Dr. Mohammed Alwosabi ECON 141 – Ch.

Notes on Chapter 7
EXPENDITURE MULTIPLIER

FIXED PRICES AND EXPENDITURE PLANS

— From the AD-AS chapter, we studied that in the long run, LAS is
vertical and price level and prices of factors of production are all
variables. The RGDP is constant at the potential GDP. Hence, AD
determines only the price in the LR.
— In the short run, price level varies along SAS but every thing else
remain constant. So AD determines both P and the amount of RGDP.
Firms increase prices if their sales increase more than they planned
and reduce prices if the quantity
sold is less than the planned sales. P
LAS
— However, firms' prices are fixed in the SAS
very short run. It is costly to change prices
every hour or every day (menu cost plus other
P VSAS
costs).
— Supply curve in the very SR is horizontal RGDP
Y
at fixed price.
— So the quantities that firms sell depend on
demand not supply (the shifts of AD). AD determines the aggregate
amount that is sold but not the price level since the price level is fixed
in the very short run.
— Thus, in the Keynesian model of aggregate expenditure, real GDP is
determined by the level of aggregate demand because this model

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

assumes that individual prices and the price level are fixed in the very
short run.
— Because, in the very short run, prices are fixed it is easy for people to
plan their expenditure. Aggregate planned expenditure (AE) is the
sum of the planned amounts of consumption expenditure (C),
investment (I), government purchase (G), net exports (NX)
So, Planned AE = C + I + G + (X – M)
— In the very SR, AE can be divided into two main components
o Autonomous expenditures: They are fixed. They do not vary
with RGDP. They exist even if RGDP = 0. They include I, G,
and X.
o Induced expenditures: They are not fixed. They depend on
RGDP. They include C and M. But C and M have their
autonomous parts as we will discuss later.
— Since RGDP influence C and M, and since C and M are components
of AE, an increase in RGDP leads to an increase in AE, and an
increase in AE leads to an increase in RGDP. Hence, there is a two-
way link between AE and RGDP.
— Before discussing the equilibrium expenditure (or equilibrium RGDP)
and before studying the multiplier let us have a look at each
component of the planned aggregate expenditures (AE).

Disposable income, Consumption Function, and Saving Function

— Consumption and saving are influenced by (1) Disposable income, (2)
The real interest rate, (3) Wealth, (4) Expected future income.
— Disposable income (Yd) equals to income (Y) minus tax plus transfer
payments. If we define net tax (T) as tax minus transfer payments
then Yd = Y – T. Yd = Y when T = 0

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

— Disposable income (Yd) is divided into consumption (C) and saving

(S). Yd = C + S
— Consumption function shows the positive relationship between
consumption expenditure (C) and disposable income (Yd), other things
remaining the same.
— It shows how much all households plan to consume at each level of
real disposable income.
— Consumption function: C = a + bYd
— Movements along C is a result of changes in Yd
— Consumption function is divided into two parts:
1. Autonomous consumption, which is the vertical axis intercept
(a), is consumption expenditure that does not depend on the
level of GDP or disposable income. It is the amount of
consumption expenditure that would occur in the SR even if
Yd=0. a > 0.
2. Induced consumption, which is bYd, is equal to consumption
caused by an increase in disposable income.
∆C
b is the slope of the consumption function. b = ,0≤b≤1
∆Yd
— Saving function shows the negative relationship between S and Yd.
— Saving (S) is not part of AE but can be derived from the consumption
function.
S = Yd – C = Yd – a - bYd = - a + (1 - b)Yd, where (- a) is the intercept
∆S
and (1-b) is the slope that is equal to 1 − b =
∆Yd
— Example
If C = 35 + 0.8Yd
S = - 35 + (1-0.8)Yd

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

— The following table and diagram shows the relationship among Yd, C
and S
C
45 0
Yd C S saving
C

