CHAPTER 28: THE AGGREGATE EXPENDITURES MODEL

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1 CHAPTER 28: THE AGGREGATE EXPENDITURES MODEL Introduction Now that you have a basic understanding of how changes in disposable income, investment, and decisions about consumption and saving affect real GOP, we will bring the aspects oft~e Keynesian aggregate expenditures model together. Chapter 28 begins with a closed private s~ctor economy and then adds intemational trade and govemment into the model. This model explams the effects of changes in spending in each sector on real GOP and recessionary and mflationary gaps, as well as the role of government in reducing such gaps. Material from Chapter 28 may appear in several multiple-choice questions on the AP macroeconomics exam, and free-resp.onse questions frequently focus on the appropriate fiscal policy measures taken to address recessionary and inflationary gaps. Bear in Mind The graphs developed throughout Chapter 28, known as the Keynesian Cross, are no longer tested as part of the AP macroeconomics exam. The concepts are important and can help you to understand macroeconomic relationships, but specific Keynesian Cross graphic concepts will not be covered here. Classical Theory Classical theory was the first modem economic theory. It was developed by economists such as Adam Smith, David Ricardo, John Stuart Mill, Thomas Malthus, and Jean Baptiste Say. Classical theorists believed that a market economy would maintain full-employment output in the long run. According to classical theorists, wages and prices were flexible, but output and employment were not. They theorized that even if an economy experienced a short-run shock like a crop failure, a war, or a discovery of new resources, market forces would automatically adjust. If spending fell in the economy, prices and wages would fall in response, enticing consumers to increase their spending again and restoring the economy to full-employment output. They were also convinced that supply would create its own demand, because the spending for resources to produce the output would create income for the resource owners to buy that output. Because they believed that a laissez-faire economy experiencing instability would self-correct, they argued that no govemment intervention was necessary. Keynesian Theory Classical theory was the dominant theory for well over a century-until the Great Depression. The Great Depression dragged on for years, with an extreme drop in GOP and a dramatic rise in unemployment, and the economy did not self-adjust. With the failure of the classical model to explain the Great Depression, British economist John Maynard Keynes brought about a whole new way of thinking about the economy. According to Keynes, who built his model on Depression-era economic conditions, output and employment were flexible, but prices and wages were not. As a result, it was possible for aggregate spending to remain lower than full-employment output. Prices were so sticky downward that they would not change in response to changes in demand. Millions of workers were unemployed, so if demand increased for products, firms could hire workers without having to raise wages to attract them. Therefore, prices need not rise. Firms had excess production capacity and unplanned inventories, so that if demand increased, a reduction in those inventories would signal to firms to increase production. The economy just needed a stimulus to bring 192 Chapter 28: The Aggregate Expenditures Model

2 aggregate demand back up. Keynes called for the government to take an instrumental role in correcting economic instability. To ~egil~ this analysis orthe Keynesian model, we make several simplifying assumptions. We begm with only households and firms- no government or international sectors. We also assume that because there are no taxes, real GOP equals disposable income. Remember, GOP can be calculated using either the expenditure or income approaches, because one factor' s spending is another factor's income. We also assume the excess plant capacity and high unemployment conditions of the Depression, so that increases in output and employment will not put upward pressure on the price level. Equilibrium GDP In a closed (no international trade) private sector (no government) economy, consumption spending by households plus planned investment spending by firms equals the aggregate (total) spending in the economy. Equilibrium output is the quantity of output at which the quantity produced (GOP) equals the quantity bought (aggregate spending), and there are no unplanned inventories. If current spending is less than production, unplanned inventories begin to rise and firms reduce production until the market returns to equilibrium. If current spending is greater than production, inventories begin to decline and firms increase output until the market returns to equilibrium. At equilibrium GOP, saving equals planned investment. In the circular flow model, saving is considered a "leakage" from the flow of income, because that income is not immediately spent for goods or services. However, firms also do not sell their entire production to households, because capital equipment sold to other firms is investment. This investment is considered an "injection" of spending back into the circular flow model. If saving is greater than investment, the leakage is greater than the injection and real GOP falls. Conversely, if investment is greater than saving, the injection is greater than the leakage and real GOP increases. Changes in Equilibrium GDP and the Multiplier Equilibrium GOP is affected by changes in consumer or investment spending, but investment is the more volatile sector. If the real interest rate increases and firms expect their rate of return on investment to be lower than the new interest rate, they reduce their investment spending. Real GOP falls as firms reduce output and employment. But the reduction in GOP doesn't just end with the initial decrease in investment. Remember, the decrease in spending rumbles through the economy over and over, and the multiplier is needed to calculate the total effect on GOP. If the initial reduction in investment is $1 million and the multiplier is 5, that initial reduction in investment will result in a $5 million reduction in real GOP. International Trade Releasing one of our beginning assumptions, we now open the economy and include net exports (exports minus imports). If exports exceed imports, net exports are positive. They increase aggregate spending and the real GOP to a higher level than they would have been in a closed economy or if trade were balanced. If imports are greater than exports, the negative net exports lower the aggregate spending and real GOP from what they would have been in a closed economy or if trade were balanced. A number offactors affect imports and exports. Ifreal incomes abroad increase, consumers in those countries are better able to afford U.S. exports and exports rise. The resulting income from Chapter 28 : The Aggregate Expenditures Model 193

