Chapter 8:
The Goods Market
and the Aggregate
Expenditures Model
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
The Historical Development of
Modern Macroeconomics

The Great Depression of the 1930s led to the
development of macroeconomics and
aggregate demand tools to deal with
recessions.

During the Depression, output fell by 30
percent and unemployment rose to 25
percent.
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2
The Historical Development of
Modern Macroeconomics

Keynes is the author of The General Theory
of Employment, Interest and Money, which
provided the new framework for
macroeconomic policy.

Keynes is pronounced “canes”
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3
Classical Economists

The Classical economists' approach was
laissez-faire (leave the market alone).

They believed the market was self-adjusting.

They concentrated on the long run and
largely ignored the short run.
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4
Classical Economics

They used microeconomic supply and
demand arguments to explain the Great
Depression.

Their solution to the high unemployment was
to eliminate labour unions and government
policies that kept wages too high.
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5
The Historical Development of
Modern Macroeconomics

Before the Depression, the prominent
ideology was laissez-faire -- keep the
government out of the economy.

After the Depression, most people believed
government should have a role in regulating
the economy.
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6
The Layperson's Explanation for
Unemployment

Laypeople believed that the depression was
caused by an oversupply of goods that
glutted the market.

They wanted the government to hire the
unemployed even if the work was not
needed.
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7
The Layperson's Explanation for
Unemployment

Classical economists opposed deficit
spending, arguing that the money to create
jobs had to be borrowed.

This money would have financed private
economic activity and jobs, so everything
would cancel out.
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8
The Essence of Keynesian Economics

Keynes thought that the economy could get
stuck in a rut as wages and price level
adjusted to sudden decreases in
expenditures.
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9
The Essence of Keynesian Economics

According to Keynes:
a decrease in spending 
job layoffs 
fall in consumer demand 
firms decrease production 
more job layoffs 
further fall in consumer demand,
and so forth
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10
Equilibrium Income Fluctuates

Income is not fixed at the economy's long-run
potential income – it fluctuates.

For Keynes there was a difference between
equilibrium income and potential income.
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11
Equilibrium Income Fluctuates

Equilibrium income – the level toward which
the economy gravitates in the short run
because of the cumulative cycles of declining
or increasing production.
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12
Equilibrium Income Fluctuates

Potential income – the level of income that
the economy technically is capable of
producing without generating accelerating
inflation.
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13
Equilibrium Income Fluctuates

Keynes felt that at certain times the economy
needed help to reach its potential income.

He believed that market forces would not
work fast enough and would not be strong
enough to get the economy out of a
recession
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14
Equilibrium Income Fluctuates

Because short-run aggregate production
decisions and expenditure decisions were
interdependent, the downward spiral could
start at any time.
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15
The Paradox of Thrift

Incomes would fall as people lost their jobs
causing both consumption and saving to fall
as well.

The economy would reach a new equilibrium
which could be at an almost permanent
recession.
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16
The Paradox of Thrift

Paradox of thrift – an increase in savings
can lead to a decrease in expenditures,
decreasing output and causing a recession.
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17
The Aggregate Expenditures Model

Using a few simplifying assumptions,
economists can construct a model of the
economy.

The Aggregate Expenditures (AE) Model
looks at how real income is determined in an
economy.
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18
The Aggregate Expenditures Model

The AE model assumes that the price level is
fixed, and explores how an initial shift in
expenditures changes equilibrium output.

The AE model quantifies the effect of
changes in aggregate expenditures on
aggregate output.
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19
Aggregate Production

Aggregate production –the total amount of
goods and services produced in every
industry in an economy.

Production creates an equal amount of
income.

