Mehdi Arzandeh, University of Manitoba

Mehdi Arzandeh, University of Manitoba
PowerPoint Presentation by Mehdi Arzandeh, University of Manitoba

© 2016 McGraw‐Hill Education Limited
The Aggregate Expenditures Model 11 LEARNING OBJECTIVES 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

The Aggregate Expenditures Model: Consumption and Saving 11.1 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

Real domestic product, GDP Investment demand curve
LO4.1 The Investment Demand Curve and the Investment Schedule FIGURE 11-1 Investment Demand Curve Investment Schedule Investment demand curve Investment schedule 20 Ig r and i (percent) Investment (billions of dollars) 8 20 20 ID 20 Real domestic product, GDP (billions of dollars) (b) Investment schedule Investment (billions of dollars) (a) Investment demand curve LO2 © 2016 McGraw‐Hill Education Limited

(1) Level of real output and income
TABLE 11-1 The Investment Schedule (in billions) (1) Level of real output and income (2) Investment (Ig) $370 $20 390 20 410 430 450 470 490 510 530 550 LO2 © 2016 McGraw‐Hill Education Limited

LO4.1 Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy TABLE 11-2 (1) Possible Levels of Employment (millions) (2) Real Domestic Output (and Income) (GDP =DI) (billions) (3) Consumption (C) (billions) (4) Saving (S) (billions) (5) Investment (Ig) (6) Aggregate Expenditure (C + Ig) (7) Unplanned Changes in Inventories (+) or (-) (8) Tendency of Employment, Output, and Income (1) 2.5 $370 $375 $-5 $20 $395 $-25 Increase (2) 5.0 390 20 410 -20 (3) 7.5 405 5 425 -15 (4) 430 420 10 440 -10 (5) 450 435 15 455 -5 (6) 470 Equilibrium (7) 490 465 25 485 +5 Decrease (8) 510 480 30 500 +10 (9) 530 495 35 515 +15 25.0 550 40 +20 * If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP This table shows equilibrium GDP using the expenditures-output approach for a private, closed economy. 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. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) at each output level. Recall that the consumption level is directly related to the level of income and that here income is equal to output. Investment is independent of income and is planned or intended regardless of the current income situation. 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. Equilibrium occurs only at $470 billion. 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. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At the $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. No level of GDP other than the equilibrium level of GDP can be sustained. ©2013 McGraw-Hill Ryerson Ltd. Chapter 9.1 6 LO3 © 2016 McGraw‐Hill Education Limited

LO4.1 KEY GRAPH - Equilibrium GDP in a Private Closed Economy FIGURE 11-2 530 510 490 470 450 430 410 390 370 45° Real domestic product, GDP (billions of dollars) Aggregate expenditures, C + Ig (billions of dollars) C + Ig (C + Ig = GDP) C Equilibrium point Aggregate expenditures Ig = $20 billion This figure graphically illustrates equilibrium GDP in a private closed economy. The aggregate expenditures schedule, C + Ig, is determined by adding the investment schedule, Ig, to the upsloping consumption schedule, C. Since investment is assumed to be the same at each level of GDP, the vertical distances between C and C + Ig do not change. Equilibrium GDP is determined where the aggregate expenditures schedule intersects the 45° line, in this case at $470 billion. C = $450 billion LO3 © 2016 McGraw‐Hill Education Limited

Other Features of Equilibrium GDP 11.4 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

Changes in Equilibrium GDP and the Multiplier 11.5 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

LO4.1 Changes in the Aggregate Expenditure Schedule and the Multiplier Effect FIGURE 11-3 510 490 470 450 430 45° Real domestic product, GDP (billions of dollars) Aggregate expenditures (billions of dollars) (C + Ig)1 (C + Ig)0 (C + Ig)2 Increase in investment Decrease in investment The figure demonstrates changes in the aggregate expenditure schedule and the multiplier effect. An upward shift of the aggregate expenditure schedule from (C + Ig)0 to (C + Ig)1 will increase the equilibrium GDP. Conversely, a downward shift from (C + Ig)0 to (C + Ig)2 will lower the equilibrium GDP. The extent of the changes in equilibrium GDP will depend on the size of the multiplier, which, in this case, is 4 (=20/5). The multiplier is equal to 1/MPS (here, 4 = 1/.25). LO5 © 2016 McGraw‐Hill Education Limited

Adding International Trade 11.6 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

Adding International Trade 11.6 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

