CHAPTER 16

THE AGGREGATE EXPENDITURE MODEL

There are two critical questions in macroeconomics:
(a) What determines the level of GDP, given a nations production capacity?
(b) What causes real GDP to rise in one period and to fall in another?
To answer these questions, we construct the aggregate expenditures model. The amount
of goods and services produced and therefore the level of employment depends on the
level of aggregate expenditures (total spending).
When aggregate expenditures fall – total output and employment decreases
When aggregate expenditures rise – total output and employment increases.
CONSUMPTION AND INVESTMENT SCHEDULES
Our first step is to look at a private closed economy.

Y=C+I
Y = Co + yd + I
Y aggregate expenditure/ income/ GDP
C consumption
I gross investment

Real Domestic 370 390 410 430 450 480 490 510 530 550
Product
(Yd = GDP)
Consumption 377.5 392.5 407.5 422.5 437.5 460 467.5 482.5 497.5 512.5
(C = Co +
cYd)
Exogenous 100 100 100 100 100 100 100 100 100 100
Consumption
(Co)
Savings -7.5 -2.5 2.5 7.5 12.5 20 22.5 27.5 32.5 37.5
(S)
Investment 20 20 20 20 20 20 20 20 20 20
(I)
Aggregate 297.5 412.5 427.5 442.5 457.5 480 487.5 502.5 517.5 532.5
Expenditures
(Y = C + I)
Unplanned -28.5 -22.5 -17.5 -12.5 -7.5 0 2.5 7.5 12.5 17.5
changes in
inventories
(Yd – Y)
Marginal 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75
Propensity to
Consume
(c = MRC)
An investment schedule represents the investment plans of businesses in the same way
the consumption schedule represents the consumption plans of households.
We will assume that this planned investment is independent of the level of current
disposable income or real output.
At levels of GDP BELOW equilibrium, the economy wants to spend at higher levels than the
levels of GDP the economy is producing.
At levels of GDP ABOVE equilibrium, businesses will find that these total outputs fail to
generate the spending needed to clear the shelves of goods. Being unable to recover
their costs, businesses will cut back on production.

EQUILIBRIUM GDP
Equilibrium level is the level at which total quantity of goods produced (Yd = GDP)
equals the total quantity of goods purchased (Y = C + I).

Y=C+I
Y = Co + cYd + I
Y = 100 + 0.75Yd + 20
Y – 0.75Yd = 120
*Y = Yd at this stage
0.25Y = 120
Y = 120/0.25
Y = R480
►The slope of the aggregate expenditure schedule (Y = C + I) is constant and equals the
MPC.
►AT all points on the 45º line, equilibrium GDP is possible.
►The R490 billion level of real GDP is not at equilibrium because planned aggregate
expenditure is less than real GDP (Y < Yd)
►The R430 billion level of real GDP is not at equilibrium because planned aggregate
expenditure exceeds real GDP (Y > Yd)

Calculate in each of the following examples either the unknown factor or solve for the
problem.
(a) Co = 30, I = 40, Y =?, S =?, c = 0.75 and 1-c=?
Y=C+I
Y = Co + cYd + I
Y = 30 + 0.75Yd + 40
Y – 0.75YYd = 70
Y = Yd at this stage
0.25Y = 70
Y = R280

S = -Co + (1-c) (Yd)

1-c = 1-0.75
c = 0.25
S = -30 + (0.25) (280)
S = R40

(b) Co = 80, I = 20, Y =?, S=?, c=? and 1-c=0.1

1-c=0.1
c=0.9
Y=C+I
Y = Co + cYd + I
Y = 80 + 0.9Yd + 20
Y – 0.9Yd = 100
Y = Yd at this stage
0.1Y = 100
Y = R1000

S = -Co + (1-c) (Yd)

S = -80 + (0.1) (1000)
S = R20

SAVINGS AND PLANNED INVESTMENT

Savings and planned investment are EQUAL at equilibrium level of GDP.