Thus, actual production and actual income
are always equal.
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20
Aggregate Production

Graphically, aggregate production in the AE
model is represented by a 45° line through
the origin

At all points on this Aggregate Production
Curve, income equals production.
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21
The Aggregate Production Curve
Real
production
C
A
$4,000
Potential income
45º
0
Aggregate production
(production = income)
$4,000
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Real income
22
Aggregate Expenditures

Aggregate expenditures – the total amount
of spending on final goods and services in
the economy:




Consumption – spending by households.
Investment – spending by business.
Spending by government.
Net foreign spending on Canadian goods – the
difference between Canadian exports and
imports.
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23
Autonomous and Induced
Expenditures

Autonomous expenditures are
expenditures that are independent of income.


Autonomous expenditures change because
something other than income changes.
Induced expenditures – expenditures that
change as income changes.
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24
Autonomous and Induced
Expenditures

Autonomous expenditures is the level of
expenditures that would exist at zero income.

They remain constant at all levels of income.
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25
Autonomous and Induced
Expenditures

Induced expenditures are those that
change as income changes.

When income rises, induced expenditures
rise by less than the change in income.
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26
Expenditures Function

The relationship between expenditures and
income can be expressed more concisely as
an expenditures function.

An expenditures function is a
representation of the relationship between
aggregate expenditures and income.
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27
The Expenditures Function

The relationship between aggregate
expenditures and income can be expressed
mathematically:
AE = AEo + mpcY
AE = aggregate expenditures
AEo = autonomous expenditures
mpc = marginal propensity to consume
Y = income
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28
The Marginal Propensity to Consume

Marginal propensity to consume (mpc) –
the change in consumption that occurs with a
change in income.

The mpc is between 0 and 1 because
individuals tend to save a portion of an
increase in income.
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29
The Marginal Propensity to Consume

The mpc is the fraction spent from an
additional dollar of income.
change in consumption C
mpc 

change in income
Y
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30
The Marginal Propensity to Consume

The marginal propensity to consume
(mpc) is the ratio of a change in consumption
(C) to a change in income ( Y).
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31
Expenditures Function

Autonomous expenditures is the sum of the
autonomous components of expenditures:
AE = C + I + G + X – IM
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32
Graphing the Expenditures Function

The graphical representation of the
expenditures function is called the aggregate
expenditures curve.

The slope of the expenditures function tells
us how much expenditures change with a
particular change in income.
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33
Graphing the Expenditures Function
Aggregate production
AE = 1,000 + 0.8Y
Real expenditures (AE)
$12,200
10,000
AE = 2,000
8,000
Y = 2,500
6,000
5,000
4,000
2,000
1,000
0
AE 2,000

Y
2,500
AE
mpc 
 0.8
Y
slope 
45º
$5,000
$8,750 $11,250$14,000
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Real income
34
Shifts in the Expenditures Function

The aggregate expenditure curve shifts when
autonomous C, I, G, or (X – IM) change.

Autonomous Consumption expenditures
respond to changes in:



interest rates
household wealth
expectations of future conditions
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35
Shifts in the Expenditures Function

Autonomous Investment is the most volatile
component of GDP.

It responds to changes in:




interest rates
capital goods prices
consumer demand conditions
expectations regarding future economic conditions
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36
Shifts in the Expenditures Function

Autonomous exports and imports depend on
foreign and domestic incomes and relative
prices.

Autonomous Government expenditures may
also change as policies change.
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37
Determining the Equilibrium Level of
Aggregate Income

At equilibrium, planned expenditures must
equal production.

Graphically, it is the income level at which AE
equals AP.
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38
Solving for Equilibrium Graphically
Aggregate
production
Real expenditures (AE)
$14,000
Aggregate
expenditures
AE = 1,000 + 0.8Y
12,200
10,000
8,000
E
5,000
2,600
1,000
0
45°
$2,000
AE0 = $1,000
$5,000
$10,000
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$14,000
Real income
39
Solving for Equilibrium Algebraically

In equilibrium, Y = AE.

