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Aggregate Expenditure Model (Consumption & Investment Schedules (In…
Aggregate Expenditure Model
Aggregate Expenditure Model
also known as the
"Keynesian Cross Model":
The amount of goods and services produced and therefore the level of employment depend directly on the level of aggregate expenditures (total spending). Businesses will produce only a level of output that they think they can profitably sell. They will idle their workers and machinery when there are no markets for their goods and services.
Assumptions:
The most fundamental assumption behind the aggregate expenditures model is that prices in the economy are fixed.
Keynes made this assumption because he had observed that prices had not declined sufficiently during the Great Depression to boos spending and maintain output and employment at their pre-depression levels.
Keynes thought that a new economic model was needed to show how all this could have happened and how it might be reversed.
The aggregate expenditures model therefore can help us understand how the modern economy is likely to initially adjust to various economic shocks over shorter periods of time.
This model indicates
aggregate expenditures
and
equilibrium GDP
in a
private closed economy
- one
without international trade or government
.
We will assume that the presence of excess production capacity and unemployed labour implies that an increase in aggregate expenditures will increase real output and employment without raising the price level.
Consumption & Investment Schedules
An economy's investment schedule is derived from the investment demand curve and an interest rate.
In the private closed economy, the two components of aggregate expenditures are
consumption, C, and gross investment, Ig.
To add the investment decision of businesses to the consumption plans of households, we need to construct an
investment schedule
showing the amounts business firms collectively intend to invest - their planned investment - at each possible level of GDP.
Such a schedule represents the investment plans of businesses in the
same way the consumption schedule represents the consumption plans of households.
In developing the
investment schedule
, we will
assume that this planned investment is independent of the level of current disposable income or real output.
(a.) The level of investment spending (here, $20Billion) is determined by the real interest rate (here 8%) together with the investment demand curve ID.
(b.) The investment schedule Ig relates the amount of investment ($20Billion) determined in (a) to the various levels of GDP
Figure b is the economy's investment schedule Ig that shows the amount of investment forthcoming at each level of GDP. The interest rate and investment demand curve together determin this amount ($20Billion). Note that Investment Ig in Column 2 is $20 Billion at all levels of real GDP.
Equilibrium GDP: C+Ig = GDP
Economists combine consumption and investment to depict an aggregate expenditures schedule for a private closed economy. This schedule can be used to demonstrate the economy's equilibrium level of output (where the total quantity of goods produced equals the total quantity of goods purchased).
Tabular Analysis
Real Domestic Output
lists the various possible levels of total output - of real GDP - that the private sector might produce. Firms would be willing to produce any one of these 10 levels of output just
as long as the revenue that they receive from selling any particular level equals or exceeds the costs they would incur to produce it
.
Equilibrium GDP
The equilibrium output is that output whose production creates total spending just sufficient to purchase that output. So the equilibrium level of GDP is the level at which the total quantity of goods produced (GDP) equals the total quantity of goods purchased (C+Ig).
In the private closed economy, the
Equilibrium GDP
is where
C+Ig = GDP
That is the only output at which economywide spending is precisely equal to the amount needed to move that output off the shelves. At $470 billion of GDP, the annual rates of production and spending are in balance.
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Aggregate Expenditures
Aggregate expenditures consist of consumption (Column 3) plus investment (Column 5). Their sum is shown in Column 6, which along with Column 2 makes up the aggregate expenditures schedule for the private closed economy. This schedule shows the amount (C+Ig) that will be spent at each possible output or income level.
Column 5 shows the
Planned Investment
- it
shows the amounts firms plan or intend to invest, not the amounts they actually will invest if there are unplanned changes in inventories.
Disequilibrium
No level of GDP other than equilibrium level of GDP can be sustained.
At levels of GDP less than equilibrium
, spending always exceeds GDP.
An unplanned decline in business inventories would occur if this situation continued.
But businesses can adjust to such an imbalance by
stepping up production.
Greater output will increase employment and total income. This process will continue until the equilibrium level of GDP is reached.
The reverse is true at
all levels of GDP greater than the equilibrium level
.
