Log In Start studying!

Select your language

Suggested languages for you:
StudySmarter - The all-in-one study app.
4.8 • +11k Ratings
More than 3 Million Downloads
Free
|
|

Aggregate Expenditures Model

Aggregate Expenditures Model

Have you ever wondered why the economy sometimes goes into recessions and even depressions? If so, you are definitely not alone. Many great economists have thought about this same question. Some of them developed the aggregate expenditures model to help answer this question. Want to learn more? Keep on reading!

Aggregate Expenditures Model Definition

What is the definition of the aggregate expenditures model? Well, let's talk about what the model can do for us. The aggregate expenditures model explains what causes real GDP to rise and fall.

The aggregate expenditures model shows how total spending (aggregate expenditures) affects the amount of goods and services produced.

The amount of goods and services produced in turn has implications for the level of employment in the economy.

It is also known as the Keynesian cross model because it traces its roots to the work of the well-known British economist John Maynard Keynes.

The popular economics theory at the time said that prices would adjust accordingly and solve the problems of over-supply and under-supply. However, during the Great Depression, firms did not lower their prices sufficiently as the economy slowed. As goods started to pile up in their warehouses, firms reduced production and laid off workers. This exacerbated the over-supply problem as unemployed people had to cut back on their spending.

Keynes observed this and wanted to develop a new economic model to try to understand how the Great Depression happened. This model later became the aggregate expenditures model that we are talking about now. The most important assumption behind the model is that prices are fixed so that the market can't simply sort itself out in the event of a recession or depression.

Want to learn more about price rigidity? Check out our explanation: Sticky Prices.

Aggregate Expenditures Example

Here is an example that helps us better understand the idea of aggregate expenditures. Consumption, planned investment, government purchases, and net exports make up aggregate expenditures.

When the economy is in a recession, the government will try to boost aggregate expenditures to get the economy back on track. It can do this in two ways: the government can increase its own spending or it can try to get others (people or firms) to increase their spending.

The government can spend money on building new infrastructure projects. In the aftermath of the Great Depression, the US government implemented many public works projects as part of the New Deal. These projects provided work to unemployed people and created demand for building materials, which had downstream impacts that further increased aggregate expenditures.

The government can stimulate others' spending by cutting taxes on individuals and firms. It can also do so by increasing transfer payments, such as food stamps and unemployment insurance, to people and firms. These measures are usually a major part of the stimulus packages that governments implement during recessions.

Aggregate Expenditures Components

The aggregate expenditures model consists of four components: consumption, investment, net exports, and government purchases. Let's go through them one by one.

Aggregate Expenditures Components: Consumption

How much people will consume depends on how much disposable income they have. This relationship is given by the consumption schedule, shown in Figure 1 below. The consumption schedule is also called the consumption function. As you will expect, people consume more as their disposable income increases.

Aggregate expenditures model The consumption schedule StudySmarterFig. 1 - The consumption schedule.

But the consumption schedule is flatter than the 45-degree line, meaning that consumption doesn't increase as fast as disposable income. Think about it, we usually don't spend our entire increase in income because we would like to save some of that, as long as we have enough to satisfy our current consumption needs. To put this another way, the marginal propensity to consume is less than 1.

Need a refresher? Read our explanation: Marginal Propensity to Consume.

Aggregate Expenditures Components: Investment

The level of planned investment by firms is given by the investment demand curve, shown in Figure 2a. The investment demand curve slopes downward. Investment demand increases when the real interest rate is lower. If the current real interest rate is 2%, firms will demand $40 billion of investment goods. We assume that firms' planned investment does not depend on the level of real output (real GDP). Therefore, the investment schedule is flat in Figure 2b. Firms will spend $40 billion in investment regardless of the current real output level.

Aggregate expenditures model The investment demand curve and the investment schedule StudySmarterFig. 2 - The investment demand curve and the investment schedule.

Aggregate Expenditures Components: Government Purchases and Net Exports

Let's not forget about the government sector. The government also spends money on purchasing goods and services. Think of it as consumption by the government. These government purchases are of course part of aggregate expenditures.