LO4.1 TABLE 11-3 Net Export Schedule (1) Domestic output (GDP = DI) (billions) (2) Exports (X) (3) Imports (M) (4) Net Exports (Xn ) (2)- (3) (5) Marginal propensity to import (MPM) Δ(3)/Δ(1) $370 $40 $15 $+25 390 40 20 +20 (20-15)/( ) = 0.25 410 25 +15 0.25 430 30 +10 450 35 +5 470 490 45 -5 510 50 -10 530 55 -15 550 60 -20 In this table, column Xn1 shows that exports exceed imports by $5 billion at each level of GDP. Column Xn2 shows imports exceed exports by $5 billion at each level of GDP. Since the net exports are constant at all GDP levels, we are assuming that net exports are independent of GDP. This data will be represented graphically in the figure on the next slide. LO6 © 2016 McGraw‐Hill Education Limited

Adding International Trade 11.6 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/( ) = 2 LO6 © 2016 McGraw‐Hill Education Limited

LO4.1 Determinants of the Equilibrium Levels of Output and Income in an Open Economy (Without Government) TABLE 11-4 (1) Domestic Output (and Income) (GDP = DI), (billions) (2) Aggregate Expenditures for private economy (no G) (C+Ig), (3) Exports (X) (4) Imports (M) (5) Net Exports, Xn (3)- (4) (6) Aggregate Expenditures for open economy (no G) (C+Ig+Xn), $370 $395 $40 $15 $+25 $420 390 410 40 20 +20 430 425 25 +15 440 30 +10 450 455 35 +5 460 470 490 485 45 -5 480 510 500 50 -10 530 515 55 -15 550 60 -20 This table shows equilibrium GDP using the expenditures-output approach for a private, closed economy. It combines consumption and savings data from Tables 27.1 and the investment schedule 28.1. 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. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) at each output level. Recall that the consumption level is directly related to the level of income and that here income is equal to output. Investment is independent of income and is planned or intended regardless of the current income situation. 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. In Table 28.2, equilibrium occurs only at $470 billion. 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. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At the $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. No level of GDP other than the equilibrium level of GDP can be sustained. LO6 © 2016 McGraw‐Hill Education Limited

Aggregate expenditures
LO4.1 FIGURE 11-4 Net Exports and the Equilibrium GDP Real domestic product GDP (billions of dollars) Aggregate expenditures (billions of dollars) 510 490 470 450 430 45° (C + Ig+Xn)1 (C + Ig+Xn)0 Aggregate expenditures with positive net exports (C + Ig+Xn)2 Aggregate expenditures with negative net exports This figure illustrates the impact of net exports and equilibrium GDP. Positive net exports elevate the aggregate expenditures schedule from the closed-economy level of C + Ig to the open-economy level of C + Ig + Xn1. Negative net exports lower the aggregate expenditures schedule from the closed-economy level of C + Ig to the open-economy level of C + Ig + Xn2. LO6 © 2016 McGraw‐Hill Education Limited

Adding International Trade 11.6 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

11.7 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

11.7 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

Real Domestic Output and Income Aggregate Expenditures (C+Ig+Xn+G)
LO4.1 The Impact of Government Purchases on Equilibrium GDP TABLE 11-5 (1) Real Domestic Output and Income (GDP=DI) (billions (2) Consumption (C) (billions) (3) Saving (S) (4) Investment (Ig) (5) Net Exports (Xn) (billions) (6) Government Purchases (G) (billions) (7) Aggregate Expenditures (C+Ig+Xn+G) (2)+(4)+(5)+(6) Exports (X) Imports (M) (1) $370 $375 $-5 $20 $40 $15 $460 (2) 390 390 20 40 470 (3) 410 405 5 25 480 (4) 430 420 10 30 490 (5) 450 435 15 35 500 (6) 470 450 510 (7) 490 465 45 520 (8) 510 50 530 (9) 530 495 55 540 (10) 550 60 550 This table shows the impact of government purchases on equilibrium GDP. Before adding government purchases, equilibrium GDP had been at $470. Now with government purchases, equilibrium GDP rises to $550, implying a multiplier effect since the rise in GDP is greater than the $20 billion in additional aggregate expenditures. LO7 © 2016 McGraw‐Hill Education Limited

