Macroeconomic Principles: The Aggregate Expenditure Model

The Aggregate Expenditure Model

• Definition of Aggregate Expenditure (AE): The total amount of spending in the economy. It is calculated as the sum of consumption, planned investment, government purchases, and net exports.

• Focus of the Model: The model focuses on the short-run relationship between total spending and real Gross Domestic Product (GDP), maintaining the assumption that the price level remains constant.

• The Aggregate Expenditure Formula:

  • $AE = C + I + G + NX$

  • Where:

    • $C$ = Consumption

    • $I$ = Planned investment

    • $G$ = Government purchases

    • $NX$ = Net exports

• Macroeconomic Equilibrium Condition:

  • Equilibrium occurs when aggregate expenditure equals total production (total output).

  • Formula: $\text{Aggregate expenditure} = \text{GDP}$

  • This is analogous to microeconomic equilibrium where demand for a product equals its supply.

Determining the Level of Consumption ($C$)

• Five Key Determinants of Consumption:

  1. Current Disposable Income: The most significant determinant; as disposable income increases, consumption increases.

  2. Household Wealth: Assets minus liabilities; higher wealth typically leads to higher consumption.

  3. Expected Future Income: Expectations regarding future earnings impact current spending patterns.

  4. The Price Level: Changes in the price level affect the purchasing power of money and household wealth.

  5. The Interest Rate: Higher interest rates generally encourage saving and discourage spending on durable goods.

• The Consumption Function: The mathematical or graphical relationship between consumption and disposable income.

• Marginal Propensity to Consume (MPC):

  • The slope of the consumption function.

  • It represents the change in consumption divided by the change in disposable income.

  • Formula: $\text{MPC} = \frac{\text{Change in consumption}}{\text{Change in disposable income}} = \frac{\Delta C}{\Delta YD}$

• Relationship between National Income and Disposable Income:

  • $\text{Disposable income} = \text{national income} - \text{net taxes}$

  • $\text{National income} = \text{GDP} = \text{disposable income} + \text{net taxes}$

Income, Consumption, and Saving

• Basic Identity: National income is divided into consumption, saving, and taxes.

  • $Y = C + S + T$

  • Where $Y$ is National Income (GDP), $C$ is Consumption, $S$ is Saving, and $T$ is Net Taxes.

• Changes in Income: $\Delta Y = \Delta C + \Delta S + \Delta T$

• Simplified Model Assumption: If net taxes are assumed to be a constant amount, then $\Delta T = 0$, leading to:

  • $\Delta Y = \Delta C + \Delta S$

• Marginal Propensity to Save (MPS):

  • The change in saving divided by the change in disposable income.

  • Formula: $\text{MPS} = \frac{\Delta S}{\Delta YD}$

• The Sum of Propensities: Since any additional dollar of income is either spent or saved (assuming taxes are constant), the following holds true:

  • $\frac{\Delta Y}{\Delta Y} = \frac{\Delta C}{\Delta Y} + \frac{\Delta S}{\Delta Y}$

  • $1 = \text{MPC} + \text{MPS}$

Determinants of Other AE Components

• Planned Investment ($I$):

  • Expectations of Future Profitability: Optimism or pessimism of firms regarding the economic outlook.

  • The Interest Rate: There is an inverse relationship; higher interest rates increase the cost of borrowing, resulting in less investment spending.

  • Taxes: Lower corporate income taxes increase the after-tax profitability of investment, encouraging spending.

  • Cash Flow: The difference between cash revenues received and cash spending by a firm; higher cash flow facilitates investment.

• Government Purchases ($G$):

  • Includes all spending by federal, state, territory, and local governments on consumption goods and investment goods (e.g., infrastructure like roads and bridges).

  • Exclusion: Social security, pensions, or unemployment benefits (transfer payments) are NOT included in aggregate expenditure because they do not represent the purchase of new goods or services.

• Net Exports ($NX$):

  • Relative Price Levels: The price level in Australia relative to price levels in other countries.

  • Relative Growth Rates: The economic growth rate in Australia relative to growth rates in other countries.

  • Exchange Rate: The value of one country’s currency in terms of another country’s currency. A stronger Australian dollar typically makes exports more expensive and imports cheaper, potentially reducing net exports.

