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The Aggregate Expenditures Model - Coggle Diagram
The Aggregate Expenditures Model
Originated in the writings 1936 writings of British Economist John Maynard Keynes.
Components of Aggregate Expenditure (AE):
Consumption (C): Household spending on goods and services.
Consumption Function: C = a + bYd (where a is autonomous consumption, b is marginal propensity to consume, and Yd is disposable income)
Investment (I): Business spending on capital goods, inventories, and structures.
Government Spending (G): Government purchases of goods and services.
Net Exports (NX): Exports minus imports.
Equilibrium Level of Income:
The level of income where planned aggregate expenditures (AE) equal total output (GDP).
Graphically represented by the intersection of the AE curve and the 45-degree line.
Multiplier Effect:
The process by which an initial change in spending leads to a larger change in total income and output.
Multiplier = 1 / (1 - MPC) (where MPC is marginal propensity to consume).
Shifts in the AE Curve:
Factors that change the components of AE (C, I, G, NX) will shift the AE curve.
An increase in any component shifts the AE curve upward, leading to a higher equilibrium income.
A decrease in any component shifts the AE curve downward, leading to a lower equilibrium income.
Stuck Price Model:
Prices are assumed to be sticky in the short run, meaning they don't adjust immediately to changes in demand or supply.
This leads to fluctuations in output and employment rather than price changes in response to demand shocks.
The model helps explain short-run economic fluctuations.
Key Points:
The aggregate expenditure model is a key tool for understanding how changes in spending can impact the overall economy.
The multiplier effect highlights the potential for small changes in spending to have large impacts on output.
Government spending can be used to influence the level of economic activity.
The stuck price model introduces the concept of price rigidity, which is crucial for understanding short-run economic fluctuations.
Consumption Schedule
A consumption schedule is a table or graph that shows the relationship between disposable income and consumption.
It illustrates how much households plan to consume at different levels of income.
The slope of the consumption schedule is the marginal propensity to consume (MPC), which represents the change in consumption for each unit change in income.
Investment Schedule
An investment schedule shows the relationship between the level of income and planned investment.
Unlike consumption, investment is often assumed to be relatively independent of income in the short run. Therefore, the investment schedule is often represented as a horizontal line.
However, in the long run, investment might be positively correlated with income.
Investment Demand Curve
The investment demand curve relates the level of investment to the interest rate.
It slopes downward, indicating that as the interest rate decreases, the quantity of investment demanded increases.
This is because a lower interest rate reduces the cost of borrowing, making investment projects more profitable.
Equilibrium and Disequilibrium GDP
Equilibrium GDP
Equilibrium GDP occurs when planned aggregate expenditures (AE) equal total output (GDP).
This is the level of income at which there are no unplanned changes in inventories.
Graphically, it's the point where the AE curve intersects the 45-degree line.
Disequilibrium GDP
Disequilibrium GDP occurs when planned aggregate expenditures (AE) do not equal total output (GDP).
This leads to unplanned changes in inventories.
If AE is greater than GDP, there is unplanned inventory depletion, leading to an increase in production to meet demand.
If AE is less than GDP, there is unplanned inventory accumulation, leading to a decrease in production to reduce excess inventory.
The economy tends to gravitate towards
equilibrium GDP
as businesses adjust production levels in response to unplanned inventory changes. However, various factors can disrupt this equilibrium, leading to periods of expansion or recession.
Leakages and Injections
Leakages
Savings (S): Money saved rather than spent on consumption.
Taxes (T): Income paid to the government.
Imports (M): Spending on goods and services produced abroad.
Injections
Investment (I): Spending by businesses on capital goods.
Government Spending (G): Government expenditures on goods and services.
Exports (X): Spending by foreigners on domestically produced goods and services.
For the economy to be in equilibrium, total leakages must equal total injections:
S + T + M = I + G + X
When leakages exceed injections, there is a decrease in aggregate demand, leading to a decline in output and income. Conversely, when injections exceed leakages, there is an increase in aggregate demand, leading to an increase in output and income.
Full-Employment GDP
Full-employment GDP represents the level of real GDP produced when an economy is operating at full capacity, with unemployment at the natural rate.
It's also referred to as potential GDP or long-run GDP.
At full employment, the economy is producing its maximum sustainable output without creating inflationary pressures.
Recessionary Expenditure Gap
A recessionary expenditure gap occurs when the actual level of GDP is below the full-employment GDP.
This gap indicates that the economy is operating below its potential and there is a certain level of cyclical unemployment.
To close a recessionary gap, government policies aim to increase aggregate demand.
Inflationary Expenditure Gap
An inflationary expenditure gap occurs when the actual level of GDP exceeds the full-employment GDP.
This gap indicates that the economy is overheating, which can lead to inflationary pressures.
To close an inflationary gap, government policies aim to reduce aggregate demand.