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10
C HAPTE R
The Aggregate
Expenditures Model
10 - 1
Simplifying Assumptions for the Private
Closed-Economy model





Assumptions:
A closed economy with no international trade (no
exports or imports).
Government is ignored (no government purchases and
no taxes).
Although both households and businesses save, we
assume here that all saving is personal.
Depreciation and net foreign income are assumed to be
zero for simplicity.
The economy has excess production capacity, so an
increase in AD will raise output and employment, but
not prices.
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Two reminders concerning the assumptions:
1. They leave out two key components of
aggregate demand (government spending and
foreign trade), because they are largely affected
by influences outside the domestic market
system.
2. With no government or foreign trade, GDP,
national income (NI), personal income (PI), and
disposable income (DI) are all the same.
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Tools of Aggregate Expenditures Theory:
Consumption and Investment Schedules
 The theory assumes that the level of output and
employment depend directly on the level of
aggregate expenditures. Changes in output reflect
changes in aggregate spending.
 In a closed private economy the two components
of aggregate expenditures are:
– Consumption (C).
– Gross investment (Ig).
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Investment Schedule:
 The relationship between investment and GDP
shows the amounts business firms collectively
intend to invest at each possible level of GDP
or DI.

In developing the investment schedule, it is
assumed that investment is independent of the
current income.

The assumption that investment is independent
of income is a simplification, but it will be used
here.
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Model Simplifications
• Investment demand vs. schedule
Investment
Demand
Curve
8
20
ID
20
Investment (billions of dollars)
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Investment Schedule
Investment (billions of dollars)
r and i (percent)
Investment Demand Curve
Investment
Schedule
20
Ig
Real GDP (billions of dollars)
Equilibrium GDP: Expenditures-Output
Approach
 Recall that consumption level is directly related
to the level of income and that here income is
equal to output level.
 Investment is independent of income here and is
planned or intended regardless of the current
income situation.
 Equilibrium GDP is the level of output whose
production will create total spending just
sufficient to purchase that output. Otherwise
there will be a disequilibrium situation.
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Equilibrium GDP
(2)
Real
(7)
(8)
Domestic (3)
(5)
(6)
Unplanned Tendency of
Output Con(1)
(4)
Investment Aggregate Changes in Employment,
sump(and
Employ- Income) tion Saving (S)
(Ig)
Expenditures Inventories Output, and
ment (GDP=DI) (C)
(1) – (2)
(C+Ig)
(+ or -)
Income
…in Billions of Dollars
In millions
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(1) 40
$370
$375
$-5
20
$395
$-25
Increase
(2) 45
390
390
0
20
410
-20
Increase
(3) 50
410
405
5
20
425
-15
Increase
(4) 55
430
420
10
20
440
-10
Increase
(5) 60
450
435
15
20
455
-5
Increase
(6) 65
470
450
20
20
470
0
Equilibrium
(7) 70
490
465
25
20
485
+5
Decrease
(8) 75
510
480
30
20
500
+10
Decrease
(9) 80
530
495
35
20
515
+15
Decrease
(10) 85
550
510
40
20
530
+20
Decrease
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 At levels below equilibrium, businesses will adjust to
excess demand (revealed by the declining inventories)
by stepping up production. They will expand
production at any level of GDP less than the $470
billion equilibrium. As GDP rises, the number of jobs
and total income will also rise
 At levels of GDP above equilibrium, aggregate
expenditures will be less than GDP. Businesses will
have unsold output (Unplanned inventory investment)
and will cut back on the rate of production. As GDP
declines, the number of jobs and total income will also
decline, but eventually the GDP and aggregate spending
will be in equilibrium at $470 billion.
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Private spending, C + I g (billions of dollars)
EQUILIBRIUM GDP
(C + Ig = GDP)
$530
C + Ig
Equilibrium
510
C
490
470
Ig = $20 Billion
450
430
410
C =$450 Billion
390
370
45
o
o
370 390 410 430 450 470 490 510 530 550
Real domestic product, GDP (billions of dollars)
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EQUILIBRIUM GDP
 At equilibrium, saving (leakage) and Planned
Investment (injection) are Equal:
Leakage = Injection
(S) = (I)
or
No Unplanned Changes in Inventories (Unplanned
inventory = 0)
Disequilibrium
 Above Equilibrium
Leakage (S) > Injection (I)
• Unplanned inventory accumulation
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 Below Equilibrium
 Leakage (S) < Injection (I)
 Unplanned inventory depletion
 Saving represents a “leakage” from spending stream and
causes (C) to be less than GDP.
