PowerPoint Presentation by Mehdi Arzandeh, University of Manitoba The Aggregate Expenditures Model 11 LEARNING OBJECTIVES LO11.1 LO11.2 LO11.3 LO11.4 LO11.5 LO11.6 LO11.7 LO11.8 Explain how sticky prices relate to the aggregate expenditures model. Explain how an economy’s investment schedule is derived from the investment demand curve and an interest rate. Illustrate how economists combine consumption and investment to depict an aggregate expenditures schedule and equilibrium output for a private closed economy. Discuss the two other ways to characterize the equilibrium level of real GDP in a private closed economy: (1) saving = investment and (2) unplanned changes in inventories. Analyze how changes in equilibrium GDP can occur in the aggregate expenditures model and how those changes relate to the multiplier. Explain how economists integrate the international sector (exports and imports) into the aggregate expenditures model. Explain how economists integrate the public sector (government expenditures and taxes) into the aggregate expenditures model. Differentiate between equilibrium GDP and full-employment GDP, and identify and describe the nature and causes of recessionary expenditure gaps and inflationary expenditure gaps. © 2016 McGraw‐Hill Education Limited 11-2 11.1 The Aggregate Expenditures Model: Consumption and Saving Assumptions and Simplifications • Use the Keynesian aggregate expenditures model • Prices are fixed • GDP = DI • Begin with private, closed economy • Consumption spending • Investment spending LO1 © 2016 McGraw‐Hill Education Limited 11-3 The Investment Demand Curve and the Investment Schedule FIGURE 11-1 Investment demand curve 8 20 ID Investment Schedule Investment (billions of dollars) r and i (percent) Investment Demand Curve Investment schedule Ig 20 20 20 Investment (billions of dollars) (a) Investment demand curve LO2 © 2016 McGraw‐Hill Education Limited Real domestic product, GDP (billions of dollars) (b) Investment schedule 11-4 TABLE 11-1 LO2 The Investment Schedule (in billions) (1) Level of real output and income (2) Investment (Ig) $370 $20 390 20 410 20 430 20 450 20 470 20 490 20 510 20 530 20 550 20 © 2016 McGraw‐Hill Education Limited 11-5 TABLE 11-2 Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy (2) Real Domestic Output (and Income) (GDP =DI) (billions) (3) Consumption (C) (billions) (4) Saving (S) (billions) (1) 2.5 $370 $375 (2) 5.0 390 (3) 7.5 (1) Possible Levels of Employment (millions) (5) Investment (Ig) (billions) (6) Aggregate Expenditure (C + Ig) (billions) (7) Unplanned Changes in Inventories (+) or (-) (8) Tendency of Employment, Output, and Income $-5 $20 $395 $-25 Increase 390 0 20 410 -20 Increase 410 405 5 20 425 -15 Increase (4) 10.0 430 420 10 20 440 -10 Increase (5) 12.5 450 435 15 20 455 -5 Increase (6) 15.0 470 450 20 20 470 0 Equilibrium (7) 17.5 490 465 25 20 485 +5 Decrease (8) 20.0 510 480 30 20 500 +10 Decrease (9) 22.5 530 495 35 20 515 +15 Decrease (10) 25.0 550 510 40 20 530 +20 Decrease * If depreciation and net foreign that all9.1 saving occurs in the household sector of the ©2013 McGraw-Hill Ryerson Ltd. factor income are zero, government is ignored and it is assumed Chapter economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP LO3 © 2016 McGraw‐Hill Education Limited 6 11-6 KEY GRAPH - Equilibrium GDP in a Private Closed Economy FIGURE 11-2 530 C + Ig Aggregate expenditures, C + Ig (billions of dollars) 510 (C + Ig = GDP) 490 470 450 C Equilibrium