The Aggregate
Expenditure Model
I. Tools of the Aggregate
Expenditures Model:
• Aggregate expenditures – refers to the economy’s
total spending. The Aggregate expenditure model
was developed by John Maynard Keynes.
• The basic premise of the AE model (also known as
the consumption function graph) states, the amount
of goods and services produced depend directly on
the level of AE (total spending).
• In other words, when AE fall, total output (GDP)
and employment decrease; when AE rises, total
output (GDP) and employment increase.
• It’s a measurement of GDP performance.
• An illustration of the relationship between
consumption and savings in the entire economy
(aggregate).
• Savings is defined as “not spending” or that part of
DI not consumed.
Savings = DI – C (consumption)
Right now we
are going to
assume that
the U.S. is a
closed economy $530
510
and the only
490
two variables 470
are personal 450
consumption & 430
gross
410
investment
390
spending. We’ll 370
deal with
o
government
spending & net
exports later.
C + Ig
45
o
370
390
410 430 450
470
490 510 530 550
Consumption and DI from
1988-2000
CONSUMPTION (billions of dollars per year)
The 45 degree line represents C = DI.
$7000
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
6000
C = DI
5000
4000
3000
2000
1000
45°
0
$1000
Actual consumer spending
2000
3000
4000
5000
6000
7000
DISPOSABLE INCOME (billions of dollars per year)
The vertical distance between actual consumption and the 45 degree
line represents the amount saved.
Consumption Schedule
[direct relationship between income & consumption]
Consumption
(billions of dollars)
Our
consumption
line is
upward
sloping;
because
when DI
increases,
then
consumption
increases.
$530
510
Consumption
490
470
450
430
410
390
370
45
o
o
370
390
410 430 450 470 490 510 530 550
Disposable Income (billions of dollars)
The Consumption Function,
measures
different consumption and saving levels
at different GDP (total output) levels.
APC and APS
APC - percentage of income (Y) that is
consumed.
APS – percentage of income (Y) that is
saved
APC = C/Y = $48,000/$50,000 = .96
APS = S/Y = $2,000/$50,000 = .04
1
APC = C/Y = $52,000/$50,000 = 1.04
1
APS = S/Y = -$2,000/$50,000 = -.04 APS = S/Y
Since there are only two things you can do
with income (C or S), the sum of APC &
APS equals 1.
But what if total output changes (increase)? How
do we calculate the percentage of this new income
that will be consumed and the percentage that will
be saved?
MPC, & MPS
MPC - percentage change in income consumed.
MPS - percentage change in income saved.
Let’s say income increase by $1,000, and
consumption increase by 2/3;
MPC = C/ Y = $750/$1,000 = .75
1
MPS = S/ Y = $250/$1,000 = .25
Since there are only two things you can do with the
increased income, the sum of MPC & MPS equals 1.
Consumption
So far we have been looking at how changes in DI effect
C & S, which is illustrated by moving points on a fixed
consumption curve. The more we have the more we
consume and save.
S
D
SAVING
Consumption
C2
C
A
C1
Dissaving
B
o
45
o
H
E
F
Disposable Income
But there are
certain nonincome
$530
determinants
that can increase 510
490
or decrease
470
consumption,
450
thus shifting the 430
entire curve up 410
or down.
390
370
The
determinants are
o
called WHET.
C2
C1
Consumption
of savings
45
o
370 390 410 430 450
470
490 510 530 550
Real GDP
Non-income Determinants:
•Wealth; the greater the wealth of households, the larger their
consumption. Wealth means real assets (house, cars, T.V.) and
financial assets (stocks, bonds, insurance policies).
• Household debt; increasing debt means increasing
consumption.
• Expectation; future expectations about rising prices or
income can increase consumption.
• Taxation; a tax decrease will increase both consumption and
savings.
o
Saving
Any increase in
consumption will
mean an equal
decrease in savings.
Because you can
only do one of the
two with a dollar.
Consumption
Increase in Consumption (Decrease in Saving)
C2
C1
Increases in
consumption
means…
o
45
Disposable Income
Decrease
S1
S2 in saving
o
Disposable Income
Increase in Consumption (Decrease in Saving)
Consumption
The exception is a
change in taxes. A
decrease in taxes will
increase DI, which is
subject to MPS/MPC
rules. Some of the
new income will be
consumed and some
o
saved.