3 the exports also allows Americans to increase their imports from other countries. A second factor affecting international trade is the use of trade barriers. I f another country imposes tariffs on imports. consumers in that country buy fewer American exports, reducing our net exports. Ifwe retaliate by imposing our own tariffs on imports from that country, our imports fall as well, so the relative ettect on net exports depends on the relative strength of the trade barriers. A third factor affecting net exports is the exchange rate. If the dollar appreciates, imports appear to be less expensive because their currency is less expensive, so imports increase. At the same time, the relative price of American goods to foreign consumers seems to have increased, so they buy less, reducing our exports. Because exports fall and imports increase, net exports fall and real GDP decreases. Were the value of the dollar to depreciate, the effects would be reversed. The Public Sector Releasing another beginning assumption, we now add government revenues and spending to the economy in order to see the full picture of the mixed-market economy. Remember the GDP formula C + I + G + (X - M); the government sector completes the formula. In this analysis, we assume that government spending does not affect the other sectors and that government collects the same amount of tax revenue, no matter what happens to GDP. Increases in government spending increase aggregate spending and the real GDP. Just as with consumption and investment spending, government spending is affected by the multiplier. If government spending increases by $10 million and the multiplier is 5, the real GDP would increase by $50 million. If government spending decreased, the real GDP would decrease as well. Taxes also affect real GDP. A lump-sum tax is a tax that brings in the same amount of revenue to the government, regardless of the level ofgdp. When a tax is instituted, consumers pay part of the tax from savings and the other part from reduced consumption. We know the percentages from the marginal propensities to consume and save. If the MPC is 0.8, a $10 million tax will reduce consumption by $8 million; the other $2 million of tax revenue will come from reduced saving. Therefore, the increase in tax lowers the real GDP by the amount that consumption falls-by $8 million, not the entire $10 million. Conversely, a reduction in taxes will lead to a higher real GDP. It is very important to note that changes in government spending and changes in taxes have different effects on real GDP. Changes in government spending have a full impact on real GDP, because the spending goes right out into the economy. However, when taxes are changed, this action has less than a full impact on the economy, because due to the MPC and MPS, part of the impact is on consumption and part is on saving. For example, if the government increases spending by $50 million, the real GDP initially increases by $50 million. If taxes decrease by $50 million and the MPC is 0.8, the real GDP initially only increases by $40 million because the other $10 million is an increase in saving. Bear in Mind It is important to keep in mind the differences between the effects of taxation and spending; spending has a fuller effect on GDP than taxes because consumers save some of tax cuts and use savings to pay part of tax increases. Questions about this particular concept commonly appear on the AP macroeconomics exam. 194 Chapter 28: The Aggregate Expenditures Model

