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Aggregate Expenditure Model

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Aggregate Expenditure Model. Overview. With this section we begin to build a model of the economy. Early on our focus will be on answering a few basic questions:1) What determines the level of RGDP?, and 2) Why does RGDP go up and down over time? - PowerPoint PPT Presentation

Text of Aggregate Expenditure Model

Chapter 25

Aggregate Expenditure Model#OverviewWith this section we begin to build a model of the economy. Early on our focus will be on answering a few basic questions:1) What determines the level of RGDP?, and 2) Why does RGDP go up and down over time?Some guy named John Maynard Keynes (rhymes with rains, like in the southern plains Keynes is a peculiar spelling to us, aint it? Keynesian is pronounced by saying Keynes Ian real fast please do not say Ka knee sion), was one of the first folks to work out this model. Others have tinkered with it since the mid-1930s. #OverviewKeynes felt that in the short run the price level in the economy was fixed. Producers will supply all that demanders want, without changes in the price level.

We will build a model of RGDP in this section based on this idea. In the chapter it might seem that we are talking about GDP. But in a time of no price level change, GDP = RGDP. #Basic ideaThe amount of goods and services produced(and therefore the level of employment) depend directly on the level of total aggregate expenditure.

Aggregate expenditure represents the spending plans of the players of the economic game. We assume for now we have only two players, households andbusinesses. Household expenditures are called consumption expenditures(C) and business expenditures are called investment expenditures(I). Note the book has a subscript g on I. I will not type it to save time and space.#Key point of our theoryAggregate expenditure will be C + I and these terms represent plans. GDP will be measured on the horizontal axis and the 45 degree line will translate the GDP to a vertical distance. You recall from the actual measurement we have GDP = C + I. These actual measurements are just labeled GDP.We will play a scenario analysis and just pick a GDP level. At that GDP level we will compare the actual C and actual I that result with what has been planned.#Graph we useC, I450C+ICoutputGDP1The level of output in the economy will be where the C+I line crosses the 450 line.The only way outputcan change in ourmodel is if C or I should change.To fully understand this theory we need to 1) understand the mechanics of this graph 2) Understand why we look at where C+I crosses the 450 line 3) see why C and I combined appear this way in the graph.#mechanicsC, I450C+ICoutputGDP1If you just focus youreyes of the 450 line you could note a square. The nice thing about a squareis that the length of the bottom equals the length of the height.{{We want to train our eyes to first consider a level of output along the horizontal axis and compare that output with the level of C+I. But C+I is measured vertically. The level of output can be converted to a vertical distance by thinking of the box height.#practiceC, I450C+ICGDPoutputAT the level of outputshown, which is greater,output or C+I?Remember to translate the output to the height of the boxand that really is the height of the 450 line. #practice againC, I450C+ICGDPAT the level of outputshown, which is greater,output or C+I?output#practice one more timeC, I450C+ICGDPAT the level of outputshown, which is greater,output or C+I?output#C againRecall that C stands for household consumption and we said it is a plan by households to consume at various levels of income given2) the wealth of households3) expectations,4) real interest rates,5) Household debt,6) taxation.Note this about the model: If we think about any GDP level the C line tells us what consumers plan to spend. Then when a GDP level actually happens the actual consumption will be the amount on the C line above the GDP level. In other words the planned consumption always equals the actual consumption.#I againRecall that I stands for business investment and we said it is a plan by businesses at various levels of income given 1) Acquisition, maintenance, and operating costs, 2) Business taxes, 3) technological change, 4) stock of capital goods on hand, and 5) expectations, and 6) the interest rate.Note 2 things here: i) investment is constant at various GDP levels, and ii) investment is different from C in a fundamental way. Business have to think about how much C will be and they have to plan their own investment which includes how much to put in inventory.#More I againIf businesses miscalculate C the amount that ends in inventory will be different than what businesses plan and this will cause them to change the amount of output they make. We will see this real soon, I just want to tip you off to be on the lookout for it.On the next slide you see how I add the constant amount I onto the C line to get C + I. Most of the time we will skip putting in the I line by itself. #C+IC+ICI} I} CPutting the C and I lines together meansat each output leveladd up C and I.

