9
C HAPTE R
The Aggregate
Expenditures Model
10 - 1
Simplifying Assumptions for the Private
Closed-Economy model
•
•
•
•
•
Assumptions:
We first assume a “closed economy” with no
international trade (no exports or imports).
Government is ignored (no government purchases and
no taxes).
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.
The economy has excess production capacity, so an
increase in AD will raise output and employment, but
not prices.
10 - 2
•
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.
10 - 3
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 (C).
– gross investment (Ig).
10 - 4
Investment Schedule:
• The relationship between investment and GDP
shows the amounts business firms collectively
intend to invest at each possible level of GDP
or DI.
•
In developing the investment schedule, it is
assumed that investment is independent of the
current income.
•
The assumption that investment is independent
of income is a simplification, but it will be used
here.
10 - 5
Investment
Demand
Curve
Investment
Schedule
Investment
(billions of dollars)
Expected rate of return, r, and
real interest rate, i (percents)
INVESTMENT DEMAND & SCHEDULE
Ig
20
8
20
20
ID
20
Investment
(billions of dollars)
10 - 6
Real Domestic Product, GDP
(billions of dollars)
Equilibrium GDP: Expenditures-Output
Approach
• 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.
10 - 7
Equilibrium GDP: Expenditures-Output
Approach
Unplanned change in
inventories
Empl.
C+I
Unpl. Output
Empl. GDP C
S
I (Ag.Exp) Invent. Income
40
370 375 -5 20
395
-25
+
45
390 390 0 20
410
-20
+
50
410 405 5 20
425
-15
+
55
430 420 10 20
440
-10
+
60
450 435 15 20
455
-5
+
65
470 450 20 20
470
0
Equilib.
70
490 465 25 20
485
5
75
510 480 30 20
500
10
80
530 495 35 20
515
15
85
550 510 40 20
530
20
10 - 8
• 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 - 9
Private spending, C + I g (billions of dollars)
EQUILIBRIUM GDP
(C + I g = GDP)
$530
C + Ig
Equilibrium
510
C
490
470
Ig = $20 Billion
450
430
410
C =$450 Billion
390
370
45
o
o
370 390 410 430 450 470 490 510 530 550
Real domestic product, GDP (billions of dollars)
10 - 10
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)
• Unplanned inventory accumulation
10 - 11
Disequilibrium
• Below Equilibrium
Leakage (S) < Injection (I)
• Unplanned inventory depletion
• 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.
10 - 12
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.
1.
If aggregate spending is less than equilibrium GDP, then
businesses will find themselves with unplanned inventory
investment on top of what was already planned.
2.
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.
3.
At equilibrium there are no unplanned changes in inventory.
10 - 13
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 or unintended decline in
inventories.
• 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 planned.
• Only where planned investment and saving are equal there will be
no unintended investment or disinvestment in inventories to drive
the
10
- 14GDP down or up.
Changes in Equilibrium GDP and the Multiplier
•
An initial change in spending (caused by shifts in C and I) will
be acted on by the multiplier to produce larger changes in output.
•
The “initial change” is in planned investment spending. It could
also result from a non-income-induced changes in consumption.
Impact of changes in investment.
•
Suppose investment spending rises by 5 billion (due to a rise in
expected rate of return or to a decline in interest rates).
1. The increase in aggregate expenditures from investment leads to
an increase in equilibrium GDP ( size depends on the multiplier).
2. Conversely, a decline in investment spending leads to a decrease
in equilibrium GDP (size depends on the multiplier).
10 - 15
Private spending (billions of dollars)
CHANGES IN EQUILIBRIUM GDP
AND THE MULTIPLIER
510
Equilibrium GDP
GDP
at Ig1Equilibrium
level of investment
at Ig0 level of investment
(C + Ig )
1
(C + Ig )
490
0
Increases
in the level
of C + Ig
470
450
430
o
45
o
430
450
470
490
510
Real domestic product, GDP (billions of dollars)
10 - 16
Private spending (billions of dollars)
CHANGES IN EQUILIBRIUM GDP
AND THE MULTIPLIER
510
Equilibrium GDP
at Ig2 level of investment
(C + Ig )
0
(C + Ig )
490
2
470
Decreases
in the level
of C + Ig
450
430
o
45
o
430
450
470
490
510
Real domestic product, GDP (billions of dollars)
10 - 17
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.
10 - 18
The net export schedule
• Shows hypothetical amount of net exports that will
occur at each level of GDP. Note that we assume that net
exports are 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.
• 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.
10 - 19
Net Exports, Xn
(billions of dollars)
Private spending (billions of dollars)
INTERNATIONAL TRADE AND
AGGREGATE EXPENDITURES
10 - 20
510
Aggregate Expenditures
with Positive Net Exports
C + Ig + Xn1
C + Ig
490
470
450
430
45 o
o
430
450
470
490
510
Real domestic product, GDP (billions of dollars)
Net exports schedule
+5
0
-5
430
450
470
490
510
Real GDP
Net Exports, Xn
(billions of dollars)
Private spending (billions of dollars)
INTERNATIONAL TRADE AND
AGGREGATE EXPENDITURES
10 - 21
510
Aggregate Expenditures
with Negative Net Exports
C + Ig
C + Ig + Xn2
490
470
450
430
45 o
o
430
450
470
490
510
Real domestic product, GDP (billions of dollars)
Net exports schedule
+5
0
-5
430
450
470
490
510
Real GDP
International economic linkages
Circumstances or policies abroad affect domestic GDP
1. Prosperity abroad: generally raises our exports and transfers
some of their prosperity to us. (Conversely, recession abroad has
the reverse effect.)
