Aggregate Expenditures Model


For Aggregate Demand and Aggregate Supply (related), click here.

The aggregate expenditures model refers to a graph containing a 45-degree line (Keynesian equilibrium of consumption and spending) and a plot of GDP (or consumption or production) against expenditures.
-An increase in aggregate expenditures will increase real output and employment but not raise the price level (McConnel and Brue)

Closed Economy

Closed economies are relatively simple (compared to an open economy),
A closed economy contains:
  • no government spending
  • no exports and imports
  • no taxes
  • closed economies are purely theoretical and used for calculation purposes, as countries involve other factors that are present in an open economy

and its two proponents of real GDP are:
  • investment
  • consumption
  • saving is not included in GDP as this money is not put into the economy and benefits the economy in no way

Planned Investment- the amount that firms plan or intend to invest at each possible level of GDP.
  • represents the investment plans of businesses in the same way the consumption represents the consumption plans of households
.
Investment Schedule- a curve or schedule that shows the amounts firms plan to invest at various possible values of real GDP.
  • the investment schedule shows the amount of investment forthcoming at each level of GDP

At each level of real GDP, investment is assumed to be constant, the value of which is derived from an investment demand curve (seen below):
investmentdemand.png
Thus, in a closed economy:

real GDP = consumption + investment

Equilibrium GDP

Possible equilibrium GDPs in an economy (closed and open) are denoted by the 45-degree line in the graph shown below:
aepic1.png
The aggregate expenditures curve is denoted by the C+I curve (consumption + investment, not 1), contains all possible levels of GDP it can sustain, and meets the equilibrium GDP at point E. At levels of GDP below E, investment exceeds output (since GDP and output are interchangeable on the x-axis). At all values of consumption before E, the values of consumption (expenditures) on the C+I line are greater than those on the 45-degree line. This produces a shortage in which the economy is willing to spend more than it can produce. Following from this, at all values of consumption past E, consumption on the aggregate expenditures model is less than the values on the 45-degree line. This means that the economy produces more than it is willing to buy.
  • Dissaving occurs at a point that consumption exceeds disposable income, i.e. consumers spend more than 100% of their disposable income; average propensity consume is greater than 1.
  • Saving occurs at a point that consumption is less than disposable income.
  • Saving is what causes consumption to be less than total output of GDP.
  • Any GDP for which saving exceeds investment is an above equilibrium.

  • Disequilibirum: No level of GDP other than the equilibrium level of GDP can be sustained.
    • GDP below equilibrium: the economy wants to spend at higher levels than the levels of GDP the economy is producing.
      • As a result of stepping up production there will be greater output which will increase employement and greater total income. (McConnel/Brue. 175)
    • GDP above the equilibrium: total outputs fail to generate the spending needed to clear the shelves of goods (McConnell Brue 174-175).
      • As a result bussineses can cut back on production at the cost of fewer jobs and a decline in total income. (McConnell/Brue, 175)

The MPS' relation to the aggregate expenditures model

The slope of the aggregate expenditures curve is the MPS (marginal propensity to save), a measure indicating what percent of every extra dollar of GDP would be saved. For example, if the slope of the C+I curve is 0.45, the MPS of the economy is 0.45 as well. If the GDP of this economy was increased by one dollar, 45 cents of that extra dollar would be saved by consumers. The marginal propensity is inversely related to the economy's multiplier:

multiplier = 1/MPS

where the multiplier is the net effect of changes in the contributors to GDP, and the MPS is determined by the slope of the aggregate expenditures curve.
Through the multiplier effect, an initial change in investment spending can cause a magnified change in domestic ouput and income.

Open Economy


The open economy factors in imports and exports which contribute to net exports, government spending and taxes. Therefore, in an open economy:
  • A significant advantage in an open economy is the larger variety of goods exposed to consumers.
  • An open economy trades, thus the exports and imports are factored in
  • An open economy is the direct opposite of a closed economy

GDP = consumption + investment + government spending + net exports

Consumption

All of the goods and services purchased by households are counted under consumption expenditures. These expenditures are inclusive of all the purchases of durable goods, non-durable goods, and services. So, for example, a new car purchased as a final good by a household would be considered under consumption.

