Chapter 9
Building the Aggregate Expenditures Model
Two of most critical questions in macroeconomics are:
1. What determines the level of GDP given a nation’s production
capacity?
2. What causes real GDP to rise in one period and to fall in another?
To answers these questions, we construct the aggregate expenditures model.
Assumptions:
o Complications arising from government expenditures, taxes, exports,
and imports will be deleted
o Assume all savings consist of personal saving
o Depreciation and net foreign factor is ZERO
o Excess production capacity
o Unemployed labor
o Price level is constant
Implications:
o Aggregate spending initially consist of only consumption and
investment
o Gross domestic production, national income, personal income, and
disposable income are equal
Tools of Aggregate Expenditure Model
o The basic premise of the aggregate expenditures model is that the
amount of goods and services produced and therefore the level of
employment depend directly on the level of aggregate expenditures
o Business will produce only a level of output that they think that they
can profitably sell
o When aggregate expenditures fall, total output and employment
decrease
o When aggregate expenditures rise, total output and employment
increase
o An increase in aggregate expenditures will increase real output and
employment but will not raise the price level
Consumption and Savings
o Savings = Disposable income – Consumption
o Determinants of Consumption
o Income or disposable income
o As DI rises, savings increases
o As DI falls, saving decrease
o Households consume most of their disposable income
o Consumption and savings are directly related to the income
level
o Consumption Schedule
o Reflects the direct consumption –disposable income
relationships suggested by the data
o Households spend a larger proportion of a small disposable
income than a large disposable income
o Savings Schedule
o S = DI – C
o If households consume a smaller and smaller proportion of DI
as DI increase, then they must be saving a larger and larger
proportion
o Households can consume more than their income by liquidating
wealth
o Break-even income is $390. The income level at which
households plan to consume their entire incomes.
Level of Output
And Income
GDP = DI
$
370.00
$
$
$
$
$
$
$
390.00
410.00
430.00
450.00
470.00
490.00
510.00
C
S
$ 375.00 $ (5.00)
$ 390.00 $
$ 405.00 $
5.00
$ 420.00 $ 10.00
$ 435.00 $ 15.00
$ 450.00 $ 20.00
$ 465.00 $ 25.00
$ 480.00 $ 30.00
APC
1.01
1.00
0.99
0.98
0.97
0.96
0.95
0.94
APS
(0.01)
MPC
MPS
0.75
0.25
0.75
0.25
0.75
0.25
0.75
0.25
0.75
0.25
0.75
0.25
0.75
0.25
0.00
0.01
0.02
0.03
0.04
0.05
0.06
$
$
530.00
550.00
$ 495.00 $ 35.00
$ 510.00 $ 40.00
0.93
0.93
0.75
0.25
0.75
0.25
0.75
0.25
0.07
0.07
o At all higher income, households plan to save part of their incomes
Average and Marginal Propensities
Average Propensity to Consume (APC)
o Fraction or percentage of total income that is consumed
o Consumption/income
Average Propensity to Save (APS)
o Fraction of total income that is saved
o Savings/income
Note: APC + APS = 1 Therefore the percentage saved plus percentage
consumed must equal one since DI = C + S
Marginal Propensity to Consume (MPC)
o Change in consumption/change in income
o Slope of the consumption schedule
Marginal Propensity to Save (MPS)
o Change in saving/change in income
o Slope of the savings schedule
Note: MPC + MPS = 1
Nonincome determinants of consumption and savings
o Wealth
o Greater the wealth households have accumulated, the larger is
their collective consumption at any level of current income
o Wealth = real assets + financial assets
o Households save to accumulate wealth
o When some other factor boosts household wealth, households
reduce their saving and increase their spending –
 Wealth effect – shifts the saving schedule downward and
shifts the consumption schedule upward
o Expectations
o Taxation
o Household debt
Investment
o Expenditures on new plants, capital equipment, machinery,
inventories, and so on
o The investment decision is a marginal benefit – marginal cost
decision.
o The marginal benefit from investment is the expected rate of
return businesses hope to realize.
o The marginal cost is the interest rate that must be paid for
borrowing funds
o Expected rate of return
o Investment spending is guided by the profit motive
o Real Interest Rate
o Interest – financial cost of borrowing the money required to
purchase the machinery
o Interest cost = interest rate X amount borrowed
o We invest when the expected rate of return = real interest rate
o Investment Demand curve
o Total demand for investment goods by the entire business
sector
o Inverse relationship between the interest rate and the dollar
quantity of investment demanded conforms with the law of
demand
o Shifts
 Acquisition, maintenance, and operating costs
 Business taxes
 Technological change
 Stock of capital goods on hand
 Expectations
Equilibrium GDP
o Aggregate expenditures
o Consist of consumption plus investment
o Equilibrium output is that output whose production creates total
spending just sufficient to purchase that output
o The equilibrium level of GDP is the level at which the total quantity
of goods produced (GDP) equals the total quantity of goods purchased
(C + I).
Diseqiulibrium GDP
o No level of GDP other than the equilibrium level of GDP can be
sustained
o Levels below, the economy wants to spend at higher levels that the
levels oaf GDP the economy is wiling to produce