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Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0030342333
Copyright © 2002 by Thomson Learning, Inc.
The Aggregate
Expenditures Model
Copyright © 2002 by Thomson Learning, Inc.
Consumption Depends on
Disposable Income

Marginal propensity to save (MPS)

the change in savings divided by the
change in disposable income
Copyright © 2002 by Thomson Learning, Inc.
Consumption Depends on
Disposable Income

Current consumption spending depends
on many factors.






age
family size
interest rates
expected future disposable income
wealth
current disposable income

Empirical studies show that most people’s
consumption spending is closely tied to their
disposable income.
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Consumption Depends on
Disposable Income

If your disposable income is



$0, you spend $8,000 (that means you
have to borrow or reduce your existing
savings just to survive).
$20,000, you’ll spend $8,000 plus 75
percent of $20,000 (which equals
$15,000), for total spending of $23,000.
$40,000, you’ll spend $8,000 plus 75
percent of $40,000 (which equals
$30,000), for total spending of $38,000.
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Consumption Function
Consumption
Function
Consumption
$38,000
$23,000
$21,500
B
A
$8,000
0
$18,000 $20,000 $40,000
Disposable Income
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Consumption Depends on
Disposable Income

Marginal propensity to consume (MPC)


MPC = C/DY
The flip side of the marginal propensity
to consume is the marginal propensity
to save (MPS)


the proportion of additional income that you
would save or not spend on goods and
services today.
MPS = S/DY.
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Consumption Depends on
Disposable Income


The slope of the line represents the
marginal propensity to consume.
Aggregate consumption gives a
functional relationship called a
consumption function.
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Consumption Depends on
Disposable Income

Let’s suppose consumption spending in
the economy is something like $1 trillion
plus 75 percent of income.


Consumption is partly autonomous (the $1
trillion part, which people would spend no
matter what their income, which depends
on the current interest rate, real wealth,
debt, and expectations),
and partly induced, which means it
depends on income, the portion that’s
equal to 75 percent of income.
Copyright © 2002 by Thomson Learning, Inc.
Consumption Depends on
Disposable Income

If we assume that investment,
government purchases, and net exports
are zero, aggregate expenditure is just
equal to the amount of consumption
spending represented by our
consumption function.
Copyright © 2002 by Thomson Learning, Inc.
Equilibrium in the Aggregate
Expenditure Model

At the equilibrium level of output,
planned production of goods and
services (RGDP) is equal to the
aggregate expenditures (AE)—the total
planned spending for these goods and
services.
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Exhibit 2
Aggregate
Expenditure
AE = RGDP
45°
0
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RGDP
Equilibrium in the Aggregate
Expenditure Model

The 45-degree line illustrates
coordinates where the number on the
horizontal axis, representing the amount
of output in the economy, is equal to the
number on the vertical axis,
representing the amount of aggregate
expenditure in the economy.

If equilibrium output is $5 trillion, then
aggregate expenditure must equal $5
trillion.
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Equilibrium in the Aggregate
Expenditure Model

What if output were lower than its
equilibrium level RGDP1?
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Exhibit 3
Aggregate
Expenditure
C
D
AEE
A
AE1
0
B
RGDP1 RGDPE RGDP2
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AE1 = RGDP
Aggregate
Expenditure =
Consumption
Equilibrium in the Aggregate
Expenditure Model

When output is RGDP1, AE is greater
than output labeled the distance AB
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People would be buying more goods and
services (A) than were being produced (B).
Inventories would decrease.
Production would increase to increase
inventory stocks.
Output would increase in the economy.
This process would continue until output
reached its equilibrium level, where the two
lines intersect.
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Equilibrium in the Aggregate
Expenditure Model

When output is RGDP2, above
equilibrium, economic forces would act
to reduce output.
AE (D) is less than output (C).
 People wouldn’t buy all the output.
 Production would be reduced.
 Inventories would be bulging.
 Rational firms would reduce output and
production until inventory stocks return to
the desired level and the equilibrium level
of output was reached.
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
Equilibrium in the Aggregate
Expenditure Model



Aggregate expenditure is shown by the
flatter line (labeled “Aggregate
Expenditure = Consumption”).
The equilibrium condition is shown by
the 45-degree line (labeled “AE =
RGDP”).
The only point for which consumption
spending equals aggregate expenditure
equals output is the point where those
two lines intersect.
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Adding Investment, Government
Purchases, and Net Exports


Suppose that consumption depends on
the level of income or output in the
economy, but that investment,
government purchases, and net exports
do not.
Instead, investment, government
purchases, and net exports depend on
other factors in the economy such as
interest rates, political considerations, or
the condition of foreign economies.
Copyright © 2002 by Thomson Learning, Inc.
Adding Investment, Government
Purchases, and Net Exports