Note if C or I should change, the C+I linewill shift. #EquilibriumBefore I mentioned we need to understand why we look at where C+I crosses the 450 line to get the GDP level in the economy. The reason is based on producers of output wanting their inventory to be at the right level.

If producers (businesses) find that inventories are being depleted more than they want, they will produce moregoods and services to get the inventory to the level they desire. GDP would rise.If producers find that inventories are being accumulated more than they want, they will produce less goods and services to get the inventory to the level they desire. GDP would fall.#equilibriumIn the graph we had before the height of the 450 line represents the level of output produced. This productionwould include what firms feel they need to produce to make inventory what they want.The C+I line indicates how much goods and serviceshouseholds and businesses want to buy.If C+I is greater than the output produced then inventoriesmust be depleted more than business want and thus outputis expanded.If C+I is less than the output produced then inventories must be accumulating more than business want and thus output is lowered.#disequilibriumC, I450C+ICGDPoutputAT the level of outputshown, which is greater,output or C+I?Since C+I is greater than the output, inventories must befalling and production will be increased. In our theorythe output shown couldnt exist for long given the C+I plans of households and businesses. So at the current time the level of output shown is ruled out as the current level of output.#disequilibrium againC, I450C+ICGDPAT the level of outputshown, which is greater,output or C+I?outputSince C+I is less than the output, inventories must be risingand production will be decreased. In our theory the output shown couldnt exist for long given the C+I plans of households and businesses. So at the current time the level of output shown is ruled out as the current level of output.#EquilibriumC, I450C+ICGDPAT the level of outputshown, which is greater,output or C+I?outputIn this diagram at the output level shown C+I = outputand firms have no reason to change production becauseinventories are at the right level.#Change in EquilibriumIf households or businesses change their expenditure plans, then the C+I line will shift and the level of output will change. The output change is the same if we have a shift of the C line or the I line in the same amount.#Change in investmentGDPC, IC1+I1C1+I2GDP1 GDP2Say the economy has C1+I1 and the resultingGDP1. Now if the interest rate should fallinvestment would riseto, say I2. The resultwould be C1+I2 and GDP2. GDP increasesbecause with the additional I inventorieswould be too low and thus production, and hence GDP, would increase.##Change in investmentGDPC, IC1+I1C1+I2GDP1 GDP2Now we want to note thechange in GDP is greater than the change in investment. The change in investment is the vertical shift of theC+I line and the changein GDP is the horizontal change fromGDP1 to GDP2. The idea that the change in GDP is greater than the shift inthe curve is the multiplier. We saw this already!ABD##The multiplierIn the graph on the previous slide I should probably have the C + I be steeper than what I have. For most of what I want to communicate the graph is fine. But here it is misleading.Note when investment goes up GDP rises. The GDP rise can be seen as either distance increase D or distance A + B. Since we move to points on the 45degree line A + B = D.Now A is the initial change in investment. The B is all the rounds of addition consumption that result from A. D is a multiple of A, as we saw before.#GovernmentIn our model the government can have an impact on the economy in two ways:1) by affecting expenditures directly by its own expenditures, what will be called G,2) by changing taxes and thus changing consumption C.

Government expenditure in this model will not depend on the level of GDP, but instead depend on the political process. Thus G will look much like I in the model and can change if done so in the political arena.Remember if taxes change by some amount w, C changes in the opposite direction by MPC times w. ##RGDP graphGRGDPG1In the RGDP diagram the level of G will not depend on the level of RGDP. In this regard it is similar to investment. The level of G can shift up or down, as we will see shortly. #RGDP graphC, I, GRGDPG1The expenditure line is now the C+I+G line and the equilibrium level of RGDP occurs where the C+I+G line cross the 45 degree line as we said in the past.C1+I1+G1#exampleC, I, GRGDPC1+I1+G2C1+I1+G1RGDP1 RGDP2Say the government decides to spend more. If the MPC = .8, how much does RGDP rise?#Tax changeXRGDPC2+I1+G1C1+I1+G1RGDP1 RGDP2Say the government decides to tax less. If the MPC = .8, how much does RGDP rise?This answer to this question requires some thought. Lets do some of this. More on the next screen.#Tax changeA change in the level of taxation has an impact on the consumption of the household. If taxes change by a dollar, for example, the income households have to d