Chapter 11: The Aggregate Expenditures Model Notes Model of Aggregate Expenditures Study Notes

Assumptions and Simplifications (LO11.1)

• The Keynesian Aggregate Expenditures Model: This model is used to analyze the relationship between the total amount of spending in the economy and the total amount of output produced.
• "Stuck Price" Model: The model assumes a fixed-price environment where prices do not adjust immediately to changes in economic conditions.
• Private, Closed Economy: Initial analysis begins with an economy that excludes the public sector (government) and the foreign sector (international trade).
  • Consumption Spending ($C$): Purchases made by households.
  • Investment Spending ($I_g$): Purchases of capital goods by firms.
• Disposable Income ($DI$): The model assumes that Gross Domestic Product ($GDP$) is equal to Disposable Income ($DI$).
  • $GDP = DI$

Investment Demand and the Investment Schedule (LO11.2)

• Investment Demand Curve: Reflects the relationship between the expected rate of return ($r$) and the real interest rate ($i$). As interest rates fall, the quantity of investment demanded increases.
• The Investment Schedule: In this model, planned investment ($I_g$) is often assumed to be independent of the level of current disposable income or real output (autonomous investment).
• Tabular Representation (in billions):

Determination of Equilibrium GDP in a Private Closed Economy (LO11.3)

• Core Assumption: If depreciation and net foreign factor income are zero, and government/saving within firms are ignored, then $GDP = NI = PI = DI$. Households receive disposable income equal to the value of total output.
• Equilibrium Condition: Equilibrium occurs where Aggregate Expenditures ($AE$) equal Real Domestic Output ($GDP$).
  • $AE = C + I_g = GDP$

Data Table for a Private Closed Economy (Values in Billions except Employment):

Other Features of Equilibrium GDP (LO11.4)

• Saving and Investment Relationship: At equilibrium, saving equals planned investment ($S = I_g$).
  • Leakage: Saving ($S$) is a leakage as it represents income not spent on consumption.
  • Injection: Investment ($I_g$) is an injection as it represents spending on production not originating from consumers.
• Unplanned Inventory Changes:
  • At equilibrium, unplanned inventory changes are zero.
  • Firms have no incentive to change production levels because the amount they produce exactly matches the amount demanded.

Changes in Equilibrium GDP and the Multiplier Effect (LO11.5)

• Shift in Schedules: An increase in investment spending will shift the Aggregate Expenditures ($C + I_g$) line upward, leading to a new, higher equilibrium GDP.
• The Multiplier: A change in initial spending (like Investment) results in a larger change in equilibrium GDP.
  • In the provided examples, an increase in investment shifts equilibrium from $\$470$ to $\$490$ billion ($\Delta GDP = \$20$ billion for a $\Delta I_g$ presumably smaller, reflecting the multiplier).

Adding International Trade: The Private Open Economy (LO11.6)

• Net Exports ($X_n$): The difference between Exports ($X$) and Imports ($M$).
  • $X_n = X - M$
• Impact on Aggregate Expenditures:
  • $AE = C + I_g + X_n$
  • Exports create domestic production, employment, and income.
  • Imports involve domestic income being spent on goods produced abroad.
• Net Export Schedules:
  • Positive Net Exports ($X > M$): Shifts the total $AE$ schedule upward, increasing equilibrium GDP.
  • Negative Net Exports ($X < M$): Shifts the total $AE$ schedule downward, decreasing equilibrium GDP.
• Global Perspectives (2020 Data in billions):
  • Positive Net Exports: China ($\$340$), Germany ($\$245$), South Korea ($\$65$), Mexico ($\$20$), United Kingdom ($\$5$).
  • Negative Net Exports: Japan ($\$-7$), Bangladesh ($\$-20$), Canada ($\$-38$), France ($\$-50$), United States ($\$-690$).
• International Linkages:
  • Prosperity Abroad: Increases the demand for U.S. exports.
  • Exchange Rates: A depreciation of the dollar makes U.S. goods cheaper, typically increasing exports ($X$).
  • Tariffs and Devaluations: Using these to increase exports can backfire if other nations retaliate, leading to lower GDP for all participating parties.

Adding the Public Sector (LO11.7)

• Government Purchases ($G$): Direct spending by the government on goods and services is an injection into the AE stream.
  • $AE = C + I_g + X_n + G$
• Taxes ($T$): Policies often assume a "Lump-Sum Tax," which is a tax of a constant amount regardless of the level of GDP.
  • Taxes reduce Disposable Income ($DI$).
  • $DI = GDP - T$
  • The reduction in $C$ caused by a tax is equal to $T \times MPC$.
• The Impact of Government Spending on Equilibrium:
  • In the model, adding $\$20$ billion in government purchases ($G$) while exports and imports are equal ($X_n = 0$) shifts equilibrium GDP from $\$470$ billion to $\$550$ billion.

Comprehensive Equilibrium Table (Private and Public Sectors): (Assuming $T = \$20$ billion, $I_g = \$20$ billion, $X_n = 0$, and $G = \$20$ billion)

Equilibrium versus Full-Employment GDP (LO11.8)

• Recessionary Expenditure Gap: Occurs when aggregate spending is insufficient to achieve the full-employment GDP level. Total spending is below the 45-degree line at the full-employment output level.
  • Solution: Increase $G$ and/or decrease $T$.
  • Example: A recessionary gap of $\$5$ billion requires an increase in spending to move GDP from $\$490$ to $\$510$ billion (full employment).
• Inflationary Expenditure Gap: Occurs when aggregate spending exceeds the amount needed to purchase the full-employment GDP. This leads to upward pressure on prices.
  • Solution: Decrease $G$ and/or increase $T$.
  • Example: An inflationary gap of $\$5$ billion at a full employment level of $\$510$ billion causes equilibrium GDP to rise to $\$530$ billion.

Applications and Theories

• The COVID-19 Recession (2020):
  • Began in February 2020.
  • Marked by significant declines in Consumption ($C$) and Investment ($I_g$).
  • Resulted in a substantial recessionary expenditure gap.
• Keynesian Policies in Action:
  • The Federal Government lowered interest rates sharply.
  • Congress passed the CARES Act, providing $\$2.2$ trillion in stimulus to counteract the recession.
• Say’s Law (Classical Economics):
  • Claims "Supply creates its own demand."
  • Assumes the economy will automatically adjust to full employment via price and wage flexibility.
  • Advocates for a Laissez-faire (hands-off) government policy.
• Keynesian Economics:
  • Argues that cyclical unemployment can occur because the economy will not necessarily correct itself.
  • Advocates that the government should actively manage macroeconomic instability through spending and taxation policies.