The Aggregate Expenditures Model 11 The Aggregate Expenditures Model The chapter begins with the simple version of the AE model, that of a closed, private economy. Equilibrium GDP is determined and multiplier effects are briefly reviewed. The simplified “closed” economy is then “opened” to show how it would be affected by exports and imports. Government spending and taxes are brought into the model to include the “public” aspects of the system. The price level is assumed constant in this chapter unless stated otherwise, so the focus is on real GDP. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Assumptions and Simplifications Not at full-employment Prices are fixed GDP = DI Begin with private, closed economy No government No trade Keynes developed this model during the depression of the 1930s and the model can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector; households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same. LO1

Investment Schedule (Ig) Shows the amount that businesses plan to invest at different levels of GDP Assume investment (Ig) is independent of GDP => investment is constant at all GDP levels LO1

GDP, output, income are the same Leakages/Injections Leakages – Income not used to buy domestically produced goods and services Injections – Spending in addition to consumption expenditures on domestically produced goods and services GDP, output, income are the same LO1

Aggregate Expenditures Aggregate expenditures = total spending Economic speak The amount of goods and services produced and therefore the level of employment depend directly on the level of aggregate expenditures LO1

Equilibrium GDP TABLE 28.2 Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy (1) Possible Levels of Employment, Millions (2) Real Domestic Output (and Income) (GDP = DI),*Billions (3) Consumption (C), Billions (4) Saving (S), (5) Investment (Ig), (6) Aggregate Expenditure (C+Ig), (7) Unplanned Changes in Inventories, (+ or -) (8) Tendency of Employment, Output, and Income (1) 40 $370 $375 $-5 $20 $395 $-25 Increase (2) 45 390 20 410 -20 (3) 50 405 5 425 -15 (4) 55 430 420 10 440 -10 (5) 60 450 435 15 455 -5 (6) 65 470 Equilibrium (7) 70 490 465 25 485 +5 Decrease (8) 75 510 480 30 500 +10 (9) 80 530 495 35 515 +15 (10) 85 550 40 +20 * If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP Table 28.2 shows equilibrium GDP using the expenditures-output approach for a private, closed economy. Table 28.2 combines consumption and savings data from Tables 27.1 and the investment schedule 28.1. Real domestic output in column 2 shows ten possible levels that producers are willing to offer, assuming their sales would meet the output planned. In other words, they will produce $370 billion of output if they expect to receive $370 billion in revenue. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) at each output level. Recall that the consumption level is directly related to the level of income and that here income is equal to output. Investment is independent of income and is planned or intended regardless of the current income situation. Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output. Otherwise there will be a disequilibrium situation. In Table 28.2, equilibrium occurs only at $470 billion. At $410 billion GDP level, total expenditures (C + Ig) would be $425 = $405(C) + $20 (Ig) and businesses will adjust to this excess demand (revealed by the declining inventories) by stepping up production. They will expand production at any level of GDP less than the $470 billion equilibrium. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At $510 billion level, C + Ig = $500 billion. Businesses will have unsold, unplanned inventory investment and will cut back on the rate of production. As GDP declines, the number of jobs and total income will also decline, but eventually the GDP and aggregate spending will be in equilibrium at $470 billion. No level of GDP other than the equilibrium level of GDP can be sustained. LO1

Planned vs. Actual Investment Actual investment includes planned investment (Ig) and unplanned changes in inventories. As a result, actual investment equals savings at all GDP levels. LO4

Multiplier Effect A change in spending changes real GDP more than the initial change in spending Multiplier = change in real GDP initial change in spending Changes in spending ripple through the economy to generate event larger changes in real GDP. This is called the multiplier effect. Multiplier = change in real GDP / initial change in spending. Alternatively, it can be rearranged to read change in real GDP = initial change in spending x multiplier. Points to remember about the multiplier: The initial change in spending is usually associated with investment because it is so volatile, but changes in consumption (unrelated to income), net exports, and government purchases also are subject to the multiplier effect. The initial change refers to an up-shift or down-shift in the aggregate expenditures schedule due to a change in one of its components, like investment. The multiplier works in both directions (up or down). It occurs because of the interconnectedness of the economy. Change in GDP = multiplier x initial change in spending LO4

