Induced expenditure, on the other hand, is the opposite. It refers to spending that varies with the level of income. The more income people have, the more they tend to spend. This article will focus on induced expenditure, explaining its components, how it’s calculated, and its impact on the economy.
In economics, total spending in an economy is called aggregate expenditure. This spending can be broken down into two main categories: autonomous expenditure and induced expenditure. Autonomous expenditure refers to spending that happens regardless of the level of income in the economy. For example, even if everyone lost their jobs tomorrow, people would still need to buy some food and essential goods.
Understanding the induced expenditure
Induced expenditure is a type of expenditure where the amount varies with income. In macroeconomics, it represents spending by four macroeconomic sectors: household, business, government, and external. In this case, we are using real GDP to represent income. Some expenditures from the four sectors are autonomous, while others depend on real GDP.
Difference between autonomous expenditure and induced expenditure
Autonomous expenditure contrasts with induced expenditure. Variations in income (or real GDP) do not affect autonomous spending. On the other hand, it depends on other factors such as discretionary government policies, interest rates, and global economic growth. Exports and spending on necessities are examples.
Meanwhile, induced expenditure varies and depends on income. Some components of induced expenditure, such as consumption, investment, and government spending, are positively correlated with real GDP. When real GDP grows, induced expenditures increase. Conversely, when real GDP falls, it decreases. Spending on durable goods is an example.
Induced expenditure examples
The multiplier effect works through the aggregate expenditure of four macroeconomic sectors, namely household consumption, business investment, government spending, and net exports. All four make up GDP. The increase in the four increases the GDP, and conversely, the increase in GDP affects all four.
However, you must remember that some of the components of the four expenditures act as induced expenditures, while others act as autonomous expenditures.
Let us discuss the four of them one by one.
Household consumption
Growing real GDP indicates an increase in economic activity. In an economic cycle, we call this economic expansion. During this period, the economy prospered. Businesses increased production, recruited more workers, and created more income for the household sector.
Assuming income tax is unchanged, an increase in household income will increase disposable income, which is income after tax. Higher disposable income encourages households to demand more goods and services.
Higher household consumption raises aggregate demand and stimulates businesses to increase production (real GDP grows). Finally, it increases income further, which in turn increases the demand for goods and services.
The opposite applies; when real GDP falls, the economy worsens, and the prospect of household income falls. Household spending fell, but not on all goods and services.
Households may spend less on some items, especially durable goods such as cars. Therefore, we categorize the expenditures on these goods as induced consumption because they depend on income.
On the other hand, even though income has fallen, households are still spending money on food and beverages. Because such spending is independent of income, we call it autonomous consumption.
Business investment
When the economy expands (real GDP grows), businesses are more confident about investing in physical capital. They see consumer demand growing stronger and profit prospects improving. They then increase production to make more profit.
To increase production, they then buy new equipment or build new factories. Such investment not only increases production capacity but also increases labor productivity. By purchasing more sophisticated production equipment, the company can produce more output using the same input.
Increased production activities create more jobs. Consumers see their wages, income, and employment prospects as improving, prompting them to increase their consumption of goods and services.
An increase in consumption encourages businesses to increase production, create more jobs, and increase consumer income.
For such reasons, business investment falls into the category of induced expenditure. Capital investment increases according to economic conditions and real GDP.
Meanwhile, several other investments fall into the autonomous investment category. They do not depend on the real GDP. Examples of autonomous investments include inventory replacement.
The modernization of factories and machinery to support competitiveness is another example. Businesses continue to do so to offset depreciation, increase production capacity, and support competitiveness, even when economic growth is negative.
Government spending
Increased business activity during economic expansion generates more tax revenue for the government. During this period, the economy also prospered. Hence, the government also saw an increase in taxes from the household and business sectors.
Governments use additional tax revenues to increase spending on goods and services. For example, they launched several infrastructure projects, both physical, such as roads and bridges, and non-physical, such as health and education.
