Quiz 24: The Monetary System

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AGGREGATE EXPENDITURE What are the components of aggregate expenditure? In the model developed in this chapter, which components vary with changes in the level of income? What determines the slope of the aggregate expenditure line?

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Aggregate Expenditure Aggregate expenditure is the sum of total spending at each level of income for a given price level during a particular time period. In general, aggregate expenditure is defined as the sum of expenditures on consumption, investment, government expenses, and net exports. Components of aggregate expenditure Aggregate expenditure comprises the following components: • Household final consumption expenditure.• Gross private domestic investment. • Government final consumption expenditure.• Net exports. Household final consumption expenditure Household final consumption expenditure is the total expenditure incurred by all the households of an economy to purchase final goods and services for private uses. Gross private domestic investment Gross private domestic investment is the sum of gross domestic fixed capital formation and change in the net inventories, during a given period.Government final consumption expenditure Government final consumption expenditure is the total expenditure incurred by the government of an economy to purchase final goods and services to meet internal and external security, social security etc.Net exports Net export is defined as the difference between a country's exports minus imports at a given period.Components of aggregate expenditure and change in level of income More general aggregate income-expenditure model assumes that the investment, government expenses, and net exports are independent of the change in level of income.Therefore, change in the level of income would change the aggregate expenditure only by altering the level of consumption expenditure incurred by the households. So, the slope of the aggregate expenditure line will be subject to change in the consumption expenditure of households. Change in the consumption expenditure due to change in income can be tracked by the marginal propensity to consume, which is the slope of the consumption expenditure.Derivation of the slope of Aggregate Expenditure Assume that the investment, government expenses, and net exports are independent of change in the level of income. Then, the aggregate income-expenditure model can be written as follows. Where, autonomous consumption expenditure.c = marginal propensity to consume.Y = disposable income. = consumption expenditure = autonomous investment, government spending, and net exports, respectively. To solve for the level of income, the aggregate income-expenditure model can be obtained as follows: …… (1)Equation (1) is differentiated with respect to the level of income to obtain the slope of the aggregate expenditure function. Thus, the slope of the aggregate expenditure curve is .

Q 2

REAL GDP DEMANDED In your own words, explain the logic of the income-expenditure model. What determines the amount of real GDP demanded?

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Aggregate Income-Expenditure Model Assuming there is no depreciation of capital stock or no fall in net inventories and no savings of firms, aggregate income-expenditure model states that each dollar of expenditure on final goods and services results in a dollar of income.In simple words, income-expenditure model states that when there is no depreciation of capital stock and no business saving, then an economy's aggregate expenditure results in aggregate income, which is equal to the real gross domestic product (Real GDP). Determination of Real GDP demanded Real GDP is determined at the intersection point between the aggregate expenditure line and the 45-degree line. The 45-degree line reflects the locus of points where aggregate income is equal to the real GDP. In simple words, income-expenditure model states that at the given price level, real GDP demanded is determined where the aggregate expenditure and real GDP are equal. Real GDP can be stated as the aggregate output or aggregate income. Real GDP is measured on horizontal axis and aggregate expenditure is measured on vertical axis. Below the intersection point, desired spending is more than the real GDP and above the intersection point, real GDP is more than the desired spending.

Q 3

REAL GDP DEMANDED What equalities hold at the level of real GDP demanded? When determining real GDP demanded, what do we assume about the price level? What do we assume about inventories?

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Real GDP demanded and aggregate Demand-Supply Identity Equilibrium of an economy occurs where aggregate demand is equal to the aggregate supply. Thus, at equilibrium, aggregate demand-supply identity holds. Aggregate demand-supply identity is also known as aggregate expenditure-income identity. At the point of equilibrium, real GDP demanded equals real GDP or aggregate output produced.Aggregate Demand-Supply Identity Aggregate demand-supply identity can be written as follows: or or Where, Y = Level of income or money supply in an economy. C = Consumption expenditure of households. S = Savings by households. I = Investment. G = Government Spending.(X-M) = Net exports. Assumptions: Aggregate Demand-Supply Identity At the equilibrium, real GDP demanded equals real GDP, keeping price level constant. But inventories of firms vary according to the operational situations of firms. If firms are operating at the level of output which (real GDP) is less than the real GDP demanded, that is, when firms are under-producing, then those firms will expand their stock of inventories to meet the actual real GDP demanded.Similarly, when firms are over-producing than what they require to meet the real GDP demanded, then the firms will reduce their inventory holdings.