Multiplier & Marginal Propensities Multiplier and MPC directly related Multiplier and MPS inversely related Multiplier = 1 1- MPC Multiplier = 1 MPS The significance of the multiplier is that a small change in investment plans or consumption-saving plans can trigger a much larger change in the equilibrium level of GDP. The magnitude of the change in GDP is dependent on the size of the MPC and MPS. LO4

Adding International Trade Include net exports spending in aggregate expenditures Private, open economy Xn can be positive or negative Net exports are independent of GDP => net exports are constant at all GDP levels Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports (X) create domestic production, income, and employment due to foreign spending on U.S. produced goods and services. Imports (M) reduce the sum of consumption and investment expenditures by the amount expended on imported goods, so this figure must be subtracted so as not to overstate aggregate expenditures on U.S. produced goods and services. Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and thus have an expansionary effect. Negative net exports decrease aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary effect. LO4

Adding the Public Sector Government purchases do not impact private spending Taxes are personal Lump sum tax Simplifying assumptions are helpful for clarity when we include the government sector in our analysis. We simplified investment and net export schedules that are used by assuming that they are independent of the level of current GDP. 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 a constant amount and independent of the GDP level (a lump-sum tax). An increase in taxes has an indirect effect on aggregate expenditures because taxes reduce disposable incomes first, and then C falls by the amount of the tax times the MPC. With the addition of government to aggregate expenditures, the economy is now a mixed, open economy. LO4

Government Purchases and Eq. GDP TABLE 28.4 The Impact of Government Purchases on Equilibrium GDP (1) Real Domestic Output and Income (GDP=DI), Billions (2) Consumption (C), Billions (3) Saving (S), (4) Investment (Ig), (5) Net Exports (Xn), Billions (6) Government Purchases (G), Billions (7) Aggregate Expenditures (C+Ig+Xn+G), (2)+(4)+(5)+(6) Exports (X) Imports (M) (1) $370 $375 $-5 $20 $10 $415 (2) 390 390 20 10 430 (3) 410 405 5 445 (4) 430 420 460 (5) 450 435 15 475 (6) 470 450 490 (7) 490 465 25 505 (8) 510 480 30 520 (9) 530 495 35 535 (10) 550 510 40 550 TABLE 28.4 shows the impact of government purchases on equilibrium GDP. Before adding government purchases, equilibrium GDP had been at $470. Now with government purchases equilibrium GDP rises to $550, implying a multiplier effect since the rise in GDP is greater than the $20 billion in additional aggregate expenditures. LO4

Taxation and Equilibrium GDP TABLE 28.5 Determination of the Equilibrium Levels of Employment, Output, and Income: Private and Public Sectors (1) Real Domestic Output and Income (GDP), Billions (2) Taxes (T), Billions (3) Disposable Income (DI), Billions, (1)-(2) (4) Consump-tion (Ca), (5) Saving (Sa), (6) Invest-ment (Ig), (7) Net Exports (Xn), Billions (8) Govern-ment Pur-chases (G), Billions (9) Aggregate Expendi-tures (Ca +Ig+Xn +G), (4)+(6)+(7)+(8) Exports (X) Imports (M) (1) $370 $20 $350 $360 $-10 $10 $400 (2) 390 20 370 375 -5 10 415 (3) 410 390 430 (4) 430 410 405 5 445 (5) 450 420 460 (6) 470 450 435 15 475 (7) 490 470 490 (8) 510 465 25 505 (9) 530 510 480 30 520 (10) 550 530 495 35 535 Table 28.5 shows the determination of the equilibrium levels of employment, output, and income with the private sector and taxes. With taxes of $20 billion at all levels of GDP, equilibrium GDP falls from $550 to $490. Again, we can see that there is a multiplier effect. The multiplier = 60/15 = 4. LO4