point Aggregate expenditures Ig = $20 billion 430 410 390 C = $450 billion 370 45° 370 390 410 430 450 470 490 510 530 550 Real domestic product, GDP (billions of dollars) LO3 © 2016 McGraw‐Hill Education Limited 11-7 11.4 Other Features of Equilibrium GDP SAVING EQUALS PLANNED INVESTMENT • saving represents a leakage of spending • investment can be thought of as an injection of spending NO UNPLANNED CHANGES IN INVENTORIES • unplanned increases in inventories result when firms produce above-equilibrium GDP output level • unplanned decreases in inventories result when firms produce below-equilibrium GDP output level LO4 © 2016 McGraw‐Hill Education Limited 11-8 11.5 Changes in Equilibrium GDP and the Multiplier • In the private closed economy, the equilibrium GDP will change in response to changes in either the investment schedule or the consumption schedule • Because changes in the investment schedule usually are the main source of fluctuations, we direct our attention to them… LO5 © 2016 McGraw‐Hill Education Limited 11-9 Aggregate expenditures (billions of dollars) FIGURE 11-3 Changes in the Aggregate Expenditure Schedule and the Multiplier Effect (C + Ig)1 (C + Ig)0 (C + Ig)2 510 490 Increase in investment Decrease in investment 470 450 430 45° 430 450 470 490 510 Real domestic product, GDP (billions of dollars) LO5 © 2016 McGraw‐Hill Education Limited 11-10 Adding International 11.6 Trade Net Exports and Aggregate Expenditures • Exports (X) create domestic production, income and employment • Imports (M) represent goods and services produced abroad • In an open economy, aggregate spending is C+ Ig + Xn, where Xn = (X - M) • Xn can be either positive or negative LO6 © 2016 McGraw‐Hill Education Limited 11-11 Adding International 11.6 Trade Determinants of Net Export • If GDP in other countries is growing, demand for our exports will increase • Our imports are dependent on our own GDP • Both imports and exports are affected by the exchange rate • depreciation • appreciation LO6 © 2016 McGraw‐Hill Education Limited 11-12 TABLE 11-3 LO6 Net Export Schedule (1) Domestic output (GDP = DI) (billions) (2) Exports (X) (billions) (3) Imports (M) (billions) (4) Net Exports (Xn ) (2)- (3) (billions) $370 $40 $15 $+25 390 40 20 +20 (20-15)/(390-370) = 0.25 410 40 25 +15 0.25 430 40 30 +10 0.25 450 40 35 +5 0.25 470 40 40 0 0.25 490 40 45 -5 0.25 510 40 50 -10 0.25 530 40 55 -15 0.25 550 40 60 -20 0.25 © 2016 McGraw‐Hill Education Limited (5) Marginal propensity to import (MPM) Δ(3)/Δ(1) 11-13 Adding International 11.6 Trade Imports and the Multiplier • Marginal Propensity to Import (MPM) • MPM = ΔM (import) / ΔGDP • MPM is the slope of net export schedule • Open Economy Multiplier • • • • The closed economy the multiplier is 1/MPS Expenditure on imports is a leakage Open economy multiplier = 1/ (MPS + MPM) From the data of Table 11-3: • Multiplier = 1/(0.25+0.25) = 2 LO6 © 2016 McGraw‐Hill Education Limited 11-14 TABLE 11-4 LO6 Determinants of the Equilibrium Levels of Output and Income in an Open Economy (Without Government) (1) Domestic Output (and Income) (GDP = DI), (billions) (2) Aggregate Expenditures for private economy (no G) (C+Ig), (billions) (4) Imports (M) (billions) (5) Net Exports, Xn (3)- (4) (billions) (6) Aggregate Expenditures for open economy (no G) (C+Ig+Xn), (billions) (3) Exports (X) (billions) $370 $395 $40 $15 $+25 $420 390 410 40 20 +20 430 410 425 40 25 +15 440 430 440 40 30 +10 450 450 455 40 35 +5 460 470 470 40 