Macroeconomics – Chapter 23: Aggregate Expenditure and Output in the Short Run

Macroeconomics – Chapter 23: Aggregate Expenditure  and Output in the Short Run


[Music] Intel is the world’s largest semiconductor manufacturer and a major supplier of the microprocessors
and memory chips found in most personal computers. Because of its dependence on computer sales,
Intel is vulnerable to the swings of the business cycle.
In recent years sales of computers have declined because many consumers and businesses switched
to using tablets and smartphones to access the Internet.
In addition, Intel is hurt during recessions. During the last quarter of 2008, Intel’s revenues
fell 90 percent, and it laid off 6,000 workers. Intel bounced back in 2010 as the U.S. economy
recovered from the 2007-2009 recession. But unexpectedly slow growth in U.S. Real
GDP in 2012 contributed to a decrease in revenue. Intel and other firms experience swings in
sales and revenue as a result of fluctuations in total spending, or aggregate expenditure,
in our economy. This has ripple effects across the economy,
felt in employment levels, and the level of consumer spending, and expansion or contraction.
Thanks Pavel Molchanov joining us Raymond James Keith McCullough with me
energy obviously outperforming the broader market would you buy energy yes
yes I like buying inflation we’ve liked buying inflation since the being of the
year we were bearish on inflation for the two years before that so you have to
be a little careful particularly if the strength and the dollar continues the
weakness in the euro there’s a lot to think about on these trades but net net
net being long energy instead of something that’s getting jammed like the
US consumer is kind of the way that we’ve been set up so in an environment
where we see an economy bumping along the bottom you know that GDP number
you’re not buying it yesterday 4% you don’t think the New York Times is going
to tell you that 4% GDP is the new number this is all about how great the
GDP was just but you know it’s so volatile I mean I don’t understand how
you go from a 2.9 percent contraction to four percent growth number well it’s
just math so again if you just look at how GDP is reported in terms of the
sequential x’ as bad as you get was as good as you can look next which is as
bad as you can look after that so again what you get from a netting perspective
is an annualized GDP number for the first half of 0.87 percent and the
street is still out there in the feds out there three plus percent GDP
expectations in the back half so that looks next to mathematically impossible
particularly for the third quarter which is why I think you get bonds down for a
day yields up for a day it’s just one more buying opportunity in the slow
growth trade which is long but don’t forget we also have what two more
revisions right on GDP so I mean we defer for the first quarter we started
off positive yeah we started off with growth and then we wait to contraction
yep you know we could go contraction as well
any other bit the other big thing to think about is how good GDP was in the
third quarter last year so we’re talking about sequential or the rate of change
from bad to good to bad but if you look at it year over year last year in the
third quarter four point one eight percent GDP is a very difficult
comparison moreover the inflation number was very very low last year the deflator
was testing a 40-year low you have to subtract not to get on this is real a
real sophisticated math way to subtract inflation from the top line to get a
real GDP number and that’s the big paradox of the Fed there is nothing real
about a policy to inflate there’s just a policy to inflate asset prices
which jams a lot of people and give you a sustained economic recovery [Music] Aggregate expenditure, AE, is total spending
in the economy: the sum of consumption, planned investment, government purchases, and net
exports. The aggregate expenditure model is a macroeconomic
model that focuses on the short-run relationship between total spending and real GDP, assuming
that the price level is constant. The key idea of the model is that in any particular
year, the level of GDP is determined mainly by the level of aggregate expenditure.
In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and
Money, a book that analyzed the relationship between changes in aggregate expenditure and
changes in GDP. Keynes identified four components of aggregate
expenditure that together equal GDP: Consumption (C)
Planned Investment (I) Government Purchases (G)
Net Exports (NX) We say it like this:
Aggregate expenditure=Consumption + Planned Investment + Government purchases + Net exports
But we write it with the letters: AE=C + I + G + NX
In this case, AE replaces Y or GDP, but also note “I” now stands for Planned Investment.
This is a difference from what you learned in terms of measuring the GDP.
Pay attention to this one, it will serve you well. Inventories are goods that have been produced but not yet sold.
For the economy as a whole, we can say that actual investment spending will be greater
than planned investment spending when there is an unplanned increase in inventories.
