The Aggregate Expenditures Model The beginning of the study of Macroeconomic Models and Fiscal Policy Please listen to the audio as you work through the slides.

Learning objectives Students should be able to thoroughly and completely explain: 1.The Aggregate Expenditure Model, its components, how the components interact. 2.The recessionary expenditure gap 3.The inflationary expenditure gap. 4.The Aggregate Demand Aggregate

Two critical questions in Macroeconomics 1.What determines the level of GDP, given a nation’s productive capacity? 2.What causes real GDP to rise in one period and to fall in another?

Our approach here is similar to the way we developed the circular flow model Start with the private closed economy – No international trade – No government purchases and taxes Expand it to look at the mixed economy that includes international trade and domestic government spending – Imports and exports – Government purchases and taxes

Aggregate Expenditures Model Assumptions 1.A Private Closed Economy 1.Defer Government & Taxes 2.Defer Exports and Imports 2.Real GDP = DI – to simplify the model a.If real GDP is $500 Billion, then households receive $500 Billion in DI to consume or save. 3.Excess Production Capacity & Unemployed Labor Exists a.Increased Aggregate Expenditures will increase real output and employment but not raise prices.

Add the Investment decisions of businesses to the Consumptions plans of households Construct an investment schedule showing planned investment at each possible level of GDP Planned investment is independent of the level of current DI or real output

Investment Demand & Schedule Expected rate of return, r, and real interest rate, i (percents) Investment (billions of dollars) Investment (billions of dollars) 20 8 Real Domestic Product, GDP (billions of dollars) I D IgIg Investment Demand Curve Investment Schedule Amount of Investment forthcoming at each level of GDP 20

Combine the consumption schedule and the Investment schedule to explain: The equilibrium levels of: 1.output, 2.Income, and 3.Employment in the private closed economy.

Equilibrium GDP Terminology Real Domestic Output – definition The possible levels of real total output the business sector might produce. Firms will produce $370 Billion of output incurring $370 Billion of costs (wages, rents, etc) only if they believe they can sell the output for $370 Billion. Aggregate Expenditures Schedule – Shows aggregate consumption and investment expenditures, at each possible output level. Equilibrium GDP – the level of output where production creates total spending just sufficient to purchase that output

Equilibrium GDP GDP = C + I g At this point there is: no overproduction, or excess total spending that draws down inventories of goods and prompts increases in the rate of production.

° Disposable Income (billions of dollars) Consumption and Investment (billions of dollars) C I g = $20 Billion Aggregate Expenditures C = $450 Billion C + I g (C + I g = GDP) Equilibrium Point Equilibrium GDP

GDP below and above equilibrium (disequilibrium) The adjustment process What if: GDP below equilibrium level (spending greater than output) Economy wants to spend higher levels than the levels of GDP (output) the economy is producing. Buyers would be taking goods off the shelves faster than firms could produce them. Unintended decline in inventories. Business adjust by stepping up production which leads to increased employment and total income. Process continues until equilibrium is restored.

GDP below and above equilibrium (disequilibrium) The adjustment process What if: GDP below equilibrium level (spending > output) Economy wants to spend higher levels than the levels of GDP the economy is producing. Buyers would be taking goods off the shelves faster than firms could produce them. Unintended decline in inventories. Business adjust by stepping up production which leads to increased employment and total income. Process continues until equilibrium is restored. What if: GDP above equilibrium level (spending < Output) Business finds that these levels of output fail to generate the spending needed to clear the shelves of goods. Inventories build up Business will cut back on production. The decline in output would lead to fewer jobs and a decline in total income Process continues until equilibrium is restored.

° Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) Changes in Equilibrium GDP Increase in Investment by $5 B (C + I g ) 0 Decrease in Investment by $5 B (C + I g ) 2 (C + I g ) 1 The Multiplier Effect

(1) Change in Income (2) Change in Consumption (MPC =.75) (3) Change in Saving (MPS =.25) Increase in Investment of $5 Second Round Third Round Fourth Round Fifth Round All other rounds Total $ $ $ $ $ $ 5.00 Rounds of Spending 12345All $ $5.00 $3.75 $2.81 $2.11 $1.58 $4.75 ΔI= $5 billion The Multiplier Effect

Now we add International Trade to the model Net Exports Positive if exports > imports Negative if imports > exports Net Exports and Aggregate Expenditures C + I g + ( X – M ) X n = ( X – M ) C + I g + X n

International Trade and Aggregate Expenditures Net Export Schedule – level of net exports at each level of GDP Net Exports and Equilibrium GDP Positive Net Exports Other things equal, positive net exports increase aggregate expenditures and GDP beyond what it would be in a closed economy. Negative Net Exports Other things equal, negative net exports reduce aggregate expenditures and GDP below what they would be in a closed economy.

Real GDP Net Exports X n (billions of Dollars) Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) ° Net Exports and Equilibrium GDP Aggregate Expenditures with Positive Net Exports C + I g Aggregate Expenditures with Negative Net Exports C + I g +X n2 C + I g +X n1 X n1 X n2 Positive Net Exports Negative Net Exports

International Economic Linkages Prosperity Abroad Raises the level of real output & income in US. Tariffs on goods imported from US (our exports) They improve their economy and depress ours Exchange Rates Depreciation – price of US goods to them goes down, US exports go up, US imports go down, net exports go up, GDP goes up. Appreciation

Net Exports of Goods Selected Nations, 2006 Positive Net ExportsNegative Net Exports Canada France Japan Italy Germany United Kingdom United States Source: World Trade Organization

Now we add the Public Sector to the model Simplifying Assumptions 1.Government purchases do not affect consumption and investment spending 2.All taxes are personal Tax collections are fixed and unrelated to GDP

45° Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) Government Spending Effect C Government Spending of $20 Billion C + I g + X n C + I g + X n + G $20 Billion Increase in Government Spending Yields an $80 Billion Increase In GDP

45° Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) Lump Sum Tax Effect $15 Billion Decrease In Consumption From a $20 Billion (MPC=.75) Increase in Taxes C d + I g + X n + G C + I g + X n + G $20 Billion Increase in Taxes Yields a $60 Billion Decrease In GDP – Why?

Recessionary Expenditure Gap The amount by which actual GDP falls short of full-employment GDP

Recessionary Expenditure Gap Actual GDP is below full employment GDP Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) ° AE 0 - full employment spending AE 1 – actual Full Employment Recessionary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

Inflationary Expenditure Gap The amount by which an economy’s aggregate expenditures at the full- employment GDP exceed those just necessary to achieve the full- employment level of GDP. The amount by which actual GDP exceeds full-employment GDP

Inflationary Expenditure Gap Actual GDP is above full employment GDP Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) ° AE 0 hypothetical spending at full employment AE 2 actual spendinng Full Employment Inflationary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

The Complete Model GDP and full employment Multiplier effects – Government spending – Lump sum taxes – Balanced Budget case Recessionary gap – Policy options Inflationary gap - Demand pull inflation – Policy options

Limitations of the Model Does Not Show Price-Level Changes Ignores Premature Demand-Pull Inflation Limited Real GDP to the Full-Employment Level Does not Deal with Cost-Push Inflation Does not Allow for “Self-correction”

Let’s See What You Know about Macroeconomics so far. Including the topic of the Aggregate Expenditures Model, please tell us what you know about Macroeconomics. Step 1 – Construct an outline based on the key concepts of the AE Model (for example) - C, I, G, Xn – Under each element, outline it’s key elements – Etc. Step 2 – Add content about each of the key points Step 3 – Review for completeness Step 4 - Present

The basic macroeconomic relationships introduced a number of key concepts. 1.Please explain the relationship between income, consumption, savings, and GDP 2.Please explain the relationship between interest rates, expected rates of return, investment, and GDP 3.Please explain the concept of the multiplier, including: 1.What information is required to calculate the spending multiplier 2.List and explain the 3 different multipliers that we discussed. 3.Explain how the multiplier works to impact GDP?