1. The Aggregate Expenditures Model28
The Aggregate Expenditures Model
The chapter begins with the simple version of the AE model: that of a closed, private economy. The equilibrium GDP is determined and multiplier effects are briefly reviewed. The simplified “closed” economy is then “opened” to show how it would be affected by exports and imports. Government spending and taxes are brought into the model to include the “public” aspects of the system. The price level is assumed constant in this chapter unless stated otherwise, so the focus is on real GDP.
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. The Aggregate Expenditures Model
Learning objectives – After reading this chapter, students should be able to:
1.Illustrate how economists combine consumption and investment to depict an aggregate expenditures schedule for a private closed economy.
2.Discuss 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.Analyze how changes in equilibrium real GDP can occur in the aggregate expenditures model and describe how those changes relate to the multiplier.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-2

3. The Aggregate Expenditures Model
4.Explain how economists integrate the public sector (government expenditures and taxes) and the international sector (exports and imports) into the aggregate expenditures model.
5.Identify and describe the nature and causes of “recessionary expenditure gaps” and “inflationary expenditure gaps.”
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-3

4. The Aggregate Expenditures Model
Assumptions and Simplifications
Keynes developed the aggregate expenditures model during the Great Depression because previous economic theory predicted that prices would fall to boost spending and move the economy to full-employment.
Prices did not fall sufficiently during the Great Depression.
Keynes’ model is based on fixed prices and the adjustment of employment and GDP to economic shocks when prices are inflexible.
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-4

5. The Aggregate Expenditures Model
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-5

6. The Aggregate Expenditures Model
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.
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-6

7. The Aggregate Expenditures Model
In developing the investment schedule, it is assumed that investment is independent of the current income. The line Ig (gross investment) in Figure 31.1b shows this graphically related to the level determined by Figure 31.1a.
The assumption that investment is independent of income is a simplification, but will be used here.
Figure 31.1a shows the investment schedule from GDP levels given in Table 30.1.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-7

8. The Aggregate Expenditures Model
Investment Demand Curve
Investment Schedule
Investment
demand
curve
Investment
schedule 20 Ig
r and i (percent)
Investment (billions of dollars) 8 20 20 ID
Figure 28.1 reflects (a) the investment demand curve and (b) the investment schedule. (a) The level of investment spending (here, $20 billion) is determined by the real interest rate (here, 8 percent) together with the investment demand curve, ID. (b) The investment schedule, Ig, relates the amount of investment ($20 billion) determined in (a) to the various levels of GDP. 20
Investment
(billions of dollars)
(a)
Investment demand curve
Real domestic product, GDP
(billions of dollars)
(b)
Investment schedule
28-8

9. The Aggregate Expenditures Model
IV. Equilibrium GDP: C+Ig = GDP
Look at Table 31.2, which combines data of Tables 30.1 and 31.1.
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-9

10. Equilibrium GDP
Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy
(1)
Possible Levels of Employment, Millions
(2)
Real Domestic Output (and Income) (GDP = DI),*Billions
(3)
Consumption (C),
Billions
(4)
Saving (S),
(5)
Investment (Ig),
(6)
Aggregate Expenditure (C+Ig),
(7)
Unplanned Changes in Inventories, (+ or -)
(8)
Tendency of Employment, Output, and Income
(1) 40
$370
$375
$-5
$20
$395
$-25
Increase
(2) 45
390 20
410
-20
(3) 50
405 5
425
-15
(4) 55
430
420 10
440
-10
(5) 60
450
435 15
455 -5
(6) 65
470
Equilibrium
(7) 70
490
465 25
485 +5
Decrease
(8) 75
510
480 30
500
+10
(9) 80
530
495 35
515
+15
(10) 85
550 40
+20
* If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP
This table shows equilibrium GDP using the expenditures-output approach for a private, closed economy. It combines consumption and savings data from Tables 27.1 and the investment schedule 28.1.
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) at each output level. Recall that the consumption level is directly related to the level of income and that here income is equal to output. Investment is independent of income 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. In Table 28.2, 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 the $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. No level of GDP other than the equilibrium level of GDP can be sustained.
28-10