Net exports are another component of aggregate expenditures. Goods and services that are exported to foreign countries are produced in the home country and therefore generate jobs and incomes in the home country as well. On the other hand, imports from foreign countries are not produced in the country, and their production in foreign countries does not generate jobs and incomes at home. Therefore, when we measure aggregate expenditures, we add the value of exports and subtract the value of imports. In other words, we add the value of net exports.

Aggregate Expenditures Model Formula

The aggregate expenditure formula is:

\(C + I_p + G + NX = GDP\)

This formula gives us the equilibrium level of output. We have the total spending on goods on the left-hand side: consumption, planned investment, net exports, and government purchases. On the right-hand side, we have the real output level. So, in equilibrium, we have the total spending on goods equal to the level of real output. Makes sense!

There will be no unplanned investment in equilibrium.

Figure 3 below shows the equilibrium GDP in the aggregate expenditures model. The equilibrium is where the AE curve intersects with the 45-degree line. Note that the 45-degree line represents where aggregate expenditures are equal to real GDP.

Aggregate expenditures model Equilibrium GDP StudySmarterFig. 3 - Equilibrium GDP in the aggregate expenditures model.

Aggregate Expenditures Model: Multiplier

The multiplier plays a crucial role in the aggregate expenditures model. It tells us how an initial change in spending will result in a change in real GDP. We can see this by looking at Figure 4, which shows how the equilibrium GDP changes as a result of an initial increase in consumption.

Aggregate expenditures model The multiplier effect StudySmarterFig 4. Aggregate expenditures and the multiplier effect.

In Figure 4, we see that an initial increase of $20 billion in consumer spending shifts up the aggregate expenditures curve by this exact amount. But the increase in real GDP as a result of this initial increase in consumption is larger than $20 billion - it increases by $80 billion.

So what is the multiplier in this case? We can calculate that easily with this formula:

\(\hbox {Multiplier} = \frac {\hbox {Change in real GDP}} {\hbox {Initial change in spending}}\)

\(\hbox {Multiplier} = \frac {\hbox {\$80 million}} {\hbox {\$20 million}} = 4 \)

The multiplier is 4.

Once we know the size of the multiplier, we can also calculate the marginal propensity to save (MPS) and the marginal propensity to consume (MPC):

\(\hbox {Multiplier} = \frac {1} {MPS} = \frac {1} {1-MPC} \)

\(4 = \frac {1} {MPS} \)

\(MPS = 0.25\)

\(MPC = 1 - MPS = 1 - 0.25 = 0.75 \)

The Differential Impacts of Government Purchases and Taxes

The government sector affects aggregate expenditures in two ways. Government purchases add to aggregate expenditures. On the other hand, the government collects taxes from people and firms, which in turn reduces consumption and investment spending. But, it is important to note that government purchases and taxation don't have the same impacts on aggregate expenditures.

Government purchases are a part of the aggregate expenditures formula. Any increase in government spending on purchasing goods is a direct increase in total spending. On the other hand, a change in taxation affects aggregate expenditures indirectly by affecting consumption and investment decisions.

For example, if the government spends $20 billion more in government purchases, that is a $20 billion initial increase in aggregate expenditures. But if the government cuts total tax collections from individuals by $20 billion, the initial increase in aggregate expenditures has to work through the marginal propensity to consume (MPC). If the MPC is 0.75, the initial increase in aggregate expenditures through consumption is \(\hbox {\$20 billion} \times 0.75 = \hbox {\$15 billion} \).

Do you want to learn more? We've got you covered. See our explanation: The Multiplier Effect.

Aggregate Expenditures and Aggregate Demand

What do aggregate expenditures (AE) have to do with aggregate demand (AD)? The aggregate expenditures model tells us the equilibrium real GDP given the AE curve; the aggregate demand curve shows the relationship between real GDP and the aggregate price level. So both have to do with real GDP, and we can actually find the corresponding points if we stack the two graphs together.

Aggregate expenditures model An increase in AE causes the AD curve to shift outward StudySmarterFig. 5 - An increase in AE causes the AD curve to shift outward.