Actual investment spending will be less than planned investment spending when there is
an unplanned decrease in inventories. Actual investment will equal planned investment
only when there is no unplanned change in inventories. For the economy as a whole, macroeconomic equilibrium occurs where aggregate expenditure
equals total production, or GDP. Keep your attention focused on the difference
between GDP and AE, because the measurement is different only in respect to Actual Investment,
in GDP, versus Planned Investment in AE. We will focus on Planned Investments in the
economy as it relates to the Business Cycle, periods of expansion, and contraction.
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 firms sell what they expected to sell.
In this case, their inventories will be unchanged, and they will not have an incentive to increase
or decrease production. The economy will be in macroeconomic equilibrium.
When economists forecast that aggregate expenditure is likely to decline, the federal government
may implement macroeconomic policies in an attempt to head off the fall in expenditure
and keep the economy from falling into recession. Think about Whirlpool making desirable products
integrating new technologies and keeping products at the cutting edge of consumer demand.
As Whirlpool contacts business that sell their retail consumer appliances, they schedule
how to plan for big purchase events, like Christmas or the start of Fall Semester at
colleges all around the country. Whirlpool is attuned to what retail stores
are ordering for their monthly demand. They know when sales are dropping below expected
levels and when demand increases. These expected demand levels guide company
employment scheduling. When slowdowns are expected, the company can
produce within scheduled guidelines. When they are unexpected, it means a slowdown
is in effect and layoffs become a reality. Inventory changes are often an important indicator
of the near-future direction of GDP. [Music] Korea’s top economic policymaker is pledged to take a more active role in
supporting the job market and people’s livelihoods in light of the ongoing
economic and political turmoil rattling the country Shin Semin tells us what the
Finance Ministry has planned for 2017 Korea’s finance minister has promised to
strengthen the government’s role in creating jobs and stabilizing livelihood
issues the government will do all it can to reach a target goal for government
spending next year we’re also prepared to implement public projects to boost
people’s livelihoods as soon as possible speaking at a ministerial-level meeting
on the economy on Wednesday human host said that all things will be done to
ensure next year’s budget is ready so there’s no delay in its implementation
at the beginning of the year you added that special teams will be put in place
to ensure any delayed government wages will be settled before the end of the
year the finance minister also said he would work to support young Koreans
looking to get a job by classifying potential jobs by country and sector he
added that the ministry will also boost a drop market in the service sector
starting by improving aviation distribution competitiveness the Korean
economy is currently faced a number of challenges including faltering exports
and slowed domestic consumption that’s on top of the ongoing political scandal
sparked by the motion to impeach president park a variable that’s likely
to dent foreign investment in the months to come you added that his team is doing
its best to ensure such political uncertainties will not hurt the economy
adding that his economic team will remain on high alert to gauge the impact
of both internal and external events including the U.S. feds meeting this
week Shin Semin Arirang news There are four components of aggregate expenditure.
Each component is measured in real terms. Keeping them in Real terms puts the comparison
out of the influences of changing price levels and inflation’s impacts.
Consumption is by far, the largest component of aggregate expenditure.
Take a look at how consumption has changed in respect to recessions in the US economy.
When a contraction starts, household spending drops, or at least slows until the expansion
restarts. The five most important variables that determine
the level of consumption are current disposable income, household wealth, expected future
income, the price level, and the interest rate.
Current Disposable Income starts with household income, but is affected by savings and investments.
As changes in income happen, so does the household’s consumption expenditures.
Household wealth is determined not only by the income levels and rates of saving, but
also by investments, and stock and bond value. That makes the positive side of the equation,
but from that comes liabilities like mortgages, student loans, car loans, and the similar
financial obligations. Expected Future Income is an interesting situation
to affect consumer behavior. But, it does make a difference for how people
spend their resources; based on what you will make, or what you did make.
Some people will spend on expectations: I got a new job with a raise in salary, so I
will start spending it NOW. Maybe even go into debt to afford that new
life style starting right now! Others, like commission based professionals
will practice consumption-smoothing. Consumption-smoothing means that part of income
from commissions is held in savings and added to each period, so that when demand drops
and commissions are reduced, the saved resources can be used to live on.
