MACROECONOMICS - CLUTCH CH DERIVING THE AGGREGATE EXPENDITURES MODEL

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2 CONCEPT: AGGREGATE EXPENDITURES MODEL AND MACROECONOMIC EQUILIBRIUM Aggregate expenditures (AE) represent the total in an economy The aggregate expenditures model describes the relationship between and > Key Assumption: Prices are > Key Idea: In any particular year, the level of is determined by the level of aggregate expenditure GDP = C + I + G + NX AE = Macroeconomic Equilibrium occurs when EXAMPLE: Find macroeconomic equilibrium using the information in the following table: Real GDP (Y) Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) $16,000 $12,400 $3,500 $3,200 $1,000 $18,000 $13,700 $3,500 $3,200 $1,000 $20,000 $15,000 $3,500 $3,200 $1,000 $22,000 $16,300 $3,500 $3,200 $1,000 $24,000 $17,600 $3,500 $3,200 $1,000 Aggregate Expenditure (AE) Unplanned Changes in Inventories If AE = GDP Inventories the economy is - Everything produced is purchased If AE < GDP Inventories GDP and employment - Purchases are than production If AE > GDP Inventories GDP and employment - Purchases are than production Page 2

3 CONCEPT: GRAPHING MACROECONOMIC EQUILIBRIUM The aggregate expenditures model describes the relationship between and Aggregate Expenditures Model Amount (in billions) Consumption Y Investment 1 Government Purchases 0.5 Net Exports 0.5 C + I C + I + G 2 C + I + G + NX Macroeconomic Equilibrium occurs where the AE (C + I + G + NX) line crosses the Page 3

4 CONCEPT: AGGREGATE EXPENDITURES MODEL IN A PRIVATE CLOSED ECONOMY The aggregate expenditures model describes the relationship between and A private closed economy is a country that have government or international trade Private Closed Economy Amount (in billions) Consumption Y Investment 1 C + I Macroeconomic Equilibrium occurs where the AE (C + I) line crosses the Page 4

5 CONCEPT: AGGREGATE EXPENDITURES MODEL IN A PRIVATE OPEN ECONOMY The aggregate expenditures model describes the relationship between and A private open economy is a country that have government Private Open Economy Amount (in billions) Consumption Y Investment 1 Net Exports 0.5 C + I C + I + NX Macroeconomic Equilibrium occurs where the AE (C + I+ NX) line crosses the Page 5

6 CONCEPT: AGGREGATE EXPENDITURES MODEL AND THE MULTIPLIER EFFECT The multiplier effect describes how an initial boost in spending leads to a much higher increase in Aggregate Expenditures Model Amount (in billions) Consumption Y Investment (old) 1 Government 0.5 Purchases Net Exports 0.5 C + I + G + NX (old) Investment (new) C + I + G + NX (new) Multiplier Effect Total Increase in GDP = 1 Initial Spending Boost 1 MPC Page 6

7 CONCEPT: COMPONENTS OF AGGREGATE EXPENDITURE The level of aggregate expenditures is determined by the level of each of C + I + G + NX Determinants of Consumption: Disposable Income (refer to Consumption Function videos) Price level Household wealth Interest rate Expected future income Determinants of Planned Investment: Expectations of Future Profitability Interest Rate Taxes Cash Flow Determinants of Government Purchases: Government Policies and Decision Making (Fiscal Policy) Determinants of Net Exports: Price Level in USA vs. other countries GDP Growth in USA vs. other countries Exchange Rate between USD and other currencies High US Inflation more Low US Inflation more High US Growth Low US Growth USD value rises USD value falls Page 7

8 CONCEPT: QUANTITATIVE ANALYSIS OF AGGREGATE EXPENDITURE MODEL We can use linear equations to solve for macroeconomic equilibrium where Recall the calculation of Aggregate Expenditures: Macroeconomic Equilibrium can be stated as the point where: Y = C + I + G + NX The trickiest part of the solution is that the formula for consumption uses the variable for GDP (Y) > Consumption, C = A + MPC(YD), is dependent on GDP (Y) because: - Higher GDP leads to higher disposable income - Higher disposable income leads to higher consumption EXAMPLE: Use the following information to solve for macroeconomic equilibrium: C = 2, Y I = 3,200 G = 2,800 X = 500 M = 1,500 PRACTICE: Use the following information to solve for macroeconomic equilibrium (T is a lump-sum tax): C = 1, (Y-T) I = 3,400 G = 2,600 + T X = 750 M = 2,000 T = 500 Page 8

9 CONCEPT: DERIVING THE MULTIPLIER ALGEBRAICALLY We can use a simplified aggregate expenditures model to show how the multiplier is derived: The multiplier signifies the multiple increase in GDP based on an initial increase in spending Recall the calculation of the multiplier: Multiplier = 1 1 MPC To derive it algebraically we start with a private closed economy (no government and no international trade) AE = C + I AE = A + MPC(YD) + I Since there are no taxes or government transfers in this model, then GDP (i.e. national income) = Disposable Income In equilibrium, GDP = AE Rearrange the formula algebraically and solve for GDP Analysis: A $1 increase in spending (from a change in A or I) will result a 1/(1-MPC) increase in equilibrium GDP Page 9