Aggregate Expenditure Model notes

Aggregate Expenditure Model

• Definition: The aggregate expenditure (AE) model helps to understand the short-run behavior of the macroeconomy.

• Origin: Developed by John Maynard Keynes to explain persistent unemployment during the Great Depression.

Economic Fluctuations

• Characteristics:

  • Irregular in length and unpredictable in severity.

  • Effects include widespread impact across the economy.

  • Unemployment vs. Output: Inversely related (as unemployment rises, output falls).

  • Inflation Patterns: Typically falls during recessions and rises in periods of economic expansion.

Components of Aggregate Expenditure

• Formula: $AE = C + I + G + NX$

  • C = Consumption

  • I = Investment

  • G = Government Spending

  • NX = Net Exports (exports - imports)

• Connection to GDP: Aggregate expenditure is equivalent to GDP, total output, national income, and national production.

Marginal Propensity to Consume (MPC)

• Definition: The proportion of income that is consumed rather than saved.

• Calculation:

  • $MPC = rac{ ext{Change in Consumption (C)}}{ ext{Change in Income (Y)}}$

  • Example:

  • Income Increase: $1,000

  • Consumption Increase: $900

  • Thus, $MPC = rac{900}{1000} = 0.9$

Determinants of Consumption

• Factors Influencing Consumption:

  • Current Income: Increases consumption.

  • Wealth: Increases consumption.

  • Expected Future Income: Increases consumption.

  • Interest Rates: Increase in rates typically decreases consumption.

Determinants of Investment

• Factors Influencing Investment:

  • Interest Rates: Higher rates decrease investment.

  • Expected Profitability: Higher expectations increase investment.

  • Business Taxes: Increases in taxes decrease investment.

Government Spending and Net Exports

• Government Spending (G): Determined by policy, does not solely depend on standard macroeconomic factors.

• Net Exports (NX): Dependent on:

  • Domestic income, foreign income, and exchange rates.

  • Consumers' tastes for foreign goods and trade policies can also impact.

Planned Aggregate Expenditure (PAE)

• Definition: Represents planned production and consumption decisions.

  • $PAE = C + I + G + NX$

• Equilibrium: Occurs when PAE equals actual GDP (Y).

  • For equilibrium: $PAE = Y$

Output Gap

• Full Employment Output: Highest level of GDP without cyclical unemployment.

• Recessionary Output Gap: Occurs when actual output is less than full employment output ( Y < Y_f ).

  • $ext{Recessionary Output Gap} = Y_f - Y$

• Inflationary Output Gap: Occurs when actual output exceeds full employment output ( Y > Y_f ).

  • $ext{Inflationary Output Gap} = Y - Y_f$

Expenditure Multiplier Effect

• Final Multiplier Formula: Measures how an initial change (e.g., government spending) results in greater than proportional changes in output.

• Multiplier Calculation:

  • $ext{Multiplier} = rac{1}{1 - MPC}$

• Example Multiplier Impact: If the government increases spending by $20 billion, follow-up increases in consumption are calculated as:

  • $ext{Total Change in Demand} = (1 + MPC + MPC^2 + MPC^3 + . . .) imes 20 ext{ billion}$

Practical Applications and Calculations

• Calculating PAE:

  • Substitute values into the PAE formula to find aggregate expenditure at specific income levels.

• Determine Unplanned Inventory: Evaluate changes in inventories by analyzing Y relative to planned expenditures.

• Graphical Representation: Utilize the Keynesian cross diagram to visualize equilibria and shifts in demand.