Substituting in for aggregate expenditures,
we have
Y = AE0 + mpcY
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40
Solving for Equilibrium Algebraically

Now solve for equilibrium income:
Y – mpcY = AE0
Y (1 – mpc) = AE0
Y = [ 1/ (1 – mpc) ] * AE0
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41
The Multiplier Equation

The multiplier equation tells us that income
equals the multiplier times autonomous
expenditures.
Y = Multiplier X Autonomous expenditures
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42
The Multiplier Equation

The multiplier process amplifies changes in
autonomous expenditures.

What forces are operating to ensure that the
income level we determined is actually the
equilibrium income level?
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43
The Multiplier Process

When aggregate production do not equal
aggregate expenditures:
Businesses change production levels,
which changes income,
which changes expenditures,
which changes production,
which changes income,

which changes . . . etc.
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44
The Multiplier Process

The process ends when aggregate
production equals aggregate expenditures.

Firms are selling all they produce, so they
have no reason to change their production
levels.
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45
The Multiplier Process
Real expenditures (AE)
C, I, G,
(X – IM)
A1 Aggregate
production
Aggregate
A2 expenditures
AE = 1,000 + 0.8Y
$14,000
$13,200
10,000
C
B1
6,000
B2
2,000
0
45°
$2,000
$5,000
$10,000
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$14,000
Real income
46
The Circular Flow Model and the
Multiplier Process

The circular flow model provides the intuition
behind the multiplier process.

The flow of expenditures equals the flow of
income.
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47
The Circular Flow Model and the
Multiplier Process

Expenditures are injections into the circular
flow.

The mpc measures the percentage of
expenditures that get injected back into the
economy each round of the circular flow.

But there are withdrawals.
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48
The Circular Flow Model and the
Multiplier Process

Economists use the term the marginal
propensity of save (mps) to represent the
percentage of income flow that is withdrawn
from the economy for each round of the
circular flow.
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49
The Circular Flow Model and the
Multiplier Process

By definition:
mpc + mps = 1

Alternatively expressed:
mps = 1 - mpc
multiplier = 1/mps
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50
The Circular Flow Model and the
Multiplier Process
Aggregate income
Households
Firms
Aggregate expenditures
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51
The AE Model in Action

The AE model illustrates how a change in
autonomous expenditures changes the
equilibrium level of income.
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52
The Multiplier Model in Action

Autonomous expenditures are determined
outside the model and are not affected by
changes in income.

When autonomous expenditures shift, the
multiplier process is called into play.
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53
The Steps of the Multiplier Process

The income adjustment process is directly
related to the multiplier.

Any initial shock (a change in autonomous
AE) is multiplied in the adjustment process.
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54
The Steps of the Multiplier Process

The multiplier process repeats and repeats
until a new equilibrium level is finally reached.
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55
Shifts in the Aggregate Expenditure
Curve
C, I
Aggregate production
$4,200
E0
4,160
20
AE0 = 832 + .8Y
AE1 = 812 + .8Y
832
812
0
$20
12.8
20
D AEA = $20
D AEA = $16
D AEA = $12.8
$16
4,100
4,060
E0
E1
$100
$4,060
E1
$4,160 Real income
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100
56
First Five Steps of Four Multipliers
mpc = 0.5
mpc = 0.75
100
100
75
56.25
50
42.19
31.64
25
12.5 6.25
Multiplier = 1/(1-0.5) = 2
Multiplier = 1/(1-0.75) = 4
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57
First Five Steps of Four Multipliers
mpc = 0.8
mpc = 0.9
100
100
80
64
90
81
72.9
65.61
51.2
40.96
Multiplier = 1/(1-0.8) = 5
Multiplier = 1/(1-0.9) = 10
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58
Examples of the Effect of Shifts in
Aggregate Expenditures

There are many reasons for shifts in
autonomous expenditures:




Natural disasters.
Changes in investment caused by technological
developments.
Shifts in government expenditures.
Large changes in the exchange rate.
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59
The Effect of Shifts in Aggregate
Expenditures

An understanding of these shifts can be
enhanced by tying them to the formula:
AE = C + I + G + X - IM
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60
Upward Shift of AE
Real
expenditures
$4,210
Aggregate production
AE1
30
AE0
Y 
4,090
1,052.5
 4 AE0   120
30
1,022.5
0
1
AE0 
1 - 0.75
$120
$4,090
$4,210
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Real income
61
Downward Shift of AE
Real
expenditures
$4,152
Aggregate production
AE0
30 AE1
Y 
4,062
1,412
 3 AE0   90
30
1,382
0
1
AE0 
1 - 0.66
$90
$4,062
$4,152
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Real income
62
Real World Examples

Canada in 2000.

