The Aggregate Expenditures Model What determines the level of GDP, given the nation’s production capacity? What causes real GDP to rise in one period and fall in another?

Learning objectives How economists combine Consumption and Investment to Depict an Aggregate Expenditures Schedule for a Private Closed Economy Three Characteristics of the Equilibrium Level of Real GDP in a Private Closed Economy – Aggregate Expenditures = Output – Saving = Investment – No Unplanned Changes in Inventories How Changes in Equilibrium Real GDP Occur and Relate to Multiplier Integrate Government and Foreign Sectors into AE model

Recap: We looked at 3 basic relationships: – How income relates to consumption & saving – How interest rate affects investment spending – How changes in spending work through the system to create larger changes in output Here we introduce the more theoretically rigorous explanation for these relationships – the Aggregate expenditures (AE) model

The Aggregate Expenditures model We use the aggregate expenditures (AE) model to answer these questions Keynes developed the theory that emphasizes the importance of aggregate demand for economic performance Basic premise of the model is – that the amount of goods & services produced (real GDP) & therefore the level of employment depend directly on the level of aggregate expenditures (total spending) Therefore when aggregate expenditures fall, total output & employment decrease & vice versa Equilibrium income level is attained where aggr. exp/demand is equal to aggr. Output/Real GDP

Components of Aggr. Expenditure In a two sector economy aggr. Exp. consists of consumption exp (C) and investment exp (I). With govt. exp (G) and foreign sector (X n ), aggr. expenditure = C + I + G + X n Aggr. Exp = Aggr. Output. This gives equilibrium GDP level Consumption Function The sizes of consumption and saving are determined by the size of disposable income C = f(Y d ); Saving = f(Y d ) Level of C and S are influenced by the size of MPC & MPS

Determinants of Consumption There are other non-income determinants of Consumption & Saving in the economy: Wealth of households/consumers Indebtedness of households/consumers Level of consumers’ expectations Taxation Shifts in consumption and saving schedules/levels are because of changes in non-income determinants.

Investment- Main determinants Second component of aggr. exp is Investment I = f(i, r) Investment which refers to spending on new plants, capital equipment, machinery etc Main determinant of invest. are Expected rate of net profit (r) The real interest rate (i) If r exceeds i, it will be profitable to invest Real interest rate = Nominal interest rate minus Inflation

Other Determts. of Investment In addition to the main determinants of investment, there are other determinants: Acquisition, maintenance costs, etc. Business taxes Technological changes Business expectations Stock of capital goods on hand (Inventories) Change in these determinants will result in shifts in investment demand curve

Equilibrium GDP The equlm. Output level is that level output whose production creates total spending just sufficient to purchase that output. Production of any level of output will generate an identical amount of income which is shared by consumers, investors, government and foreign sector. Change in aggr. Exp. (mainly due to change in investment spending) brings change in equlm. GDP through multiplier, which is liked to MPC and MPS levels.

Change in Equlm. GDP- Leakages and Injections Aggregate Expenditure = C + I Part of disposable income of households is saved. Saving, therefore, is a leakage in income & exp. stream. Saving is what keeps consumption short of total output or GDP. But business sector does not sell its entire output to consumers as some part of output (capital/investment goods) will be sold within business sector. Therefore, Investment can be thought of as injection of spending into the income-exp. stream

Equilibrium GDP Other Features… – At equilibrium injections (planned investment) Equals leakages (Saving ), i.e., S=I Saving is a Leakage or withdrawal of spending from the income-expenditure stream and causes C to be less than GDP Investment (purchases of capital goods) is an Injection of spending into the income-expenditures stream, so this investment spending can replace the leakage due to saving If leakage is > injection, i.e., saving > investment, then C + I g > GDP, spending is greater that production.

Equilibrium GDP Other Features… – An increase in leakage without corresponding increase in injection cause equilibrium GDP to fall; example is the paradox of thrift – if all households decide to save more, they can result saving less – In equilibrium there are no unplanned changes in inventory – C + I g = GDP; S = I and no unplanned changes in inventories are characteristics of equilibrium GDP in the private closed economy. – Actual investment = planned investment + unplanned changes in inventories – Unplanned changes in inventories act as a balancing item that equates the actual amounts saved and investment at any period

Changes in equilibrium GDP & the multiplier an initial Δ in spending will be acted on by the multiplier to produce larger Δs in output The “initial change” can be planned investment spending or nonincome-induced Δ in consumption. Suppose a P10 million increase in investment spending increases aggregate spending and raises it from P380 million to P420 million. Calculate the investment multiplier; MPS; the amount of saving generated. Compare the saving generated with the initial change in investment.

International trade – 3 sector model Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand and imports contract aggregate spending on domestic output. – Exports (X) create domestic production, income, and employment due to foreign spending on domestic produced goods and services. – Imports (M) reduce the sum of consumption and investment expenditures by the amount expended on imported goods – At equilibrium GDP =C + I g + (X – M)

International trade – 3 sector model Net Exports Schedule - Shows hypothetical amount of net exports (X - M) that will occur at each level of GDP Assumes that net exports are autonomous or independent of the current GDP level. Net Exports and Equilibrium GDP – Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and thus have an expansionary effect. The multiplier effect also is at work here. – Negative net exports decrease aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary effect. The multiplier effect also is at work here. – Use figure 9.4 for graphical analysis

Adding the public sector – mixed economy Adding government purchases & taxes to the model We assume government purchases do not impact private spending schedules. We assume that net tax revenues are derived entirely from personal taxes so that GDP, NI, and PI remain equal. DI is PI minus net personal taxes. We assume tax collections are independent of GDP level (a lump-sum tax) Increases in government spending boost aggregate expenditures. Government spending is subject to the multiplier. Use table 9.4 & figure 9.5 for analysis

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

Adding the Public Sector –mixed economy Lump-Sum Tax Increase and GDP Taxes reduce DI and, therefore, consumption and saving at each level of GDP. An increase in taxes will lower the aggregate expenditures schedule relative to the 45- degree line and reduce the equilibrium GDP. (use table 9.5) Government purchases and taxes have different impacts

Four sector open economy C d + I g + X n + G = GDP Leakages – saving, taxes & imports – they are uses of income that subtract from potential consumption. Consumption will be < GDP Injections – investment, exports & government purchases - At equilibrium, injections into the income- expenditures stream equal leakages from the income stream: S d + M + T = I g + X + G. therefore there are no unplanned changes in inventories

Inflationary & Deflationary gaps Keynesians argue that an economy may not achieve full employment in the short-ru or even in the long run Deflationary (recessionary) gap – occurs when the equilibrium level of GDP obtains below the full employment level. Could be caused by lack of AE Keynes solution to deflationary gap is to increase government spending financed by borrowing Inflationary gap - occurs if AE exceeds the potential output of the economy. Here equilibrium will be achieved, but at a level of output above the full employment level

Summary Two-sector closed economy – Sectors – households & firms – Aggregate expenditures – consist of C + I – Equilibrium obtains where GDP = C + I or S=I – One injection (I) & one leakage (S) Three sector open economy – Sectors – households, firms & foreign sector – Aggregate expenditures – consist of C + I + Xn – Equilibrium obtains where GDP=C + I+ Xn or S + M=I + X – Two injections (I & X) and two leakages (S & M) Four-sector economy (open with government) – Sectors – households, firms, foreign sector & government – Aggregate expenditures – consist of C + I + Xn + G – Equilibrium obtains where GDP = C + I + Xn + G – Three injections (I, X & G) and three leakages (S, M & T)