An economy will tend towards that level of GDP at which total desired spending is equal to the amount produced. In other words, GDP equals aggregate expenditures of consumption, gross investment, government spending, and net exports. GDP will then fluctuate whenever there are changes in any of these spending components. By implication, GDP need not reach equilibrium at a level consistent with full employment of its resources. For example, if there is too little spending by consumers or by businesses, GDP will fall short of the full employment level, creating a recessionary gap.

Now click here to view an interactive exercise. This will open a new browser window. Then answer the questions below.

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The left side of the window shows the current level of taxes as well as the levels of each of the components of aggregate expenditures - C, Ig, G, and X_n - as they are related to the level of GDP. The right side of the window illustrates how these expenditures are combined to form the aggregate expenditures relationship. The consumption graph is drawn such that the marginal propensity to consume is 0.6 while investment, government spending and net exports are assumed to be independent of the level of GDP.

To use the graph, click on and adjust any of the sliders adjacent to Investment (I), Government expenditure (G), Consumption expenditure (C), or Lump-sum taxes (T) graphs. These actions will be reflected as autonomous changes in Aggregate Expenditures. Click on the Adjust Income button to restore the economy to equilibrium GDP; click the Reset button to restore all spending components to their original values.

1. Total production is currently £5000 billion. What are the current levels of Consumption, Investment, Government expenditure, taxes, and net exports? What is the current equilibrium level of GDP?

2. By how much does equilibrium GDP change if desired investment spending increases by £400 billion? What is the value of the multiplier? What is the value of the MPC?

3. Suppose the government decides to increase spending by £200 billion. What impact will this have on equilibrium GDP? How does this compare with a £200 billion decrease in taxes?

Click Reset. Both an increase in government spending and a reduction in taxes lead to an increase in desired expenditure. First, drag the Government Spending slider to raise government spending by £200 billion. Note that AE also rises by £200 billion, so that aggregate expenditures exceeds the amount produced at this level of GDP. Click on the Adjust Income button to observe the economy’s readjustment to its new equilibrium income of £5500 billion. (The change in income is the multiplier of 2.5 times the change in government spending.)

Click the Reset button to restore the previous income and spending levels. To observe the impact of taxes, click on the Tax slider to reduce taxes by £200 billion. This raises disposable income by £200 billion, of which £80 billion saved and £120 is spent: note the increase in the consumption line by £120 billion. Again, there is an excess of desired spending over production and equilibrium GDP will rise. However, because the amount of increased spending caused by lower taxes is less than the amount of the tax decrease itself, the increase in income is smaller for a tax decrease than it is for an increase in government expenditures. Click on the Adjust Income button; equilibrium income rises to £5300 billion. Comparing these two outcomes, we see that the increase associated with a tax cut is only 0.6 times as large as that from an equal increase in government spending: £300 = 0.6 x £500. That this value is the same as the MPC is no coincidence.

4. In late 2000 and early 2001, the stock market declined substantially and many people’s wealth, in the form of retirement accounts, employee stock ownership plans, and other stock accounts, was substantially reduced. How might this have affected equilibrium GDP?

5. Suppose the economy is at equilibrium at the full employment level of GDP of £5000, labeled as Y* in the graph. Further suppose that a fall in consumer confidence dropped consumption spending by £400 billion. How large a recessionary gap would be created? What policies might restore the economy to full employment?

6. Experiment on your own. What conclusions can you draw about the relationship between levels of the components of aggregate expenditure and equilibrium GDP?