A 0 1.5 -1.5
6
B 2 3.0 -1.0
1.5 dissaving
C 4 4.5 -0.5
D 6 6.0 0 0 Yd
6
S
E 8 7.5 +0.5
F 10 9.0 +1.0 S

0 Yd
6
-1.5

— On any graph where the vertical and horizontal axes are scaled the
same and where Yd is on the horizontal axis and C is on the vertical
axis, the 45° line is the line that extends out from the origin and has a
slope of one. Any point on the 45° line represents an equilibrium
between the disposable income to the consumption function (Yd = C).
— The slope of the consumption function is less than the slope of the 45-
degree line but not equal to zero
— The vertical distance between the 45-degree line and the consumption
line represents saving or dissaving.
o If C is above the 45° line ⇒ C > Yd ⇒ Dissaving (negative
saving) (dissaving: the use of past saving)
o If C is on the 45° line ⇒ C = Yd ⇒ zero saving
o If C is below the 45° line ⇒ C < Yd ⇒ positive saving

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

— A change in Yd leads to changes in C and S, and brings movement

along the consumption function and saving function; all other
influences on C and S are fixed.
— Exercise
Suppose the first line in the table does not exist,
1. How to find the autonomous consumption (a)?
C = a + bYd. From the second row in the table (or any other row)
you can present the relationship
∆C 4.5 − 3 1.5
3 = a + b (2); but we know that b = = = = 0.75
∆Yd 4−2 2
Therefore, 3 = a + 0.75 (2) or a = 3 - 1.5 = 1.5
2. What is the planned consumption (C) if Yd = 7?
C = 1.5 + 0.75 (7)
— Exercise
In the above figure, when Yd is 6 induced consumption is 4.5. Why?

Marginal Propensities to Consume and Save:

— The extent to which C changes when Yd changes depends on the
marginal propensity to consume.
— The marginal propensity to consume (MPC) is the fraction of a
change in Yd that is consumed. It represents how much of the
increase in income will be spent on goods and services, as opposed
to saving it.
— For linear consumption function, MPC is constant at every level of Yd.
But it is not necessarily to be this way. In general, the lower is the Yd
the higher the MPC and the higher the income the lower the MPC.
— The MPC is affected by the consumers’ confidence and the interest
rates.

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

∆C
— MPC= = b = the slope of the consumption function, 0 ≤ MPC ≤1
∆Yd
— Mostly, C would increase by less amount than the increase in Yd.
increases
— The marginal propensity to save (MPS) is the fraction of a change in
Yd that is saved
∆S
— MPS = = (1 – b) = the slope of the saving function, 0 ≤ MPS ≤1
∆Yd
— Exercise:
Show that MPC + MPS = 1
Since C + S = Yd, any increase in Yd is either consumed or saved
∆C + ∆S = ∆Yd

Divide both sides by ∆Yd

∆C ∆S
+ =1
∆Yd ∆Yd
MPC + MPS = 1
Thus, MPS = 1 – MPC, and MPC = 1- MPS
— Example:
If the increase of Yd from $4 billions to $6 billions lead to an increase
∆C 3 . 6 − 2 1. 6
in C from $2 billion to $3.6 billion, MPC = = = = 0.80
∆Yd 6−4 2

⇒ 80 % of the increase in Yd will go to consumption of goods and

services.
Since b = MPC = 0.80 then MPS = 1- MPC = 1- b = 1- 0.80 = 0.20
— Exercise:
Suppose Yd increased by $100 and as a result C increased by $ 60
what is the MPS?