4 L"akagl'S and Injections Now that we have included all four sectors of spending into the circular market flow, we must address the leakages and injections in the model, recognizing that the leakages from the Ilow must equal the injections into the flow. Saving, imports, and taxes are all leakages from the circular flow, because they represent income that was not spent to purchase output in the domestic economy. Investment, exports, and government spending arc all injections into the circular flow, because they represent additional spending beyond current income to purchase output in the domestic economy. At the equilibrium GOP, the sum of the leakages must equal the sum of the injections. If the leakages and injections differ, GOP is not at equilibrium. The Recessionary Expenditure Gap In the Keynesian model, current spending and full-employment GOP need not be at the same output. In fact, Keynesian analysis, developed during the Great Depression, illustrated GOP output at a rate well below potential GOP output and full employment. A recessionary expenditure gap is the amount by which current aggregate spending is less than the spending necessary to reach full-employment GOP. An initial decrease in spending is then subject to the multiplier, so a $3 billion recessionary expenditure gap with a multiplier of 5 will eventually create a current GOP of$15 billion less than full-employment GOP. Keynes advocated government action, or fiscal policy, to correct the economic instability that led to less than full-employment GOP. If government increases spending or lowers taxes, each policy will increase aggregate spending and help restore full-employment GOP. In the case of the $3 billion recessionary expenditure gap discussed above, government need only increase its spending by that same amount to fill the entire $15 billion negative GOP gap between current GOP and full-employment output, because the same multiplier that affects the initial decrease in spending also works to multiply the increase in government spending and return the economy to full employment. Spending Multiplier = MPS Change in Real GOP = Spending Multiplier x Change in Government Spending The second tool of fiscal policy is to lower taxes. In the case of the $3 billion recessionary expenditure gap, government must reduce taxes by enough to eventually fill the $15 billion difference between current GOP and full-employment GOP. But remember that taxes are not as effective as government spending in changing GOP, because with tax changes, only a fraction of consumption will be affected; the rest of the effect is in saving. So if government reduced taxes by $3 billion, it would not create the full $15 billion. A multiplier of 5 indicates the marginal propensity to save is 0.2, so consumers would actually save 20 percent of their tax cut ($0.6 billion) and spend the other $2.4 billion. Therefore, tax changes must be larger than government spending changes to achieve the same result. How large must a tax change be to make up for the recessionary expenditure gap? Chapter 28: The Aggregate Expenditures Model 195

5 Amount by Which Tax Must Be Decreased = MPC x Recessionary Gap If the recessionary expenditure gap is $3 billion and the MPC is 0.8, govern.ment must redu~e t I taxes by $3 biliion multiplied by I / MPC (I /0.8 = 1.25), or $3.75 billion, m ord~r to comp e e y.. h MPS f 02 mdtcates that filithe gap. If the government reduces taxes by $3.75 btlh~n.' t e.0. fujlconsumers wili save $0.75 biliion and spend the other $3 btlhon, returnmg GOP to employment GOP over time. Tax Multiplier = MPC x MPS Change in Real GDP - Tax Multiplier x Change in Taxes The Inflationary Expenditure Gap An inflationary expenditure gap occurs when the aggregate expenditures in the economy are greater than what is necessary to produce full-employment output. While an economy may be able to temporarily produce an output greater than fuji-employment level via employees working overtime and the heavier use of other resources, such an output cannot be sustained in the long term. Therefore, any increased spending beyond full-employment can only cause demand-pull inflation, raising prices. An inflationary expenditure gap can be reduced by fiscal policy: by increasing taxes or reducing government spending. Government spending has the stronger effect because it receives the fuji effect of the multiplier, while changes in taxes are less effective because consumers will reduce saving to pay for some amount of the tax. Therefore, taxes must be increased by a larger amount than the spending would be reduced in order to obtain the same effect. Multiple-Choice Questions 1. Classical theorists believed that if total spending in the economy fell below fullemployment output, (A) the economy would self-correct through lower wages and prices. (B) government should intervene by raising spending. (C) government should correct the problem by raising taxes. (D) the economy would tend to remain below full employment for months. (E) lower imports and increased exports would correct the imbalance An unexpected increase in inventories would signal firms to (A) hire more workers. (B) raise wages. (C) decrease output. (D) raise product prices. (E) increase the cost of production. Which of the following is a leakage from the circular market flow? (A) investment (B) exports 196 Chapter 28: The Aggregate Expenditures Model