 Some of output is planned for business investment and
not consumption, so this investment spending can
replace the leakage due to saving.
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Unplanned expenditures
The unplanned portion is reflected as a business expenditure,
even though the business may not have desired it, because the
total output has a value that belongs to someone - either as a
planned purchase or as an unplanned inventory.
1. If aggregate spending is less than equilibrium GDP, then
businesses will find themselves with unplanned inventory
investment on top of what was already planned.
2. If aggregate expenditures exceed GDP, then there will be
less inventory investment than businesses planned as
businesses sell more than they expected. This is reflected as
a negative amount of unplanned investment in inventory.
3. At equilibrium there are no unplanned changes in
inventory.
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Quick Review
 Equilibrium GDP is where aggregate expenditures equal real
domestic output: C + planned Ig = GDP
 A difference between saving and planned investment
causes a difference between the production and spending
plans of the economy as a whole.
 A difference between production and spending plans leads
to unintended inventory investment or unintended decline in
inventories.
 As long as unplanned changes in inventories occur,
businesses will revise their production plans upward or
downward until the investment in inventory is equal to what
they planned.
 Only where planned investment and saving are equal there
will be no unintended investment or disinvestment in
inventories to drive the GDP down or up.
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Changes in Equilibrium GDP and the Multiplier
 An initial change in spending (caused by shifts in C and I)
will be acted on by the multiplier to produce larger changes
in output.
 The “initial change” is in planned investment spending. It
could also result from a non-income-induced changes in
consumption.
Impact of changes in investment.
Suppose investment spending rises by 5 billion (due to a rise in
expected rate of return or to a decline in interest rates).
1. The increase in aggregate expenditures from investment
leads to an increase in equilibrium GDP (size depends on the
multiplier).
2. Conversely, a decline in investment spending leads to a
decrease in equilibrium GDP (size depends on the multiplier).
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Private spending (billions of dollars)
CHANGES IN EQUILIBRIUM GDP
AND THE MULTIPLIER
510
Equilibrium GDP
GDP
at Ig1Equilibrium
level of investment
at Ig0 level of investment
(C + Ig )
1
(C + Ig )
490
0
Increases
in the level
of C + Ig
470
450
430
o
45
o
430
450
470
490
510
Real domestic product, GDP (billions of dollars)
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Private spending (billions of dollars)
CHANGES IN EQUILIBRIUM GDP
AND THE MULTIPLIER
510
Equilibrium GDP
at Ig2 level of investment
(C + Ig )
0
(C + Ig )
490
2
470
Decreases
in the level
of C + Ig
450
430
o
45
o
430
450
470
490
510
Real domestic product, GDP (billions of dollars)
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International Trade and Equilibrium Output
 Net exports affect aggregate expenditures in an open
economy. Exports expand aggregate spending and
imports contract aggregate spending on domestic output.
 Exports (X) create domestic production, income, and
employment due to foreign spending on domestically
produced goods and services.
 Imports (M) reduce the sum of consumption and
investment expenditures by the amount expended on
imported goods, so this figure must be subtracted so as
not to overstate aggregate expenditures on domestically
produced goods and services.
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The net export schedule
 Shows hypothetical amount of net exports that will
occur at each level of GDP. Note that we assume that
net exports are independent of the current GDP level.
 Positive net exports increase aggregate expenditures
beyond what they would be in a closed economy and
thus have an expansionary effect. The multiplier effect
also is at work.
 Negative net exports decrease aggregate expenditures
beyond what they would be in a closed economy and
thus have a contractionary effect. The multiplier effect
also is at work here.
