1. 9
The Aggregate Expenditures
Model
O 9.1

2. Learning objectives In this chapter students will learn:
1. How economists combine consumption and investment to depict an aggregate expenditures schedule for a private closed economy.
2. The three characteristics of the equilibrium level of real GDP in a private closed economy: aggregate expenditures = output; saving = investment; and no unplanned changes in inventories.
3. How changes in equilibrium real GDP can occur and how those changes relate to the multiplier.
4. How economists integrate the public sector (government expenditures and taxes) and the international sector (exports and imports) into the aggregate expenditures model.
5. About the nature and causes of “recessionary expenditure gaps” and “inflationary expenditure gaps.”

3. Simplifying Assumptions for the Private Closed Economy model
We first assume a “closed economy” with no international trade. Government is ignored.
Although both households and businesses save, we assume here that all saving is personal.
Depreciation and net foreign income are assumed to be zero for simplicity.
There are two reminders concerning these assumptions.
1. They leave out two key components of aggregate demand (government spending and foreign trade), because they are largely affected by influences outside the domestic market system.
2. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.

4. Tools of Aggregate Expenditures Theory: Consumption and Investment Schedules
The theory assumes that the level of output and employment depend directly on the level of aggregate expenditures. Changes in output reflect changes in aggregate spending.
In a closed private economy the two components of aggregate expenditures are consumption and gross investment.
The consumption schedule was developed in Chapter 8 (see Figure 8.2a).
In addition to the investment demand schedule, economists also define an investment schedule that shows the amounts business firms collectively intend to invest at each possible level of GDP or DI.

5. 1. In developing the investment schedule, it is assumed that investment is independent of the current income. The line Ig (gross investment) in Figure 9.1b shows this graphically related to the level determined by Figure 9.1a.
The assumption that investment is independent of income is a simplification, but will be used here.
3. Figure 9.1a shows the investment schedule from GDP levels given in Table 8.1.

6. Consumption and Investment
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)

7. Equilibrium GDP: Expenditures-Output Approach
Look at Table 9.2, which combines data of Tables 8.1 and 9.1.
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) forthcoming at each output level.
1. Recall that consumption level is directly related to the level of income and that here income is equal to output level.
2. Investment is independent of income here 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.

8. 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 -)
S-I
(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
The three conditions
of equilibrium
Graphically…

9. 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.
At levels below equilibrium, businesses will adjust to 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. As GDP rises, the number of jobs and total income will also rise
At levels of GDP above equilibrium, aggregate expenditures will be less than GDP. Businesses will have unsold output (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.

10. Consumption and Investment
Equilibrium GDP
530
510
490
470
450
430
410
390
370
45°
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

11. In Table 9.2, 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.

12. EQUILIBRIUM GDP
At equilibrium, saving (leakage) and Planned Investment (injection) are Equal:
Leakage = Injection
(S) (I) or
No Unplanned Changes in Inventories (Unplanned inventory = 0)
Above Equilibrium
Leakage (S) > Injection (I)
This leads to unplanned inventory accumulation
Below Equilibrium
Leakage (S) < Injection (I)
This leads to unplanned inventory depletion.

13. Remember “saving represents a “leakage” from spending stream and causes C to be less than GDP”.
Some of output is planned for business investment and not consumption, so this investment spending can replace the leakage due to saving

14. Unplanned expenditures
The unplanned portion is reflected as a business expenditure, even though the business may not have desired it, because the total output has a value that belongs to someone - either as a planned purchase or as an unplanned inventory.
If aggregate spending is less than equilibrium GDP, then businesses will find themselves with unplanned inventory investment on top of what was already planned.
If aggregate expenditures exceed GDP, then there will be less inventory investment than businesses planned as businesses sell more than they expected. This is reflected as a negative amount of unplanned investment in inventory.
At equilibrium there are no unplanned changes in inventory.

15. Quick Review
Equilibrium GDP is where aggregate expenditures equal real domestic output: C + planned Ig = GDP
A difference between saving and planned investment causes a difference between the production and spending plans of the economy as a whole.
A difference between production and spending plans leads to unintended inventory investment (accumulation) or unintended decline in inventories (depletion).
As long as unplanned changes in inventories occur, businesses will revise their production plans upward or downward until the investment in inventory is equal to what they are planned.
Only where planned investment and saving are equal will there be no unintended investment or disinvestment in inventories to drive the GDP down or up.

16. Changes in Equilibrium GDP and the Multiplier
As developed in Chapter 8, an initial change in spending will be acted on by the multiplier to produce larger changes in output.
The “initial change” represented in the text and Figure 9.3 is in planned investment spending. It could also result from a nonincome-induced change in consumption.
The multiplier in Figure 9.3 is 4 (=1/MPS)
Figure 9.3 shows the impact of changes in investment. Suppose investment spending rises (due to a rise in profit expectations or to a decline in interest rates).