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

60
MPC = = 0.60 Since MPS = 1 – MPC ⇒ MPS = 1- 0.60 = 0.40
100

Other influences on C and S (Shifts of the Curves)

— Some other factors that influence C and S includes
1. Real interest rate (r)
2. Wealth
3. Expected future income
— While the change in disposable income results in a movement along
the consumption function, a change in any of these other influences
leads to a change in autonomous consumption and results in a
parallel shifts of the consumption function and the saving function.
— Slope does not change because it depends on the Yd which is
assumed fixed.
— When r↓, or when wealth or expected income↑, C↑ and shifts
consumption function upward, and S↓ and shifts saving function
downward. These usually occur during the expansion phase of
business cycle.
— When r↑ or when wealth or expected income↓, C↓ and shifts
consumption function downward, and S↑ and shifts saving function
upward. Such shifts often occur when a recession begins.
— Consumption function could rotate if the autonomous part does not
change but there is a change in the slope and the induced component
as a result of change in Yd.
— Consumption function could shift and rotate if changes in autonomous
and induced components occur simultaneously. That is if Yd and the
one of the other influences change at the same time.

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

Import Function
— Like consumption, import is also influenced by RGDP. The import
function is M = a + mY. If a = 0 then, M = mY.
— M depends on income (RGDP). Other things remaining the same, the
greater the RGDP the larger is the quantity of imports. The
relationship between M and RGDP is determined by the marginal
propensity to import (MPI)
— The marginal propensity to import (MPI) is the fraction of an
increase in RGDP on M. MPI is the change in imports divided by the
change in disposable income. With MPI = 0.05. If income (Y) rises by
$100, imports will rise by $5.
∆M ∆M ∆NX
MPI = = = , 0 ≤ MPI ≤ 1
∆RGDP ∆Y ∆Y
(Since we assumed X is fixed in the very SR, the change in NX is a
result of change in M)
— MPI = 0 if we assume the country has no economic relations with the
rest of the world (closed economy)

Autonomous Expenditure
— As mentioned earlier, planned I, G, and X are autonomous
(independent of RGDP) in the very SR.
— Their effect will be an upward or downward shift of AE
— The slope of the aggregate expenditure curve equals the change in
planned expenditure divided by the change in real GDP.
— It is greater than 0 and less than 1

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

AE 45 0
C+I+G+X

C+I+G+X-M

C+I+G

C+I

0
RGDP

DETERMINATION OF EQUILIBRIUM EXPENDITURES

— Aggregate expenditure function explains the relationship between
aggregate planned expenditure and real GDP
— Actual aggregate expenditure is always equal to RGDP. But planned
aggregate expenditure (AE) is not necessarily equal to actual
aggregate expenditure and therefore is not equal to RGDP.
— Actual expenditure and planned expenditure differ from each other
because of "unintended inventory accumulation".
— Firms might end up with inventories that are greater or smaller than
planned. Planned investment does not include "unintended inventory
accumulation". Therefore, actual expenditure might differ from
planned expenditure because actual investment differs from planned
investment. For example, if a company produces 100 cars, expecting
to sell all of them this year but only sells 70 cars this year, then the

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

remaining 30 are counted in GDP as unplanned inventory investment.

(The first 70 car sold are counted as consumption.)
— Aggregate expenditure curve slopes upward is because, in part,
consumption expenditure increases when real GDP increases.

Equilibrium expenditure
— Equilibrium expenditure is the level of aggregate expenditure that
occurs when planned aggregate expenditures equal the actual
aggregate expenditure (i.e., equal to RGDP) (and planned investment
equals actual investment)
RGDP = AE = C + I + G + NX
— When the price level is fixed, equilibrium expenditure determines
RGDP. When planned aggregate expenditure and actual aggregate
expenditure (RGDP) are unequal, a process of convergence toward
equilibrium expenditure (equilibrium RGDP) occurs.
— At the equilibrium expenditure consumers are willing to buy exactly the
amount of output that is produced and unplanned changes in
inventory must be zero.
— Example:

Actual AE Planned Change in Unplanned RGDP &

(RGDP) AE Inventory (Y – AE) Employment

0 200 -200 Increasing

200 300 -100 Increasing
400 400 0 Constant
600 500 100 Decreasing
800 600 200 Decreasing
1000 700 300 Decreasing