Q 4

WHEN OUTPUT AND SPENDING DIFFER What role do inventories play in determining real GDP demanded? In answering this question, suppose initially that firms are either producing more than people plan to spend, or producing less than people plan to spend.

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Q 5

Simple Spending Multiplier "A rise in investment in an economy leads to a rise in spending." Use the spending multiplier to verify this statement.

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Q 6

Case Study: The Ripple Effect of 9/11 How do events, such as the World Trade Center and Pentagon attacks described in the case study "The Ripple Effects of 9/11" affect the aggregate expenditure line and the aggregate demand curve? Explain fully. Reference Case study: Public Policy The Ripple Effect on the Economy of 9/11 When hijacked planes hit the World Trade Center and the Pentagon, America's sense of domestic security changed. The thousands of lives lost and the billions of dollars of property destroyed were chronicled at length in the media. Let's look at the impact of the tragedy on just one industry-air travel-to see how slumping demand there affected aggregate expenditure. Once aviation regulators became aware of the hijackings, they grounded all nonmilitary aircraft immediately. This cost the airlines hundreds of millions of dollars a day in lost business. During the days following the attack, video of the second plane crashing into the twin towers was shown again and again, freezing this image in people's minds and heightening public concerns about airline safety. These worries, coupled with the airport delays from added security (passengers were told to arrive up to three hours before flights), reduced the demand for air travel once planes were allowed to fly again. For short flights, it became quicker and easier to drive than to fly. Two weeks after the attacks, airlines were operating only 75 percent of their flights, and these flights were only 30 percent full instead of the usual 75 percent full. Airlines requested federal support, saying they would go bankrupt otherwise. Congress quickly approved a $15 billion aid package of loans and grants. Despite the promise of federal aid, airlines laid off 85,000 workers, or about 20 percent of their workforce. Flight reductions meant that as many as 900 aircraft would be parked indefinitely, so investment in new planes collapsed. Boeing, the major supplier of new planes and America's leading exporter, announced layoffs of 30,000 workers. This triggered layoffs among suppliers of aircraft parts, such as jet engines and electronic components. For example, Rockwell Collins, an electronics supplier, said 15 percent of its workforce would lose jobs. Other suppliers in the airline service chain also cut jobs. Sky Chef, a major airline caterer, laid off 4,800 of its 16,000 employees. Airports began rethinking their investment plans. Half the major U.S. airports said they were reevaluating capital improvement plans to see if these investments made sense in this new environment. Honolulu airport, for example, suspended plans to add extra gates and renovate its overseas terminals. Within three weeks after the attacks, job cuts announced in the industry exceeded 150,000. These were part of only the first round of reduced consumption and investment. In an expanding economy, job losses in one sector can be made up by job expansions in other sectors. But the U.S. economy was already in a recession at the time of the attack, having lost about a million jobs between March 2001 and September 2001. People who lost jobs or who feared for their jobs reduced their demand for housing, clothing, entertainment, restaurant meals, and other goods and services. For example, unemployed flight attendants would be less likely to buy new cars, reducing the income of autoworkers and suppliers. People who lost jobs in the auto industry would reduce their demand for goods and services. So the reductions in airline jobs had a ripple effect. Airlines are only one part of the travel industry. With fewer people traveling, fewer needed hotel rooms, rental cars, taxi rides, and restaurant meals. Each of those sectors generated a cascade of job losses. The terrorist attacks also shook consumer confidence, which in September 2001 suffered its largest monthly drop since October 1990, on the eve of the first Persian Gulf War. Within 10 days following the attacks, the number of people filing for unemployment benefits jumped to a nine-year high. Again, these early job losses could be viewed as just part of the first round of reduced aggregate expenditure. The second round would occur when people who lost jobs or who feared they would lose their jobs started spending less. The U.S. economy continued to shed jobs for nearly two years after the attacks, losing about 2 million more jobs. Researchers estimate that business interruptions resulting from the attacks cost the U.S. economy a little over $100 billion, or about 1 percent of GDP.