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Net Exports and
Equilibrium GDP
Aggregate Expenditures
(billions of dollars)
510
Aggregate
Expenditures
490 with Positive
Net Exports
C + Ig+Xn1
C + Ig
C + Ig+Xn2
Aggregate
Expenditures
with Negative
Net Exports
470
450
430
45°
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Net Exports Xn
(billions of
Dollars)
430
450
470
490
510
Real GDP (billions of dollars)
+5
0
-5
Positive Net Exports
450
470
Negative Net Exports
490
Xn1
Xn2
Real
GDP
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International economic linkages
1. Prosperity abroad: generally raises our exports and
transfers some of their prosperity to us. (Conversely,
recession abroad has the reverse effect.)
2. Tariffs on Kuwaiti products: may reduce our exports and
depress our economy, causing us to retaliate and worsen the
situation.
3. Changes in exchange rates:
 Depreciation of the KD lowers the cost of Kuwaiti goods to
foreigners and encourages exports from Kuwait, while
discouraging the purchase of imports in Kuwait. This could
lead to higher real GDP or to inflation, depending on the
domestic employment situation.
 Appreciation of the KD could have the opposite impact.
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Net Exports of Goods
Select Nations, 2006
Negative Net Exports
Positive Net Exports
+31
Canada
France
-45
Japan
-27
+70
Italy
+203
Germany
United Kingdom
-171
-881
-700
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United States
200
150
100
50
0
50
100
150 200
250
Source: World Trade Organization
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Adding the Public Sector
Simplifying assumptions:
1. Simplified investment and net export schedules are used.
Assume they are independent of the level of current
GDP.
2. Assume government purchases do not impact private
spending schedules.
3. Assume that net tax revenues are derived entirely from
personal taxes so that GDP, NI, and PI remain equal.
4. Assume that tax collections are independent of GDP
level (i.e., it is a lump-sum tax)
5. The price level is assumed to be constant unless
otherwise indicated.
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Impact of government spending
 Increases in government spending boost aggregate
expenditures. It is subject to the multiplier effect.
Impact of Taxes
 Taxes reduce DI and, therefore, consumption and
saving at each level of GDP.
 An increase in taxes will lower the aggregate
expenditures schedule relative to the 45-degree line and
reduce the equilibrium GDP, and a decrease in tax will
do the opposite.
 At equilibrium GDP, the sum of leakages equals the
sum of injections, i.e.,
Saving + Imports + Taxes = Investment + Exports + Government Purchases.
(leakage)
=
(injection)
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Adding the Public Sector
(1)
(5)
Level of
(7)
Net Exports
(2)
Output
(Xn)
Aggregate
(4)
(6)
Consumpand
(3)
Investment Exports Imports Government Expenditures
tion
Income
(C+Ig+Xn+G)
Saving (S)
(Ig)
(G)
(C)
(GDP=DI)
(X)
(M)
(2)+(4)+(5)+(6)
…in Billions of Dollars
(1) $370
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$375
$-5
$20
10
10
20
$415
(2)
390
390
0
20
10
10
20
430
(3)
410
405
5
20
10
10
20
445
(4)
430
420
10
20
10
10
20
460
(5)
450
435
15
20
10
10
20
475
(6)
470
450
20
20
10
10
20
490
(7)
490
465
25
20
10
10
20
505
(8)
510
480
30
20
10
10
20
520
(9)
530
495
35
20
10
10
20
535
(10) 550
510
40
20
10
10
20
550
ADDING THE PUBLIC SECTOR
Aggregate Expenditures (billions of dollars)
Government Purchases and Equilibrium GDP
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C + Ig + Xn + G
Government
Spending of
$20 Billion
o
45
C + Ig + Xn
C
o
470
550
Real domestic product, GDP (billions of dollars)
ADDING THE PUBLIC SECTOR
Aggregate Expenditures (billions of dollars)
Lump-Sum Tax and Equilibrium GDP
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$15 Billion Decrease
in Consumption from
a $20 Billion Increase
in Taxes
o
45
C + Ig + Xn + G
Ca + Ig + Xn + G
o
490
550
Real domestic product, GDP (billions of dollars)


a.
Government purchases and taxes have different
impacts.
Equal additions in government spending and taxation
increase the equilibrium GDP.
If G and T are each increased by a particular amount,
the equilibrium level of real output will rise by that
same amount.
b. Example, an increase of $20 billion in G and an
offsetting increase of $20 billion in T will increase
equilibrium GDP by $20 billion.