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

AE

unplanned increase
45 0
in inventories
AE

400

200 unplanned reduction

in inventories

RGDP
400
— In this example, equilibrium expenditure is at $400 million where AE =
RGDP at which 45° line intersects AE line. (At equilibrium, what is the
autonomous expenditure? What is the induced expenditure?)
— How the economy achieves equilibrium RGDP?
— When RGDP, for example, is at $200 million actual expenditure is also
200 million but AE is 300 million, so AE is greater than Y. When
people plan to spend $300 million and firms produce goods and
services worth only $200 million, firms will try to meet the planned
spending by taking from inventories what is worth to $100, which is
the difference between planned spending and actual production.
Therefore, firms' inventories fall by $100 million. Because the change
in inventory is part of the investment, actual investment is now $100
million less than planned investment. To restore inventories to their
target level, firms hire additional labor and increase production. So
RGDP increases. This process ends when RGDP equals AE and
unplanned inventory change is zero.
— Thus, wherever RGDP (or Y) is less than AE, unplanned inventories
decrease and investment decreases which leads RGDP (and
employment) to increase.

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

— If RGDP is above the equilibrium expenditure which means firms are

producing more than they can sell, firms' unplanned inventories
increase and in response firms decrease production and RGDP (and
employment) decreases until it reaches equilibrium. At equilibrium,
where RGDP = AE, firms do not change their production.

Changes in the Equilibrium RGDP

— When autonomous expenditure increases, AE increases and AE curve
shifts up, and as a result the equilibrium RGDP (Y) increases. But we
can observe that the increase in the equilibrium RGDP is larger than
the increase in the autonomous expenditure.
— Example:
Suppose AE increases by $100 million because of an increase in
investment (I) by $100 million.

AE
Original New
Y
AE AE 45 0
AE1
0 200 300
AE0
200 300 400 600
400 400 500
400
600 500 600
800 600 700 200

1000 700 800

RGDP
400 600

— As a result of an increase in investment by 100 million AE increases

by a 100 million and AE curve shifts up by a 100 million from AE0 to
AE1, at each level of RGDP. This upward shift in the AE resulted in a
new equilibrium expenditure point where AE = RGDP = $600 million.

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

Thus, an increase in investment by $100 million resulted in an

increase in the equilibrium RGDP by $200 million.
— The increase in equilibrium expenditure by more than the increase in
the autonomous expenditure is due to the multiplier effect.
— The concept of the multiplier process became important in the 1930s
when Keynes suggested it as a means to achieving full employment.
This approach meant to help overcome a shortage of business capital
investment.

THE MULTIPLIER AND THE EQUILIBRIUM RGDP

— In the above example, when planned investment (I) increased by $100
millions, AE increases and RGDP (Y) increases. When Y increases
Yd increases and as a result C increases. The increase in C will lead
to an increase in AE which in turn cause Y to increase and these
multiples will continue.
— The person who receives that money as payment will turn around and
spend some of it. And the same thing will happen when the other
person spends his money -- the person he paid the money to will turn
around and spend some of it, too. The chain of spending continues
until there's nothing left to spend.
— Thus, the initial increase in I brings a bigger increase in AE since I
does not increases only by itself but it induces an increase in C.
— Therefore, the equilibrium expenditure increases by the sum of the
initial increase in the autonomous expenditure and the increase in the
induced expenditure as well.
— The same analysis applies to a decrease in autonomous expenditure.
— The multiplier indicates how many times (or multiples) the equilibrium
RGDP would increase when an initial increase in autonomous