40 0 470 490 485 40 45 -5 480 510 500 40 50 -10 490 530 515 40 55 -15 500 550 530 40 60 -20 510 © 2016 McGraw‐Hill Education Limited 11-15 FIGURE 11-4 Net Exports and the Equilibrium GDP (C + Ig+Xn)1 (C + Ig+Xn)0 (C + Ig+Xn)2 Aggregate expenditures (billions of dollars) 510 Aggregate expenditures 490 with positive net exports Aggregate expenditures with negative net exports 470 450 430 45° 430 450 470 490 510 Real domestic product GDP (billions of dollars) LO6 © 2016 McGraw‐Hill Education Limited 11-16 Adding International 11.6 Trade Net Exports and Equilibrium GDP • A decline in net exports decreases aggregate expenditures and reduces GDP • A rise in net exports increases aggregate expenditures and increases GDP LO6 © 2016 McGraw‐Hill Education Limited 11-17 Adding International 11.6 Trade International Economic Linkages • Prosperity Abroad • Exchange Rates • Tariffs and Devaluations LO6 © 2016 McGraw‐Hill Education Limited 11-18 11.1 GLOBAL PERSPECTIVE Net Exports of Goods, Selected Nations, 2014 Source: CIA World Factbook, www.cia.gov LO6 © 2016 McGraw‐Hill Education Limited 11-19 11.7 Adding the Public Sector Simplifying Assumptions • government purchases do not cause any shift in consumption or investment schedules • net tax revenues are derived totally from personal taxes • taxes do not vary with GDP LO7 © 2016 McGraw‐Hill Education Limited 11-20 11.7 Adding the Public Sector Government Purchases and Equilibrium GDP • Increases in public spending shift the AE schedule upward and result in higher equilibrium GDP • Examples • suppose government add $40 billion of purchases • suppose government also imposes $40 billion of lump- sum tax LO7 © 2016 McGraw‐Hill Education Limited 11-21 TABLE 11-5 (1) Real Domestic Output and Income (GDP=DI) (billions The Impact of Government Purchases on Equilibrium GDP (5) Net Exports (Xn) (billions) Imports (M) (6) Government Purchases (G) (billions) (7) Aggregate Expenditures (C+Ig+Xn+G) (billions) (2)+(4)+(5)+(6) (2) Consumption (C) (billions) (3) Saving (S) (billions) (4) Investment (Ig) (billions) (1) $370 $375 $-5 $20 $40 $15 $40 $460 (2) 390 390 0 20 40 20 40 470 (3) 410 405 5 20 40 25 40 480 (4) 430 420 10 20 40 30 40 490 (5) 450 435 15 20 40 35 40 500 (6) 470 450 20 20 40 40 40 510 (7) 490 465 25 20 40 45 40 520 (8) 510 480 30 20 40 50 40 530 (9) 530 495 35 20 40 55 40 540 (10) 550 510 40 20 40 60 40 550 LO7 Exports (X) © 2016 McGraw‐Hill Education Limited 11-22 Aggregate expenditures (billions of dollars) FIGURE 11-5 Government Spending and the Equilibrium GDP C + Ig + Xn + G C + Ig + X n C Government spending of $40 billion 45° 470 550 Real domestic product, GDP (billions of dollars) LO7 © 2016 McGraw‐Hill Education Limited 11-23 TABLE 11-6 Determination of the Equilibrium Levels of Employment, Output, and Income (in billions): Private and Public Sectors (7) Net Exports (Xn) Imports (M) (8) Government Purchases (G) (9) Aggregate Expenditures (C+Ig+Xn +G) (4)+(6)+(7)+( 8) $40 $15 $40 $440 20 40 20 40 450 -5 20 40 25 40 460 390 0 20 40 30 40 470 410 405 5 20 40 35 40 480 40 430 420 10 20 40 40 40 490 (7) 490 40 450 435 15 20 40 45 40 500 (8) 510 40 470 450 20 20 40 50 40 510 (9) 530 40 490 465 25 20 40 55 40 520 (10) 550 40 510 480 30 20 40 60 40 530 (1) Real Domestic Output and Income (GDP=DI) (2) Taxes (T) (3) Disposable Income (DI) (1) - (2) (4) Consumption (C) (5) Saving (S) (3) - (4) (6) Investment (Ig) Exports (X) (1) $370 $40 $330 $345 $-15 $20 (2) 390 40 350 360 -10 (3) 410 40 370 375 (4) 430 40 390 (5) 450 40 (6) 470 LO7 © 2016 McGraw‐Hill Education Limited 11-24 FIGURE 11-6 Taxes and the Equilibrium GDP C + Ig + Xn + G Aggregate expenditures (billions of dollars) Ca + Ig + Xn + G $20 billion decrease on aggregate expenditure. 