Now, aggregate expenditure (AE)
consists of

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
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
consumption (C) plus
investment (I) plus
government purchases (G) plus
net exports (NX):
AE  C + I + G + NX.
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Adding Investment, Government
Purchases, and Net Exports


The components of aggregate
expenditure result in an upward-sloping
line because consumption increases as
income increases.
Allowing for investment, government
purchases, and net exports, the
autonomous portion of aggregate
expenditure is larger.
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Exhibit 4
Aggregate
Expenditure
AE1 = C + I + G + NX
Equilibrium Level
AEE
AE1
45°
0
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RGDPE
RGDP
Adding Investment, Government
Purchases, and Net Exports

As before, the equilibrium occurs where
the two lines cross, that is, where the
aggregate expenditure line intersects
the equilibrium line, which is the 45degree line.
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Shifts in Aggregate Expenditure

Aggregate expenditure increases due to
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More optimistic expectations
Easier credit conditions (interest rates decline)
Real wealth increases
Firms increase their investment (especially if
their productivity rises or the interest rate
declines)
Government increases its spending
Net exports rise as foreign economies
improve their economic health
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 5
Aggregate
Expenditure
($ trillion)
AE2 = $2.5 trillion +
(0.75 × Output)
Z
$10
$8
$2.5
$2
AE1 = $2 trillion +
(0.75 × Output)
A
45°
0
Copyright © 2002 by Thomson Learning, Inc.
RGDP
($ trillion)
From Aggregate Expenditure to
Aggregate Demand


To go from the aggregate expenditure
model to aggregate demand, all we
need to consider is how the price level
affects the components of aggregate
demand.
Now we allow the components of
aggregate expenditure to depend on the
price level.
Copyright © 2002 by Thomson Learning, Inc.
From Aggregate Expenditure to
Aggregate Demand

When the price level falls

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Consumption rises, because people’s real
wealth rises (the real wealth effect).
Investment increases because interest
rates decline (the interest-rate effect).
Furthermore, net exports rise because
domestic goods become relatively cheaper
than foreign goods (the open economy
effect).
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 6
Aggregate
Expenditure
AE
(PL = 90)
AE
(PL = 100)
AE
(PL = 110)
B
A
C
RGDP
Price
Level
110
100
90
C
A
B
Aggregate
Demand
0
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$7 $8 $9
RGDP
($ trillion)
From Aggregate Expenditure to
Aggregate Demand

When the price level is 100,
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the aggregate expenditure is the curve
labeled AE(PL = 100) in the top diagram.
The equilibrium in the Keynesian-cross
model occurs at point A.
Point A in the bottom diagram corresponds
to a price level of 100 and output of $8
trillion.
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From Aggregate Expenditure to
Aggregate Demand

If the price level falls from 100 to 90,
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The aggregate-expenditure curve shifts up
to AE(PL = 90).
A new equilibrium occurs at point B.
Point B in the bottom diagram corresponds
to price level 90 and output $9 trillion.
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From Aggregate Expenditure to
Aggregate Demand

If the price level rises to 110,
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The aggregate-expenditure curve shifts
down to AE(PL = 110).
The new equilibrium in the aggregate
expenditure diagram occurs at point C.
Point C in the bottom diagram corresponds
to a price level of 110 and output of $7
trillion.
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From Aggregate Expenditure to
Aggregate Demand


The higher the price level, the lower is
aggregate demand.
Carrying out this same experiment for
every possible price level would trace
out the entire aggregate demand curve,
as shown.
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Shifts in Aggregate Demand

Changes in any of the components of
aggregate expenditure that occur for
any reason other than a change in the
price level or output lead to a shift of the
aggregate demand curve.


whenever the autonomous parts of
consumption, investment, government
purchases, or net exports increase
Such a change would shift the
aggregate-expenditure curve upwards.
Copyright © 2002 by Thomson Learning, Inc.
Exhibit 7
Aggregate
Expenditure
AE
(PL = 90)
D
AE
(PL = 110)
A
45°
RGDP
Price
Level
100
D
A
AD2
AD1
0
Copyright © 2002 by Thomson Learning, Inc.
$8
$8.5
RGDP
($ trillion)
Shifts in Aggregate Demand


We denote the original aggregateexpenditure curve AE1 and the new
aggregate-expenditure curve AE2.
Originally the economy is in equilibrium
at point A with output of $8 trillion and a
price level of 100.
Copyright © 2002 by Thomson Learning, Inc.
Shifts in Aggregate Demand


After the increase in government
purchases, the aggregate-expenditure
curve shifts up, moving the economy to
a new equilibrium at point D with output
of $8.5 trillion and price level remaining
at 100.
For any other given price level,
equilibrium output would also be higher
after an increase in government
purchases.
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Shifts in Aggregate Demand

So, the new aggregate demand curve
on the lower diagram shifts to the right.
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