2. Tariffs on Kuwaiti products: may reduce our exports and
depress our economy, causing us to retaliate and worsen the
situation.
3. Changes in exchange rates: depreciation or appreciation.
– Depreciation of the KD lowers the cost of Kuwaiti goods to foreigners and
encourages exports from Kuwait, while discouraging the purchase of
imports in Kuwait. This could lead to higher real GDP or to inflation,
depending on the domestic employment situation.
10–- 22 Appreciation
of the KD could have the opposite impact.
GLOBAL PERSPECTIVE
NET EXPORTS OF GOODS, 2001
Negative Net Exports
Positive Net Exports
Canada
France
Germany
Italy
Japan
United Kingdom
United States
-400
-140
-100
-60
-20
0
20
60
Billions of Dollars
10 - 23
Source: World Trade Organization
100
Adding the Public Sector
Simplifying assumptions:
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 that tax collections are independent of GDP level
(i.e., it is a lump-sum tax)
5. The
10 - 24price level is assumed to be constant unless otherwise indicated.
Impact of government spending
1. Increases in government spending boost aggregate
expenditures.
2. Government spending is subject to the multiplier.
Impact of Taxes:
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, and a decrease in tax will
do the opposite.
10 - 25
• At equilibrium GDP, the sum of leakages equals
the sum of injections, i.e.,
Saving + Imports + Taxes = Investment + Exports + Gov’t Purch.
(leakage)
10 - 26
=
(injection)
GDP(DI)
370
390
410
430
450
470
490
510
530
550
570
10 - 27
C
375
390
405
420
435
450
465
480
495
510
525
S
-5
0
5
10
15
20
25
30
35
40
45
I
20
20
20
20
20
20
20
20
20
20
20
X
10
10
10
10
10
10
10
10
10
10
10
M
10
10
10
10
10
10
10
10
10
10
10
G AE(C+I+Xn+G)
20
415
20
430
20
445
20
460
20
475
20
490
20
505
20
520
20
535
20
550
20
565
ADDING THE PUBLIC SECTOR
Aggregate Expenditures (billions of dollars)
Government Purchases and Equilibrium GDP
10 - 28
C + Ig + Xn + G
Government
Spending of
$20 Billion
o
45
C + Ig + Xn
C
o
470
550
Real domestic product, GDP (billions of dollars)
ADDING THE PUBLIC SECTOR
Aggregate Expenditures (billions of dollars)
Lump-Sum Tax and Equilibrium GDP
10 - 29
$15 Billion Decrease
in Consumption from
a $20 Billion Increase
in Taxes
o
45
C + Ig + Xn + G
Ca + Ig + Xn + G
o
490
550
Real domestic product, GDP (billions of dollars)
•
Government purchases and taxes have different
impacts.
•
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. Example, an increase of $20 billion in G and an
offsetting increase of $20 billion in T will increase
equilibrium GDP by $20 billion.
10 - 30
Explanation
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.
c.
The overall result is a rise in initial spending of $20 billion
minus a fall in initial spending of $15 billion (.75 x $20 billion),
which is a net upward shift in aggregate expenditures of $5
billion.
d.
When this is subject to the multiplier effect, which is 4 (MPC
=.75) in this example, the increase in GDP will be equal to $4 ×
$5 billion or $20 billion, which is the size of the change in G.
10 - 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.
10 - 32
• Equilibrium is found when the leakages equal the
injections. 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.
10 - 33
Equilibrium vs. Full-Employment GDP
A recessionary expenditure gap exists when
equilibrium GDP is below full-employment GDP.
•
A recessionary gap is the amount by which aggregate
expenditures fall short of those required to achieve the
full-employment level of GDP, or the amount by
which the schedule would have to shift upward to
realize the full-employment GDP.
•
The effect of the recessionary gap is to pull down the
prices of the economy’s output.
10 - 34
• An inflationary gap exists when aggregate
expenditures exceed full-employment GDP, it
exists when aggregate spending exceeds what is
necessary to achieve full employment.
• The inflationary 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 gap is to pull up the
prices of the economy’s output.
10 - 35
FULL-EMPLOYMENT GDP
Aggregate Expenditures (billions of dollars)
Recessionary Gap
10 - 36
AE0
AE1
530
510
Recessionary Gap
= $5 Billion
490
Full Employment
o
45
o
490
510
530
Real domestic product, GDP (billions of dollars)
FULL-EMPLOYMENT GDP
Aggregate Expenditures (billions of dollars)
Inflationary Gap
10 - 37
530
AE2
AE0
Inflationary Gap
= $5 Billion
510
490
Full Employment
o
45
o
490
510
530
Real domestic product, GDP (billions of dollars)
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.”
10 - 38
• 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.
• 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. The Depression seemed to
refute the classical idea that markets were self-correcting and would provide full
employment.
• 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.
10 - 39