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

expenditure occurs. When autonomous expenditure increases,

equilibrium aggregate expenditure increases by a greater amount due
to the multiplier.
— The multiplier effect magnifies small changes in spending into larger
changes in output and income.
— Since the equilibrium RGDP (or the equilibrium expenditure) increases
by more than the increase in autonomous expenditure, this means the
multiplier which is the change in the equilibrium expenditure divided by
the change in the autonomous expenditure is greater than one.
∆Y
Multiplier = m = f1
∆I
— Example:
Find the multiplier if I increased by a $100 million and as a result Y
increased by $200 millions.
∆Y 200
m= = =2
∆I 100
— Example:
Suppose I increased by $100 million and the multiplier was found to
be equal to 2, what is the increase in the RGDP?
∆Y = m. ∆I = 2.100 = 200
— Example:
Suppose the country's equilibrium RGDP $1000 million and the
multiplier = 2.5. Now, if the country wants to increase its RGDP by
$200 million how much should the country spend in investment?
∆Y 200
∆I = = = 80
m 2 .5

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

Marginal Propensities and the Multiplier

— The marginal propensity to consume (MPC) determines the magnitude
of the multiplier. The larger is the MPC the larger is the multiplier.
— Assuming, the change in Y results from change in I plus change in C,
everything else remaining the same,
∆Y = ∆C + ∆I
∆C
Since MPC = , ∆C = MPC × ∆Y
∆Y
Thus ∆Y = (MPC)( ∆Y ) + ∆I
(1-MPC) ∆Y = ∆I
∆I
∆Y =
1 − MPC
Divide both sides by ∆I results in the multiplier
∆Y 1
m= =
∆I 1 − MPC
1
Since MPS = 1- MPC, m =
MPS
The higher the MPC (the lower the MPS), the greater is the multiplier
effect.
— Example:
If MPC is 0.80 and the autonomous investment increases by $200,
what is the amount of the increase in RGDP?
1
The simple output multiplier is m = =5
1 − 0.80
So the $200 initial increase in investment ultimately increases RGDP
by 5 x $200 = $1,000.

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

— In general, the steeper the aggregate expenditure curve the larger the
multiplier; and the flatter the aggregate expenditure curve the smaller
the multiplier.

The Output Multiplier with Imports

— When domestic income rises, consumers wish to purchase more
goods and services. Some of the things they wish to consume are
imports. When income rises, demand for foreign goods and services
also rises. This lowers the demand for the country’s goods and
services and thus reduces the multiplier effect.
— Using the same method as before we can add MPI and obtain the
∆Y 1 1
multiplier as m = = =
∆I 1 − MPC + MPI MPS + MPI
— Imports make the multiplier smaller than it otherwise would be
because spending on imports does not increase real GDP
domestically. RGDP increases only by goods and services produced
inside the country. Hence, the larger is the MPI, the smaller is the
changes in the country's RGDP.
— The multiplier increases if MPC increases, MPS decreases or MPI
decreases
— From the multiplier equation we conclude
⎛ 1 ⎞ ⎛ 1 ⎞
∆Y = ⎜ ⎟ ∆I = ⎜ ⎟ ∆I , and
⎝ 1 − MPC + MPI ⎠ ⎝ MPS + MPI ⎠
∆I = (1 - MPC + MPI)∆Y = ( MPS + MPI )∆Y
— Example:
Suppose the MPC = 0.8 and MPI = 0.05. The value of the output
1 1
multiplier is = = 4.
1 − 0.8 + 0.05 0.25

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

The propensity to import tends to lower the multiplier effect because

demand for domestically produced final goods and services falls.
— Example:
Suppose you are asked to find equilibrium RGDP given the following
consumption and investment functions. Assume that government
spending, taxes, and net exports are all zero:
C = 100 + 0.9Y
I = 100
Step (1): multiplier = 1/(1-MPC) = 1/(1-0.9) = 1/0.1 = 10
Step (2): total autonomous spending = a + I + G + NX = 100 + 100
+ 0 + 0 = 200
Step (3): Y = 10 * 200 = 2000