Higher government spending stimulates the economy to grow. Economic activity increases and creates more income for households and more profits for businesses, which in turn leads to higher tax revenue.
Another example of induced expenditure is transfer payments, such as unemployment benefits. They correlate with real GDP but in the opposite direction. They increase during a recession because the unemployment rate increases. Conversely, when the economy expands, it decreases as the unemployment rate decreases.
Meanwhile, some of the government’s routine expenditures are categorized as autonomous expenditures. Even though the economy is falling, the government still has to pay salaries to government staff.
Net exports
Remember, of the net export components, only imports represent induced expenditure. On the other hand, exports are autonomous because they do not depend on domestic economic growth. But, they are more dependent on external factors such as global economic growth.
Imports have a significant inducible component. To meet the other three sectors’ expenditure, supply does not only come from domestic but also from imports. If the domestic supply is insufficient, it will increase imports. Increased imports reduce net exports and undermine real GDP growth, ceteris paribus.
Induced expenditure formula
Economists use a simple formula to describe the relationship between aggregate expenditure, autonomous expenditure, and induced expenditure. In the linear equation, the aggregate expenditure formula is as below:
- AE = a + bY
Where:
- AE = aggregate expenditure
- a = intercept, which represents autonomous expenditure
- b = slope, which represents the marginal propensity to consume
- bY = induced expenditure
- Y = national or disposable income (represented by real GDP)
Assume the above equation is like below:
AE = 5 + 0.5Y
From this equation, you can see that when national income (Y) is equal to zero, aggregate expenditure is $5. Meanwhile, if income increases by $1, aggregate expenditure increases by $0.5.
Induced expenditure and multiplier effect
The increase in induced spending creates a multiplier for the economy. For example, higher real GDP increases disposable income, ultimately encouraging the consumption of goods and services. An increase in real GDP indicates a growing economy. Businesses increase production, creating more jobs and income in the economy.
Higher income encourages more consumption of goods and services in the economy. Businesses respond by increasing production and recruiting workers, pushing real GDP higher. That, in turn, creates more income.
Higher incomes encourage households to increase consumption. Such situations continue and produce a multiplier effect.
The size of the multiplier depends on the marginal propensity to consume (MPC) in the economy. The MPC shows you how much additional consumption is due to an increase in disposable income.
Economists formulate the multiplier as follows:
- Multiplier = 1 / (1-MPC)
From the formula, you can see the higher the MPC, the more significant the multiplier effect. Conversely, the lower the MPC, the lower the multiplier effect.
Note that the formula assumes no change in income or import taxes.
Let’s take the previous formula: AE = 5 + 0.5Y
Since the MPC is equal to 0.5, we can calculate the economy’s multiplier as 2 = 1- (1-0.5). It shows you when aggregate expenditure increases by $1, income (real GDP) doubles.
To prove it, I simulate it using the following data. ∆Y/∆AE represents the multiplier, the magnitude of the real GDP change when aggregate expenditure changes.
| Y | ∆Y | a | AE | ∆AE | ∆Y/∆AE |
| 1 | 1 | 5 | 5.5 | ||
| 3 | 2 | 5 | 6.5 | 1 | 2 |
| 7 | 4 | 5 | 8.5 | 2 | 2 |
| 13 | 6 | 5 | 11.5 | 3 | 2 |
| 21 | 8 | 5 | 15.5 | 4 | 2 |
| 31 | 10 | 5 | 20.5 | 5 | 2 |
| 43 | 12 | 5 | 26.5 | 6 | 2 |
| 57 | 14 | 5 | 33.5 | 7 | 2 |
| 73 | 16 | 5 | 41.5 | 8 | 2 |
| 91 | 18 | 5 | 50.5 | 9 | 2 |
| 111 | 20 | 5 | 60.5 | 10 | 2 |
| 133 | 22 | 5 | 71.5 | 11 | 2 |
