Aggregate Expenditure and Output in the Short Run

The Aggregate Expenditure Model

The aggregate expenditure model is a macroeconomic framework that examines the short-run relationship between total spending (aggregate expenditure) and real GDP, under the assumption that the price level is constant. This model is essential for understanding how total output is determined in the short run.

• Aggregate Expenditure (AE): The total amount of spending in the economy, composed of four main components:

  • Consumption (C): Spending by households on goods and services.

  • Planned Investment (I): Planned spending by firms on capital goods and by households on new homes.

  • Government Purchases (G): Spending by all levels of government on goods and services.

  • Net Exports (NX): The value of exports minus the value of imports.

• Key Assumption: The price level is constant in the short run.

Planned vs. Actual Investment

The aggregate expenditure model uses planned investment rather than actual investment. The distinction is important because planned investment does not include unplanned changes in inventories (goods produced but not yet sold).

• Actual Investment = Planned Investment + Unplanned Change in Inventories

• Macroeconomic Equilibrium: Occurs when planned investment equals actual investment (i.e., no unplanned change in inventories).

Equilibrium Conditions:

• (Aggregate Expenditure)

• (Gross Domestic Product, where I is actual investment)

Relationship between Aggregate Expenditure and GDP

The relationship between aggregate expenditure and GDP determines whether the economy is in equilibrium, and how it will adjust if not.

Determining the Level of Aggregate Expenditure in the Economy

Determinants of Consumption

Consumption is the largest component of aggregate expenditure and is influenced by several factors:

• Current Disposable Income: Higher disposable income leads to higher consumption.

• Household Wealth: Greater wealth increases consumption.

• Expected Future Income: Households smooth consumption based on expectations of future income.

• The Price Level: Higher prices reduce real wealth and consumption.

• The Interest Rate: Higher interest rates reduce consumption, especially of durable goods.

The Volatility of Consumer Spending on Durables

Spending on consumer durables (e.g., cars, appliances) is more volatile than spending on non-durables or services due to:

• Durable goods are long-lived

• Good substitutes exist

• High prices make them risky purchases

• Pent-up demand typically follows a recession

• Interest rates fluctuate

The Consumption Function and Marginal Propensities

The consumption function shows the relationship between consumption and disposable income. The marginal propensity to consume (MPC) is the fraction of additional income that is spent on consumption.

• Formula:

• Marginal Propensity to Save (MPS):

• Any increase in income is either consumed (MPC) or saved (MPS).

Example: If disposable income increases by MPC = \frac{364}{530} \approx 0.69$.

Consumption and National Income

In this model, national income and GDP are assumed to be equal. Disposable income is national income minus net taxes (taxes minus transfer payments).

• Assuming net taxes are constant, changes in disposable income equal changes in national income.

Determinants of Planned Investment

Planned investment is influenced by:

• Expectations of Future Profitability

• The Interest Rate

• Taxes

• Cash Flow

Government Purchases

Government purchases include all spending by federal, state, and local governments on goods and services (excluding transfer payments). These purchases generally increase over time but can fluctuate due to policy changes or economic conditions.

Net Exports

Net exports (NX) are affected by:

• The price level in the U.S. relative to other countries

• The growth rate of GDP in the U.S. versus other countries

• The exchange rate between the dollar and other currencies

When U.S. goods become more expensive relative to foreign goods, imports rise and exports fall, reducing net exports.

Graphing Macroeconomic Equilibrium

The 45°-Line Diagram (Keynesian Cross)

Macroeconomic equilibrium occurs where planned aggregate expenditure equals real GDP. This is illustrated using the 45°-line diagram, where the line represents all points where AE = GDP.

• If AE > GDP, inventories fall, and firms increase production.

• If AE < GDP, inventories rise, and firms decrease production.

• Equilibrium is where the AE line crosses the 45° line.

Recessionary Gap: If equilibrium occurs below potential GDP, the economy is in a recession.

The Role of Inventories

Inventories are crucial in adjusting output. Unplanned changes in inventories signal firms to adjust production, moving the economy toward equilibrium.

• Unplanned inventory increases: Firms reduce production.

• Unplanned inventory decreases: Firms increase production.

Table: Macroeconomic Equilibrium Example

The Multiplier Effect

Understanding the Multiplier

The multiplier effect describes how a change in autonomous expenditure (such as investment, government purchases, or net exports) leads to a larger change in equilibrium GDP.

• Autonomous expenditures do not depend on GDP.

• Induced expenditures (like consumption) do depend on GDP.

• The multiplier amplifies the initial change in spending.

Multiplier Formula

• General formula:

• For example, if , then

• A $200 billion increase in equilibrium GDP.

Process: Each round of spending induces further consumption, but each round is smaller than the last, forming a geometric series.

Summary of the Multiplier Effect

• The multiplier works for both increases and decreases in autonomous expenditure.

• The larger the MPC, the larger the multiplier.

• Real-world factors (imports, inflation, taxes) can reduce the actual multiplier below the theoretical value.

Appendix: The Algebra of Macroeconomic Equilibrium

Aggregate Expenditure Equations

Example equations for the components of aggregate expenditure:

• Consumption:

• Planned Investment:

• Government Purchases:

• Net Exports:

• Equilibrium:

Substituting the values:

This solution gives the equilibrium level of GDP for the given parameters.