In Figure 5, we see that if we hold the price level constant at P1, an increase in aggregate expenditures will give us a higher level of real GDP. This corresponds to an outward shift of the AD curve.

On the other hand, movement along the AD curve means a change in the aggregate price level. If we hold everything else constant, when the price level increases, aggregate expenditures will decrease. This is shown in Figure 6 below. An increase in the aggregate price level causes the AE curve to shift downward.

Why is that? An increase in the price level affects three components of aggregate expenditures: consumption, planned investment, and net exports. Think about it. When inflation is higher, you are likely to consume less because your money now has less purchasing power. Inflation will increase the interest rate, causing firms to spend less on investment goods and consumers to cut back on big-item purchases because they are likely to have to borrow for these. Inflation also makes exports more expensive for foreign consumers and imports relatively cheaper for domestic consumers, therefore reducing net exports.

Aggregate expenditures model An increase in the price level causes AE curve to shift downward StudySmarterFig. 6 - An increase in the price level causes the AE curve to shift downward.

Aggregate Expenditures Model - Key takeaways

  • The aggregate expenditures model shows how total spending (aggregate expenditures) affects the amount of goods and services produced.
  • Consumption, investment, government purchases, and net exports are components of aggregate expenditures.
  • The formula for the aggregate expenditures model is \(C + I_p + G + NX = GDP\)
  • We can actually find the corresponding points on the aggregate expenditures (AE) and the aggregate demand (AD) graphs if we stack the two graphs together.

Frequently Asked Questions about Aggregate Expenditures Model

Consumption, investment, government purchases, and net exports.

The aggregate expenditure formula is: 

C + Ip + G + NE = GDP.

It tells us how a change in total spending will affect the real GDP.

Anything that affects the four components: consumption, investment, government purchases, and net exports.

The most important assumption of the model is that prices are fixed.

Final Aggregate Expenditures Model Quiz

Question

What do we have on the two axes of the aggregate expenditures graph?

Show answer

Answer

Aggregate expenditures (total spending) and real GDP (real output).

Show question

Question

What is another name for the aggregate expenditures model?

Show answer

Answer

The Keynesian cross model.

Show question

Question

Which of the following is NOT an example of a component of aggregate expenditures?

Show answer

Answer

The government's new infrastructure spending.

Show question

Question

Which of the following are components of aggregate expenditures?

Show answer

Answer

Government purchases.

Show question

Question

What is another name for aggregate expenditures?

Show answer

Answer

Total spending

Show question

Question

The level of planned investment by firms is given by the _______?

Show answer

Answer

Investment demand curve.

Show question

Question

What is the formula for finding the equilibrium GDP in the aggregate expenditures model?

Show answer

Answer

\(C + I_p + G + NX = GDP \)

Show question

Question

An initial increase in spending will cause a larger increase in real GDP because of the ______ effect.

Show answer

Answer

Multiplier

Show question

Question

Which of the following will NOT happen if inflation is higher?

Show answer

Answer

People will be able to consume more.

Show question

Question

What happens to the aggregate expenditures curve if net exports increases?

Show answer

Answer

The AE curve shifts upward.

Show question

60%

of the users don't pass the Aggregate Expenditures Model quiz! Will you pass the quiz?

Start Quiz

Discover the right content for your subjects

No need to cheat if you have everything you need to succeed! Packed into one app!

Study Plan

Be perfectly prepared on time with an individual plan.

Quizzes

Test your knowledge with gamified quizzes.

Flashcards

Create and find flashcards in record time.

Notes

Create beautiful notes faster than ever before.

Study Sets

Have all your study materials in one place.

Documents

Upload unlimited documents and save them online.

Study Analytics

Identify your study strength and weaknesses.

Weekly Goals

Set individual study goals and earn points reaching them.

Smart Reminders

Stop procrastinating with our study reminders.

Rewards

Earn points, unlock badges and level up while studying.

Magic Marker

Create flashcards in notes completely automatically.

Smart Formatting

Create the most beautiful study materials using our templates.

Sign up to highlight and take notes. It’s 100% free.

Get FREE ACCESS to all of our study material, tailor-made!

Over 10 million students from across the world are already learning smarter.

Get Started for Free
Illustration