9 The Aggregate Expenditures Model O 9.1

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

Consumption and Investment Simplifications Private Closed Economy Planned Investment Investment Schedule Investment Demand Curve Investment Schedule Investment Demand Curve Investment Schedule 20 Ig r and i (percent) Investment (billions of dollars) 8 20 20 ID 20 Investment (billions of dollars) Real GDP (billions of dollars)

Consumption and Investment Equilibrium GDP: C + Ig = GDP Real Domestic Output Aggregate Expenditures Aggregate Expenditures Schedule Equilibrium GDP Disequilibrium W 9.1

Consumption and Investment (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 G 9.1

Other Features… Equilibrium GDP Saving Equals Planned Investment Leakage Injection No Unplanned Changes in Inventories

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

International Trade Net Exports and Aggregate Expenditures Net Exports Schedule Net Exports and Equilibrium GDP Positive Net Exports Negative Net Exports International Economic Linkages Prosperity Abroad Tariffs Exchange Rates

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 Trade Net Exports of Goods - Select Nations, 2004 GLOBAL PERSPECTIVE Net Exports of Goods - Select Nations, 2004 Negative Net Exports Positive Net Exports -700 200 150 100 50 0 50 100 150 200 250 Canada +37 -17 France Germany +195 -2 Italy Japan +111 -117 United Kingdom -707 United States Source: World Trade Organization

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

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

Adding the Public Sector Cd + Ig + Xn + G = GDP Leakages Injections No Planned Inventory Changes Sd + M + T = Ig + X + G W 9.2 G 9.2

Equilibrium Versus Full-Employment GDP Recessionary Expenditure Gap 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

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

Equilibrium Versus Full-Employment GDP W 9.3 Application: U.S. Recession of 2001 Inflationary Expenditure Gap U.S. Inflation in the Late 1980s Full-Employment Output with Large Negative Net Exports Negative Net Exports

Equilibrium Versus Full-Employment GDP Limitations of the Model Does Not Show Price Level Changes Ignores Premature Demand-Pull Inflation Limits Real GDP to the Full-Employment Level of Output Does Not Deal with Cost-Push Inflation Does Not Allow for “Self-Correction”

Say’s Law - The Great Depression and Keynes Last Word Classical School – Automatic Self-Adjustment to Full Employment – Mill, Ricardo Views Based Upon “Say’s Law” - J.B. Say (1767-1832) – Supply Creates its Own Demand Great Depression Caused Questions Keynes Answered in his General Theory of Employment, Interest, and Money Income and Saving Discrepancies Volatility in Investment Spending Cyclical Unemployment Can Occur Government Should Be Active in the Recovery Process O 9.2

Key Terms planned investment investment schedule aggregate expenditures schedule equilibrium GDP leakage injection unplanned changes in inventories net exports lump-sum tax recessionary-expenditure gap inflationary-expenditure gap

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