Investment

These expenditures refer to the purchases made by firms on plants, or machinery and other types of equipment. Other types of construction, such as houses and apartments are also considered under investment, because they could potentially be rented. Additionally, fluctuations in inventory are also counted under investment from year to year. For example, assume that in the year 2010 there was an excess of $1000 worth of keyboards. This amount would be added into the inventories category. If, then the next year the demand for keyboards increases, and all the keyboards produced that year are sold and the inventory consisting of the $1000 worth of keyboards is also sold, that $1000 will be subtracted from the total investment expenditures, in order to avoid double counting. [1]

At equilibrium GDP in an economy that is private and closed, i.e., there is neither government spending and collection of taxes nor imports and exports, there are no unexpected increases/decreases in inventories, meaning that there are no unplanned changes in inventories. This is because firms cannot sell unplanned inventories to a public who isn't demanding them. The saving equals the total planned investment. Actual investment, has two components: planned investment and unplanned changes in the inventory. Actual investment matches total savings in an economy that is both closed and private.[2]

There is a significant difference between the investment demand curve and the investment schedule. The demand curve is a downward slope however the investment schdeule is just a horizontal line at the level of investment.

  • There are unplanned changes in inventories at equilibrium GDP.
  • Equilibrium occurs only when planned investment and saving are equal. But when unplanned changes in inventories are considered, investment and saving are always equal, regardless of the level of GDP,

Net Exports

Net exports are imports subtracted from exports. All other things equal, when net exports are positive, net exports increase aggregate expenditures and GDP beyond what they would be in a closed economy. Conversely, negative net exports decrease aggregate expenditures and GDP to lower levels than what they would be in a closed economy. Net exports are also affected by the multiplier process (ie. when the MPS of an economy is 0.25, and net exports change by an increase of $10,000, the AE curve will shift fourfold).
If the U.S. dollar was to appreciate in respect to foreign currencies, the foreign nation would be able to purchase less U.S. dollars and therefore would be able to purchase less U.S. goods and services. Conversely, U.S. consumers would be able to purchase more of foreign currencies than before. Ceteris paribus, U.S. exports in this case would decrease, while imports increase. GDP would fall, because the net exports component of GDP would decrease. [3]
  • Saving is what causes consumption to be less than total output of GDP.
  • Any GDP for which saving exceeds investment is an above equilibrium.

Negative Net Exports
  • Other things equal, negative net exports reduce aggregate expenditures and GDP below what they would be in a closed economy. (McConnell/Brue, 180)
  • International Economic Linkages
    • Prosperity Abroad: If the real output and income increases in foreign nations the U.S. trades with, U.S.'s real GDP would increase.
      • This is because US would be able to sell more goods abroad, thus raising U.S. net export.
      • If another country increases tariffs on US goods then the US in turn will increase tariffs on their goods. This is not good for either economy because it reduces international trade.
    • Tariffs
      • Tariffs can be negative exporting countries. Example: A foreign country(A) increases tariffs to reduce imports, so they can increase production in their economy. When they restrict their imports to stimulate their economy, this also restricts the country(B)'s exports depressing country(B)'s economy.
      • Exchange Rates: If the dollar relative to other currencies depreciates (the dollar can buy less foreign money), this enables people abroad to obtain more dollars with each unit of their currencies.
  • Exchange Rates
    • An exchange rate is the rate at which one currency is traded for another.
    • If the price of the dollar falls exports will increase and imports will decease. Thereby increasing the net exports and increasing the US GDP
    • The foreign exchange market determines exchange rates.
    • The position of the economy determines whether the depreciation of the dollar will raise GDP or cause inflation
      • If the economy is operating below its full-employment level, depreciation of the dollar will increase aggregate expenditures thus raising real GDP (McConnell and Brue)
      • If the economy is at full-employment, the increase in net exports and aggregate expenditures will cause demand-pull inflation. (McConnell and Brue)

Government Spending and Taxes

All else held equal, increases in government spending (injections) will shift the aggregate expenditures curve further upward and extend the equilibrium GDP further, and decreases in government spending will have the opposite effect. Both are held under the multiplier effect as well.