As a consultant, this is the only way I have been able to survive business cycles as they
contracted. Resisting the urge to splurge is important,
but sometimes moderate indulgence is good. We have seen different expressions of how
the markets react to business cycles, but very often prices rise from year to year.
When prices climb and our salaries remain level, we are experiencing a drop in our effective
incomes. The immediate impact is a reduction in Real
consumer spending. Remember The Wealth of Nations by Adam Smith,
and how we were told that people and businesses consider self-interests when making economic
choices. By that, when interest rates climb, people
will save more interest bearing money, than spend it.
They will also borrow less, because the cost of borrowing carries a heavier load to repayment
obligations. This impacts durable goods more than non-durables,
so your food purchases will likely see only minor adjustments, but your whirlpool and
GMC purchases may be delayed until the economy settles more to your side of the ledger.
The consumption function is the relationship between consumption spending and disposable
income. The marginal propensity to consume, MPC, is
the slope of the consumption function: It is the amount by which consumption spending
changes when disposable income changes. Generally, as a country we have a fairly consistent
level of MPC as each new dollar earned, results in a consistent level of consumption spending.
This is relatively consistent for the person making $30,000 a year, who then receives a
salary increase to $32,500 a year. The MPC will remain relatively consistent
with the new salary. More is spent, but as a percent of the total,
it remains generally the same. We can write the expression for the MPC as:
MPC=Change in Consumption / Change in Disposable Income. That is, the Change in Consumption / Change in Disposable Income. Between 2002 and 03, as a country our MPC was about 0.97.
Taken literally, it means you earned $32,000 and spent about $31,000 on Consumption.
Or in steps, your increase in salary by $2,500 resulted in $2,425 additional consumption
spending. Consumption spending by households depends
on disposable income, but we want to focus on the relationship between consumption spending
and GDP. The difference between GDP and national income
is small and in this class it can be ignored. Disposable income is equal to national income
plus transfer payments minus taxes. Taxes minus transfer payments are equal to
net taxes so we can write: Disposable income=National income – Net
taxes. This equation can be rearranged as:
National income=GDP=Disposable income + Net taxes. I shared the MPC for the US in 2002-03 as 97%.
Now we consider how this is calculated. Look at the left-most column to see how National
Income rose by $2,000 billion, and consumption rose by $1,500 billion.
The MPC maintained the rate of 0.75, National Income rose $2,000 billion, and Consumption
went up $1,500 billion. For the economy as a whole:
National income=Consumption + Saving + Taxes. When national income increases, there must
be a combination of increases in consumption, saving, and taxes:
Change in national income=Change in consumption + Change in saving + Change in taxes.
Using symbols, where Y represents national income, and GDP, C represents consumption,
S represents saving and T represents taxes, we can write:
Y=C + S + T, and:
ΔY=ΔC + ΔS + ΔT. We can assume that taxes are always a constant
amount, so the following is also true: ΔY=ΔC + ΔS. The marginal propensity to save, MPS, is the amount by which saving changes when disposable
income changes. If we divide the previous equation by ΔY,
we get ΔY/ΔY=ΔC/ΔY + ΔS/ΔY
or: 1=MPC + MPS
This equation tells us that when taxes are constant, the marginal propensity to consume
plus the marginal propensity to save must always equal 1. Investment in the US economy is fickle and responds to perceptions as well as measurable
accounts of the economy. Look, for instance, at the drop in Investment
spending as the Great Recession slammed the economy.
Today’s recovery cycle only recaptured the Real Gross Private Domestic Investment of
$2,774 billion from the first quarter 2006, in the fourth quarter of 2014.
That expansion was thwarted in the third quarter 2015 as it again started a downward trend.
The four most important variables that determine the level of investment are:
1. Expectations of future profitability 2. The interest rate
3. Taxes: The federal government imposes a corporate income tax on the profits corporations
earn, including profits from the new buildings, equipment, and other investment goods they
purchase. A reduction in the corporate income tax
increases the after-tax profitability of investment spending.
Investment tax incentives also increase investment spending.
