TOTAL SPENDING AND GDP:

CAN IT GO WRONG?
MACROECONOMICS LECTURE 7
PGP-21
BUILDING BLOCKS OF CLASS
How aggregate spending is affected by
various parameters
Consumption- Income, Wealth,
Preferences
Investment Interest rate, Business
expectations
Govt Spending

Net exports Exchange rate policy,

Interest rate (Hot money flows)
C+I+G+Net exports = Aggregate Spending
 We also know GDP = Aggregate Spending
From the circular flow we know

All Spending = All income

Second BLOCK
Real GDP
Price level come into play
Real GDP Nominal GDP Inflation
Real GDP can be viewed as aggregate
output; aggregate income
BRINGING THE BLOCKS TOGETHER
How much each components of Aggregate
spending will spend on Indian output at
each levels of real GDP.
How to derive the aggregate demand
curve which might tell us how much of
output is demanded at each price level.
How we use the relationship of Real GDP
and Agg spending to prove this point?
FISCAL STIMULUS HOW DOES IT
IMPROVE ECONOMY
Direct government spending can provide a direct
boost to the GDP growth, at least in the short-
term, especially in an economy plagued
by surplus capacity across several sectors.
The benefits of increased government spending
on the GDP growth come with a multiplier effect;
the crucial question that immediately follows is
the value of the multiplier
Bose and Bhanumurthy estimated the capital
expenditure multiplier to be 2.45 so that an
increase in capital expenditure by the
government by Rs 1 crore would raise the GDP
by Rs 2.45 crore
 Assuming that inflation does not accelerate, the
expected fiscal stimulus package of Rs 40,000
crore will therefore raise real GDP by about Rs 1
lakh crore over the next 12 months.
More than raising the GDP growth rate, the
objective of the contemplated fiscal stimulus
package is generating employment.
Employment multipliers for Rural Road
Construction in Gujarat are as high as 2.6.
A multiplier of three means that to increase
output of rural roads construction by Rs 100,000,
three additional workers per day over one year
are required
 Now, if the GDP growth rate were to increase by
the estimated 2% (from the Type II expenditure
multiplier), then six crore jobs can be created

Suppose the government spends Rs 100,000 on

building a new rural road. The first step here
would mean an increase in the order book of the
contractor-firm. Nominal GDP increases by the
amount spent by the government. The contractor-
firm may then place an order for (say) Rs 20,000
on another firm for (say) asphalt.
 If the asphalt producer has surplus capacity, the
output will be forthcoming so that real GDP
increases. Similarly, if there is surplus labour
available, the contractor-firm and asphalt
producer can employ people at the going wage
rate. The employed persons would then spend on
various consumer and wage goods, triggering off
a positive chain reaction that yields a multiple
(Type II) increase in output or real GDP and
employment across various sectors of the
economy.
THE AGGREGATE EXPENDITURES MODEL.

This model relates aggregate

expenditures, which equal the sum of
planned levels of consumption,
investment, government purchases, and
net exports at a given price level, to the
level of real GDP.
Suppose the price level =130 (30% more
than 1 year ago)
How much of planned spending has
happened to real GDP ( actual
expenditure)
WHERE IS THE DIVERGENCE
People, firms, and government agencies
may not always spend what they had
planned to spend.
If so, then actual real GDP will not be the
same as aggregate expenditures, and the
economy will not be at the equilibrium
level of real GDP.
HOW THE AGGREGATE EXPENDITURES MODEL WORKS:
SIMPLIFIED MODEL AND ASSUMPTIONS

We assume two components: consumption

and investment
With no foreign sector gross domestic
income in this economy and disposable
personal income would be nearly the
same.
No depreciation and undistributed
corporate
Therefore, disposable personal income and
real GDP are identical.
 Assume that the only component of aggregate
expenditures that may not be at the planned
level is investment.
Firms determine a level of investment (PE)
Some investment is unplanned ( Inventories)
WHY?
Firms sells less Inventories
Firms sells more (unplanned investment would be
negative)

Planned and unplanned investment play key roles

in the aggregate expenditures model.
AUTONOMOUS AND INDUCED AGGREGATE
EXPENDITURES

Expenditures that do not vary with the level of

real GDP are called autonomous aggregate
expenditures. ( Planned investment) : Investment
and income in last class.
Expenditures that vary with real GDP are
called induced aggregate expenditures:
Consumption with vary with income (MPC).