A lump-sum tax is a tax that provides equal amounts of revenue at each level of GDP. Taxes reduce disposable income and thus consumption and saving. How much these fall is determined by the MPC and MPS (ie. if the MPC is 0.25 and taxes reduce consumption by $5000, the net effect of taxes would be a $20000 decrease in consumption. Apply the same towards saving and the MPS). Lump-sum taxes shift the aggregate expenditures model downward, ceteris paribus.

MPC + MPS = 1, so if MPC = 0.25, then MPS must equal 0.75.

Leakages and Injections

Leakages are withdrawals from spending in aggregate expenditures, while injections are increases in aggregate spending. At the equilibrium GDP of an economy, leakages must equal injections.
In a closed economy, the injections are equal the leakaes, such that saving is equal to the gross private domestic investment.
In an open economy, leakages are savings (after tax), imports, and taxes. Injections are investment, exports, and government spending. At the equilibrium GDP:
S( savings) + M ( imports) + T ( taxes) = I ( investments) + X ( exports) + G( government purchases)
S + M + T = I + X + G


What Does GDP not Include?

  • Second hand-sales: Used goods that are sold again are not counted. For example, if an individual sells a used 1987 Nissan sedan to his neighbor, this transaction will not be counted as GDP, in order to avoid multiple counting. The car was included in GDP when it was originally purchased as new.
  • Sales of Intermediate Goods: These are goods that are purchased by a firm so that they can be used in the production process of another good. For example, if a factory purchases steel to make steel ladders, the steel will be considered an intermediate good. The steel ladder, on the other, hand will be considered a final good when a consumer purchases it. [4]
  • GDP also fails to account for utility received, or the pleasure gained form a job or from items



Gaps in GDP


There are two types of gaps: recessionary gaps and inflationary gaps. These are both affected by the multiplier process and produce net effects modified by the MPS to create GDP gaps.

Recessionary gaps are the amount by which aggregate expenditures at the full-employment GDP (the GDP at which all resources are used) fall short of those needed to attain full-employment GDP. Graphically speaking, this is the vertical distance measured by the AE curve "falling short" of or under the full-employment AE curve (reference to the 45-degree line).
  • Example: The recession that took place in 2001 is an example of recessionary gap. Since investment spending went down and reduced the expenditures.

Inflationary gaps are the amount by which aggregate expenditures at the full-employment GDP exceed those needed to attain full-employment GDP.
  • Excessive spending will cause nominal GDP to increase but real GDP wont

Demand-pull inflation can occur if there is an inflationary gap. Real GDP will not increase, but nominal GDP will rise because of the higher price level.
Demand Pull Inflation can be the result of rising consumption from sectors of AD.
Price level rises because the economy goes beyond its full-employment output.
Since 1980 the U.S has not had an episode of rising inflation, but has had an inflationary gap. In 1980 the economy moved beyond full-employment output and price level rose.


Limitations of the Model

  • The model can only account for demand-pull inflation. It is incapable of showing the price level rising as a result of excessive aggregate expenditures. It can’t measure the rate at which prices are being inflated (McConnell and Brue, 187).
  • The model solely deals with demand-pull inflation rather than cost-push inflation (McConnell and Brue, 189).
  • The AE Model does not allow for the possibility of an economy expanding beyond its full-employment real GDP (McConnell and Brue, 189).
  • An actual economy is capable of self –correcting inflationary or recessionary gaps due to some internal features. The aggregate expenditures model does not take these features into account and as a result, the notion of ‘self-correction’ is left out (McConnell and Brue, 189).
  • The aggregate expenditures does not address cost push inflation
  • The aggregate expenditures model does not show price level changes. It has no way of measuring the rate of inflation.
  • The model does not show price-level changes.
  • The model limits real GDP to the full-employment level of output.
  • The model ignores premature demand-pull inflation.
  • The model does not allow for "self-correction."

  1. ^ Barron's AP Microeconomics/ Macroeconomics 4th Edition, pg 209
  2. ^ McConnell and Brue, Economics: Principles, Problems, and Policies Sixteenth Edition, pg. 178
  3. ^ McConnell and Brue, Economics: Principles, Problems, and Policies Sixteenth Edition, pg. 181
  4. ^
                                                              • Barron's AP Microeconomics/ Macroeconomics 4th Edition, pg 213