1. The Aggregate Expenditures Model The beginning of the study of Macroeconomic Models and Fiscal Policy Please listen to the audio as you work through the slides.

2. Learning objectives
Students should be able to thoroughly and completely explain:
The Aggregate Expenditure Model, its components, how the components interact.
The recessionary expenditure gap
The inflationary expenditure gap.

3. Two critical questions in Macroeconomics
What determines the level of GDP, given a nation’s productive capacity?
What causes real GDP to rise in one period and to fall in another?

4. Start with the private closed economy
Our approach here is similar to the way we developed the circular flow model
Start with the private closed economy
No international trade
No government purchases and taxes
Expand it to look at the mixed economy that includes international trade and domestic government spending
Imports and exports
Government purchases and taxes

5. Aggregate Expenditures Model
Assumptions
A Private Closed Economy
Defer Government & Taxes
Defer Exports and Imports
Real GDP = DI – to simplify the model
If real GDP is $500 Billion, then households receive $500 Billion in DI to consume or save.
Excess Production Capacity & Unemployed Labor Exists
Increased Aggregate Expenditures will increase real output and employment but not raise prices.

6. Add the Investment decisions of businesses to the Consumptions plans of households
Construct an investment schedule showing planned investment at each possible level of GDP
Planned investment is independent of the level of current DI or real output

7. Investment Demand & Schedule Real Domestic Product, GDP
Curve
Investment
Schedule
Amount of Investment
forthcoming at each
level of GDP Ig 20
(billions of dollars)
Investment
Expected rate of return, r, and
real interest rate, i (percents) 8 20 20
I D 20
Investment
(billions of dollars)
Real Domestic Product, GDP
(billions of dollars)

8. Combine the consumption schedule and the Investment schedule to explain:
The equilibrium levels of:
output,
Income, and
Employment
in the private closed economy.

9. Equilibrium GDP Terminology
Real Domestic Output – definition
The possible levels of real total output the business sector might produce.
Firms will produce $370 Billion of output incurring $370 Billion of costs (wages, rents, etc) only if they believe they can sell the output for $370 Billion.
Aggregate Expenditures Schedule – Shows aggregate consumption and investment expenditures, at each possible output level.
Equilibrium GDP – the level of output where production creates total spending just sufficient to purchase that output

10. GDP = C + Ig Equilibrium GDP At this point there is:
no overproduction, or excess total spending that draws down inventories of goods and prompts increases in the rate of production.

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

12. GDP below and above equilibrium (disequilibrium) The adjustment process
What if:
GDP below equilibrium level (spending greater than output)
Economy wants to spend higher levels than the levels of GDP (output) the economy is producing.
Buyers would be taking goods off the shelves faster than firms could produce them.
Unintended decline in inventories.
Business adjust by stepping up production which leads to increased employment and total income.
Process continues until equilibrium is restored.

13. GDP below and above equilibrium (disequilibrium) The adjustment process
What if: GDP below equilibrium level (spending > output)
Economy wants to spend higher levels than the levels of GDP the economy is producing.
Buyers would be taking goods off the shelves faster than firms could produce them.
Unintended decline in inventories.
Business adjust by stepping up production which leads to increased employment and total income.
Process continues until equilibrium is restored.
What if: GDP above equilibrium level
(spending < Output)
Business finds that these levels of output fail to generate the spending needed to clear the shelves of goods.
Inventories build up
Business will cut back on production.
The decline in output would lead to fewer jobs and a decline in total income
Process continues until equilibrium is restored.

