Chapter 31: The Aggregate Expenditures Model
The two most important questions in macroeconomics:
(i) How is an economy's output measured?
(ii) Why does an economy grow?
To find the answers, we can construct the aggregate expenditures model
Aggregate expenditures model, also known as the "Keynesian Cross" model, was developed by British economist John Maynard Keynes
The basic premise is that the amount of goods and services produced and, therefore, the level of employment depend directly on the level of aggregate expenditures (total spending).
Most fundamental assumption: Prices in the economy are fixed and thus cannot be changed.
The keynesian aggregate expenditures model is insightful because:
It clarifies aspects of the severe 2007-2009 U.S recession like why unexpected initial declines in spending caused even larger declines in real GDP.
It helps us to understand the thinking behind stimulus programs (tax cuts and government spending) enacted by the government during times of recession
It can help us understand how the modern economy is likely to initially adjust to various economic shocks over shorter periods of time.
It helps us to understand the affects of the many prices in the modern economy that are inflexible downward over relatively short periods of time.
The aggregate expenditures model in the private closed economy
Aggregate Expenditures
Two components of aggregate expenditures
(ii) Gross investment (Ig)
Investment schedule
A table of numbers showing the amounts that firms collectively plan and intend to invest at each possible level of GDP.
Investment demand curve (ID)
Shows that the level of investment spending is determined by the real interest rate together with the expected rate of return.
Equilibrium GDP: C + Ig = GDP
Annual rates of spending and production are in balance
No over production
No excess of total spending
Graphical analysis
45 degree line: A graphical statement of the equilibrium condition
Disequilibrium:
Levels of GDP less than equilibrium
Total aggregate expenditure exceeds real GDP
Unplanned decline in inventories
Businesses increase production
Increase in employment
Increase in total income
Levels of GDP greater than equilibrium
Real GDP exceeds total aggregate expenditure
Unplanned surplus in inventories
Businesses cut back on production
Decrease in employment
Decrease in total income
Savings and planned investment are equal: S = Ig
There are no unplanned changes in inventories
Savings (S) is also known as leakage
It is a withdrawal of spending from the economy's circular flow of income and expenditures
Causes consumption to be less than the total output or GDP
Leads to a decline in total output or real GDP
If firms produce output or real GDP greater than equilibrium GDP and sales fall short of production, there is an unplanned increase in inventories.
Unplanned increase in inventories is added to planned investment and this total equals the actual investment
If firms produce output or real GDP less than equilibrium GDP and sales exceed production, there is an unplanned decrease in inventories.
Unplanned decrease in inventories is subtracted from the planned investment and this total equals the actual investment
Investment (Ig) is also known as injection
It is the purchase of capital goods and thus adds spending into the income-expenditure stream.
It is a potential replacement for the leakage of saving
If injection of investment exceeds the leakage of saving then: C + Ig (aggregate expenditure) will be greater than real GDP.
Larger injection of investment spending will drive up the production of real GDP higher.
If leakage of saving at a certain level of GDP exceeds the injection of investment then: C + Ig (aggregate expenditure) will be less than real GDP.
The spending deficiency will reduce production of real GDP.
(i) Consumption (C)
Marginal propensity to consume = aggregate expenditures line