S=I
-Co + (1-c) (Yd) = I
S savings
I planned investment
Co exogenous consumption
c marginal propensity to consume
Yd GDP
S=I
-Co + (1-c) (Yd) = I
-100 + (1- 0.75) (Yd) = 20
-100 + 0.25Yd = 20
0.25Y = 120
Y = R480
CHANGES IN EQUILIBRIUM GDP AND THE MULTIPLIER
In the private closed economy, the equilibrium GDP will change in response to changes in
either the investment schedule or consumption schedule.

Calculate in each of the following examples the change in Y and the new levels of GDP
given the changes in one of the aggregate expenditure components, using the
multiplier concept.

(a) Y1 = 280 and c = 0.75. I increases by 60.

New Y = Y1 + ∆Y
Y1 = 280
∆Y = k x ∆Aggregate Expenditure (I)
k = 1/1- MPC
MPC = c
k = 1/1-0.75
k=4
∆Y = 4 x 60
∆Y = 240
New Y = 280 + 240
New Y = R520
(b) Y1 = 1000 and (1-c) = 0.1. I increases by 20.
New Y = Y1 + ∆Y
Y1 = 1000
∆Y = k x ∆Aggregate Expenditure (I)
k = 1/1-MPC
MPC = c
k = 1/1- 0.9
k = 10
∆Y = 10 x 20
∆Y = 200
New Y = 1000 + 200
New Y = R1200

ADDING THE PUBLIC SECTOR

Our next step is to move from a private (no government) closed economy to an
economy with a public sector/ mixed economy by adding government purchases and
taxes to the model.
We assume that government purchases are independent of the level of GDP and do not
alter the consumption and investment schedules.

Real 370 390 410 430 450 480 490 510 530 550 560
Domestic
Output
(Yd = GDP)
Consumption 377.5 392.5 407.5 422.5 437.5 460 467.5 482.5 497.5 512.5 520
(C = Co +
cYd)
Exogenous 100 100 100 100 100 100 100 100 100 100 100
Consumption
(Co)
Savings -7.5 -2.5 2.5 7.5 12.5 20 22.5 27.5 32.5 37.5 40
(S)
Investment 20 20 20 20 20 20 20 20 20 20 20
(I)
Exogenous 20 20 20 20 20 20 20 20 20 20 20
Government
spending
(G)
Aggregate 417.5 432.5 447.5 462.5 477.5 500 205.5 522.5 537.5 552.5 560
Expenditure
(Y = C + I +
G)
 Y=C+I+G
Y = Co + cYd + I + G
Y aggregate expenditure
C consumption
I investment
G exogenous government spending

GOVERNMENT PURCHASES/SPENDING AND EQUILIBRIUM GDP

METHOD 1 METHOD 2 METHOD 3

Y=C+I+G S=I+G New Y = Y1 + ∆Y

Y = Co + cYd + I + G -Co + (1-c) (Yd) = I + G Y1 = 480
Y = 100 + 0.75Yd + 20 + 20 -100 + (1-0.75) (Yd) = 20 + 20 ∆Y = k x ∆Aggregate
Y – 0.75Yd = 140 0.25Y = 140 Expenditure (G)
*Y = Yd at this stage Y = 140/0.25 k = 1/1- MPC
0.25Y = 140 Y = R560 MPC = c
Y = 140/0.25 k = 1/1-0.75
Y = R560 k=4
∆Y = 4 x 20
∆Y = 80
New Y = 480 + 80
New Y = R560
Calculate in each of the following examples the new levels of GDP given the added
government expenditure. Select the best suited method, given the information that is
available. (you can use two methods to compare your answers to make sure you did it
correctly)
a) Co = 50, I = 30 and b) Co = 70, (1-c) = 0.25, c) Y1 = 280, c = 0.75, I = 20
c = 0.8 and G = 40 is added I = 40 and G = 50 is added and G = 60 is added
Y=C+I+G S=I+G New Y = Y1 + ∆Y
Y = Co + cYd + I + G -Co + (1-c) (Yd) = I + G Y1 = 280
Y = 50 + 0.8Yd + 30 + 40 -70 + 0.25Yd = 40 + 50 ∆Y = k x ∆Aggregate
Y – 0.8Yd = 120 0.25Y = 160 Expenditure (G)
0.2Y = 120 Y = R640 k = 1/1- MPC
Y = R600 MPC = c
k = 1/1-0.75
k=4
∆Y = 4 x 60
∆Y = 240
New Y = 280 + 240
New Y = R520

