Aggregate Expenditures Model

Aggregate Expenditures (AE)

The sum of all expenditures made in an economy on consumption, gross investment, government purchases, and net exports. In equilibrium, aggregate expenditures equals income, or real GDP.

Aggregate Expenditure Model

A model, developed by John Maynard Keynes, that relates income and expenditure in an economy such that, in equilibrium, total expenditures in the economy will be equal to total output.

Real GDP Expenditures

Real GDP (Y) = Consumption (C) + Gross Investment (I) + Government Purchases (G) + Net Exports (NX)

Disposable Income (DI)

The amount of income available to spend or save after taxes have been paid; calculated as

income (Y) minus taxes (T), or DI = Y - T.

Taxes (T)

Revenues collected by the government from individuals and firms.

Marginal Propensity to Consume (MPC)

The fraction of each additional dollar of income that is spent on consumption. MPC = Change in Consumption/Change in Income.

Marginal Propensity to save (MPS)

The fraction of each additional dollar of income that is saved. MPS = Change in Savings/Change in Income.

The Consumption/Saving Identity

MPC + MPS = 1

consumption schedule

A graph showing the relationship between income and consumption. Consumption is on the Y axis and Disposable Income is on the X axis.

Equilibrium line

In the aggregate expenditures model, the 45-degree line through the origin that represents all points at which aggregate expenditures (A) are equal to output, or real GDP (Y).

Autonomous consumption (A)

The level of consumption expenditure when income is equal to zero. Autonomous consumption is funded by drawing on savings or by borrowing.

Savings schedule

A graph showing the relationship between income and savings. Y axis: Savings. X axis: Disposable Income.

Savings

Savings = Disposable Income - Consumption.

Investment demand

The negative relationship between the quantity of new physical capital demanded by firms and the prevailing interest rate.

Expected rate of return

An anticipated increase in profit resulting from additional investment; expressed as a percentage of the monetary cost of the additional investment.

Interest rate

The payment made to agents that lend or save money, expressed as an annual percentage of the monetary amount lent or saved. Sometimes called nominal interest rate or price of money.

Real interest rate

The interest rate paid to lenders and savers when the expected rate of inflation equals zero; the inflation-adiusted return, equal to the nominal interest rate minus the inflation rate.

Capital goods

Durable (long-lasting) goods that are used to produce other goods and services. Sometimes referred to

Simply as capital.

Marginal decision making

The process of making choices in increments by evaluating the additional, or marginal, benefit against the additional, or marginal, cost of an action.

Optimization

The idea that people make choices in order to maximize the overall benefit, or utility, of an action subject to its cost. People will engage in an activity as long as the marginal benefit of an activity is greater than or equal to its marginal cost.

Optimization rule for an activity

If MB ≥ MC, do it

If MB < MC, don't do it

Optimization rule for investment

If Expected Rate of Return ≥ Cost of Investment, invest.

If Expected Rate of Return < Cost of Investment, do not invest.

Investment schedule

In the aggregate expenditures model, a horizontal line showing the relationship between gross investment (I) and the level of real GDP (Y) in the economy.

Government purchases schedule

In the aggregate expenditures model, a horizontal line showing the relationship between government purchases (G) and the level of real GDP (Y) in the economy.

net exports schedule

In the aggregate expenditures model, a horizontal line showing the relationship between net exports (NX) and the level of real GDP (Y) in the economy.

Expenditures multiplier

The effect that a $1 change in expenditure has on real GDP; calculated as the ratio of the total change in real GDP due to a change in initial expenditure.

Multiplier effect

The concept that an additional dollar of expenditures will result in the creation of more than one dollar's worth of real GDP.

Tax multiplier

The effect that a $1 change in taxes has on real GDP; in the aggregate expenditures model, calculated as the change in output divided by an initial change in taxes.

Aggregate Expenditure Model, Expanded Form

AE = A + [MPC x (Y - T)] + I + G + NX

Aggregate Expenditures Model - Equilibrium

Y = [(1/1-MPC) x (A+I+G+NX] + [(-MPC/1-MPC) x T]

recessionary gap

The difference, or gap, between expenditure when real GDP is below the full-employment level and the level of expenditure at full-employment real GDP.

Inflationary gap

The difference, or gap, between expenditure when real GDP is above the full-employment level and the level of expenditure at full-employment real GDP.

Output gap

The difference, or gap, between current real GDP and full-employment real GDP.