4. Cash flow: Cash flow is the difference between the cash revenues received by a firm and the
cash spending by the firm. Future Profitability expectations are in the
category of perceptions by business people as the path to making a profit is considered.
When these perceptions are made in the aftermath of a recession, businesses recognize that
money has been lost, resources for new expansion are reduced, and risk taking is avoided when
possible. This is further compromised when the government
is challenged to support government programs and seek new funding through increased business
taxes. The potential of increased taxes on business
success will lead businesses to further limit expansionary efforts.
During recessions, few businesses will make investments.
Some businesses operate on retained earnings and supplement it with borrowed money.
The Real interest rate is the clincher for business borrowing decisions.
When it rises, businesses will reduce their level of borrowed funds.
As we will see soon in this class Monetary policy sets the Prime Interest Rate determined
by the US Federal Reserve, and is a pivotal interest rate determining the availability
of money and interest rate for businesses. Taxes, it has been said, are best when paid
by someone else! But in the real world, governments seek money
most often through the successes of businesses. Also coming soon in this class we will talk
about how Fiscal policies made by the President and Congress can speed or slow the economy
through taxation on businesses. Sometimes tax programs encourage investments,
and sometimes they penalize businesses for making money.
Businesses make money by taking risks, inventing new products and processes, and doing a better
job of what they are good at. When they experience success, they can retain
some earnings to reinvest in the business. This money, known as profit, is often the
most critical component of cash flow to fund operations.
It is the driver of business investment spending. Intel knows and feels the impacts of recessions
on its business operations. In an effort to insulate the company’s dependence
on Durable Good Desktop computers, Intel has shifted a portion of its investments into
making processors for tablet computers and Smart Phones.
These are considered less durable than desktop computers, they cost less.
This has enabled Intel to level out its revenues through business cycles. The tablets powered by Intel The essentials are packed There’s no speed limit And plenty of fuel in the tank It makes a perfect vacation Experience amazing Tablet performance
Only with Intel inside. [Music] [Music==>] [Music] Total government purchases include all spending by federal, state, tribal, and local governments
for goods and services. It does not include transfer payments for
things like unemployment insurance or Social Security payments.
It only includes payments for goods and services the government receives because of the payments.
Generally, government expenses increased through time, as government organizations took advantage
of increases in productivity and technologies adopted by domestic businesses.
During the recovery period for the Great Recession, the Obama Administration in March 2013 ordered
the enactment of the Sequestration rule, which included a reduction of government spending
that sent some government employees away from work, and stopped most government contracts
executed by private businesses. Net exports equals exports minus imports.
The three most important variables that determine the level of net exports are:
* The price level in the United States relative to the price levels in other countries.
* The growth rate of GDP in the United States relative to the growth rates of GDP in other
countries. * The exchange rate between the dollar and
other currencies. As consumers, we have generally become less
biased against foreign imports today, than we were several decades ago.
The biggest reason may be the influence of lower prices on imported goods from low cost
providers, such as Mexico and China. This price comparison is derived from comparisons
between countries. For instance, if the US Price level rises
faster than the price level in Mexico, then US Net Exports will Decrease, because US goods
become more expensive relative to Mexican goods, therefore, US imports will rise and
our exports will fall. There is a logic to these interactions and
I recommend you pause the video right here to study these and make that reasoning clear
to your understanding of this introduction to International Economics.
It is fundamental to Macroeconomics; make it yours! Steve Jobs, of Apple, Inc. designed the IPhone and made the technology
possible. He is the epitome of American Entrepreneurs.
He is also attuned to the risks of Globalization associated with the Rule of Law.
He was attracted to low cost labor in several countries and the level of technology advanced
in some countries. To abate his concerns with lax Rule of Law
enforcement in other countries, Apple decided to distribute IPhone manufacture across several
countries. No single manufacturer holds the full design
schematic to the IPhone. China was selected as the point of final assembly.
So, if China doesn’t represent much of the value of manufacturing the iPhone, what countries
do? Japan, South Korea, and Germany.
Together these three countries make up over 63 percent of the value of the iPhone.
These developed economies are masters of advanced manufacturing and have relied on shrewd business
practices along with cutting edge technologies and smart workforce training programs to sustain
their manufacturing sectors. The outcome of which is that they, not us,
are adding manufacturing value to what essentially is an American invention.
