The Aggregate Expenditures Model Chapter 28 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

28-2 Chapter Objectives Aggregate expenditures for a private closed economy Characteristics of equilibrium real GDP in a private closed economy Changes in equilibrium real GDP and the multiplier Adding the government and international sectors Recessionary and inflationary expenditure gaps

28-3 Model Simplifications Private closed economy Consumption and investment only Prices are fixed Excess capacity exists Unemployed labor exists Disposable income = real GDP –No taxes

28-4 Model Simplifications Investment demand vs. schedule r and i (percent) Investment (billions of dollars) ID 20 8 Real GDP (billions of dollars) 20 Investment (billions of dollars) IgIg Investment Demand Curve Investment Schedule 20 Investment Demand Curve Investment Schedule

28-5 Equilibrium GDP Real GDP = C + I g Aggregate expenditures –Equal to C + I g –Aggregate expenditures schedule Quantity goods produced = quantity goods purchased Disequilibrium –Only 1 equilibrium level of GDP

28-6 (1)40 (2)45 (3)50 (4)55 (5)60 (6)65 (7)70 (8)75 (9)80 (10)85 $ $ $ $ Increase Equilibrium Decrease $ (2) Real Domestic Output (and Income) (GDP=DI) (3) Con- sump- tion (C) (4) Saving (S) (1) – (2) (5) Investment (I g ) (6) Aggregate Expenditures (C+I g ) (7) Unplanned Changes in Inventories (+ or -) (8) Tendency of Employment, Output, and Income (1) Employ- ment …in Billions of Dollars Equilibrium GDP In millions

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

28-8 Equilibrium GDP Saving equals planned investment –Leakage –Injection No unplanned inventory changes

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

28-10 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

28-11 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

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

28-13 Adding the Public Sector GDP = C d + I g + X n + G Lump sum taxes –Taxes affect disposable income –Consumption and the MPC Leakages = S d + M + T Injections = I g + X + G S d + M + T = I g + X + G

28-14 Adding the Public Sector (1)$370 (2) 390 (3) 410 (4) 430 (5) 450 (6) 470 (7) 490 (8) 510 (9) 530 (10) 550 $ $ $ $ (1) Level of Output and Income (GDP=DI) (2) Consump- tion (C) (3) Saving (S) (4) Investment (I g ) (5) Net Exports (X n ) (6) Government (G) (7) Aggregate Expenditures (C+I g +X n +G) (2)+(4)+(5)+(6) Exports (X) Imports (M) …in Billions of Dollars

° 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

° 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

28-17 Recessionary Expenditure Gap GDP is below full employment Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) ° AE 0 AE 1 Full Employment Recessionary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

28-18 Inflationary Expenditure Gap GDP is above full employment Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) ° AE 0 AE 2 Full Employment Inflationary Expenditure Gap = $5 Billion $5 Billion Gap Yields $20 Billion GDP Change

28-19 The Complete Model GDP and full employment Multiplier effects –Government spending –Lump sum taxes Recessionary gap –Policy options Inflationary gap –Demand pull inflation

28-20 Application U.S. economy late 1990’s –Too much investment –Stock market bubble –Consumer debt –Fraudulent business practice Aggregate expenditure falls U.S. recession of 2001 Terror attacks prolonged recession

28-21 The Great Depression Classical economics –Mills and Ricardo –Prices adjust to maintain full employment Say’s Law –Supply creates its own demand Depression challenged the theory New theory developed –Keynes –Aggregate expenditure model

28-22 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

28-23 Next Chapter Preview… Aggregate Demand and Aggregate Supply