LO4.1 FIGURE 11-5 Government Spending and the Equilibrium GDP 45° Real domestic product, GDP (billions of dollars) Aggregate expenditures (billions of dollars) C + Ig + Xn + G C + Ig + Xn C Government spending of $40 billion The figure illustrates the impact of government spending on equilibrium GDP. The addition of government expenditures, G, to our analysis raises the aggregate expenditures (C + Ig + Xn + G) schedule and increases the equilibrium level of GDP, as would an increase in C, Ig, or Xn. The multiplier is again 4 (80/20). LO7 © 2016 McGraw‐Hill Education Limited

LO4.1 Determination of the Equilibrium Levels of Employment, Output, and Income (in billions): Private and Public Sectors TABLE 11-6 (1) Real Domestic Output and Income (GDP=DI) (2) Taxes (T) (3) Disposable Income (DI) (1) - (2) (4) Consump-tion (C) (5) Saving (S) (3) - (4) (6) Invest-ment (Ig) (7) Net Exports (Xn) (8) Govern-ment Pur-chases (G) (9) Aggregate Expendi-tures (C+Ig+Xn +G) (4)+(6)+(7)+(8) Exports (X) Imports (M) (1) $370 $40 $330 $345 $-15 $20 $15 $440 (2) 390 40 350 360 -10 20 450 (3) 410 370 375 -5 25 460 (4) 430 390 30 470 (5) 450 410 405 5 35 480 (6) 470 430 420 10 490 (7) 490 435 15 45 500 (8) 510 50 510 (9) 530 465 55 520 (10) 550 60 530 This table shows the determination of the equilibrium levels of employment, output, and income with the private sector and taxes. With taxes of $20 billion at all levels of GDP, equilibrium GDP falls from $550 to $490. Again, we can see that there is a multiplier effect. The multiplier = 60/15 = 4. LO7 © 2016 McGraw‐Hill Education Limited

LO4.1 FIGURE 11-6 Taxes and the Equilibrium GDP 45° Real domestic product, GDP (billions of dollars) Aggregate expenditures (billions of dollars) C + Ig + Xn + G Ca + Ig + Xn + G $20 billion decrease on aggregate expenditure. This figure reflects the impact of taxes on equilibrium GDP. If the MPC is .75, the $20 billion of taxes will lower the consumption schedule by $15 (20 x .75) billion and cause a $60 billion decline in the equilibrium GDP. In the open economy with government, equilibrium GDP occurs where Ca (after-tax income) + Ig + Xn + G = GDP. Here, that equilibrium is $490 billion. LO7 © 2016 McGraw‐Hill Education Limited

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

Equilibrium versus Full-Employment GDP 11.8 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

Recessionary expenditure gap Aggregate expenditures
LO4.1 FIGURE 11-7 Recessionary and Inflationary Expenditure Gaps Real GDP (a) Recessionary expenditure gap Aggregate expenditures (billions of dollars) 530 510 490 45° AE0 AE1 Recessionary expenditure gap = $10 billion This graph shows the recessionary expenditure gap. The equilibrium and full-employment GDPs may not coincide. A recessionary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP fall short of those needed to achieve the full-employment GDP. Here, the $5 billion recessionary expenditure gap causes a $20 billion negative GDP gap. See the next slide for the graph of the inflationary expenditure gap. Full employment LO8 © 2016 McGraw‐Hill Education Limited

Inflationary expenditure gap Aggregate expenditures
LO4.1 FIGURE 11-7 Recessionary and Inflationary Expenditure Gaps Real GDP (b) Inflationary expenditure gap Aggregate expenditures (billions of dollars) 530 510 490 45° AE2 Inflationary expenditure gap = $10 billion AE0 Full employment This graph shows the inflationary expenditure gap. The equilibrium and full-employment GDPs may not coincide. An inflationary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP exceed those just sufficient to achieve the full-employment GDP. Here, the inflationary expenditure gap is $5 billion; this overspending produces demand-pull inflation. LO8 © 2016 McGraw‐Hill Education Limited

Equilibrium versus Full-Employment GDP 11.8 Application: The Recession of Late 2008 recession began Aggregate expenditures declined Consumption spending declined Investment spending declined Recessionary expenditure gap The federal government undertook various Keynesian policies in and 2009 to try to eliminate the recessionary expenditure gap. LO8 © 2016 McGraw‐Hill Education Limited

LO4.1 Say’s Law, the Great Depression, and Keynes The LAST WORD 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

LO4.1 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

Mehdi Arzandeh, University of Manitoba

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