Does that make the IPhone a Chinese export to the USA?
Most likely it is not in the absolute sense of the definition, but for the World Trade
Organization, apparently it is. [Music] More people in the shops full employment and low interest rates helped Germany’s
economy to its strongest growth in five years in 2016 there was a 2% increase in
consumer spending while government expenditure increased by 4.2 percent the
German Statistics Office estimates growth in the euro zone’s largest
economy was around 1.9 percent for all of last year rising inflation from
higher oil prices is expected to reduce purchasing power this year however
restraining growth from consumption government spending on settling and
training refugees could also taper off with fewer arrivals and economists
expect the growth drivers to change with a moderate shift from domestic demand to
stronger export activity however possible protectionist trade policy by
the Trump administration in the US and state interference in China could hurt
German exports We can use a 45°-line diagram to illustrate
macroeconomic equilibrium. In a graph, the line represents all the points
that are equal distances from both axes. Because macroeconomic equilibrium occurs where
planned aggregate expenditure equals GDP, we know that all points of macroeconomic equilibrium
must lie along the 45° line. We assume that the variables that determine
planned investment, government purchases, and net exports will all remain constant,
as well as the variables other than GDP that affect consumption.
Where the aggregate expenditure, AE, line crosses the 45° line, planned aggregate expenditure
is equal to GDP, and the economy is in macroeconomic equilibrium.
Be aware, the Pepsi Corporation does not produce a bottle of Pepsi and hand it to a consumer
– on the spot manufacturing. They make projections about demand for their
product so they can supply it to the retailers who will store it at their shops and ultimately
sell it to consumers. That process can take weeks, even months or
years, to cycle through the process from product initiation to final sales and consumption.
This is where the 45 degree line comes into effect.
At point B, 8 bottles of Pepsi are produced, X axis, and 8 bottles are sold, Y axis, we
are in equilibrium in the marketplace. Nirvana is achieved and the economy is stable.
Now take a look at point C, where retailers sell 10 bottles of Pepsi, but only 6 were
produced by Pepsi. In the marketplace, people increased their
demand for Pepsi and bought more bottles, but the company reduced production to 6 bottles.
Pepsi supplies are being depleted, sending a clear signal to the manufacturer to increase
production! In contrast, at point D, consumers are buying
fewer bottles, yet the company continues with “normal” production levels, creating a surplus
of Pepsi and as a result, the company will slow production.
Considering Pepsi makes for a good example, but to really use this technology we apply
it to the national economy, the GDP. John Maynard Keynes was an English economist
whose ideas fundamentally changed the theory and practice of macroeconomics and the economic
policies of governments. He lived 1883 through 1946 and influenced
government leaders in Europe and America. The Keynesian cross diagram demonstrates the
relationship between Real Aggregate Expenditure, and Real GDP, measured by output.
Just as we hypothesized the sales of Pepsi and its production by manufacturer were delayed
based on the amount of Pepsi held in reserves between the manufacturer and retailer, we
can consider Aggregate Demand and Aggregate Supply as being buffered by Planned Aggregate
Expenditure. When planned AE equals GDP the national economy
is in equilibrium. The importance of this concept is seen when
considering how households each treat their income based on what is happening in the economy.
When we combine all the households in the nation, we call it Aggregate Household income.
Taken one household at a time, your household, think about new income you receive – what
do you do with it? Some of it gets spent, some of it gets saved.
Your rate of spending that new income is expressed through your personal Marginal Propensity
to Spend. Combined with all the other households in
the country, you have an Aggregate Expenditure rate for the GDP, as Consumption: C.
As an aggregate number, it fits into our nexus of Macroeconomics in the form of the GDP formula:
Y=C+I+G+NX. Seriously, I told you this will keep coming
up! Equilibrium, as expressed with the Keynesian
Cross, means that the left side equals the right side.
We believe the Keynesian cross line represents equilibrium in the economy so we insert actual
measurements of the economy to see where the economy resides currently.
