The Aggregate Expenditures Model
chapter ten
The Aggregate Expenditures model
CHAPTER OVERVIEW
We have seen in Chapter 9 three basic relationships: how income relates to consumption and saving, how the interest rate affects investment spending, and how changes in spending work through the system to create larger changes in output. In this chapter we build the more theoretically rigorous explanation for these relationships – the Aggregate Expenditures (AE) Model.
The chapter begins with the simple version of the AE model, that of a closed, private economy. Equilibrium GDP is determined and multiplier effects are briefly reviewed. The simplified “closed” economy is then “opened” to show how it would be affected by exports and imports. Government spending and taxes are brought into the model to include the “public” aspects of the system. Finally, the model is applied to two historical periods in order to consider some of the model’s deficiencies. The price level is assumed constant in this chapter unless stated otherwise, so the focus is on real GDP.
The Last Word traces briefly the historical development of the AE theory.
WHAT’S NEW
Chapters 10 through 12 are now organized into Part 3, a unit titled “Macroeconomic Models and Fiscal Policy.” This slight restructuring reflects primarily the changes to Chapters 9 and 10, and otherwise does not represent a significant change in coverage.
This chapter develops the aggregate expenditures (AE) analysis in its entirety. Instructors that prefer to bypass the AE model can proceed directly to Chapter 11 (Aggregate Demand / Aggregate Supply) without students missing the key underlying concepts. In the previous edition the model was covered in Chapters 9 and 10; now it is in Chapter 10 only.
Discussion of the balanced budget multiplier has been replaced with a brief discussion of the “differential impacts” of government purchases (G) and taxes (T).
New applications of recessionary gaps (recession of 2001) and inflationary gaps (late 1980s) have replaced previous edition references to the Great Depression, Vietnam War inflation, and Japan’s 1990s recession.
The closing section, “Limitations of the Model,” now includes “It does not allow for ‘self-correction’.”
The “Last Word” on “Say’s Law, the Great Depression, and Keynes” replaces the multiplier piece that appeared in the previous edition and now appears in Chapter 9.
End-of-chapter and web-based questions have been revised and edited.
There is no “Consider This” box in this chapter, but there are two potentially useful “Concept Illustrations” that appear in the COMMENTS AND TEACHING SUGGESTIONS.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. Identify the simplifying assumptions of the Aggregate Expenditures (AE) model.
2. Explain the relationship between the investment demand curve and the investment schedule.
3. Use the consumption and investment schedules to determine the equilibrium level of GDP.
4. Explain verbally and graphically the equilibrium level of GDP.
5. Explain why above-equilibrium or below-equilibrium GDP levels will not persist.
6. Explain the basics of the classical view that the economy would generally provide full employment levels of output.
7. Trace the changes in GDP that will occur when there is a discrepancy between saving and planned investment.
8. Use the multiplier to find changes in GDP resulting from changes in spending.
9. Define the net export schedule.
10. Explain the impact of positive (or negative) net exports on aggregate expenditures and the equilibrium level of real GDP.
11. Explain the effect of increases (or decreases) in exports on real GDP.
12. Explain the effect of increases (or decreases) in imports on real GDP.
13. Describe how government purchases affect equilibrium GDP.
14. Describe how personal taxes affect equilibrium GDP.
15. Explain why an equal amount of government purchases and taxes will have a differential impact on GDP.
16. Identify a recessionary gap and explain how it relates to the U.S. recession of 2001.
17. Identify an inflationary gap and explain how it relates to the inflationary experience of the late 1980s.
18. List five limitations of the aggregate expenditures model.
19. Explain how the aggregate expenditures model emerged as a critique of Classical economics and in response to the Great Depression.
20. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. As stated earlier, some instructors may choose to skip this chapter. However, students could still benefit from the Last Word for Chapter 10.
2. Note that net exports are kept as independent of the level of GDP to keep the analysis simple. You may want to note in passing that, in fact, there tends to be a direct relationship between import spending and the level of GDP.
3. The Last Word for this chapter provides a historical backdrop for Keynesian theory. Impress upon students that Keynes developed the theory that emphasizes the importance of aggregate demand for economic performance. You may want to point out that his theory changed the way economists viewed the modern capitalist system and that he has been credited with the development of macroeconomics as a separate field. Stress that debate still lingers over whether the system is self‑correcting during periods of unemployment or inflation.
4. Data to update Figure 9-1 may be found in the most recent issue of Survey of Current Business or Economic Indicators. Web-based questions at the end of the chapter also point to sources.
5. The following “Concept Illustration” may be useful in conveying the leakages-injections approach to equilibrium GDP.
Concept Illustration … Leakages and Injections
A bathtub analogy is useful in illustrating the injections-leakages approach to equilibrium real domestic output and income (real GDP) in the private, closed economy. A tub’s faucet enables an inflow of water and the tub’s drain allows an outflow of water. The level of water in the tub remains constant when the inflow from the faucet equals the outflow from the drain. If the inflow exceeds the outflow, the level of water rises. If the inflow is less than the outflow, the level of water level recedes.
The inflow, outflow, and level of water in the tub are analogous to investment (Ig), saving (S), and real GDP, respectively, in a private, closed economy. Equilibrium real GDP occurs where the investment injection (inflow) just equals the saving leakage (drain). If the investment injection exceeds the saving leakage, real GDP expands until saving increases sufficiently to equal the level of investment. If the investment injection is less than the saving leakage, real GDP declines until saving falls sufficiently to equal investment. In both cases equilibrium is achieved where investment equals saving.
In the economy represented in Table 9-4, equilibrium real GDP is $470 billion. In view of the bathtub analogy, it is not surprising to discover that investment and saving flows are each $20 billion.