6 (C) govenunentspending (0) consumer spending (E) saving 4. According to Keynesian theory, an increase in investment spending causes (A) a decrease in the national debt. (8) a decrease in the price level. (C) an increase in tax revenues. (0) an increase in output. (E) a decrease in imports. 5. At equilibrium GOP, (A) unplanned inventories are greater than planned inventories. (8) there are no unplanned inventories. (C) planned inventories are greater than saving. (0) unplanned inventories are increasing. (E) planned inventories are zero. 6. All of the following factors would increase equilibrium GOP EXCEPT (A) incomes abroad increasing. (8) the value of the dollar depreciating. (C) foreign countries increasing trade barriers on U.S. products. (0) tax rates increasing. (E) govenunent spending decreasing. 7. If govenunent wants to change both spending and taxes in a way that has no effect on real GOP, it must (A) increase spending by more than it increases taxes. (8) decrease spending by more than it decreases taxes. (C) increase spending by more than it decreases taxes. (0) decrease spending by less than it increases taxes. (E) decrease spending by more than it increases taxes. 8. If the economy experiences a recession with a current spending gap $1,000 below fullemployment output and the marginal propensity to consume is 0.8. how much must government increase spending to restore the economy to full-employment GOP? (A) $500 (8) $200 (C) $800 (0) $5 (E) $20 Free-Response Questions 1. Assume the United States economy is producing at full-employment output, the government has a balanced budget, and imports and exports are balanced. (a) Now assume that, because of a significant increase in interest rates, firms change their level of investment. (i) Explain whether investment will increase or decrease. (ii) Explain how the change in investment will affect real GOP. (iii) Explain how the change in real GOP will affect employment. Chapter 28: The Aggregate Expenditures Model 197

7 ... Id k t restore the economy to full- Identify one fiscal pohcy action the government cou ta e 0 employment GOP. 2. (a) (b) Assume the United States economy is producing at full-employment output, the government has a balanced budget, and imports and exports are balanced.. Now assume that Canada, a major buyer of U.S. exports, goes into a recession. As a. result, current GOP falls to $100 billion less than full-employment GOP and the margmal propensity to consume is 0.6. (i) Explain the reason for the effect of Canada' s recession on U.S. GOP. (ii) Identify the formula for the spending multiplier. (iii) (iv) Calculate the spending multiplier. Calculate the amount by which government spending must increase to return current GOP to full-employment GOP.. Would an increase in government spending or a decrease in taxes have a larger Impact on real GOP? Explain. Multiple-Choice Explanations I. (A) Classical economists believed the economy would correct itself, because lower demand would lead to lower prices and wages, which would lead to higher spending again, correcting to full employment automatically. 2. (C) An unexpected increase in inventories indicates that consumer demand for products has decreased and firms should reduce production. 3. (E) Saving represents income not spent in the circular flow and a leakage from the amount of spending in the economy. 4. (D) Increased investment spending increases the real GOP, which increases output and employment. 5. (8) At equilibrium GOP, there are no unplarmed inventories; firms sell what they produce, though some planned inventories may exist. 6. (C) Trade barriers cause less foreign spending for U.S. products, reducing equilibrium GOP. 7. (D) Government spending changes have a full effect on the economy, but because tax changes partly affect saving for consumers, tax changes are less effective and must be greater. 8. (8) IfMPC = 0.8, the multiplier is 5 (l I MPS = 1 / 0.2 = 5). To increase GOP by a $1,000 recessionary gap, the government must increase spending by $200, which is subject to the multiplier ($200 x 5), to create the $1,000. Free-Response Explanations I. 7 points (6 + I) (a) 6 points: I point is earned for stating that investment will decrease. 1 point is earned for explaining that because of the higher interest rate, the cost of the investment is now greater than the expected return from the investment. I point is earned for stating that real GOP will decrease. I point is earned for stating that investment is one of the components ofreal GOP (C + I + G + X - M), so if investment falls, real GOP falls. I point is earned for stating that employment will decrease. I point is earned for explaining that as output falls, fewer workers are needed to roduce that output, so employment falls. p 198 Chapter 28: The Aggregate EXpenditures Model

8 (b) 1 point: 1 point is earned for identifying either an increase in government spending or a decrease in taxes points (4 + 2) (a) 4 points: 1 point is earned for explaining that as Canadian incomes fall, their demand for U.S. exports falls, reducing U.S. real GDP. 1 point is earned for identifying the U.S. spending multiplier as 1 / MPS. I point is earned for calculating the spending multiplier as 2.5 (1 /0.4). 1 point is earned for calculating the minimum increase in government spending as $40 billion ($100 billion / 2.5). (b) 2 points: I point is earned for stating that an increase in government spending has a larger impact on real GDP. I point is earned for explaining that if taxes are reduced, consumers will save part of the tax reduction rather than spending all of it in the economy. Chapter 28: The Aggregate Expenditures Model 199