The Aggregate Expenditure Model
Lesson 18

Introduction to Aggregate Expenditure Function

Aggregate consumption function - how aggregate consumption relates to GDP

• Assume no income taxes; thus disposable income (DI) = GDP
  • Autonomous Spending (A) - the y-intercept
    • Spending is independent of income (i.e. GDP)
    • Consumers still need a level of spending with no income
      • Food
      • Shelter, etc.
  • MPC - the slope of the line
    • Give consumers $1 more dollar in income, MPC is the amount that goes to spending
  • Aggregate Expenditures (AE) - total spending by all institutions in an economy
    • The y-axis

A graph of the consumption is below:

• Investment - assume investment is independent of GDP
  • Gross investment (Ig) - all investment in society

Aggregate Expenditures (AE) - restrict ourselves to consumers and business investment

• Assume Equilibrium - Aggregate Expenditures = GDP, because AE is one definition of GDP
  • Equilibrium GDP is denoted as GDP*
  • This is the 45⁰ line

How the multiplier enters the aggregate expenditure function
Substitute the consumption function and equilibrium condition into the AE and use algebra to solve for GDP*

Equilibrium is stable

• At GDP₁, Aggregate Expenditures exceeds GDP
  • Businesses and consumers are spending more than the amount of goods and services produced in the economy
  • Inventories are falling
    • unplanned changes in inventories - businesses did not anticipate this
  • Businesses increase their production of goods and services
• At GDP₂, GDP exceeds Aggregate Expenditures
  • Businesses and consumers are spending less than the amount of businesses are producing
  • Inventories are increasing
    • unplanned changes in inventories
  • Businesses decrease their production of goods and services
• At GDP* = AE*, economy is in equilibrium
  • Leakage - withdrawal from income / expenditure stream
    • Savings is a leakage
  • Injection - money is injected into income / expenditure stream
    • Investment is an injection
  • Consumer savings = Business Investment
    • S = Ig
  • No unexpected changes in business inventories

Expanding the Aggregate Expenditure Function

International Sector

• Net exports (Xn) = Exports (X) - Imports (M)
  • If Xn > 0, country exports more than what it imports
    • Expands domestic production
    • Has multiplier effect
  • If Xn < 0, country imports more that what it exports
    • Expands production for foreign country
    • Negative multiplier effect
    • The foreign country gets the multiplier effect
• Shifting level of net exports
  1. Prosperity abroad
     • Foreign countries have rising incomes
     • They buy more exports from U.S.
     • Boosts U.S. GDP
  2. Tariffs
     • Foreign countries impose tariffs
       • Decrease U.S. exports, because tariffs cause higher prices
       • Causes U.S. GDP to be smaller
     • U.S. imposes tariffs
       • Decreases imports, because tariffs cause higher prices here
       • Causes net exports to increase
       • Causes U.S. GDP to be higher
     • Tariffs could trigger a tariff war, as other countries retaliate to U.S. tariffs
  3. Exchange Rates
     • U.S. dollar appreciates
       • U.S. exports decrease
       • U.S. imports increase
       • Thus, net exports decrease, causing GDP to contract
     • U.S. dollar depreciates
       • U.S. exports increase
       • U.S. imports decrease
       • Thus, net imports increase, causing GDP to increase

Government Sector

1. Government spends at level G
   • Independent of GDP
   • If government spending increases by $1, then AE shifts up by $1
   • GDP increases by $1 times the multiplier
2. Government finances spending through taxes
   • Lump sum taxes - taxes are assessed as a fixed dollar amount
   • If government increases taxes by $1, then AE shifts down by $1*MPC
     • Households pay taxes through reduced consumption and from savings
       • Proportion of taxes from reduced consumption is MPC
       • Proportion of taxes from savings is MPS

Equilibrium

• Leakages - withdrawals from income / expenditure stream
  • Savings
  • Taxes
  • Imports
• Injections - income is injected into income / expenditure stream
  • Investment
  • Government spending
  • Exports
• Equilibrium
  • AE = GDP
  • AE = C + Ig + G +Xn
  • Leakages = Injections
  • S + T + M = Ig + G + X

Note - Similar substitute C = A + (MPC)(GDP) into AE = C + Ig + G + Xn

GDP* = multiplier [A + Ig + G +Xn]

Shifting the Aggregate Expenditure Function

• Example 1 - President Bush gives every family $600
  • Increases autonomous spending
    • The $600 is independent from GDP income
  • A.E. function shifts upward by $600
    • GDP increases more than $600 from the multiplier effect

• Example 2 - Businesses are pessimistic about the future
  • Businesses decrease gross investment
  • A.E. shifts downward by the decrease in gross investment
  • GDP decreases more than the drop from investment, because of the negative multiplier effect

• Example 3 - Government increases government spending on the military, in order to invade a country
  • A.E. shifts upward by the increase in government spending
  • GDP increases more than the increase of government spending because of the multiplier effect

• Example 4 - Incomes for foreign countries fall from the 2008 financial crisis
  • Demand for U.S. exports fall, thus net exports fall
  • A.E. shifts downward by the decrease of net exports
  • GDP falls more than the decrease in net exports from the negative multiplier effect

• Recession - GDP falls below the full-employment GDP
  • Decrease in consumer spending (A or MPC)
  • Decrease in government spending or increase in taxes
  • Decrease in business gross investment
  • Exports decrease or imports increase
• Demand pull inflation - if A.E. increases where GDP grows faster than the full-employment GDP
  • Increase in consumer spending (A or MPC)
  • Increase in government spending or decrease in taxes
  • Increase in business gross investment
  • Exports increase or imports decrease
• Model is simple
  • Many things in the economy are occurring
  • U.S. net exports have been negative for 40 years
  • Counter balanced from strong business investment, government spending, and consumer spending

A.E. is only one graph of the economy. Macroeconomists use several graphs to explain how economy respond to changes in economic events.

Terminology