We might like to be in equilibrium, but really we are generally a little “out of wack” and
sometimes, “a lot out of wack”. The blue line shows current consumption in
the economy. It is not on a perfectly 45 degree arc, but
it does intersect the Keynesian cross line. The Keynesian cross diagram, or 45-degree
line diagram, shows a desired total spending, or aggregate expenditure, also called “aggregate
demand” curve. Current expenditures, shown in blue, is drawn
as a rising line since consumers will have a larger demand with a rise in disposable
income, which increases with total national output.
Understand, this blue line represents only aggregate Consumption: C.
We go back to our GDP formula, to add Planned Investments.
Next Government spending, Finally, Net Exports.
Here NX is shown as an increase for simplicity on this diagram, but currently we know that
NX is a negative number in the USA, so it would actually show as a lowering of this
combination of lines. For now, we show it as a positive factor:
for simplicity. Equilibrium in this diagram occurs where Aggregate
Demand, AD, equals the total amount of national output, Y, which corresponds to total national
income or production. Here, total demand equals total supply.
We are at equilibrium: $10 trillion. All in: we call this the Aggregate Expenditure
Function. Next, we start to fiddle with it, put it out
of balance. We do this because we know the economy is
not always in balance. Recent memory tells us this started in the
2007-09 US recession, and it is still out of wack, seeking that elusive equilibrium
balance. We consider what would happen if instead of
$10 trillion AE, we were at $9 trillion AE? This is an unplanned decrease in inventories
held by businesses. It might be Pepsi bottles, and American made
automobiles, softwood lumber supplies, and everything else made in the USA, known as
Aggregate Supplies. This unplanned decrease in inventories results
in businesses stepping up their production to move from the $8 trillion in Real GDP to
$10 trillion, where equilibrium is found. On the other side, what if AE was found at
$11 trillion? It would be seen as an unplanned increase
in inventories. Businesses are making more than what the market
will bear, so businesses will decrease their production so consumers will “catch up” with
their ready-made products. Businesses will slow production, often seen
as employees who are laid-off. It does cause the economy to slow down, but
overall, equilibrium is again achieved at $10 trillion. Equilibrium can be a finicky balance. It is this way because that balance keeps
the economy growing at a steady pace. The Natural Rate of unemployment, about 5%
in our economy, is maintained while businesses expand and grow at a predictable rate.
When AE is lowered, or lapses into a shortfall, the result is a recession.
Here we see how the economy slows from the $10 trillion Real GDP down the 45 degree line
to $9.8 trillion where equilibrium is seen at $9.8 trillion Real AE.
The economy is slowed and we see something very obvious that is off this graph: unemployment
increases. Whenever planned aggregate expenditure is
less than real GDP, some firms will experience an unplanned increase in inventories.
If firms accumulate excess inventories, then even if spending quickly returns to its normal
levels, firms will have to sell these excess inventories before they can return to producing
at normal levels. They return to these normal levels by hiring
workers who were laid off in the preceding recession.
It takes time to return to full equilibrium – sometimes a lot of time.
In forecasting real GDP, economists rely on quantitative models of the economy.
This table shows several hypothetical combinations of real GDP and planned aggregate expenditure.
Macroeconomic equilibrium occurs when the sum of consumption, planned investment, government
purchases, and net exports equals GDP. On either side of this level, above or below
it, GDP will be increasing or decreasing. $10 trillion is used as an example here, but
the actual level is influenced by the price level, inflation, and a host of other factors. [Music] Autonomous means self-governing, independent,
subject to its own laws only. In economics, autonomous expenditure is an
expenditure that does not depend on the level of GDP.
In the aggregate expenditure model, planned investment spending, government spending,
and net exports are all considered to be autonomous expenditures in respect to AE.
Consumption has an autonomous component and an induced component, that is, a component
that does depend on the level of GDP. An increase in planned investment spending
has a multiplier effect on equilibrium real GDP.
Any increase in autonomous expenditure will shift up the aggregate expenditure function
and lead to a multiplied increase in equilibrium real GDP.
This produces the upward sloping AE line. When AE increases the line showing it is boosted
upward. The movement from A to B, in this example
is seen as an increase of $100 billion Planned Investment and resulted in a $400 billion
increase in Equilibrium Real GDP. This is the Multiplier Effect.