Real Domestic 370 390 410 430 450 480 490 500 510 530 550 560
Output
(Yd = GDP)
Taxes 20 20 20 20 20 20 20 20 20 20 20 20
(T)
Consumption 362 377 392. 407. 422. 445 452. 460 467. 482. 497. 505
(C = Co + .5 .5 5 5 5 5 5 5 5
cYd)
Exogenous 100 100 100 100 100 100 100 100 100 100 100 100
Consumption
(Co)
Savings -12. -7.5 -2.5 2.5 7.5 15 17.5 20 22.5 27.5 32.5 35
(S) 5
Investment 20 20 20 20 20 20 20 20 20 20 20 20
(I)
Exogenous 20 20 20 20 20 20 20 20 20 20 20 20
Government
spending
(G)
Aggregate 402 417 432. 447. 462. 485 492. 500 507. 522. 537. 545
Expenditure .5 .5 5 5 5 5 5 5 5
(Y = C + I + G)

Y=C+I+G
Y = Co + cYd + I + G
Y = Co + c (Y – T) + I + G
Y aggregate expenditure
C consumption
I investment
G exogenous government spending
 TAXATION AND EQUILIBRIUM GDP
METHOD 1 METHOD 2 METHOD 3

Y=C+I+G S+T=I+G New Y = Y1 - ∆Y

Y = Co + cYd + I + G -Co + (1-c) (Yd) + T = I + G Y1 = 560
Y = Co + c (Y – T) + I + G -100 + (1-0.75) (Y – T) + T = 20 + ∆Y = k x ∆Aggregate
Y = 100 + 0.75(Y – 20) + 20 + 20 Expenditure (C)
20 -100 + (0.25) (Y – 20) + 20 = 40 k = 1/1- MPC
Y = 100 + 0.75Y – 15 + 20 + -100 + 0.25Y -5 + 20 = 40 MPC = c
20 0.25Y =125 k = 1/1-0.75
1Y – 0.75Y = 125 Y = R500 k=4
0.25Y = 125 ∆Y = 4 x (cT)
Y = R500 ∆Y = 4 x 15 (0.75 x 20)
∆Y = 60
New Y = 560 - 80
New Y = R500

ADDING INTERNATIONAL TRADE

Our final step is to move from a closed economy to an open economy that incorporates
exports (X) and imports (M).

Y = C + I + G + Xn (X-M)
S+M+T=I+X+G
Y aggregate expenditure
C consumption
I investment
G exogenous government spending
Xn net exports
 Level of GDP Net Exports Xn1 (X>M) Net Exports Xn2 (X<M)
420 5 -5
440 5 -5
460 5 -5
480 5 -5
500 5 -5
520 5 -5
540 5 -5
560 5 -5
580 5 -5
600 5 -5

EQUILIBRIUM VS FULL-EMPLOYMENT GDP

A recessionary expenditure gap is the amount by which aggregate expenditures at the
full-employment GDP fall short of those required to achieve the full-employment GDP.
The recessionary expenditure gap will cause cyclical unemployment.
An inflationary expenditure gap is the amount by which an economy’s aggregate
expenditures at the full-employment GDP exceed those just necessary to achieve the full-
employment GDP.
The inflationary expenditure will cause demand-pull inflation.

LIMITATIONS OF THE MODEL

►it does not show price-level changes
►it ignores premature demand-pull inflation
►it limits real GDP to the full-employment level of output
►it does not deal with cost-push inflation
►it does not allow for self-correction