Saving
I’ll buy more and
save more.
C2
C1
Increases in
consumption
means…
o
45
Disposable Income
S2
Increase
S1
in saving
o
Disposable Income
Decrease in Consumption
Consumption
C1
C2
However, an increase
in taxes, will decrease
DI, thus decreasing
consumption and
savings.
Saving
o
o
o
Decreases in
consumption
means…
45
Disposable Income
Decrease
S1 in saving
S2
Disposable Income
Now let’s add gross investments to the topic and see
how it will affect aggregate expenditures.
C + Ig
$530
510
C
490
470
Ig = $20 Billion
450
430
410
C =$450 Billion
390
370
45
o
o
370
390
410 430 450
470
490 510 530 550
Real GDP
Investment:
• Investments = the expenditures on new capital
goods.
• An investments marginal benefits = the expected
rate of return a business expects from its investment.
• An investments marginal cost = the expected cost of
making the investment.
• An investment project will be profitable if its
expected rate or return (r) exceeds the expected cost
(interest rate).
• Businesses will invest if r >or = i.
Should A New Drill Press Be Purchased?
Drill Press - $1,000
A. Expected returns (profits) = $1,100 or a 10%
return.
[$100/$1,000 = 10%]
B. Nominal interest rate = 12%,
C. Inflation rate = 4%
Remember, that nominal interest rate minus anticipated
inflation rates equal real interest rates. It is the real interest
rate that determines the expected cost of an investment.
12%
Nominal
Interest
Rate
7%
Anticipated
Inflation
=
5%
Real
Interest
Rate
So firms will undertake all investments which have
an expected real interest rate less than [or equal to]
the investments expected return.
16
Lowing the real interest rate means
that investments are more profitable;
thus demand for investment funds are
greater.
interest rate (i)
14
12
10
8%
6
4%
2
0
DIg
5
10
15
20 25 30 35
QM
QM
40
There is an inverse relationship between (i) and Qm
The quantity of money demanded for
investments increases as interest rates
decrease. This is illustrated as a
movement from point to point on a
fixed investment demand curve.
16
interest rate (i)
14
12
10
8%
6
4%
2
0
DIg
5
10
15
20 25 30 35
QM
QM
40
25%
20%
15%
10%
5%
50 100 150 200 250
Qm1
Qm2
But there are non-interest rate factors that can change the
quantity demanded for investment money. Thus shifting the
entire investment demand curve to the right or left, it is called
taste.
0
Non-interest rate determinants;
• Technology; the development of new technology shifts the
investment demand curve to the right, as businesses upgrade.
• Acquisition of operation cost; when production cost fall,
expected rates of return from prospective investments rise
shifting the demand curve to the right.
• Stock of inventory; businesses with dwindling inventories
will invest in expansion, thus shifting the demand curve right.
• Taxes; lower business taxes increases the expected
profitability of investments, and shift the demand curve right.
• Expectation; optimism about future profits increase
investments and shift the demand curve right.
Volatility of Investment
R R
R
R R
R
R
Investment is the most volatile part of
aggregate expenditures, because of DIE!
Reasons for Investment Volatility
•Durability of Capital; some
machines are more durable than
other. The more durable them
capital the less need for
replacing it.
•Irregularity of innovations;
new products and processes
stimulate investment but they
occur irregularly.
Reasons for Investment Volatility
•Expectations; pessimism about
future profits will cause firms to
keep older equipment and avoid
investment.
The equilibrium level of GDP occurs where the total output,
measured by GDP, and aggregate expenditures, C + Ig are
equal.
C + Ig
$530
510
Consumption
490
470
450
430
410
390
370
45
o
o
370
390
410 430 450
470
490 510 530 550
Real GDP
Consumption
When consumption is less then GDP (below equilibrium),
the result is under spending, leading to increased
inventories of goods in the economy (called a
recessionary
Projected
spending gap).
Equilibrium
AE
Spending gap
o
Actual AE
45
o
Real GDP
When consumption is greater than GDP (above equilibrium),
the result is over spending, leading to decreased inventory of
AE2
goods in the economy (called an inflationary
spending gap).
AE1
Equilibrium
Consumption
Inflationary Spending
gap
45
o
o
Real GDP