Sticky prices and expenditure plans: behavior in the very short term with sticky prices
Here we are taking a very short-term perspective, and considering the economy during a period short enough that prices may be considered as set. In this situation, quantities sold will be determined by demand, not supply. That is, the overall price level will be sticky (since individual firms' prices are sticky), and aggregate demand determines the aggregate quantity of goods and services sold (i.e., real GDP).
We use the aggregate expenditure model to analyze this situation. The model identifies aggregate planned expenditure and uses this to explain fluctuations in aggregate demand.
Aggregate planned expenditure equals planned consumption expenditure plus planned investment plus planned government purchases plus planned exports minus planned imports. For the very short term under consideration, we assume that plans for investment, government purchases, and exports are given (fixed), while plans for consumption and imports are not fixed and depend on the level of real GDP.
Consider first consumption. We can envision the relationship between consumption and disposable income: called the consumption function, this will typically be a line with a positive slope and y-intercept, but with the slope < 1. In fact, the slope of the consumption function is the marginal propensity to consume (defined as the change in consumption associated with a change in disposable income, and approximately equal to 0.8 for the period from 1970-94).
The counterpart to the consumption function is the saving function, showing the relationship between saving and disposable income (slope = MPS, with value of about 0.2).
Given the typical consumption function (intercept >0, slope <1), the saving function will show negative saving (dissaving) for low values of disposable income and positive saving only at higher levels of disposable income. In addition, the sum of the marginal propensities to consume and save must be equal to one.
Changes in disposable income entail movements along the consumption and saving functions -- i.e., changes in consumption expenditure and saving. In addition, however, there are other influences on consumption expenditure and saving that cause shifts in the curves: falling real interest rates, and rising expected future income or increased purchasing power of net assets all tend to increase consumption and reduce saving. That is, in these circumstances the consumption function shifts up and the saving function shifts down. Such shifts are common during the expansionary phase of the business cycle, when expected future income increases.
Similarly, rising real interest rates, and falling expected future incomes or purchasing power of net assets, tend to lower the consumption function and shift up the saving function. Such changes often occur at the outset of a recession, reflecting declines in expected future income.
Our next step is to look at consumption as a function of real GDP. Since we've already seen through the consumption function that consumption is linked to disposable income, and disposable income equals real GDP minus net taxes, it should be clear that consumption will be related to real GDP. Net taxes increase as real GDP increases. In fact, with net taxes at their 1995 level of about 15 percent of real GDP (i.e., Yd = 0.85* GDP), and C = 0.8*Yd, we have C= 0.8*0.85*GDP = 0.68*GDP.
The second element in our analysis of aggregate planned expenditure that varies with real GDP even in the very short run is imports. The import function shows the relationship between imports and real GDP (reflecting the underlying influence of real GDP in increasing imports), and the slope of that function (presently about 0.15, up from only 0.07 in 1970) is the marginal propensity to import.
Real GDP with a sticky price level
We've looked at how real GDP influences planned expenditure for our two expenditure categories (consumption and imports) assumed to be responsive to fluctuations in real GDP even in the very short run. Now we look at causality in the other direction: how the various components of aggregate planned expenditure interact to determine aggregate expenditure and real GDP when the price level is sticky.
The aggregate expenditure schedule/curve shows the relationship between aggregate planned expenditure and real GDP. This is determined by adding up the fixed components (autonomous expenditure) in our analysis -- namely, investment, government expenditures, and expenditures on exports -- and the variable components (induced expenditure) -- consumption minus imports.
Actual expenditure in the aggregate will always equal real GDP (it's how we define real GDP!). However, there may be a deviation between actual and planned expenditure. Such deviations typically are picked up by changes in inventories: that is, with aggregate planned expenditure less than real GDP, inventories will begin to accumulate, and the corresponding unplanned investment (since inventory changes are part of investment) will add to planned expenditure to reach actual real GDP. However, note that the inventory accumulation will induce firms to decrease production subsequently, and hence reduce real GDP.
Likewise, if planned expenditure exceeds real GDP, inventories will be drawn down (reduced). This case in which actual investment is less than planned investment will adjust planned expenditure back into line with real GDP. At the same time, the inventory depletion will be a prompt to increased planned production subsequently, and hence increase real GDP.
Equilibrium expenditure in this context is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. At this equilibrium level, everybody's spending plans are fulfilled, and there is no tendency for real GDP to change. Hence, with a sticky price level, equilibrium expenditure determines real GDP. Geometrically, equilibrium expenditure is determined by the intersection of the aggregate planned expenditure curve with the 45 degree line through the origin.
To see why this is an equilibrium, consider the adjustments that result if aggregate planned expenditure does not equal real GDP. As described above, if AE > GDP then inventories diminish, but this decline in inventories prompts new production and hence increases subsequent GDP. Hence, the initial situation was not an equlibrium, since equilibrium means no tendency for change to take place. Similarly, GDP > AE results in inventory accumulation, but this build-up of inventories in turn creates corresponding downward pressure on next period's real GDP. Only when GDP = AE is there no tendency for change to occur.
The multiplier (brief introduction)
Autonomous expenditure refers to the sum of the components of aggregate expenditure that are not influenced by real GDP (contrasted with induced expenditure, which is the sum of the components of aggregate expenditure that do vary with real GDP). Autonomous expenditure includes investment, government purchases, exports, and autonomous consumption (the part of consumption expenditure that does not vary with real GDP).
Changes in autonomous expenditure result in changes in aggregate expenditure, and hence in the level of equilibrium expenditure and real GDP. However, the change in real GDP is ordinarily greater than the initial change in autonomous expenditure. The multiplier effect refers to the fact that equilibrium expenditure and real GDP change by more than the change in autonomous expenditure.
Consider the consequences of an increase in autonomous expenditure, as might occur with increased planned investment. This increase in planned investment will result in aggregate planned expenditure exceeding real GDP, so inventories decline. Firms respond by increasing production to restore inventories, and this increased production translates into an increased level of real GDP.
However, the increased real GDP then initiates changes in induced expenditure: with higher disposable incomes, consumption expenditure increases, generating higher incomes again and further increases in disposable income and ultimately consumption and real GDP. In brief, then, the additional income from increased autonomous expenditure induces additional expenditure, and that in turn results in further increases in income.
The size of the multiplier is defined as the change in equilibrium expenditure divided by the change in autonomous expenditure (i.e., it measures by how much the change in autonomous expenditure is multiplied when it ultimately gets translated into increased real GDP).