The Aggregate Expenditures Model

Aggregate Expenditure Model (Also known as the “Keynesian cross model” The amount of goods and services produced and therefore the level of employment depend directly on the level of aggregate expenditures (total spending) Businesses will produce only a level of output that they think they can profitable sell They will idle their workers and machinery when there are no markets for their goods and services When Aggregate Expenditures fall, total output and employment decrease (when AS rise, total output and employment increase.)

Classical vs. Keynesian Classical: S>I S = function of (i) I = function of (i) Therefore, if S > I Interest goes down so Saving goes down and Investment goes up Keynesian S = function Y So change in interest does not effect Savings I = function expected profit/interest That means in a recession business will not increase I no matter what interest is because businesses have unemployed plants. This means G has to step in.

Investment (to an economist) is spending on plant and equipment; the machinery and the buildings that a firm uses to produce output Investment is NOT the purchase of stocks and bonds or any other financial instrument.

Determinants of Investment Output and Interest rate Real GDP determines investment because it is a measure of the level of demand for the product. Businesses have a range of investment opportunities – for example They can buy a new machine that produces more than an older machine They can build a whole new factory

A business will calculate the expected profitability of the investment alternatives To be able to make an investment, the business must have the money. It can use its profits, or retained earnings Or it can borrow the money Either way, the interest rate will determine whether the business invests.

The interest rate represents the opportunity cost of using the money to buy investment goods. To decide whether to invest, businesses will compare the interest rate to the expected profit rate of the new plant and equipment If the expected profit is greater than the interest rate, firms will invest. Thus, as the interest rate goes down, more investment opportunities will be available and firms will invest more

Consumption and Saving Though not the only factor, the most important element affecting consumption (and savings) is disposable income Disposable Income – What consumers have left over to spend or save once they have paid out their net Taxes. DI = Gross Income – Net Taxes where net taxes = (taxes paid – transfers received). With no government transfers or taxation, DI = C + S Not all consumers save part of their income, typical consumers spend the majority of their disposable income and save whatever is left over.

Consumption and Saving Consumption – Even with zero disposable income, households still consume as they liquidate wealth (sell assets), spend some savings, or borrow (dissavings). At every level of DI, the consumption function tells us how much is consumed.

Marginal Propensity to Consume and Save Marginal always means an incremental change caused by an external force, or it is always the slope of a “total” function. MPC – the change in consumption caused by a change in disposable income. MPS – The change in saving caused by a change in disposable income. For every additional dollar not consumed, it is saved. So if the consumer gains $100 in disposable income, the consumer’s consumption is increased by $80 and increases saving by $20. In other words, MPC + MPS = 1

Determinants of Consumption and Saving Wealth – When the value of accumulated wealth increases, consumption functions shift upward, and the saving function shifts downward Because households can sell stock or other assets to consume more goods at their current level of disposable income. Expectations – Uncertainty or a low expectation about future income usually prompts a household to decrease consumption and increase saving. An expectation of a higher future price level spurs higher consumption right now and less saving.

Determinants of Consumption and Saving Household Debt – Households can I n crease consumption with borrowing, or debt. However, as households accumulate more and more debt, they need to use more and more disposable income to pay off the debt, and thus decrease consumption