45° 510 550 Real domestic product, GDP (billions of dollars) LO7 © 2016 McGraw‐Hill Education Limited 11-25 11.7 Adding the Public Sector Taxes and Equilibrium GDP • Differential Impacts • Equal changes in G and T do not have equivalent impacts on GDP • Injections, Leakages, and Unplanned Changes in Inventories Sa+ M + T = Ig + X +G LO7 © 2016 McGraw‐Hill Education Limited 11-26 11.8 Equilibrium versus FullEmployment GDP Recessionary expenditure gap • Insufficient aggregate spending • Spending below full-employment GDP • Increase G and/or decrease T Inflationary expenditure gap • Too much aggregate spending • Spending exceeds full-employment GDP • Decrease G and/or increase T LO8 © 2016 McGraw‐Hill Education Limited 11-27 FIGURE 11-7 Recessionary and Inflationary Expenditure Gaps Aggregate expenditures (billions of dollars) AE0 AE1 530 510 Recessionary expenditure gap = $10 billion 490 Full employment 45° 490 510 530 Real GDP (a) Recessionary expenditure gap LO8 © 2016 McGraw‐Hill Education Limited 11-28 Aggregate expenditures (billions of dollars) FIGURE 11-7 Recessionary and Inflationary Expenditure Gaps AE2 530 Inflationary expenditure gap = $10 billion AE0 510 Full employment 490 45° 490 510 530 Real GDP (b) Inflationary expenditure gap LO8 © 2016 McGraw‐Hill Education Limited 11-29 11.8 Equilibrium versus FullEmployment GDP Application: The Recession of 2008-2009 • Late 2008 recession began • Aggregate expenditures declined • Consumption spending declined • Investment spending declined • Recessionary expenditure gap • The federal government undertook various Keynesian policies in 2008 and 2009 to try to eliminate the recessionary expenditure gap. LO8 © 2016 McGraw‐Hill Education Limited 11-30 The LAST WORD Say’s Law, the Great Depression, and Keynes • Classical economics • Say’s Law • Economy will automatically adjust • Laissez-faire • Keynesian economics • Cyclical unemployment can occur • Economy will not correct itself • Government should actively manage macroeconomic instability © 2016 McGraw‐Hill Education Limited 11-31 Chapter Summary LO11.1 Explain how sticky prices relate to the aggregate expenditures model. LO11.2 Explain how an economy’s investment schedule is derived from the investment demand curve and an interest rate. LO11.3 Illustrate how economists combine consumption and investment to depict an aggregate expenditures schedule and equilibrium output for a private closed economy. LO11.4 Discuss the two other ways to characterize the equilibrium level of real GDP in a private closed economy: (1) saving = investment and (2) unplanned changes in inventories. LO11.5 Analyze how changes in equilibrium GDP can occur in the aggregate expenditures model and how those changes relate to the multiplier. LO11.6 Explain how economists integrate the international sector (exports and imports) into the aggregate expenditures model. LO11.7 Explain how economists integrate the public sector (government expenditures and taxes) into the aggregate expenditures model. LO11.8 Differentiate between equilibrium GDP and full-employment GDP, and identify and describe the nature and causes of recessionary expenditure gaps and inflationary expenditure gaps. © 2016 McGraw‐Hill Education Limited 11-31