11. Equilibrium GDP (C + Ig = GDP) Equilibrium point Aggregate
530
510
490
470
450
430
410
390
370
45°
Real domestic product, GDP (billions of dollars)
Aggregate expenditures, C + Ig (billions of dollars)
C + Ig
(C + Ig = GDP) C
Equilibrium
point
Aggregate
expenditures
Ig = $20 billion
This figure graphically illustrates equilibrium GDP in a private closed economy. The aggregate expenditures schedule, C + Ig, is determined by adding the investment schedule, Ig, to the upsloping consumption schedule, C. Since investment is assumed to be the same at each level of GDP, the vertical distances between C and C + Ig do not change. Equilibrium GDP is determined where the aggregate expenditures schedule intersects the 45° line, in this case at $470 billion.
C = $450 billion
28-11

12. The Aggregate Expenditures Model
Recall that consumption level is directly related to the level of income and that here income is equal to output level.
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.
1. In Table 31.2, this occurs only at $470 billion.
2. 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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-12

13. The Aggregate Expenditures Model
3. 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.
Graphical analysis is shown in Figure 31.2 (Key Graph). At $470 billion it shows the C + Ig schedule intersecting the 45-degree line which is where output = aggregate expenditures, or the equilibrium position.
1. Observe that the aggregate expenditures line rises with output and income, but not as much as income, due to the marginal propensity to consume (the slope) being less than 1. A part of every increase in disposable income will not be spent but will be saved.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-13

14. The Aggregate Expenditures Model
Other Features of Equilibrium GDP
Savings equals planned investment.
It is important to note that in our analysis above we spoke of “planned” investment. At GDP = $470 billion in Table 31.2, both saving and planned investment are $20 billion.
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-14

15. The Aggregate Expenditures Model
If aggregate spending is less than equilibrium GDP as it is in Table 31.2, line 8 when GDP is $510 billion, then businesses will find themselves with unplanned inventory investment on top of what was already planned. This 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 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. For example, at $450 billion GDP, there will be $435 billion of consumer spending, $20 billion of planned investment, so businesses must have experienced a $5 billion unplanned decline in inventory because sales exceed that expected.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-15

16. The Aggregate Expenditures Model
No unplanned changes in inventories.
Consider row 7 of Table 31.2 where GDP is $490 billion, here C + Ig is only $485 billion and will be less than output by $5 billion. Firms retain the extra $5 billion as unplanned inventory investment. Actual investment is $25 billion, or $5 billion more than the $20 billion planned. So $490 billion is an above-equilibrium output level.
Consider row 5, Table Here $450 billion is a below-equilibrium output level because actual investment will be $5 billion less than planned. Inventories decline below what was planned. GDP will rise to $470 billion.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-16

17. The Aggregate Expenditures Model
Changes in Equilibrium GDP and the Multiplier
As developed in Chapter 30, an initial change in spending will be acted on by the multiplier to produce larger changes in output.
1. The “initial change” represented in the text and Figure 31.3 is in planned investment spending. It could also result from a nonincome-induced change in consumption.
2. The multiplier in Figure 31.3 is 4 (=1/MPS)
Figure 31.3 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).
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-17

18. The Aggregate Expenditures Model
Figure 31.3 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.
Conversely, a decline in investment spending of $5 billion is shown to create a decrease in equilibrium GDP of $20 billion to $450 billion.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-18

19. Changes in Equilibrium GDP
510
490
470
450
430
45°
Real domestic product, GDP (billions of dollars)
Aggregate expenditures (billions of dollars)
(C + Ig)1
(C + Ig)0
(C + Ig)2
Increase in
investment
Decrease in
investment
Figure 28.3 demonstrates changes in the aggregate expenditure schedule and the multiplier effect. An upward shift of the aggregate expenditure schedule from (C + Ig)0 to (C + Ig)1 will increase the equilibrium GDP. Conversely, a downward shift from (C + Ig)0 to (C + Ig)2 will lower the equilibrium GDP. The extent of the changes in equilibrium GDP will depend on the size of the multiplier, which, in this case, is 4 (=20/5). The multiplier is equal to 1/MPS (here, 4 = 1/.25).
28-19

20. The Aggregate Expenditures Model
International Trade and Equilibrium Output
A. Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand and imports contract aggregate spending on domestic output.
Exports (X) create domestic production, income, and employment due to foreign spending on U.S. produced goods and services.
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 U.S. produced goods and services.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-20