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a.
b.
c.
d.
Explanation
An increase in G is direct and adds $20 billion to
aggregate expenditures.
An increase in T has an indirect effect on aggregate
expenditures because T reduces disposable incomes
first, and then C falls by the amount of the tax times
MPC.
The overall result is a rise in initial spending of $20
billion minus a fall in initial spending of $15 billion
(.75 x $20 billion), which is a net upward shift in
aggregate expenditures of $5 billion.
When this is subject to the multiplier effect, which is 4
(MPC =.75) in this example, the increase in GDP will
be equal to $4 × $5 billion or $20 billion, which is the
size of the change in G.
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Injections, Leakages, and Unplanned Changes in
Inventories – Equilibrium revisited
 As demonstrated earlier, in a closed private economy
equilibrium occurs when saving (a leakage) equals
planned investment (an injection).
 With the introduction of a foreign sector (net exports)
and a public sector (government), new leakages and
injections are introduced.
1. Imports and taxes are added leakages.
2. Exports and government purchases are added
injections.
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Equilibrium is found when the leakages equal the
injections. When leakages equal injections, there
are no unplanned changes in inventories.
Symbolically, equilibrium occurs when:
Sa + M + T = Ig + X + G
where Sa is after-tax saving, M is imports, T is
taxes, Ig is (gross) planned investment, X is
exports, and G is government purchases.
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
Equilibrium vs. Full-Employment GDP
A recessionary expenditure gap exists when
equilibrium GDP is below full-employment GDP.

A recessionary gap is the amount by which aggregate
expenditures fall short of those required to achieve the
full-employment level of GDP, or the amount by
which the schedule would have to shift upward to
realize the full-employment GDP.

The effect of the recessionary gap is to pull down the
prices of the economy’s output.
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 An inflationary gap exists when aggregate
expenditures exceed full-employment GDP, it
exists when aggregate spending exceeds what is
necessary to achieve full employment.
 The inflationary gap is the amount by which the
aggregate expenditures schedule must shift
downward to realize the full-employment
noninflationary GDP.
 The effect of the inflationary gap is to pull up the
prices of the economy’s output.
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FULL-EMPLOYMENT GDP
Aggregate Expenditures (billions of dollars)
Recessionary Gap
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AE0
AE1
530
510
Recessionary Gap
= $5 Billion
490
Full Employment
o
45
o
490
510
530
Real domestic product, GDP (billions of dollars)
FULL-EMPLOYMENT GDP
Aggregate Expenditures (billions of dollars)
Inflationary Gap
10 - 35
530
AE2
AE0
Inflationary Gap
= $5 Billion
510
490
Full Employment
o
45
o
490
510
530
Real domestic product, GDP (billions of dollars)
Last Word: Say’s Law, The Great Depression, and
Keynes
 Until the Great Depression of the 1930, most economists
going back to Adam Smith had believed that a market
system would ensure full employment of the economy’s
resources except for temporary, short-term upheavals.
 If there were deviations, they would be self-correcting.
A slump in output and employment would reduce prices,
which would increase consumer spending; would lower
wages, which would increase employment again; and
would lower interest rates, which would expand
investment spending.
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• Say’s law, attributed to the French economist J. B. Say
in the early 1800s, summarized the view in a few words:
“Supply creates its own demand.”
• Say’s law is easiest to understand in terms of barter.
The woodworker produces furniture in order to trade for
other needed products and services. All the products
would be traded for something, or else there would be
no need to make them. Thus, supply creates its own
demand.
• The Great Depression of the 1930s was worldwide.
GDP fell by 40 percent in U.S. and the unemployment
rate rose to nearly 25 percent. The Depression seemed
to refute the classical idea that markets were selfcorrecting and would provide full employment.
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 John Maynard Keynes in 1936 in his General Theory of
Employment, Interest, and Money, provided an
alternative to classical theory, which helped explain
periods of recession.
 Not all income is always spent, contrary to Say’s law.
 Producers may respond to unsold inventories by
reducing output rather than cutting prices.
 A recession or depression could follow this decline in
employment and incomes.
10 - 38