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Aggregate Expenditure Model

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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, ain’t 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-1930’s.

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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.

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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.

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Key point of our theory

Aggregate 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.

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Graph we useC, I 450

C+IC

outputGDP1

The 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.

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mechanicsC, I 450

C+IC

outputGDP1

If 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.

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practiceC, I 450

C+IC

GDPoutput

AT 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.

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practice againC, I 450

C+IC

GDP

AT the level of outputshown, which is greater,output or C+I?

output

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practice one more timeC, I 450

C+IC

GDP

AT the level of outputshown, which is greater,output or C+I?

output

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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.

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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.

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More I again

If 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.

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C+IC+IC

I

} I

}

C

Putting 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.

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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.

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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.

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disequilibriumC, I 450

C+IC

GDP output

AT 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 couldn’t 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.

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disequilibrium againC, I 450

C+IC

GDP

AT 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 couldn’t 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.

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EquilibriumC, I 450

C+IC

GDP

AT 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.

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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.

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Change in investment

GDP

C, I

C1+I1C1+I2

GDP1 GDP2

Say 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.

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Change in investment

GDP

C, I

C1+I1C1+I2

GDP1 GDP2

Now 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 in

the curve is the multiplier. We saw this already!

AB

D

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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.

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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.

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RGDP graphG

RGDP

G1

In 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.

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RGDP graphC, I, G

RGDP

G1

The 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

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exampleC, I, G

RGDP

C1+I1+G2

C1+I1+G1

RGDP1 RGDP2

Say the government decides to spend more. If the MPC = .8, how much does RGDP rise?

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Tax changeX

RGDP

C2+I1+G1

C1+I1+G1

RGDP1 RGDP2

Say the government decides to tax less. If the MPC = .8, how much does RGDP rise?

This answer to this question requires some thought. Let’s do some of this. More on the next screen.

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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 dispose of would really change by a dollar. Before we saw if income changed by a dollar then consumption would change by the MPC.So a change in the level of taxes will change consumption by MPC times the change taxes.

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reviewIn general thechange in RGDP =

11 - MPC

initial change in spending.

Now the initial change in spending could be from a change in1) C, but not due to a change in tax,2) I,3) GIf there is a change in the tax level use the change in the tax level as the initial change in spending, but also put minus the MPC into the numerator of the bracketed term to incorporate the impact the tax change has on the level of consumption.

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Sneaky exampleIf the government increased expenditure by 10 the C+I+G+X line would shift up by 10. If at the same time they increased taxes by 10 and the MPC was .9 the C+I+G+X line would fall by ...........................?

If we put the two together at the same time, what is called a balanced budget change(not a balanced budget), the C+I+G+X line would shift on the net..................and the total change in income would be....................?

So the balance budget change leads to RGDP increasingby the amount of the G change.

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Exports and importsAt this time we want to incorporate the foreign sector into the model. This means we need to incorporate exports and imports. Remember imports need to be incorporated because C, I and G include imported items.

By the way when we have both government and net exports in the model we have “open, mixed – economy” model. Open means international segment is included and mixed means we have government sector included.

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exports

RGDP

X

RGDP1 RGDP2

The amount of net export is not dependent on our level of RGDP. Other countries decide to buy our stuff. In our model net exports is a constant much like G and I. If they decide to buy more the line shifts up.

X

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RGDP graphC, I, G, X

RGDP

X

The expenditure line is now the C+I+G+x-M line and the equilibrium level of RGDP occurs where the C+I+G+X-M line cross the 45 degree line as we said in the past.

C1+I1+G1 +X1

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RGDP graphC, I, G, X

RGDP

C1+I1+G1 +X2

C1+I1+G1 +X1

If the mpc = .8 and net exports rises by 100, the change in income (100)/(1 - .8) = 500.

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Changes in net exportsThe net export amount can change and if so the component X will change causing the whole C + I + G + X line to shift. Net exports can change if1) Foreign economies have income growth (X rises) or decline (X falls). The idea is the amount they buy from us varies with their income. The more income the more of our stuff they buy.

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SummaryAE

RGDP

AE2

AE1

RGDP1 RGDP2

Aggregate Expenditure AE = C + I + G + X. We see the level of RGDP is determined by AE. If AE changes RGDP will change.The mechanism for change will be that inventories are

not at the planned level and thus output will be changed to meet those plans.

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GapsAE

RGDP

AE1

RGDP1

Keynes felt the economy was guided by AE. But, he also felt the resultant RGDP level may or may not occur at full employment in the economy.

So, Keynes recognized if RGDP is not at the full employment level of RGDP (the potential of the economy) then we had a problem. Let’s see these ideas next.

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Recessionary GAPAE

RGDP

AE1

RGDP1

Here full employment RGDP is above RGDP1 . The economy will stay at RGDP1 because of AE1. The problem is then that resources are left unused.Note the recessionary gap is a vertical distance and is

the amount by which AE is too low to have full employment RGDP.

Full employment RGDP

Look at that gap in the dudes teeth. You probably see the gap as a horizontal space.

The recessionary gap here is a vertical space

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Inflationary GapAE

RGDP

AE1

RGDP1

Here the actual level of output is above full employment. The problem here is that eventually there will be inflationary pressure.The inflationary gap is the vertical distance by which AE

is too high above the level that is needed to have full employment.

Inflationary Gap

Full employment RGDP