I urge you to spent mental energy to really understand this term and how it is seen in
the economy. The Multiplier Effect is at the core of this
chapter, and in Macroeconomics several effects are hinged on this concept.
Let’s see how it works and make sure you can describe it, clearly.
Businesses make Autonomous Expenditures of $100 billion.
Let’s say Whirlpool increases spending on manufacturing to increase their production.
There are no additional Induced Expenditures so the total GDP impact is $100 billion.
Because of the initial movement forward, Real GDP increases, and other firms respond by
increasing their production level, not by as much as Whirlpool did, they do it by $75
billion. Now the Total Additional GDP is $175 billion.
Round 3 happens as other businesses participate in the additional autonomous expenditure roll
to increase their spending, but again, not by as much as the previous level, in this
case it is $56 billion. The new total $231 billion.
On and on it goes as each subsequent round is less than the round before it.
Take it down to the “n-th round” where the multiplier effect totals at $400 billion.
This all started with an Autonomous Expenditure of $100 billion, ultimately resulting in the
$400 billion total additional expenditure. The multiplier effect is a real thing.
For another explanation of the Multiplier Effect, watch the ACDC Leadership video on
this topic. Mr. Clifford explains it with energy and entertainment. Right now its time to go over one of the most important concepts in your macroeconomics class something called the Multiplier Effect the Multiplier Effect Is this ever gonna end? Seriously STOP! The time it takes to realize the full impact of
the Multiplier Effect is undetermined. It can happen rapidly when the economy is
moving along nicely, or it can take months, even years to complete the cycle when the
economy is slow to recover from a recession. Mathematically, we look to the change in GDP
divided by the change in investment spending to realize the actual Multiplier Effect.
In this case, it was 4. Simply put, it is the amount each dollar spent
as planned investments is multiplied by to see its result on Equilibrium Real GDP.
The multiplier is the increase in equilibrium real GDP divided by the increase in autonomous
expenditure. The multiplier effect is the process by which
an increase in autonomous expenditure leads to a larger increase in real GDP. As Economists, we like to explain concepts in a positive sense, that is in terms of recovery.
But the negative perception is also a reality. Take for example the Great Depression of the
1930s. In 1929 the stock market made a substantial
dive, dropping value across the board. That drop in wealth by households and companies,
led to a decrease in Aggregate Expenditures by companies.
People lost their jobs, businesses closed, consumption dropped to very low levels, and
Real GDP tanked. Consumption, Investment, Exports, and Government
Spending all were reduced substantially as unemployment skyrocketed.
It is the realization of the negative side of the Multiplier Effect.
Another Autonomous event happened, starting in Europe in the form of World War II.
Initially it involved US manufacturing of armaments for sale to allied forces, but then
escalated to our involvement after Japan bombed Pearl Harbor in 1941.
Did WWII save the USA from the fallout of the Great Depression?
That would be a crass definition of the results of WWII, but it certainly helped the US economy
form a financial recovery path. Can we say that the Multiplier Effect is always
4? Not really, we need to know how to articulate
its true impacts. This is a bit of the tinkering with the numbers
to see how to figure it out. We consider a series of mathematical reductions,
with each next step diminishing from the previous. We use the Marginal Propensity to Consume
and the initial Autonomous Expenditure amount. In this example it is $100 billion.
MPC times MPC is MPC squared times $100 billion. Each next step adds an exponent value from
squared to cubed, to quadrou, to quintic, and so forth.
These are compressed into a simplified expression for the change in GDP.
Factor out the $100 billion so we can apply any autonomous expenditure we consider.
Since we know MPC is less than one, the multiplier becomes one over, one minus MPC. There are four key points about the multiplier effect:
1. The multiplier effect occurs both when autonomous expenditure increases and when
it decreases. 2. The multiplier effect makes the economy
more sensitive to changes in autonomous expenditure than it would otherwise be.
3. The larger the MPC, the larger the value of the multiplier.
And, 4. The formula for the multiplier is oversimplified
because it ignores real-world complications, such as the effect that increasing GDP can
have on imports, inflation, interest rates, and individual income taxes.
We consider it here to give you a basis for understanding how it all comes together.
