occurs when
there are no unplanned
changes in business
inventories in part (b).
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Real GDP with a Fixed Price Level but2
Convergence to Equilibrium
From Below Equilibrium
If aggregate planned
expenditure exceeds real
GDP,
there is an unplanned
decrease in inventories.
To restore inventories, firms
hire workers and increase
production.
Real GDP increases.
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Real GDP with a Fixed Price Level
From Above Equilibrium
If real GDP exceeds
aggregate planned,
there is an unplanned
increase in inventories.
To reduce inventories,
firms fire workers and
decrease production.
Real GDP decreases.
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Real GDP with a Fixed Price Level
If aggregate planned
expenditure equals real
GDP (the AE curve
intersects the 45° line), …
there is no unplanned
change in inventories.
So firms maintain their
current production.
Real GDP remains
constant.
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