1. 9
The Aggregate Expenditures
Model

2. 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

3. Simplifying assumptions
Look at aggregate expenditure and equilibrium in “private closed economy”
No government purchases and taxes
No import and export
GDP=DI , Income equal to output produced is available
Excess production capacity : increase in expenditure will increase real output and employment but not raise prices

4. Consumption and Investment Schedule
In private closed economy aggregate expenditure will consist of C and I (gross)
Consumption schedule
Need to construct an investment schedule that shows amounts business firms collectively intend to invest at each level of GDP
Assume it is independent of current level of DI

5. Consumption and Investment Schedule
20m will occur at both high and low levels of GDP (Planned)
Investment Demand Curve
Investment Schedule
Investment
Demand
Curve
Investment
Schedule 20 Ig
Investment (billions of dollars) 8 20 20 ID 20
Investment (billions of dollars)
Real GDP (billions of dollars)

6. Equilibrium GDP: C + Ig = GDP
(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…

7. 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

8. Other features of equilibrium
1)Saving and planned investment are equal -Saving is a Leakage: It causes consumption to be less than GDP -Some output is in the form of capital goods and is sold to businesses not consumers -Investment is therefore an injection-possible replacement of savings

9. Other features of equilibrium
If Leakage of saving > Injection of investment C+ I will be less than GDP
If Leakage of saving < Injection of investment- C + I will be more than GDP
Only when S exactly offsets I , C+ I will equal GDP

10. Other features of equilibrium
2) No unplanned changes in Inventories
-Consider GDP level above equilibrium : Increase in inventories
-Firms cannot profit by increasing inventories so they cut back on production
-Consider GDP level below equilibrium: Decrease in inventories

11. Planned and unplanned investment:
-Savings are equal to total investment i.e. planned and unplanned
Therefore when we say differences between I and S can occur and bring changes in equilibrium we are referring to planned investment
-If we consider both planned and unplanned they are always equal regardless of GDP

12. 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

13. Multiplier Change of 5b in investment led to 20b change in GDP
What is the multiplier?
What is MPS and MPC?

14. Add International Trade
Why include exports?
-It creates domestic production, employment and income
Why exclude imports?
-It generates production abroad. In order to avoid overstating domestic production we exclude it
Aggregate Exp = C + I + (X-M)

15. Net Exports Schedule
Lists the amount of net exports that occur at each level of GDP
Assume that net exports are independent of GDP
Positive net exports increase GDP and aggregate expenditure beyond what they would be in closed economy

16. 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

17. International Linkages
Prosperity Abroad : Trading partners income increasing will lead to more exports of home country
Tariffs: Foreign country increases tariffs to reduce its imports Home country exports decrease
Not clear if net exports increase or decrease

18. International Linkages
Exchange Rates: Home country's currency depreciates-exports become cheaper in terms of foreign currency exports increase, imports decrease  GDP expands
-But it can also cause inflation if economy is already at full employment

19. 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

20. 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

21. Taxation
Lump Sum Tax : Tax of constant amount or tax yielding same revenue at all levels of GDP
Taxes reduce DI relative to GDP
Decline in DI reduces both Consumption and Savings

22. 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

23. -Note that equal changes in G and Taxes do not have same effect on GDP
20b increase in G increases GDP by 80b
20b increase in Taxes reduced consumption by (20*0.75) and GDP by 60b
Cd + Ig + Xn + G = GDP

24. Leakages, Injections and Unplanned Inventory Changes
Private closed economy: Saving is leakage, I is injection
Open economy: Imports and taxes are added leakages and Government spending and Exports are added injections
At equilibrium leakages should equal injections and no inventory changes
Sd + M + T = Ig + X + G

25. Aggregate Expenditures
Equilibrium Versus Full-Employment GDP
Recessionary Expenditure Gap: Multiplier
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

26. Aggregate Expenditures
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

27. Limitations of the model
1)Does Not Show Price Level Changes: How much will price level rise when AE is more than output
2)Ignores Premature Demand-Pull Inflation that occurs before an economy reaches its full employment
3)Limits Real GDP to the Full-Employment Level of Output
4)Does Not Deal with Cost-Push Inflation
5)Does Not Allow for “Self-Correction”