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Q 7

THE AGGREGATE DEMAND CURVE What is the effect of a lower price level, other things constant, on the aggregate expenditure line and real GDP demanded?

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Q 8

SIMPLE SPENDING MULTIPLIER For each of the following values for the MPC, determine the size of the simple spending multiplier and the total change in real GDP demanded following a $10 billion decrease in spending: a. MPC = 0.9 b. MPC = 0.75 c. MPC = 0.6

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Q 9

SIMPLE SPENDING MULTIPLIER Suppose that the MPC is 0.8 and that $14 trillion of real GDP is currently being demanded. The government wants to increase real GDP demanded to $15 trillion at the given price level. By how much would it have to increase government purchases to achieve this goal?

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Q 10

Simple Spending Multiplier Suppose that the MPC is 0.8, while investment, government purchases, and net exports sum to $500 billion. Suppose also that the government budget is in balance. a. What is the sum of saving and net taxes when desired spending equals real GDP? Explain. b. What is the value of the multiplier? c. Explain why the multiplier is related to the slope of the consumption function.

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Q 11

INVESTMENT AND THE MULTIPLIER This chapter assumes that investment is independent of the income level in the economy. What would happen to the size of the multiplier if investment increases as real GDP increases? Explain.

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Q 12

Shifts of Aggregate Demand Assume the simple spending multiplier equals 10. Determine the size and direction of any changes of the aggregate expenditure line, real GDP demanded, and the aggregate demand curve for each of the following changes in spending: a. Spending rises by $8 billion at each income level. b. Spending falls by $5 billion at each income level. c. Spending rises by $20 billion at each income level.

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Q 13

Case Study: Bringing Theory to Life What are the components of consumption discussed in the case study? How did each component change in the recession of 2008-2009? Reference Case Study: Bringing Theory to Life? Consumer Spending on Services During the Recession As noted earlier, consumption is the largest component of aggregate spending, averaging about 70 percent of the total during the past decade. And consumption depends primarily on income. But at any given level of income, consumption depends on other factors, such as net wealth. The biggest source of net wealth for most households is their home. Nationally, home prices increased steadily between 1987 and 2006, tripling on average during a long march upward. The rise in housing prices made homeowners feel flush and thus more inclined to spend at each income level. Consumption as a share of disposable income rose from 90 percent in 1987 to 94 percent in 2006. But there is no economic law that says home prices can't fall. Let's look at what happened to consumption and real GDP when home prices turned down sharply. After peaking in 2006, average home prices in the United States dropped about 22 percent by the third quarter of 2008. That was the first sustained drop in at least two decades and it shook people up. In later chapters, we'll look at the wider fallout from the housing bust, but here the focus is on consumer spending. Percent changes in consumption, its components, and in real GDP are shown in Exhibit 6 for the four quarters in the heart of what some have called the Great Recession. Real GDP in the third quarter of 2008 fell 4.0 percent (at an annualized rate). Consumption fell 3.5 percent, the biggest drop since 1980. During the four quarters shown, the decline in GDP averaged 4.1 percent and the decline in consumption averaged 2.2 percent. As usual, consumption varied less than GDP. Let's sort consumption into its components. With the economy souring, with job prospects looking iffy, and with the stock market crashing, many households decided to put off buying new cars, new furniture, and other durable goods. Consumer spending on durable goods dropped 12.0 percent in the third quarter of 2008. That drop nearly doubled in the fourth quarter to 22.3 percent, the largest fall since 1981. For the four quarters, the decline averaged 8.2 percent. All this would be a big problem for the economy except for one fact: Durable goods account for a small share of all consumption, just 12 percent.

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Q 14

Net Exports and the Spending Multiplier Suppose that the marginal propensity to consume (MPC) is 0.8 and the marginal propensity to import (MPM) is 0.05. a. What is the value of the spending multiplier? b. By how much would the real GDP demanded change if investment increased by $100 billion? c. Using your answer to part (b), calculate the change in net exports caused by the change in aggregate output.

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Q 15

Suppose that C = 100 + 0.75( Y - 100), I = 50, G = 30, and X - M = -100, all in billions of dollars. What is the simple spending multiplier? What is real GDP demanded? What would happen to real GDP demanded if government purchases increased to $40 billion?

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