Aggregate Expenditure Model

This model is based on the assumption that the aggregate consumption is equal to the aggregate income of the economy.
According to this theory, the market is self-adjusting, meaning, any deflection from full payment position will revert back
to equilibrium.

Keynesian Economics versus Classical Economics

In classical economics, Jean- Baptiste Say, a 19th century economist, put forward a theory known simply as Say’s Law
which states that supply creates demand. It means that an individual will supply goods and services to be able to earn
income that will be used to buy other goods and services.

The Initial Aggregate Expenditure Model

Four important assumptions that would help us develop the aggregate expenditure model.
1. That the economy has no international trade transactions, arising from the exportation and importation of goods and
services to other countries. Or simply, we will assume a “closed economy”.
2. We will first ignore the participation of the government in the economy, or assume that there is a “private closed
economy”
3. Although when we talk of savings, we mean aggregate savings composed of household, government, and business; for
the convenience of everybody, we will only consider the personal savings.
4. Furthermore, there is no net primary income (NPI) or zero net dollar remittance flow from Filipinos abroad and
foreigners working in the country.

GDP/ Y – Income
S – Saving
Dissaving – The negative value of saving
TABLE 11
POINTS Y C S MPC MPS APC APS .
A 0 400 (400) 0.50 0.50 0 0
B 200 500 (300) 2.5 (1.5)
C 400 600 (200) 1.5 (0.5)
D 600 700 (100) 1.17 (0.17)
E 800 800 0 1 0
F 1000 900 100 0.90 0.10
G 1200 1000 200 0.83 0.17
H 1400 1100 300 0.79 0.21
I 1600 1200 400 0.75 0.25
J 1800 1300 500 0.72 0.28
K 2000 1400 600 0.50 0.50 0.70 0.30

Figure 11.B
Consumption (C)

1,600 -
1,400 -
1,200 -
1,000 -
800 -
600 -
400 -
200 -
Income (Y)

Adding Gross Investment to the Model

Ig – Gross investment
We are using the term “gross” investment because we are assuming that in the model, there is no depreciation involved.
Investment is any new plant, equipment, additional inventory or residential housing.

Table 11.1 Demand for Investment

investment

I
Aggregate Expenditure Data with Gross Investment (Billion)

POINTS Y GDP C Ig C + Ig S Disinvestment Effect on employment

In inventories Output and income
(1) (2) (3) (4) (5) (6) (7) = (2-5) (6)
A 0 400 200 600 (400) (600) Increase
B 200 500 700 (300) (500) Increase
C 400 600 800 (200) (400) Increase
D 600 700 900 (100) (300) Increase
E 800 800 1000 0 (200) Increase
F 1000 900 1100 100 (100) Increase
G 1200 1000 1200 200 0 Equilibrium
H 1400 1100 1300 300 100 Decrease
I 1600 1200 1400 40 200 Decrease
J 1800 1300 1500 500 300 Decrease
K 2000 1400 200 1600 600 400 Decrease

Figure 11.2 A & B

In figure 11.2, we start with the consumption function from figure 11 and adding Ig as an additional component to the
aggregate expenditure model. The distance between C and C + Ig is 200 billion pesos, (the value of planned investment).
The constant distant between C and C + Ig is constant, thus, exceeding consumption demand at each level of Income.
Equilibrium Level
In this model, the equilibrium in Table 11.1, output is given at point G (1,200) billion pesos wherein the production equals
income. Furthermore, we can observe that saving is equal to investment(S=I). Households set aside part of their income in
the form of saving for other purposes. That is why saving is a leakage to the economy because it does not go to the
purchase of goods and services resulting to a decrease in the national product.

Adding Government Spending to the Aggregate Expenditure Model without taxation

The level of spending is determined by allocational, distributional, and stabilizational needs. Allocational needs reflect
society’s view of the proper level of spending for public and merit goods. Distributional needs reflect society’s view of
equity with regards to the distribution of income. Stabilizational needs reflect a society’s view of the proper spending to
achieve unemployment, inflation, and economic growth goals. The injection leakage approach tells us that equilibrium
can be achieved if: S+T = Ig + G

The assumption is, with no imposition of tax in this model, the government spending will be financed by private saving.
Therefore,

S = Ig + G

Where:
S = saving
T = tax
Ig = private gross investment
G = government

Table 11.2 Aggregate Expenditure Data with Government Spending without Tax Imposition
Figure 11.3A & 11.3B

Effect of the Imposition of Tax

Suppose the government imposes a lump-sum tax, of a constant amount on each level of GDP. This will free the
government to rely heavily on private domestic savings in financing its spending. Assume that the government enforces a
lump sum tax of 200 billion pesos. It means that the government attains 200 billion pesos tax revenue at each level of
income.

Tabular Analysis

Yd = disposable income
Yd = Y-T
Adding Net Export Component to the Model
Net Export is the excess of the country’s export to the rest of the world, over the imports from other countries
(Xn = export - import)
Without the imposition of tax, equilibrium in this condition is when government spending is being financed by private
saving.
S + M = Ig + G + X

Factors that affect Net Export

1. Incomes of other countries
2. Trading restrictions
3. Exchange rates

Equilibrium GDP versus full employment

Recessionary Gap
 It happens when aggregate expenditure at full employment GDP is less than the required level to attain the full
employment GDP, or when the aggregate expenditure fall below the 45 degree line.
Inflationary Gap
 Is the excess of the amount of the aggregate expenditure at the full payment GDP over those necessary to realize
full employment GDP.