In our model we only take Planned investment

CONSUMPTION
Consumption contains an autonomous
component
MPC shows us a induced component. It suggests
that consumption contains induced aggregate
expenditures; an increase in real GDP raises
consumption

At a level of real GDP of $2,000 billion, for

example, consumption equals $1,900 billion: $300
billion in autonomous aggregate expenditures
and $1,600 billion in consumption induced by the
$2,000 billion level of real GDP.( 0.8*2000)=1600
HOW TO PUT THEM GRAPHICALLY
ADDING BOTH COMPONENTS TOGETHER
Aggregate expenditures equal the sum of
consumption C and planned investment IP.
Aggregate expenditures function measure total
planned spending at each level of real GDP
 At a level of real GDP of $6,000 billion, aggregate
expenditures equal $6,200 billion:

$1400 is autonomous spending starting at

vertical axis
$1,100 billion in planned investment, which is
assumed to be autonomous, and $300 billion in
autonomous consumption expenditure.
SLOPE OF AGGREGATE SPENDING CURVE
The change in aggregate expenditures divided by
the change in real GDP between any two points.
It measures the additional expenditures induced by
increases in real GDP
AE = 1600 = 0.8 = MPC
Y 2000

Changes in real GDP thus affect only consumption

through induced investment.
EQUILIBRIUM
Real GDP is a measure of the total output of firms.
Aggregate expenditures equal total planned spending on
that output.
Equilibrium in the model occurs where aggregate
expenditures in some period equal real GDP in that period.
One way to think about equilibrium is to recognize that
firms, except for some inventory that they plan to hold,
produce goods and services with the intention of selling
them.
Aggregate expenditures consist of what people, firms, and
government agencies plan to spend. If the economy is at its
equilibrium real GDP, then firms are selling what they
plan to sell (that is, there are no unplanned changes in
inventories).
A 45-degree line connects all the points at which the values
on the two axes, representing aggregate expenditures and
real GDP, are equal.
THE POINT AT WHICH THE AGGREGATE EXPENDITURES CURVE CROSSES
THE 45-DEGREE LINE IS THE EQUILIBRIUM REAL GDP, HERE ACHIEVED
AT A REAL GDP OF $7,000 BILLION
 Real GDP of $7,000 billion, the sum of
consumption and planned investment is $7,000
billionprecisely the level of output firms
produced.
At that level of output, firms sell what they
planned to sell and keep inventories that they
planned to keep.
What if firms were to produce a real GDP greater
than $7,000 billion per year, aggregate
expenditures would fall short of real GDP.
SCENERIO 1
At a level of real GDP of $9,000 billion per year,
for example, aggregate expenditures equal $8,600
billion.
Firms would be left with $400 billion worth of
goods they intended to sell but did not.

Strategy of firms ( Unplanned spending)

With those unsold goods on hand (that is, with an
unplanned increase in inventories), firms would be
likely to cut their output, moving the economy
toward its equilibrium GDP of $7,000 billion.
SCENERIO 2
If firms were to produce $5,000 billion, aggregate
expenditures would be $5,400 billion.
Strategy

Consumers and firms would demand more than

was produced; firms would respond by reducing
their inventories below the planned level (that is,
there would be an unplanned decrease in
inventories)
2) Increasing their output in subsequent periods,
again moving the economy toward its equilibrium
real GDP of $7,000 billion
 At any level of real GDP other than the equilibrium level,
there is unplanned investment.
LETS SEE THE IF AGGREGATE SPENDING
CURVE SHIFTS WHAT HAPPENS

Why should Aggregate spending curve shift

1) Planned investment increases from the
original value of $1,100 billion to a new value of
$1,400 billion.

Ooutput to firm increases and they invest in new

factory

This increase in planned investment shifts the

aggregate expenditures curve upward by $300
billion, all other things unchanged.
 New equilibrium Real GDP of $8,500 billion (7000$).
The $300 billion increase in planned investment has
produced an increase in equilibrium real GDP of
$1,500 billion.
HOW IS THIS MIRACLE POSSIBLE?