Japan in the 1990s.

The 1930s depression.
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63
Canada in 2000

Consumer confidence rose substantially
causing autonomous consumption
expenditures to increase more than
economists had predicted.

While economists had expected the economy
to grow slowly, it boomed.
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64
Japan in the 1990s

Aggregate income and production fell during
the 1990s.



A dramatic rise in the yen cut Japanese exports.
Autonomous consumption decreased as
consumers’ confidence fell
Suppliers responded by laying off workers and
cutting production.
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65
The 1930s Depression

The 1929 stock market crash, which
continued into 1930, threw the financial
markets into chaos.

This resulted in a downward shift of the AE
curve.
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66
The 1930s Depression

Frightened business people decreased
investment and laid off workers.

Frightened consumers decreased
autonomous consumption and increased
savings, thereby increasing withdrawals from
the system.

Governments cut spending to balance their
budgets, as tax revenue declined.
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67
The 1930s Depression

Business people responded by decreasing
output, which decreased income, starting a
downward cycle, thereby confirming the
fears of the businesspeople.

The process continued until the economy
settled at a low-level equilibrium, far below
the potential level of income.
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68
The 1930s Depression

The process caused the paradox of thrift,
whereby individuals attempting to save more,
spent less, and caused income to decrease.

They ended up saving not more, but less.
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69
AE Model Is Not a Complete Model

The AE model determines income given
autonomous expenditures.

These autonomous expenditures, however,
are determined by economic variables which
are not in our simple model.
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70
AE Model Is Not a Complete Model

The AE model uses aggregate expenditures
to determine equilibrium income.

It does not explain production.

It assumes firms can supply the output
demanded.
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71
Model of Aggregate Demand

Shifts may be simultaneous shifts in supply
and demand that do not necessarily reflect
suppliers responding to changes in demand.

Expansion of this line of thought has led to
the real business cycle theory of the
economy.
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72
Model of Aggregate Demand

Real business cycle theory of the
economy – changes in aggregate supply are
the principle way for real income to change.
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Prices are Fixed

The multiplier model assumes that the price
level is fixed.

The price level can change in response to
changes in aggregate demand.
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74
Does Not Include Expectations

People's forward-looking expectations make
the adjustment process much more
complicated.

Most people, however, act upon their
expectations of the future.

Business people may not automatically cut
back production and lay-off workers if they
think a fall in sales is temporary.
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75
Forward-Looking Expectations
Complicate the Adjustment Process

Rational expectations model – captures the
effect expectations have on individuals’
behaviour.

Expectations can be self-fulfilling.
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76
Consumption Behaviour

People may base their spending on lifetime
income, not yearly income.

Permanent income hypothesis -- the
hypothesis that expenditures are determined
by permanent or lifetime income.
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77
Expanded AE Model

We can increase the power of our AE model
by adding more detail.

For example, adding taxes to the model



Changes consumption expenditures.
Introduces government budget deficits and
surpluses.
Changes the multiplier.
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78
Budget Surplus Function
Budget Surplus
T-G
0
Income
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Expanded AE Model

Adding income-induced imports

Changes import spending.

Changes net exports,


and introduces trade surpluses and deficits.
Changes the multiplier.
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80
Expanded AE Model

The marginal propensity to import (mpi) gives
the increase in import spending from an
additional $1 of disposable income.


Disposable = after-tax
Mpi lies between 0 and 1
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81
The Goods Market and the
Aggregate Expenditures Model
End of Chapter 8
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82