21. The Aggregate Expenditures Model
The net export schedule (Table 31.3):
Shows hypothetical amount of net exports (X - M) that will occur at each level of GDP given in Table 31.2.
Assumes that net exports are autonomous or independent of the current GDP level.
Figure 31.4b shows Table 31.3 graphically.
a. Xn1 shows a positive $5 billion in net exports.
b. Xn2 shows a negative $5 billion in net exports.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-21

22. The Net Export Schedule
Two Net Export Schedules (in Billions)
(1)
Level of GDP
(2)
Net Exports,
Xn1 (X > M)
(3)
Xn2 (X < M)
$370
$+5
$-5
390 +5 -5
410
430
450
470
490
510
530
550
In this table, column Xn1 shows that exports exceed imports by $5 billion at each level of GDP. Column Xn2 shows imports exceed exports by $5 billion at each level of GDP. Since the net exports are constant at all GDP levels, we are assuming that net exports are independent of GDP.
This data will be represented graphically in the figure on the next slide.
28-22

23. Net Exports and Equilibrium GDP
Real domestic product 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
This figure illustrates the impact of net exports and equilibrium GDP. Positive net exports, such as that shown by the net export schedule Xn1 in (b), elevate the aggregate expenditures schedule in (a) from the closed-economy level of C + Ig to the open-economy level of C + Ig + Xn1. Negative net exports, such as that depicted by the net export schedule Xn2 in (b), lower the aggregate expenditures schedule in (a) from the closed-economy level of C + Ig to the open-economy level of C + Ig + Xn2.
Real
GDP +5 -5
Net exports, Xn
(billions of
dollars)
Positive net exports
Xn1
450
470
490
Xn2
Negative net exports
28-23

24. The Aggregate Expenditures Model
The impact of net exports on equilibrium GDP is illustrated in Figure 31.4a.
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 31.4a 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 31.2 and Figure 31.3.
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 31.4a 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).
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-24

25. The Aggregate Expenditures Model
Global Perspective 31.1 shows 2008 net exports for various nations.
International economic linkages:
1. Prosperity abroad generally raises our exports and transfers some of their prosperity to us. (Conversely, recession abroad has the reverse effect.)
2. Depreciation of a nation’s currency unit lowers the cost of that nation’s goods to foreigners and encourages exports from the nation while discouraging the purchase of imports in the nation. This could lead to higher real GDP or to inflation, depending on the domestic employment situation. Appreciation of a nation’s currency unit could have the opposite impact.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-25

26. The Aggregate Expenditures Model
Nations must be cautious when using tariffs and devaluations in an effort to increase their net exports and therefore their domestic employment and output. When other nations’ exports are restricted, they may retaliate, reducing exports and actually causing net exports to fall. This happened during the U.S. Great Depression.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-26

27. Global Perspective
This Global Perspective shows the net exports of goods for selected nations in 2008.
Source: WTO publication Used with permission of World Trade Organization,
Source: World Trade Organization,
28-27

28. The Aggregate Expenditures Model
Adding the Public Sector
A. Simplifying assumptions are helpful for clarity when we include the government sector in our analysis. (Many of these simplifications are dropped in Chapter 33, where there is further analysis on the government sector.)
Simplified the investment and net export schedules that are used. We assume they are independent of the level of current GDP.
We assume government purchases do not impact private spending schedules.
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-28

29. The Aggregate Expenditures Model
We assume tax collections are independent of GDP level (a lump-sum tax)
The price level is assumed to be constant unless otherwise indicated.
Table 31.4 gives a tabular example of including $20 billion in government spending and Figure 31.5 gives the graphical illustration. Note that the previous section’s net export information has also been included.
Increases in government spending boost aggregate expenditures.
Government spending is subject to the multiplier.
Table 31.5 and Figure 31.6 show the impact of a tax increase.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-29

30. Government Purchases and Eq. GDP
The Impact of Government Purchases on Equilibrium GDP
(1)
Real Domestic Output and Income
(GDP=DI), Billions
(2)
Consumption (C),
Billions
(3)
Saving (S),
(4)
Investment (Ig),
(5)
Net Exports
(Xn), Billions
(6)
Government Purchases
(G), Billions
(7)
Aggregate Expenditures (C+Ig+Xn+G),
(2)+(4)+(5)+(6)
Exports
(X)
Imports
(M)
(1) $370
$375
$-5
$20
$10
$415
(2) 390
390 20 10
430
(3) 410
405 5
445
(4) 430
420
460
(5) 450
435 15
475
(6) 470
450
490
(7) 490
465 25
505
(8) 510
480 30
520
(9) 530
495 35
535
(10) 550
510 40
550
This table shows the impact of government purchases on equilibrium GDP. Before adding government purchases, equilibrium GDP had been at $470. Now with government purchases, equilibrium GDP rises to $550, implying a multiplier effect since the rise in GDP is greater than the $20 billion in additional aggregate expenditures.
28-30