Operation of the multiplier

STEP 1
Firms have increased their demand for investment
goods (300 billion) creating orders for 300 Billion.
Step 2
300 billion products means 300 billion disposable
income
STEP 3
Now go back to our consumption function
C= 300 billion ( autonomous C) + 0.8 (Y)
= 0.8 (300) = 240 billion in additional
consumption
STEP 4
240 billion of new consumption requires goods
worth 240 Billion to be produced ( FIRMS)
STEP 5
240 billion goods are produced by firms and
multiplier strikes back ( 0.8 $240) = $192 new
additional consumption is generated
WHEN DOES IT STOP AND HOW FAST IT
STOPS?

The size of the additional rounds of expenditure

is based on the slope of the aggregate
expenditures function, which in this example is
simply the marginal propensity to consume.
Slope is flatter ( MPC?)
Slope is steeper (the additional rounds of
spending would have been larger)

Suppose MPC =1
AC + 0.4(300) = 120
And it takes more rounds
COMPUTATION OF THE MULTIPLIER
One way

$1,500/$300 = 5.

Second way MPC way

Multiplier = 1/(1 MPC) = 1/(1 0.8) = 1/0.2 = 5]

CASE OF MULTIPLIER EFFECT
The Ripple Effect on the Economy of 9/11

Airline industry in U.S after 9/11

Slumping demand there had a multiplier effect on
aggregate expenditure
 Where the government stimulus should be concentrating?
Government would go for targeted spending and nudge
departments especially those handling infrastructure,
employment-intensive and rural India-specific sectors to
ensure allocations are yielding results on the ground
Pronab Sen
Why?
It can identify sectors where it can put money directly into
the hands of the poor quickly. NREGS is one such area; rural
roads and minor irrigation are other areas. I think the poor
have a very high spending propensity and multiplier effects of
this move(extra money in their hands) will be strong.
THINK ABOUT SITUATION WHERE MULTPLIER
EFFECT FAILS?
 The change in the equilibrium level of income in
the aggregate expenditures model (remember
that the model assumes a constant price level)
equals the change in autonomous aggregate
expenditures times the multiplier.

Thus, the greater the multiplier, the greater will

be the impact on income of a change in
autonomous aggregate expenditures
REALISTIC MODEL
Adding the G and Net exports
Government purchases and net exportsthat we
have also assumed are autonomous
 AE curve in Panel (b) is higher than that of the
AE curve in Panel (a)

Equilibrium real GDP rises by more in Panel (a)

than in Panel (b), the multiplier in the simplified
economy is greater than in the more realistic one.
NOW IF PRICE LEVEL CHANGES WHAT
HAPPENS TO AE FUNCTION?

Till now we have a constant price

When price level changes
What is the effect of a price change in a
consumer?
1)Value of money holdings will reduce
Cuts the wealth : French household paper
2) Increases the interest rate
Demand for money > supply of money
3) Imports becomes cheaper ( higher cost of
production in home country)
 So a fall in consumption, Investment and Net
exports can cause
Effect of inflation in the Aggregate spending.

Aggregate spending to falls

Reduced real GDP
 AE (P=120)
(a)
e
The Income-
Aggregate expenditure

AE (P=130)
Expenditure Approach
(trillions of dollars)

AE (P=140)
e
and the Aggregate
Demand Curve
e At the initial price level =130, the AE
line identifies real GDP demanded of
$14.0 trillion: point e on panel (b).
45
At the higher price level of 140, the AE
line shifts down to AE, and real GDP
Real GDP
0 (b) 13.5 14.0 14.5 demanded falls to $13.5 trillion: point e
(trillions of dollars) on panel (b).
140 e At the lower price level of 120, the AE
Price level

line shifts up to AE, and real GDP

130 e demanded increases to $14.5 trillion:
point e on panel (b).
120 e
AD Connecting e, e, and e yields the
downward-sloping AD curve.
0 13.5 14.0 14.5 Real GDP (trillions of dollars)