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Macroeconomics, 9/e

Building the Aggregate Expenditures Model

# Chapter Highlights

 CHAPTER 8 The basic tools of the aggregate expenditures model are the consumption, saving, and investment schedules, which show the various amounts that households intend to consume and save and that firms plan to invest at the various income and output levels, assuming a fixed price level. The average propensitiesto consume and save show the fractions of any total income that are consumed and saved; APC + APS = 1. The marginal propensities to consume and save show the fractions of any change in total income that is consumed and saved; MPC + MPS = 1. The locations of the consumption and saving schedules are determined by (a) the amount of wealth owned by households; (b) expectations of future income, future prices, and product availability; (c) the relative size of household debt; and (d) taxation. The consumption and saving schedules are relatively stable. The immediate determinants of investment are (a) the expected rate of return and (b) the real rate of interest. The economy's investment demand curve is found by cumulating investment projects, arraying them in descending order according to their expected rates of return, graphing the result, and applying the rule that investment will be profitable up to the point at which the real interest rate, i, equals the expected rate of return, r. The investment demand curve reveals an inverse relationship between the interest rate and the level of aggregated investment. Shifts in the investment demand curve can occur as the result of changes in (a) the acquisition, maintenance, and operating costs of capital goods; (b) business taxes; (c) technology; (d) the stocks of capital goods on hand; and (e) expectations. The investment schedule shows the amount of investment forthcoming at each level of real GDP. Either changes in interest rates or shifts in the investment demand curve can shift the investment schedule. We assume that level of investment does not vary with the level of real GDP. The durability of capital goods, the variability of expectations, and the irregular occurrence of major innovations all contribute to the instability of investment spending. For a private closed economy the equilibrium level of GDP occurs when aggregate expenditures and real output are equal or, graphically, where the C + Ig line intersects the 45-degree line. At any GDP greater than equilibrium GDP, real output will exceed aggregate spending, resulting in unintended investment in inventories and eventual declines in output and income (GDP). At any below-equilibrium GDP, aggregate expenditures will exceed real output, resulting in unintended declines in inventories and eventual increases in GDP. At equilibrium GDP, the amount households save (leakages) and the amount businesses plan to invest (injections) are equal. Any excess of saving over planned investment will cause a shortage of total spending, forcing GDP to fall. Any excess of planned investment over saving will cause an excess of total spending, inducing GDP to rise. The change in GDP will in both cases correct the discrepancy between saving and planned investment. At equilibrium GDP, there are no unplanned changes in inventories. When aggregate expenditures diverge from real GDP, an unplanned change in inventories occurs. Unplanned increases in inventories are followed by a cutback in production and a decline of real GDP. Unplanned decreases in inventories result in an increase in production and a rise of GDP. Actual investment consists of planned investment plus unplanned changes in inventories and is always equal to saving. A shift in the investment schedule (caused by changes in expected rates of return or changes in interest rates) shifts the aggregate expenditures curve and causes a new equilibrium level of real GDP. Real GDP changes by more than the amount of the initial change in investment. This multiplier effect (.GDP/.Ig ) accompanies both increases and decreases in aggregate expenditures and also applies to changes in net exports (Xn ) and government purchases (G). The multiplier is equal to the reciprocal of the marginal propensity to save: The greater is the marginal propensity to save, the smaller is the multiplier. Also, the greater is the marginal propensity to consume, the larger is the multiplier. The net export schedule equates net exports (exports minus imports) to levels of real GDP. For simplicity, we assume that the level of net exports is the same at all levels of real GDP. Positive net exports increase aggregate expenditures to a higher level than they would be if the economy were "closed" to international trade. They raise equilibrium real GDP by a multiple of the net exports. Negative net exports decrease aggregate expenditures relative to those in a closed economy, decreasing equilibrium real GDP by a multiple of their amount. Increases in exports or decreases in imports have an expansionary effect on real GDP, while decreases in exports or increases in imports have a contractionary effect. Government purchases shift the aggregate expenditures schedule upward and raise GDP. Taxation reduces disposable income, lowers consumption spending and saving, shifts the aggregate expenditures curve downward, and reduces equilibrium GDP. In the complete aggregate expenditures model, equilibrium GDP occurs where Ca + Ig + Xn + G = GDP. At the equilibrium GDP, leakages of after-tax saving (Sa), imports (M), and taxes (T) equal injections of investment (Ig), exports (X), and government purchases (G). Also, there are no unplanned changes in inventories. The equilibrium GDP and the full-employment GDP may differ. The recessionary gap is the amount by which GDP falls short of full-employment GDP. This gap produces a magnified GDP gap (actual GDP minus potential GDP). The inflationary gap is the amount by which GDP exceeds full-employment GDP. This gap causes demand-pull inflation. In the 1990s, aggregate expenditures in Japan fell short of those needed to achieve full-employment real GDP. The result was a sizable recessionary gap. The aggregate expenditures model provides many insights into the macroeconomy, but it does not (a) show price-level changes, or (b) account for cost-push inflation.