Graphing Macroeconomic Equilibrium: The 45° Line Diagram

• The 45° Line (Keynesian Cross):

  • The 45° line serves as a reference where every point on the line indicates that planned real aggregate expenditure is exactly equal to real national income ($AE = Y$).

  • Points Above the 45° Line: Planned aggregate expenditure is greater than GDP (AE > GDP). Inventories will fall, and production will generally increase.

  • Points Below the 45° Line: Planned aggregate expenditure is less than GDP (AE < GDP). Inventories will rise, and production will generally decrease.

• Spending Categories on the Graph:

  • Autonomous Consumption: Consumption that occurs even if income is zero (the vertical intercept of the consumption function).

  • Induced Consumption: Consumption that is determined by and changes with the level of income.

  • The Aggregate Expenditure function is constructed by adding $I$, $G$, and $NX$ to the consumption function ($C$). Because $I$, $G$, and $NX$ are often assumed to be autonomous (fixed) in this simplified model, the AE line shifts up from the $C$ line but maintains the same slope (determined by the MPC).

Macroeconomic Fluctuations: Recessions and Expansions

• Recession/Contraction:

  • If equilibrium occurs at a level of GDP below the potential GDP, the economy is in a recession.

  • There is a "shortfall" in aggregate expenditure required to reach full employment/potential GDP.

• The Effect of Price Level Changes on Real GDP:

  • Increase in Price Level: Causes the AE line to shift downward ($AE_1$ to $AE_2$). Consumption, planned investment, and net exports decline, leading to a lower equilibrium real GDP (e.g., falling from $1000 billion to $980 billion).

  • Decrease in Price Level: Causes the AE line to shift upward. Consumption, planned investment, and net exports rise, leading to a higher equilibrium real GDP (e.g., increasing from $1000 billion to $1020 billion).

• Aggregate Demand (AD) Curve:

  • Shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

  • It is derived from the AE model by observing how changes in the price level shift the AE line and create new equilibrium levels of real GDP.

Numerical Examples

Example 1: Consumption and Income Calculations

• National Income ($Y$): $1,000 | Net Taxes: $1,000 | Disposable Income ($YD$): $0 | Consumption ($C$): $750

• National Income ($Y$): $3,000 | Net Taxes: $1,000 | Disposable Income ($YD$): $2,000 | Consumption ($C$): $2,250

• National Income ($Y$): $5,000 | Net Taxes: $1,000 | Disposable Income ($YD$): $4,000 | Consumption ($C$): $3,750

• Calculation of MPC:

  • Change in Income ($\Delta Y$) = $2,000

  • Change in Consumption ($\Delta C$) = $1,500

  • $\text{MPC} = \frac{1500}{2000} = 0.75$

Example 2: MPC and MPS Table (Assuming Taxes = 0)

• Verification: $0.6 (MPC) + 0.4 (MPS) = 1.0$

Example 3: Equilibrium and Inventory Changes

Questions & Discussion

Tutorial Question 1: Categorizing Transactions Into which category of aggregate expenditure would each of the following transactions fall?

• a. A family buys a new car.

  • Category: Consumption ($C$)

• b. A high school buys 12 new school buses.

  • Category: Government Purchases ($G$)

• c. A family builds a new house.

  • Category: Planned Investment ($I$) - Note: New residential construction is considered investment.

• d. You order a computer for your personal use.

  • Category: Consumption ($C$)

• e. An insurance company purchases 250 new computers.

  • Category: Planned Investment ($I$)

Tutorial Question 2: The Meaning of the 45° Line

• Question: What is the meaning of the 45° line in the 45° line diagram?

• Answer: It represents all points where planned aggregate expenditure equals real GDP ($AE = Y$). It serves as the locus of potential macroeconomic equilibrium points.

Tutorial Question 3: Graphing Equilibrium

• Requirement: Use a 45° line diagram to illustrate macroeconomic equilibrium.

• Details: The diagram must show the AE function ($C + I + G + NX$), the 45° reference line, and the point where they intersect, identifying the level of equilibrium real GDP. Labels should include Real Aggregate Expenditure (AE) on the vertical axis and Real GDP ($Y$) on the horizontal axis.