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The Aggregate Expenditure Model

The Aggregate Expenditure Model. The Aggregate Expenditure Model. Also know as the Income-Expenditure model or the Keynesian Cross model Assumes price level is fixed Based on planned spending , called aggregate expenditure (AE),a measure of what is wanted : AE = C + I + G + NX

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The Aggregate Expenditure Model

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  1. The Aggregate Expenditure Model

  2. The Aggregate Expenditure Model • Also know as the Income-Expenditure model or the Keynesian Cross model • Assumes price level is fixed • Based on planned spending, called aggregate expenditure (AE),a measure of what is wanted: AE = C + I + G + NX • This equation should look familiar. Why?

  3. Now recall our measure of economic activity: National Product GDP = NI = C + I + G + NX GDP : Gross domestic product NI: National income C: Private consumption I: Private domestic investment G: Government spending on goods and services (not transfers like social security) NX: Net exports (Exports minus imports)

  4. Equilibrium • Economy is in equilibrium when NP = AE • Then, what is produced (NP) is equal to planned spending (AE) • So essentially, the supply of goods (NP) equals the demand for goods (AE) • If NP>AE, inventories expand as more is produced than consumed • If NP<AE, inventories are depleted as more is consumed than produced

  5. Two Types of Spending • Autonomous spending is independent of the level of national income • Remember, because of the circular economy, national income equals national product • Induced spending rises as national income goes up

  6. The Formula of AE AE = a0 + a1*Y • a0 = autonomous spending • Does not depend on national income (Y) • Includes part of consumption (autonomous consumption), investment, government purchases and exports • a1*Y = induced spending • It rises as national income goes up • 0 < a1 < 1 • a1 is called the marginal propensity to spend • Mostly consists of induced consumption • In more complicated models, can include investment and government purchases as well • Imports decrease induced spending

  7. Consumption • The consumption function has induced and autonomous parts: C = c0 + c1*Y • c1 is called the marginal propensity to consume. • It shows the portion of each additional dollar of NI spent on consumption • It indicates how responsive consumption is to NI • 1-c1 is called the marginal propensity to save • It indicates how responsive savings is to NI

  8. Equilibrium • Recall that Equilibrium in the AE model occurs when we produce what we plan on consuming. • That is, when AE = NI or equivalently, AE=NP=Y • So we have AE = a0 + a1*Y = Y • Solving for Y gives Ye = a0/(1-a1) • Ye is the equilibrium NI

  9. Graphical Analysis 45 degree line shows when AE = NI Equilibrium is when AE cross the 45 degree line

  10. The Expenditure Multiplier • The expenditure multiplier shows how much autonomous spending is “multiplied” as it circles the economy, inducing additional spending. • The expenditure multiplier equals 1/(1-a1) • It also equals Ye/a0 • The expenditure multiplier increases if a1 gets larger. a1 increases if • c1 (the MPC) gets larger • The marginal propensity to import (induced imports) gets smaller • The tax rate decreases

  11. Shifts in the AE curve I

  12. Shifts in the AE curve II

  13. Policy Questions • Taxes: Cutting taxes gives people more disposable income. Does this increase induced or autonomous spending? • More government spending is an increase in what type of spending? Does it have a different effect than cutting taxes? • How do government policies to impede imports, increase exports, and support investment affect equilibrium GDP? • What does a larger GDP mean for jobs and unemployment?

  14. Dynamics of Adjustment

  15. More on Equilibrium • Equilibrium means what is planned is produced • Requires that leakages = injections I + G + X = S + T + M • In a simple model without government or foreign sector, that means planned investment equals planned savings

  16. More on Equilibrium (cont.) • Think of a simple economy with no government or foreign sector • Then AE=C+I (plan to consume or invest) • Of course NP=C+I too • But NI can be only for consumption or savings • So NI = C + S • Equilibrium is AE=NP, but by circular economy NP=NI, so AE=NI • Hence, AE = NI • That is, C+I = C+S, so I=S in equilibrium

  17. Savings – Investment Equilibrium In a simple model with out government or foreign sector, savings is the only leakage, investment the only injection, so equilibrium is where S=I.

  18. Consumption and the MPC • Consumption often depends on life-cycle • The MPC changes with different stages of life • MPC larger when young. People borrow for education, buying houses, etc. • MPC lower in middle age. People save for retirement, etc. • MPC rises again in retirement. • MPC also lower for wealthier individuals

  19. Consumption over time

  20. Policy Questions • Issue 1: The Bush tax cuts lowered taxes more for wealthier people than poorer people. Did this maximize the effect the tax cut would have on GDP? • Issue 2: Social security transfers income and earnings from the middle class to the elderly. How will this affect GDP?

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