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| Graphing Exercise: Equilibrium GDP In a closed private economy, where there is neither a government nor foreign sector, aggregate expenditures is equal to consumption expenditures plus planned gross investment expenditures. The equilibrium output of such an economy is that level of output at which the total amount of spending is just equal to the amount produced, or GDP. That is, equilibrium GDP = C + Ig. Consumption expenditures rise with GDP while planned gross investment is independent of the level of GDP. The aggregate expenditures schedule shows the amount of desired spending at each possible output level and can be used to determine the equilibrium level of output. Exploration: What level of GDP is sustainable as an equilibrium? Click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph illustrates the relationship between real aggregate expenditures - consumption plus planned gross investment - and the level of real GDP, labeled "Y" on the graph. The graph also illustrates a 45° line. All points on this line share the feature that spending, as measured on the vertical axis, is equal to GDP, as measured on the horizontal axis. As such, points on this line are a graphical statement of the equilibrium condition that planned expenditures equal GDP. To use the graph, click and drag on the green triangle to select a level of GDP. As you drag the triangle, note the "Y" labels on both axes. These move together along the 45° line to indicate the same level of GDP, representing potential equilibria. Click on the Income Adjustment button to observe the economy’s readjustment to equilibrium. 1. Currently the level of GDP is £470 billion. What is the level of desired consumption spending at this level of GDP? What is the level of investment spending? AnswerReading vertically up to the consumption line, we see that consumption spending is £450 billion. Investment spending adds another £20 billion. 2. At what level of GDP is saving equal to zero? At what level of GDP is saving equal to £40 billion? AnswerIn a closed, private economy, saving is the difference between GDP and consumption. On the graph, this is measured by the vertical distance between the 45° line and the consumption line. Drag the green triangle to a GDP of £430 billion. Observe that consumption equals £430 at this level of GDP. If consumers are spending all of their income, saving must equal zero: saving is zero when GDP = £430 billion. To find saving of £40 billion, we need to find the GDP at which consumption is £40 billion less. Drag the triangle to a GDP of £510 billion. Consumption is £470 at this level, or £40 billion less than GDP: saving is £40 billion when GDP = £510 billion 3. If GDP is £510, what is the level of aggregate expenditures, C + Ig? AnswerDrag the green triangle to the right, increasing GDP by £40 to £510 billion. Aggregate expenditures (AE on the vertical axis) is £490. 4. What are the MPC and the MPS in this simple closed, private economy? AnswerClick Reset. Drag the green triangle to the right, increasing GDP by £40 billion to £510 billion. On the vertical axis, observe that expenditures increase by £20 billion, from £470 billion to £490 billion. Investment is constant, so any change in aggregate expenditure must be because of changes in consumption spending. The MPC is the change in consumption expenditure divided by the change in GDP which brought it about. Accordingly, the MPC = £20/£40, or ½. The MPS and the MPC must add to one, so the MPS is also ½. 5. What happens to GDP if desired aggregate spending exceeds the amount produced? AnswerClick Reset. Drag the green triangle to the left, then back to the right, observing the level of aggregate expenditures relative to GDP (labeled "Y" on the vertical axis). Aggregate expenditures will exceed production if GDP is less than £470 billion. Drag the green triangle to a GDP less than £470 billion and click the Income Adjustment button to restore equilibrium. GDP rises until equilibrium is restored at C + Ig = GDP = £470 billion. 6. Explore on your own. How is the difference between saving and investment related to equilibrium GDP? AnswerClick Reset. Saving is measured by the vertical distance between the 45° line and the consumption line. At the current level of GDP, £470 billion, both saving and investment are £20 billion. Drag the green triangle to the left. Saving begins to fall while investment remains at £20 billion. Click the Income Adjustment button and observe that GDP will begin to rise. Drag the green triangle to the right of £470 billion. Saving rises above £20 billion while investment remains a constant £20 billion. Click the Income Adjustment button and observe that GDP begins to fall to restore equilibrium. In summary, if saving exceeds investment, GDP will begin to fall. If saving falls short of investment, GDP will rise. |