31. Government Purchases and Eq. GDP
45°
Real domestic product, GDP (billions of dollars)
Aggregate expenditures (billions of dollars)
C + Ig + Xn + G
C + Ig + Xn C
Government spending
of $20 billion
Figure 28.5 illustrates the impact of government spending on equilibrium GDP. The addition of government expenditures, G, to our analysis raises the aggregate expenditures (C + Ig + Xn + G) schedule and increases the equilibrium level of GDP, as would an increase in C, Ig, or Xn. The multiplier is again 4 (80/20).
28-31

32. The Aggregate Expenditures Model
Taxes reduce DI and, therefore, consumption and saving at each level of GDP.
An increase in taxes will lower the aggregate expenditures schedule relative to the 45-degree line and reduce the equilibrium GDP.
Table 31.5 confirms that, at equilibrium GDP, the sum of leakages equals the sum of injections. Saving + Imports + Taxes = Investment + Exports + Government Purchases.
Government purchases and taxes have different impacts.
In our example, equal additions in government spending and taxation increase the equilibrium GDP.
If G and T are each increased by a particular amount, the equilibrium level of real output will rise by that same amount.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-32

33. The Aggregate Expenditures Model
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).
An increase in G is direct and adds $20 billion to aggregate expenditures.
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.
The overall result is a rise in initial spending of $20 billion minus a fall in initial spending of $15 billion (.75 ¥ $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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-33

34. Taxation and Equilibrium GDP
Determination of the Equilibrium Levels of Employment, Output, and Income: Private and Public Sectors
(1)
Real Domestic Output and Income
(GDP=DI), Billions
(2)
Taxes
(T),
Billions
(3)
Disposable Income (DI), Billions, (1)-(2)
(4)
Consump-tion (C),
(5)
Saving (S),
(6)
Invest-ment (Ig),
(7)
Net Exports
(Xn), Billions
(8)
Govern-ment Pur-chases
(G), Billions
(9)
Aggregate Expendi-tures (C+Ig+Xn
+G),
(4)+(6)+(7)+(8)
Exports
(X)
Imports
(M)
(1) $370
$20
$350
$360
$-10
$10
$400
(2) 390 20
370
375 -5 10
415
(3) 410
390
430
(4) 430
410
405 5
445
(5) 450
420
460
(6) 470
450
435 15
475
(7) 490
470
490
(8) 510
465 25
505
(9) 530
510
480 30
520
(10) 550
530
495 35
535
This table shows the determination of the equilibrium levels of employment, output, and income with the private sector and taxes. With taxes of $20 billion at all levels of GDP, equilibrium GDP falls from $550 to $490. Again, we can see that there is a multiplier effect. The multiplier = 60/15 = 4.
28-34

35. Taxation and Equilibrium GDP
45°
Real domestic product, GDP (billions of dollars)
Aggregate expenditures (billions of dollars)
C + Ig + Xn + G
Ca + Ig + Xn + G
$15 billion
decrease in
consumption
from a
$20 billion
increase
in taxes
Figure 28.6 reflects the impact of taxes on equilibrium GDP. If the MPC is .75, the $20 billion of taxes will lower the consumption schedule by $15 (20 x .75) billion and cause a $60 billion decline in the equilibrium GDP. In the open economy with government, equilibrium GDP occurs where Ca (after-tax income) + Ig + Xn + G = GDP. Here, that equilibrium is $490 billion.
28-35

36. The Aggregate Expenditures Model
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.
Imports and taxes are added leakages.
Exports and government purchases are added injections.
Equilibrium is found when the leakages equal the injections.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-36

37. The Aggregate Expenditures Model
When leakages equal injections, there are no unplanned changes in inventories.
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-37