Businesses will find that these total outputs fail to generate the spending needed
to clear the shelves of goods. Being unable to recover their costs,
businesses will cut back on production.
Business managers would find spending is insufficient to permit the sale of all that output. Of the income that this output creates, some money would be received back by businesses as consumption spending. Though supplemented by planned investment spending total expenditures would still be below the quantity produced. If this imbalance persists, inventories would pile up.
But businesses can adjust to this unintended accumulation of unsold goods by cutting back on the rate of production.
The resulting decline in output would mean fewer jobs and a decline in total income.
Graphical Analysis
Equilibrium GDP in a private closed economy. The aggregate expenditures schedule, C+Ig is determined by adding the investment schedule Ig to the upsloping consumption schedule C. Since investment is assumed to be the same at each level of GDP, the vertical distances between C and C+Ig do not change. Equilibrium GDP is determined where the aggregate expenditures schedule intersects the 45 degree line, in this case at $470million
At any point on this line, the value of what is being measured on the horizontal axis (here, GDP) is equal to the value of what is being measured on the vertical axis (here, aggregate expenditures, or C+Ig). Therefore if equilibrium level of domestic output is determined where C+Ig = GDP, we can say that the 45 degree line is a graphical statement of that equilibrium condition.
The aggregate expenditures line C+Ig shows that total spending rises with income and output (GDP), but not as much as income rises. That is true because the marginal propensity to consume - the slope of line C - is less than 1.
A part of any increase in income will be saved rather than spent.
And because the aggregate expenditures line C+Ig is parallel to the consumption line C, the slope of the aggregate expenditures line also equals the MPC for the economy and is less than 1.
The equilibrium level of GDP is determined by the intersection of the aggregate expenditures schedule and the 45 degree line. This intersection locates the only point at which aggregate expenditures (on the vertical axis) are equal to GDP (on the horizontal axis).
It is evident that no levels of GDP above the equilibrium level are sustainable because at those levels C+Ig falls short of GDP. Graphically, the aggregate expenditures schedule lies below the 45 degree line in those situations. This underspending causes inventories to rise, prompting firms to readust production downward, in the direct of the Equilibrium level.
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Other features of Equilibrium GDP
There are 2 other ways to characterize the
equilibrium level of real GDP
in a private closed economy:
Saving = Investment
No unplanned changes in inventories
1. Saving = Planned Investment
S=Ig
Saving and Planned Investment are both equal at the Equilibrium level of GDP.
Saving is a leakage or withdrawal of spending from the economy's circular flow of income and expenditures.
Saving is what causes consumption to be less than total output or GDP. Because of saving, consumption by itself is insufficient to remove domestic output from the shelves, apparently setting the stage for a decline in total output.
However firms do not intend to sell their entire output to consumers. Some of that output will be capital goods sold to other businesses. Investment - the purchases of capital goods - is therefore an injection of spending into the income-expenditures stream. As a adjunct to consumption investment is thus a potential replacement for the leakage of saving.
If the leakage of saving at a certain level of GDP exceeds the injection of investment, then C+Ig will be less than GDP and that level of GDP cannot be sustained. Any GDP for which saving exceeds investment is an above-equilibrium GDP.
Conversely, if the injection of investment exceeds the leakage of saving, then C+Ig will be greater than GDP and drive GDP upward. Any GDP for which investment exceeds saving is a below-equilibrium GDP.
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2. No unplanned changes in inventories
As part of their investment plans, firms may decide to increase or decrease their inventories. But, there are no unplanned changes in inventories at equilibrium GDP. This fact, along with C+Ig = GDP, and S=Ig is a characteristic of Equilibrium GDP i the private closed economy.
Unplanned changes in inventories play a major role in achieving equilibrium GDP.
See example in Textbook - p420-421
When economists say differences between investment and saving can occur and bring about changes in equilibrium GDP, they are referring to planned investment and saving. Equilibrium occurs only when planned investment and saving are equal. But when unplanned changes in inventories are considered, investment and saving are always equal, regardless of the level of GDP.
That is true because actual investment consists of planned investment and unplanned investment (unplanned changes in inventories). Unplanned changes in inventories act as a balancing item that equates the actual amounts saved and invested in any period.