We can tweak the limiting assumptions, but we have time for that – after we know the
basis for it. In the short run, if households save more
of their income and spend less of it, aggregate expenditure and real GDP will decline.
John Maynard Keynes argued that if many households decide at the same time to increase their
saving and reduce their spending, they 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 saving.
Keynes referred to this outcome as the paradox of thrift. From my perspective as an Economist, a college professor, a businessman, and a father dedicated
to his grandchildren, I feel the Paradox of Thrift first hand.
We have discussed how people will save more of their money during a recession as opposed
to spending it, or going into debt when the economy is constricting.
This is a feature of the Paradox of Thrift as our entire economy feels the contractions
lingering after the 2007-09 Great Recession. [Music] When studying demand and supply, you learn that a price change is considered the most
important determinant of the quantity demanded for a good or service.
It may seem odd that in discussing the determinants of total spending or aggregate expenditure,
the most important determinant of consumption is the current disposable income of households.
If changes in price are important determinants of consumption in individual markets, why
aren’t they important in determining total consumption expenditures?
The key to answering this question is to understand the difference between a relative price change
and a change in the price level, or the average of all prices.
In microeconomics, a change in the price of a good or service is a relative price change.
For example, if the price of bottled water falls, prices of other goods and services
do not change. Because bottled water becomes less expensive
compared to other items, the quantity demanded of water will increase.
In macroeconomics, the focus is not on changes in prices and quantities in individual markets
but changes in the economy as a whole. When there is a change in the price level
this does not refer to a change in one market but instead in all markets.
An increase in the price level of 10 percent means there is no change in the relative price
of bottled water because all other prices have increased by 10 percent as well.
But if current disposable income were to increase by 10 percent, then consumers have more income
to spend on all goods and services. Economists consider this type of change to
be most important in determining consumption. I simplify the concepts so you have the ability
to gain understanding of the process. In the real world, our actions influence how
others react. When a company makes an unexpected Aggregate
Expenditure outlay in our economy, it has an impact.
Take for instance, Schweitzer Engineering of Pullman, Washington, building a new assembly
operation in Lewiston, Idaho. They used a government grant to make it, but
when they did it their influence was seen. It meant for Lewiston new assembler jobs,
it meant increased economic activities in the community, and consumer spending increased.
When folks spent their new earnings, consumption increased.
That increased spending is also seen in prices: they went up as well.
Does it push back? Sure it does, the increased price level will
cause aggregate expenditure to fall – businesses will reduce spending because of the increased
costs of spending. This causes the price level to drop.
On and on it goes until ultimately equilibrium is reached. We expect that an increase or decrease in aggregate expenditure would affect both real
GDP and the price level. There are three reasons why there is an 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 the United States rises relative to the price levels in other
countries, U.S. exports will become relatively more expensive, and foreign imports will become
relatively less expensive, causing net exports to fall.
~ A falling price level in the United States will have the reverse effect.
~ When prices rise, firms and households need more money to finance buying and selling.
~ If the money supply does not increase, the result will be an increase in the interest
rate. ~ A higher interest rate will reduce investment
spending. ~ A falling price level has the reverse effect.
The aggregate demand, AD curve is 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. Consider this now familiar 45 degree line
to see the effects of a change in the price level.
If the price level increases, businesses will decrease their Aggregate Expenditures and
Real GDP will drop. Conversely a decrease in the price level will
result in business Aggregate Expenditures increasing and the resultant Real GDP to increase. This finally links these systems back to the basics of economics: deriving a demand curve.
Graph this as the Price Level on the Y axis and Real GDP on the X.
As the Price Level drops, the amount of GDP demanded increases.
Think of this by considering: who Demands Gross Domestic Product? It is obvious, we
as a nation demand GDP and our demand is hinged on the Price Level.
Keep increasing the Price Level and eventually we all have to take a pass on our demand for
GDP. Lower the Price Level, and we all seem to
want more. It is a downward-to-the-right sloping curve. [Music]

2 Comments

  1. Dammy Ola says:

    Great tutorial, i never understood this topic at school when my lecturer thought me, until i watch your tutorial, i'm now able to understand this topic. Thanks you for this video

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