17. Figure 9.3 shows the increase in aggregate expenditures from (C + Ig)0 to (C + Ig)1. In this case, the $5 billion increase in investment leads to a $20 billion increase in equilibrium GDP.
This is based on mpc=0.75, hence the multiplier=1/(1-0.75)=4
Conversely, a decline in investment spending of $5 billion is shown to create a decrease in equilibrium GDP of $20 billion to $450 billion.
Again this is based on a multiplier’s value=4

18. Changes in Equilibrium GDP
…and the Multiplier
510
490
470
450
430
45°
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

19. International Trade and Equilibrium Output
Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand aggregate spending and imports contract aggregate spending on domestic output.
1. Exports (X) create domestic production, income, and employment due to foreign spending on Kuwait’s produced goods and services.
2. 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 Kuwait’s produced goods and services.

20. The net export schedule
The net export schedule shows hypothetical amount of net exports (X - M) that will occur at each level of GDP. Note that we assume that net exports are autonomous or independent of the current GDP level.
Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and thus have an expansionary effect. The multiplier effect also is at work. In Figure 9.4a we see that positive net exports of $5 billion lead to a positive change in equilibrium GDP of $20 billion (to $490 from $470 billion). This comes from Table 9.2 and Figure 9.3.
Negative net exports decrease aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary effect. The multiplier effect also is at work here. In Figure 9.4a we see that negative net exports of $5 billion lead to a negative change in equilibrium GDP of $20 billion (to $450 from $470 billion).

21. 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°
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

22. International economic linkages:
Global Perspective 9.1 shows 2004 net exports for various nations.
International economic linkages:
Prosperity abroad generally raises our exports and transfers some of their prosperity to us. (Conversely, recession abroad has the reverse effect.)
Tariffs on Kuwaiti products may reduce our exports and depress our economy, causing us to retaliate and worsen the situation. Trade barriers in the 1930s contributed to the Great Depression.
3. Depreciation of the KD lowers the cost of Kuwaiti goods to foreigners and encourages exports from the Kuwait, while discouraging the purchase of imports in the Kuwait. This could lead to higher real GDP or to inflation, depending on the domestic employment situation. Appreciation of the dollar could have the opposite impact.

23. International Trade Net Exports of Goods - Select Nations, 2004
GLOBAL PERSPECTIVE
Net Exports of Goods - Select Nations, 2004
Negative Net Exports
Positive Net Exports
Canada
+37
-17
France
Germany
+195 -2
Italy
Japan
+111
-117
United Kingdom
-707
United States
Source: World Trade Organization

24. Adding the Public Sector
Simplifying assumptions are helpful for clarity when we include the government sector in our analysis. (Many of these simplifications are dropped in Chapter 11, where there is further analysis on the government sector.)
1. Simplified investment and net export schedules are used. We assume they are independent of the level of current GDP.
2. We assume government purchases do not impact private spending schedules.
3. 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.
4. We assume tax collections are independent of GDP level (a lump-sum tax)
5. The price level is assumed to be constant unless otherwise indicated.

25. Saving + Imports + Taxes = Investment + Exports + Government Purchases
Table 9.4 gives a tabular example of including $20 billion in government spending and Figure 9.5 gives the graphical illustration. Note that:
1. Increases in government spending boost aggregate expenditures.
2. Government spending is subject to the multiplier.
Table 9.5 and Figure 9.6 show the impact of a tax increase.
1. Taxes reduce DI and, therefore, consumption and saving at each level of GDP.
2. An increase in taxes will lower the aggregate expenditures schedule relative to the 45-degree line and reduce the equilibrium GDP.
3. Table 9.5 confirms that, at equilibrium GDP, the sum of leakages equals the sum of injections.
Saving + Imports + Taxes =
Investment + Exports + Government Purchases

26. 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

27. Adding the Public Sector
Government Spending and GDP
45°
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

28. Adding the Public Sector
Lump-Sum Tax Increase and GDP
45°
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

29. Government purchases and taxes have different impacts.
In our example, equal additions in government spending and taxation increase the equilibrium GDP.
a. If G and T are each increased by a particular amount, the equilibrium level of real output will rise by that same amount.
b. In the text’s example, an increase of $20 billion in G and an offsetting increase of $20 billion in T will increase equilibrium GDP by $20 billion (from $470 billion to $490 billion).
The example reveals the rationale.
a. An increase in G is direct and adds $20 billion to aggregate expenditures.
b. An increase in T has an indirect effect on aggregate expenditures because T reduces disposable incomes first, and then C falls by the amount of the tax times MPC.

30. The overall result is a rise in initial spending of $20 billion minus a fall in initial spending of $15 billion (0.75 x $20 billion), which is a net upward shift in aggregate expenditures of $5 billion. When this is subject to the multiplier effect, which is 4 in this example, the increase in GDP will be equal to 4 x $5 billion or $20 billion, which is the size of the change in G. This is Known as the balanced budget multiplier.