THE MULTIPLIER AND THE PRICE LEVEL

— To study the simultaneous determination of RGDP and the price level
we use AS-AD model and the equilibrium RGDP (equilibrium
expenditure) model. The difference between AD and AE, everything
else remaining the same
o AD curve
ƒ AD curve is the negative relationship between the quantity of
RGDP demanded and the price level.
ƒ Price level is variable along AD curve.
ƒ A change in price level brings a movement along AD curve
o AE curve
ƒ AE curve is the positive relationship between AE and RGDP.
ƒ Price level is fixed along AE curve.
ƒ A change in price level shifts the AE curve

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

AE and the Price Level:

— Because the short-run aggregate expenditure model assumes that the
price level is fixed, its predicted effect of changes in autonomous
expenditure on equilibrium output is greater than the prediction of the
AD/SAS model.
— When price level changes, AE changes and the quantity of RGDP
demanded changes. It is important to note that along an AE curve
price level is fixed. But when P rises, each of wealth effect and
substitution effect reduces AE at each level of RGDP and shifts AE
curve downward. When P falls, the AE curve shifts upward.
— Example:
AE

45 0

AE2 (P=100)
600 C
AE0 (P=110)

A AE1 (P=120)
400

B
200

RGDP
200 400 600

B
120
A
110
C
100
AD

200 400 600 RGDP

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

o Along AEo curve, price level is fixed at Po = 110 and equilibrium

expenditure is 400 million at point A.
o When P increases to 120, AE decreases at each level of RGDP.
So AE curve shifts downward to AE1 curve and the equilibrium
expenditure is 200 million at point B.
o When P decreases to 100, AE shifts upward to AE2 and the
equilibrium expenditure is 600 million at point C. Points A, B, and
C on the AD curve correspond to the equilibrium expenditure
points A, B and C in the AE curves.
o When autonomous expenditure changes, the horizontal distance
by which the aggregate demand curve shifts depends on the size
of the multiplier.

Shifts in AE and AD
— Now suppose investment (I) increased by 100 million at P = 110, AE
curve shifts upward to AE1 and the equilibrium expenditure is 600 at
point B. This equilibrium expenditure of 600 million is the new RGDP
demanded at P = 110 and AD curve shifts to AD1.
— A decrease in autonomous expenditure shifts the AE curve downward
and shifts AD curve leftward
— How much AD curve shifts depends on the multiplier. The larger is the
multiplier, the larger is the shift in the AD curve that results from a
given change in autonomous expenditure.

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

AE

45 0
AE1 (P=110)

B AE0 (P=110)
600
A
400

200

RGDP
200 400 600

120
A
110 B

100 AD1
AD0

RGDP
400 600

— The conclusion
o A change in P shifts AE curve and brings a movement along the
AD curve.
o A change in any other influence on AE shifts both AE curve and AD
curve. For example, an increase in I or X increases both AE and
AD and shifts AE curve upward and AD curve rightward.

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Dr. Mohammed Alwosabi ECON 141 – Ch.7

— Example:
Refer to the following table for a country with no tax. The data includes
RGDP and planned aggregate expenditures. (All numbers are in
millions of dollars)
Y C I G NX
50 40 15 30 5
100 75 15 30 0
150 110 15 30 -5
200 145 15 30 -10
250 180 15 30 -15

a. What would be the MPC?

b. What would be the country’s autonomous consumption?
c. What would be the slope of the AE?
d. What would be the country’s MPI?
e. What is the multiplier?
f. What is the country’s equilibrium RGDP?
g. If the country wants to increase equilibrium RGDP by 30, how
much investment must be changed?
h. If investment were to increase by 10, what would be the change
in equilibrium expenditures (equilibrium RGDP)
i. What is the unplanned inventory change when GDP = 50?
— Exercise:
Suppose C = 40 + 0.8Y, MPI = 0.30, I = 100, and RGDP = 500. Now
suppose P decreases from 110 to 100 and as a result consumption
function becomes C = 60 + 0.8Y and I becomes 120
a. How much is the change in the autonomous expenditures?
b. What would be the country’s new equilibrium RGDP?

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