14. Changes in Equilibrium GDP
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 by $5 B
Decrease in
Investment by $5 B
The Multiplier
Effect

15. The Multiplier Effect (1) (2) (3) $ 5.00 $ 3.75 $ 1.25 Change in
Income
(2)
Change in
Consumption
(MPC = .75)
(3)
Change in
Saving
(MPS = .25)
Increase in Investment of $5
Second Round
Third Round
Fourth Round
Fifth Round
All other rounds
Total
$ 5.00
3.75
2.81
2.11
1.58
4.75
$ 20.00
$ 3.75
2.81
2.11
1.58
1.19
3.56
$ 15.00
$ 1.25
.94
.70
.53
.39
1.19
$ 5.00
$20.00
$4.75
15.25
$1.58
13.67
$2.11
11.56
$2.81
8.75
ΔI=
$5 billion
$3.75
5.00
$5.00 1 2 3 4 5
All
Rounds of Spending

16. International Trade to the model
Now we add
International Trade to the model
Net Exports
Positive if exports > imports
Negative if imports > exports
Net Exports and Aggregate Expenditures
C + Ig + ( X – M )
Xn = ( X – M )
C + Ig + Xn

17. International Trade and Aggregate Expenditures
Net Export Schedule – level of net exports at each level of GDP
Net Exports and Equilibrium GDP
Positive Net Exports
Other things equal, positive net exports increase aggregate expenditures and GDP beyond what it would be in a closed economy.
Negative Net Exports
Other things equal, negative net exports reduce aggregate expenditures and GDP below what they would be in a closed economy.

18. 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

19. International Economic Linkages
Prosperity Abroad
Raises the level of real output & income in US.
Tariffs on goods imported from US (our exports)
They improve their economy and depress ours
Exchange Rates
Depreciation – price of US goods to them goes down, US exports go up, US imports go down, net exports go up, GDP goes up.
Appreciation

20. Net Exports of Goods Selected Nations, 2006 -881 Negative Net Exports
Positive Net Exports
Canada
+31
-45
France
Japan
+70
-27
Italy
Germany
+203
-171
United Kingdom
-881
United States
Source: World Trade Organization

21. Now we add the Public Sector to the model
Simplifying Assumptions
Government purchases do not affect consumption and investment spending
All taxes are personal
Tax collections are fixed and unrelated to GDP

22. Government Spending Effect
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

23. Lump Sum Tax Effect $15 Billion Decrease In Consumption From
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 – Why?

24. Recessionary Expenditure Gap
The amount by which actual GDP falls short of full-employment GDP

25. Recessionary Expenditure Gap
Actual GDP is below full employment GDP
Real GDP (billions of dollars)
Aggregate Expenditures
(billions of dollars)
550
530
510
490
470
45°
AE0 - full employment spending
$5 Billion
Gap Yields
$20 Billion
GDP
Change
AE1 –actual
Recessionary
Expenditure
Gap = $5 Billion
Full
Employment

26. Inflationary Expenditure Gap
The amount by which an economy’s aggregate expenditures at the full-employment GDP exceed those just necessary to achieve the full-employment level of GDP.
The amount by which actual GDP exceeds full-employment GDP

27. Inflationary Expenditure Gap
Actual GDP is above full employment GDP
Real GDP (billions of dollars)
Aggregate Expenditures
(billions of dollars)
550
530
510
490
470
45°
AE2 actual spendinng
AE0 hypothetical spending at full employment
Inflationary
Expenditure
Gap = $5 Billion
$5 Billion
Gap Yields
$20 Billion
GDP
Change
Full
Employment

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

29. Limitations of the Model
Does Not Show Price-Level Changes
Ignores Premature Demand-Pull Inflation
Limited Real GDP to the Full-Employment Level
Does not Deal with Cost-Push Inflation
Does not Allow for “Self-correction”

30. Let’s See What You Know about Macroeconomics so far.
Including the topic of the Aggregate Expenditures Model, please tell us what you know about Macroeconomics.
Step 1 – Construct an outline based on the key concepts of the AE Model (for example) - C, I, G, Xn
Under each element, outline it’s key elements
Etc.
Step 2 – Add content about each of the key points
Step 3 – Review for completeness
Step 4 - Present

31. The basic macroeconomic relationships introduced a number of key concepts.
Please explain the relationship between income, consumption, savings, and GDP
Please explain the relationship between interest rates, expected rates of return, investment, and GDP
Please explain the concept of the multiplier, including:
What information is required to calculate the spending multiplier
List and explain the 3 different multipliers that we discussed.
Explain how the multiplier works to impact GDP?