Topic 5- Aggregate Expenditure Model PDF

31 The Aggregate Expenditures Model McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.  Chapter Objectives Aggregate expenditures for a private closed economy Characteristics...

31 The Aggregate Expenditures Model McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.  Chapter Objectives Aggregate expenditures for a private closed economy Characteristics of equilibrium real GDP in a private closed economy Changes in equilibrium real GDP and the multiplier Adding the government and international sectors Recessionary and inflationary expenditure gaps 28-2  Assumptions and Simplifications Keynesian aggregate expenditures model Prices are fixed GDP = DI depreciation and NFFI are zero government is ignored all saving are by households then GDP is equal to NI,PI, and DI. private, closed economy- C + Ig LO1  Model Simplifications Investment demand vs. schedule Investment Demand Curve Investment Schedule Investment (billions of dollars) Investment Investment Demand Schedule r and i (percent) Curve 20 Ig 8 20 20 ID 20 Investment (billions of dollars) Real GDP (billions of dollars) 28-4  Equilibrium GDP Real GDP = C + Ig Aggregate expenditures – Equal to C + Ig – Aggregate expenditures schedule Quantity goods produced = quantity goods purchased Disequilibrium 28-5 – Only 1 equilibrium level of GDP  Equilibrium GDP Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy (2) Real Domestic Output (1) (and (6) (7) (8) Possible Income) (3) (4) (5) Aggregate Unplanned Tendency of Levels of (GDP = Consumption Saving Investment Expenditure Changes in Employment, Employment, DI),*Billio (C), (S), (Ig), (C+Ig), Inventories, Output, and Millions ns Billions Billions Billions Billions (+ or -) Income (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 * If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP LO1  Equilibrium GDP C + Ig (C + Ig = GDP) C Equilibrium point Aggregate expenditures Ig = $20 billion C = $450 billion LO1 Other Features of Equilibrium GDP Saving equals planned investment Saving is a leakage of spending Investment is an injection of spending No unplanned changes in inventories No incentive for Firms to change production level LO2  Changes in Equilibrium GDP (C + Ig)1 Aggregate Expenditures (billions of dollars) 510 (C + Ig)0 (C + Ig)2 490 Increase in Investment by 5 Decrease in Investment by 5 470 450 The Multiplier Effect 430 45° 430 450 470 490 510 28-9 Real GDP (billions of dollars)  Adding International Trade Include net exports spending in aggregate expenditures Private, open economy Exports create production, employment, and income Subtract spending on imports Xn can be positive or negative LO4  The Net Export Schedule Two Net Export Schedules (in Billions) (2) (3) (1) Net Exports, Net Exports, Level of GDP Xn1 (X > M) Xn2 (X < M) $370 $+5 $-5 390 +5 -5 410 +5 -5 430 +5 -5 450 +5 -5 470 +5 -5 490 +5 -5 510 +5 -5 530 +5 -5 550 +5 -5 LO4  Net Exports and Equilibrium GDP C + Ig+Xn1 510 C + Ig Aggregate C + Ig+Xn2 Aggregate Expenditures Expenditures with Positive (billions of dollars) 490 Net Exports Aggregate 470 Expenditures with Negative Net Exports 450 430 45° 430 450 470 490 510 Real GDP (billions of dollars) Net Exports Xn (billions of Positive Net Exports Dollars) +5 Xn1 450 470 490 0 Real -5 Xn2 GDP 28-12 Negative Net Exports  International Economic Linkages Prosperity abroad Can increase exports Exchange rates Depreciate the currency to increase exports (but import will be expensive) A caution on tariffs Other countries may retaliate Lower GDP for all LO4  Global Perspective Source: World Trade Organization, www.wto.org. LO4  Adding the Public Sector Government purchases and equilibrium GDP subject to a full multiplier Taxation and equilibrium GDP Lump sum tax Partial off-setting effect on equilibrium GDP Effects of tax on DI and Consumption Balance budget multiplier = 1 LO4  Government Purchases and Eq. GDP The Impact of Government Purchases on Equilibrium GDP (1) (5) Real Net Exports (7) Domestic (Xn), Billions Aggregate Output and (2) (4) (6) Expenditures Income Consumption (3) Investment Government (C+Ig+Xn+G), (GDP=DI), (C), Saving (S), (Ig), Exports Imports Purchases Billions Billions Billions Billions Billions (X) (M) (G), Billions (2)+(4)+(5)+(6) (1) $370 $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 LO4  Government Purchases and Eq. GDP C + Ig + Xn + G C + Ig + Xn C Government spending of $20 billion LO4  Taxation and Equilibrium GDP Determination of the Equilibrium Levels of Employment, Output, and Income: Private and Public Sectors (7) (9) (1) Net Exports Aggregate Real (Xn), Billions (8) Expendi- Domestic (3) Govern- tures Output Disposable ment (C+Ig+Xn and (2) Income (4) (5) (6) Pur- +G), Income Taxes (DI), Consump- Saving Invest- Export Import chases Billions (GDP=DI), (T), Billions, tion (C), (S), ment (Ig), s s (G), (4)+(6)+(7) Billions Billions (1)-(2) Billions Billions Billions (X) (M) Billions +(8) (1) $370 $20 $350 $360 $-10 $20 $10 $10 $20 $400 (2) 390 20 370 375 -5 20 10 10 20 415 (3) 410 20 390 390 0 20 10 10 20 430 (4) 430 20 410 405 5 20 10 10 20 445 (5) 450 20 430 420 10 20 10 10 20 460 (6) 470 20 450 435 15 20 10 10 20 475 (7) 490 20 470 450 20 20 10 10 20 490 (8) 510 20 490 465 25 20 10 10 20 505 (9) 530 20 510 480 30 20 10 10 20 520 (10) 550 20 530 495 35 20 10 10 20 535 LO4  Taxation and Equilibrium GDP Aggregate expenditures (billions of dollars) C + Ig + Xn + G Ca + Ig + Xn + G $15 billion decrease in consumption from a $20 billion increase in taxes 45° 490 550 Real domestic product, GDP (billions of dollars) LO4  Equilibrium versus Full- Employment Recessionary expenditure gap Insufficient aggregate spending Spending below full-employment GDP level- negative GDP gap Increase G and/or decrease T Inflationary expenditure gap Too much aggregate spending Spending exceeds full-employment GDP level- demand-pull inflation Decrease G and/or increase T LO5  Equilibrium versus Full- Employment AE0 530 AE1 Aggregate expenditures (billions of dollars) 510 Recessionary 490 expenditure gap = $5 billion Full employment 45° 490 510 530 Real GDP (a) Recessionary expenditure gap LO5  Equilibrium versus Full- Employment AE2 Inflationary AE0 expenditure gap = $5 billion Full employment LO5  Application: The Recession of 2007-09 December 2007 recession began Aggregate expenditures declined Consumption spending declined Investment spending declined Recessionary expenditure gap LO5  Application: The Recession of 2007-09 Federal government undertook Keynesian policies Tax rebate checks $787 billion stimulus package LO5  Say’s Law, Great Depression, Keynes Classical economics (focus more on the supply side) Say’s Law- supply creates demand Economy will automatically adjust Laissez-faire and the price mechanism Keynesian economics (focus on the demand side) Cyclical unemployment can occur Economy will not correct itself Government should actively manage macroeconomic instability through managing aggregate spending