6. After learning the AE model, students may reach the conclusion that increasing saving is bad because of the contractionary impact it has on consumption and, by extension, aggregate spending. This is, of course, the famous “paradox of thrift,” and if you choose to include such a discussion in your course, you may find the following “Concept Illustration” useful.
Concept Illustration … The Paradox of Thrift
In Chapter 2 we said that a higher rate of saving is good for society because it frees resources from consumption uses and directs them toward investment goods. More machinery and equipment means a greater capacity for the economy to produce goods and services.
But implicit within this “saving is good” proposition is the assumption that increased saving will be borrowed and spent for investment goods. If investment does not increase along with saving, a curious irony called the paradox of thrift may arise. The attempt to save more may simply reduce GDP and leave actual saving unchanged.
Our analysis of the multiplier process helps explain this possibility. Suppose an economy that has a MPC of .75, a MPS of .25, and a multiplier of 4, decides to save an additional $200 billion. From the social viewpoint, a penny saved that is not invested is a penny not spent and therefore a decline in someone’s income. Through the multiplier process, the $200 billion of reduced consumption spending lowers real GDP by $800 billion (4 x $200 billion).
The $800 billion decline of real GDP, in turn, reduces saving by $200 billion (= MPS of .25 x $800 billion), which completely cancels the initial $200 billion increase of saving. Here, the attempt to increase saving is bad for the economy: it creates a recession and leaves saving unchanged.
For increased saving to be good for an economy, greater investment must accompany greater saving. If investment replaces consumption dollar-for-dollar, aggregate expenditures stay constant and the higher level of investment raises the economy’s future growth rate.
STUDENT STUMBLING BLOCKS
1. When introducing the investment, net export, and government purchases schedules, be sure to emphasize that the graphs are horizontal because of the exogenous nature of the variables, not because the values are unchanging.
2. When the model is complete (GDP = C + Ig + Xn + G), students may confuse the equilibrium equation with the accounting identity presented in Chapter 7. You may need to visually separate planned and unplanned investment in the equation to help them see the difference between the two equations.
3. Some students will need to be reminded that in the AE model, unplanned inventory build-ups or depletions are corrected by adjusting production, not by altering prices.
LECTURE NOTES
I. Introduction—What Determines GDP?
A. This chapter focuses on the aggregate expenditures model. We use the definitions and facts from previous chapters to shift our study to the analysis of economic performance. The aggregate expenditures model is one tool in this analysis. Recall that “aggregate” means total.
B. As explained in this chapter’s Last Word, the model originated with John Maynard Keynes (pronounced “Canes”).
C. The focus is on the relationship between income and consumption and savings.
D. Investment spending, net exports, and government purchases, important parts of aggregate expenditures, are also examined.
E. Finally, these spending categories are combined to explain the equilibrium levels output and employment in at first a private (no government), domestic (no foreign sector) economy. Therefore, GDP = NI = PI = DI in this very simple model.
F. The revised model adds realism by including the foreign sector and government in the aggregate expenditures model.
G. Applications of the new model include two U.S. historical periods (the 2001 recession and the late 1980s inflation).
II. Simplifying Assumptions for the Private Closed-Economy model
A. We first assume a “closed economy” with no international trade.
B. Government is ignored.
C. Although both households and businesses save, we assume here that all saving is personal.
D. Depreciation and net foreign income are assumed to be zero for simplicity.
E. 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.
III. Tools of Aggregate Expenditures Theory: Consumption and Investment Schedules
A. 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.
B. In a closed private economy the two components of aggregate expenditures are consumption and gross investment.
C. The consumption schedule was developed in Chapter 9 (see Figure 9-2a).
D. In addition to the investment demand schedule, economists also define an investment schedule that shows the amounts business firms collectively intend to invest at each possible level of GDP or DI.
1. In developing the investment schedule, it is assumed that investment is independent of the current income. The line Ig (gross investment) in Figure 10-1b shows this to be graphically related to the level determined by Figure 10-1a.
2. The assumption that investment is independent of income is a simplification, but it will be used here.
3. Figure 10-1a shows the investment schedule from GDP levels given in Table 9-1.
IV. Equilibrium GDP: Expenditures-Output Approach
A. Look at Table 10-2, which combines data of Tables 9-1 and 10-1.
B. Real domestic output in column 2 shows ten possible levels that producers are willing to offer, assuming their sales would meet the output planned. In other words, they will produce $370 billion of output if they expect to receive $370 billion in revenue.
C. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) forthcoming at each output level.
1. Recall that consumption level is directly related to the level of income and that here income is equal to output level.
2. Investment is independent of income here and is planned or intended regardless of the current income situation.
D. 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.
1. In Table 10-2, this occurs only at $470 billion.
2. At $410 billion GDP level, total expenditures (C + Ig) would be $425 = $405(C) + $20 (Ig) and businesses will adjust to this 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.
3. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At $510 billion level, C + Ig = $500 billion. Businesses will have unsold, 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.
E. Graphical analysis is shown in Figure 10-2 (Key Graph). At $470 billion it shows the C + Ig schedule intersecting the 45-degree line which is where output = aggregate expenditures, or the equilibrium position.
1. Observe that the aggregate expenditures line rises with output and income, but not as much as income, due to the marginal propensity to consume (the slope) being less than 1.
2. A part of every increase in disposable income will not be spent but will be saved.
3. Test yourself with Quick Quiz 10-2.
V. Two Other Features of Equilibrium GDP
A. Savings and planned investment are equal.
1. It is important to note that in our analysis above we spoke of “planned” investment. At GDP = $470 billion in Table 10-2, both saving and planned investment are $20 billion.