9 The Aggregate Expenditures Model

Chapter Objectives 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 AE = 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 Recessionary and Expansionary Expenditure Gaps

Simplifying assumptions Look at aggregate expenditure and equilibrium in “private closed economy” No government purchases and taxes No import and export GDP=DI , Income equal to output produced is available Excess production capacity : increase in expenditure will increase real output and employment but not raise prices

Consumption and Investment Schedule In private closed economy aggregate expenditure will consist of C and I (gross) Consumption schedule Need to construct an investment schedule that shows amounts business firms collectively intend to invest at each level of GDP Assume it is independent of current level of DI

Consumption and Investment Schedule 20m will occur at both high and low levels of GDP (Planned) Investment Demand Curve Investment Schedule Investment Demand Curve Investment Schedule 20 Ig Investment (billions of dollars) 8 20 20 ID 20 Investment (billions of dollars) Real GDP (billions of dollars)

Equilibrium GDP: C + Ig = GDP (2) Real Domestic Output (and Income) (GDP=DI) (3) Con- sump- tion (C) (4) Saving (S) (1-2) (5) Investment (Ig) (6) Aggregate Expenditures (C+Ig) (7) Unplanned Changes in Inventories (+ or -) (8) Tendency of Employment Output and Income (1) Employ- ment …in Billions of Dollars 40 45 50 55 60 65 70 75 80 85 $370 390 410 430 450 470 490 510 530 550 $375 390 405 420 435 450 465 480 495 510 $-5 5 10 15 20 25 30 35 40 20 $395 410 425 440 455 470 485 500 515 530 $-25 -20 -15 -10 -5 +5 +10 +15 +20 Increase Equilibrium Decrease Graphically…

Consumption and Investment Equilibrium GDP 530 510 490 470 450 430 410 390 370 45° 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) Consumption (billions of dollars) C + Ig (C + Ig = GDP) C Equilibrium Point Aggregate Expenditures Ig = $20 Billion C = $450 Billion

Other features of equilibrium 1)Saving and planned investment are equal -Saving is a Leakage: It causes consumption to be less than GDP -Some output is in the form of capital goods and is sold to businesses not consumers -Investment is therefore an injection-possible replacement of savings

Other features of equilibrium If Leakage of saving > Injection of investment C+ I will be less than GDP If Leakage of saving < Injection of investment- C + I will be more than GDP Only when S exactly offsets I , C+ I will equal GDP

Other features of equilibrium 2) No unplanned changes in Inventories -Consider GDP level above equilibrium : Increase in inventories -Firms cannot profit by increasing inventories so they cut back on production -Consider GDP level below equilibrium: Decrease in inventories

Planned and unplanned investment: -Savings are equal to total investment i.e. planned and unplanned Therefore when we say differences between I and S can occur and bring changes in equilibrium we are referring to planned investment -If we consider both planned and unplanned they are always equal regardless of GDP

Changes in Equilibrium GDP …and the Multiplier 510 490 470 450 430 45° 430 450 470 490 510 Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) (C + Ig)1 (C + Ig)0 (C + Ig)2 Increase in Investment Decrease in Investment

Multiplier Change of 5b in investment led to 20b change in GDP What is the multiplier? What is MPS and MPC?

Add International Trade Why include exports? -It creates domestic production, employment and income Why exclude imports? -It generates production abroad. In order to avoid overstating domestic production we exclude it Aggregate Exp = C + I + (X-M)

Net Exports Schedule Lists the amount of net exports that occur at each level of GDP Assume that net exports are independent of GDP Positive net exports increase GDP and aggregate expenditure beyond what they would be in closed economy

Aggregate Expenditures International Trade Net Exports and Equilibrium GDP Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) 510 490 470 450 430 45° 430 450 470 490 510 C + Ig+Xn1 C + Ig Aggregate Expenditures with Positive Net Exports C + Ig+Xn2 Aggregate Expenditures with Negative Net Exports Real GDP +5 -5 Net Exports Xn (billions of Dollars) Positive Net Exports Xn1 450 470 490 Xn2 Negative Net Exports

International Linkages Prosperity Abroad : Trading partners income increasing will lead to more exports of home country Tariffs: Foreign country increases tariffs to reduce its imports Home country exports decrease Not clear if net exports increase or decrease

International Linkages Exchange Rates: Home country's currency depreciates-exports become cheaper in terms of foreign currency exports increase, imports decrease  GDP expands -But it can also cause inflation if economy is already at full employment

Adding the Public Sector Government Purchases and GDP (1) Level of Output and Income (GDP=DI) (2) Consump- tion (C) (3) Saving (S) (4) Investment (Ig) (5) Net Exports (Xn) (6) Government (G) (7) Aggregate Expenditures (C+Ig+Xn+G) (2)+(4)+(5)+(6) Exports (X) Imports (M) …in Billions of Dollars $370 390 410 430 450 470 490 510 530 550 $375 390 405 420 435 450 465 480 495 510 $-5 5 10 15 20 25 30 35 40 $20 20 10 10 20 $415 430 445 460 475 490 505 520 535 550

Adding the Public Sector Government Spending and GDP 45° 470 550 Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) C + Ig + Xn + G C + Ig + Xn C Government Spending of $20 Billion $20 Billion Increase in Government Spending Yields an $80 Billion Increase In GDP

Taxation Lump Sum Tax : Tax of constant amount or tax yielding same revenue at all levels of GDP Taxes reduce DI relative to GDP Decline in DI reduces both Consumption and Savings

Adding the Public Sector Lump-Sum Tax Increase and GDP 45° 490 550 Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) C + Ig + Xn + G Cd + Ig + Xn + G $15 Billion Decrease In Consumption From a $20 Billion (MPC=.75) Increase in Taxes $20 Billion Increase in Taxes Yields a $60 Billion Decrease In GDP

-Note that equal changes in G and Taxes do not have same effect on GDP 20b increase in G increases GDP by 80b 20b increase in Taxes reduced consumption by (20*0.75) and GDP by 60b Cd + Ig + Xn + G = GDP

Leakages, Injections and Unplanned Inventory Changes Private closed economy: Saving is leakage, I is injection Open economy: Imports and taxes are added leakages and Government spending and Exports are added injections At equilibrium leakages should equal injections and no inventory changes Sd + M + T = Ig + X + G

Aggregate Expenditures Equilibrium Versus Full-Employment GDP Recessionary Expenditure Gap: Multiplier Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) 550 530 510 490 470 45° 490 510 530 AE0 $5 Billion Gap Yields $20 Billion GDP Change AE1 Recessionary Expenditure Gap = $5 Billion Full Employment

Aggregate Expenditures Equilibrium Versus Full-Employment GDP Inflationary Expenditure Gap Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) 550 530 510 490 470 45° 490 510 530 AE2 AE0 Inflationary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change Full Employment

Limitations of the model 1)Does Not Show Price Level Changes: How much will price level rise when AE is more than output 2)Ignores Premature Demand-Pull Inflation that occurs before an economy reaches its full employment 3)Limits Real GDP to the Full-Employment Level of Output 4)Does Not Deal with Cost-Push Inflation 5)Does Not Allow for “Self-Correction”