38. The Aggregate Expenditures Model
Equilibrium vs. Full-Employment GDP
A recessionary expenditure gap exists when equilibrium GDP is below full-employment GDP. (See Key Graph 31.7a)
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 31.5, 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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-38

39. The Aggregate Expenditures Model
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.
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.
An inflationary expenditure gap exists when aggregate expenditures exceed full-employment GDP.
Figure 31.7b shows that a demand-pull inflationary expenditure gap of $5 billion exists when aggregate spending exceeds what is necessary to achieve full employment.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-39

40. The Aggregate Expenditures Model
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.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-40

41. Equilibrium versus Full-Employment
Real GDP
(a)
Recessionary expenditure gap
Aggregate expenditures
(billions of dollars)
530
510
490
45°
AE0
AE1
Recessionary
expenditure
gap = $5 billion
This graph shows the recessionary expenditure gap. The equilibrium and full-employment GDPs may not coincide. A recessionary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP fall short of those needed to achieve the full-employment GDP. Here, the $5 billion recessionary expenditure gap causes a $20 billion negative GDP gap.
See the next slide for the graph of the inflationary expenditure gap.
Full
employment
LO5

42. Equilibrium versus Full-Employment
Real GDP
(b)
(billions of dollars)
Aggregate expenditures
530
510
490
45°
AE2
Inflationary
expenditure
gap = $5 billion
AE0
This graph shows the inflationary expenditure gap. The equilibrium and full-employment GDPs may not coincide. An inflationary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP exceed those just sufficient to achieve the full-employment GDP. Here, the inflationary expenditure gap is $5 billion; this overspending produces demand-pull inflation.
Full
employment
LO5

43. The Aggregate Expenditures Model
Application: The Recession of 2007 – 2009
The U.S. economy entered a recession in December 2007
After-tax consumption and planned investment both decreased with a much greater fall in investment.
Aggregate expenditures decreased (shifted down), creating the largest recessionary expenditures gap since the Great Depression.
Unemployment rate increased to more than 10%.
The U.S. government adopted Keynesian policies in 2008 and 2009.
In 2008 the U.S. Federal government provided $100 billion in tax rebate checks, hoping to increase consumption and aggregate expenditures, but most people paid off their debt and there was not any increase in aggregate expenditures.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-43

44. The Aggregate Expenditures Model
In 2009 the U.S. Federal government passed a $787 billion stimulus package with large increases in government spending to try to increase aggregate expenditures, increase GDP and increase employment.
Greater evaluation of these policies will take place in Chapter 33.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-44

45. The Aggregate Expenditures Model
LAST WORD: Say’s Law, The Great Depression, and Keynes
Until the Great Depression of the 1930, most economists going back to Adam Smith had believed that a market system would ensure full employment of the economy’s resources except for temporary, short-term upheavals.
If there were deviations, they would be self-correcting. A slump in output and employment would reduce prices, which would increase consumer spending; would lower wages, which would increase employment again; and would lower interest rates, which would expand investment spending.
Say’s law, attributed to the French economist J. B. Say in the early 1800s, summarized the view in a few words: “Supply creates its own demand.”
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-45

46. The Aggregate Expenditures Model
Say’s law is easiest to understand in terms of barter. The woodworker produces furniture in order to trade for other needed products and services. All the products would be traded for something, or else there would be no need to make them. Thus, supply creates its own demand.
Reformulated versions of these classical views are still prevalent among some modern economists today.
The Great Depression of the 1930s was worldwide. GDP fell by 40 percent in U.S. and the unemployment rate rose to nearly 25 percent (when most families had only one breadwinner). The Depression seemed to refute the classical idea that markets were self-correcting and would provide full employment.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-46

47. The Aggregate Expenditures Model
John Maynard Keynes in 1936 in his General Theory of Employment, Interest, and Money, provided an alternative to classical theory, which helped explain periods of recession.
Not all income is always spent, contrary to Say’s law.
Producers may respond to unsold inventories by reducing output rather than cutting prices.
A recession or depression could follow this decline in employment and incomes.
The modern aggregate expenditures model is based on Keynesian economics or the ideas that have arisen from Keynes and his followers since. It is based on the idea that saving and investment decisions may not be coordinated, and prices and wages are not very flexible downward. Internal market forces can therefore cause depressions and government should play an active role in stabilizing the economy.
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-47

48. The Aggregate Expenditures Model
Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
28-48
LO1