31. Injections, Leakages, and Unplanned Changes in Inventories – Equilibrium revisited
As demonstrated earlier, in a closed private economy equilibrium occurs when saving (a leakage) equals planned investment (an injection).
With the introduction of a foreign sector (net exports) and a public sector (government), new leakages and injections are introduced.
1. Imports and taxes are added leakages.
2. Exports and government purchases are added injections.
Equilibrium is found when the leakages equal the injections.
1. When leakages equal injections, there are no unplanned changes in inventories.
2. Symbolically, equilibrium occurs when Sa + M + T = Ig + X + G, where Sa is after-tax saving, M is imports, T is taxes, Ig is (gross) planned investment, X is exports, and G is government purchases.

32. Equilibrium vs. Full-Employment GDP
A recessionary expenditure gap exists when equilibrium GDP is below full-employment GDP. (See Figure 9.7a)
Recessionary expenditure gap of $5 billion is the amount by which aggregate expenditures fall short of those required to achieve the full-employment level of GDP.
In Table 9.5, assuming the full-employment GDP is $510 billion, the corresponding level of total expenditures there is only $505 billion. The gap would be $5 billion, the amount by which the schedule would have to shift upward to realize the full-employment GDP.
Graphically, the recessionary expenditure gap is the vertical distance by which the aggregate expenditures schedule (Ca + Ig + Xn + G)1 lies below the full-employment point on the 45-degree line.

33. Because the multiplier is 4, we observe a $20-billion differential (the recessionary gap of $5 billion times the multiplier of 4) between the equilibrium GDP and the full-employment GDP. This is the $20 billion GDP gap we encountered in Chapter 7’s Figure 7.3.
An inflationary expenditure gap exists when aggregate expenditures exceed full-employment GDP.
Figure 9.7b shows that a demand-pull inflationary expenditure gap of $5 billion exists when aggregate spending exceeds what is necessary to achieve full employment.
The inflationary expenditure gap is the amount by which the aggregate expenditures schedule must shift downward to realize the full-employment noninflationary GDP.
The effect of the inflationary expenditure gap is to pull up the prices of the economy’s output.
In this model, if output can’t expand, pure demand-pull inflation will occur (Key Question 13).

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

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

36. XII. Limitations of the Model
The aggregate expenditures model has five limitations.
1. The model can account for demand-pull inflation, but it does not indicate the extent of inflation when there is an inflationary gap. It doesn’t measure inflation.
2. It doesn’t explain how inflation can occur before the economy reaches full employment (premature demand-pull inflation).
3. It doesn’t indicate how the economy could produce beyond full-employment output for a time.
4. The model does not address the possibility of cost-push type of inflation.
5. It doesn’t allow for “self-correction,” built-in features of the economy that tend to ameliorate recessionary and inflationary gaps.
In Chapter 10, these deficiencies are remedied with a related aggregate demand-aggregate supply model.

37. 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 ( ) – 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

38. 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

39. XI. Historical Applications
The U.S. recession of 2001 provides a good illustration of a recessionary expenditure gap.
1. U.S. overcapacity and business insolvency resulted from excessive expansion by businesses in the 1990s, a period of prosperity.
2. Internet-related companies proliferated during the 1990s, despite their lack of profitability, but fueled by speculative interest in the stocks of these start-up firms.
3. Consumer debt grew as people borrowed against their expectations of rising wealth in financial markets.
4. Fraud by executives and accountants led to speculative excesses and set up firms to fail.
5. Beginning in 2000, a dramatic drop in stock market values occurred, causing pessimism and highly unfavorable conditions for acquiring additional investment funds.

40. 6. In March 2001 aggregate expenditures declined and the economy fell into its 9th recession since 1950.
7. The terrorist attacks on September 11, 2001, further undermined consumer confidence and contributed to the downturn.
8. Unemployment has since declined, but for a long period it remained high, leading some to refer to the upturn as a “jobless recovery,” where output rises, but labor market conditions remain weak.
In 2005 the U.S. experienced both full employment (no recessionary or inflationary expenditure gap) and large negative net exports.
1. These two events seemingly contradict, as theory would predict that negative net exports would lead to recessionary conditions.
2. Domestic consumption (negative saving), investment, and government purchases maintained full employment conditions despite the negative net exports.
3. Domestic spending was supported by foreign lending, allowing the full employment conditions to occur.

41. U.S. Inflation in the late 1980s provides an example of an inflationary expenditure gap period.
1. Strong economic growth in the late 1980s gave way to increasing rates of inflation.
2. Inflation rose from 1.9% in 1986 to 3.6, 4.1, and 4.8% in the years that followed.
3. Inflationary pressure subsided with the recession and the recessionary gap that emerged.

42. Next Chapter Preview… Aggregate Demand and Aggregate Supply