ECON 2 PRINCIPLES OF ECONOMICS 2

THE AGGREGATE EXPENDITURES MODEL

Lesson 10

Aggregate Expenditures (AE) Model  At GDP levels above equilibrium, AE will be less
 Also known as Keynesian Cross model than GDP; businesses will have unsold, unplanned
 Keynes developed this model during the Great inventory investment and will cut back rates of
Depression of the 1930s and it can help explain how production. As GDP declines, the number of jobs
modern economies adjust to economic shocks and total income will also decline until equilibrium is
 Helps address 2 questions: (1) What determines the reached
level of GDP? (2) What causes GDP to rise and Other Features of Equilibrium GDP
fall? 1) Savings and planned investment are equal
Assumptions and Simplifications  Saving is a “leakage” or withdrawal of spending
1) Not at full employment from the circular flow of income and
2) Prices are fixed expenditures
3) GDP = DI  Some output is planned for business
4) Begin with private, closed economy (no investment, not consumer consumption, so this
government, no trade) investment spending (or “injection” of spending
into the circular flow) can replace the leakage
Tools for Aggregate Expenditures Theory:
due to saving
Consumption and Investment Schedules
2) In equilibrium, there are no unplanned changes in
In a closed private economy, there are two inventory
components of aggregate expenditures (AE):
Changes in Equilibrium GDP and the Multiplier
Consumption (C) and Gross Private Investment (Ig).
Consumption Schedule (C) - refer to previous lesson
Investment Schedule (Ig)
 Shows the amount that businesses plan to invest at
different levels of GDP
 Assume investment is independent of GDP;
investment is constant at all GDP levels
Equilibrium GDP in a Closed Private Economy = C + Ig

 In a closed private economy, the equilibrium GDP

will change in response to changes in either the
investment schedule or the consumption schedule
 If the expected rate of return on investment rises or
that the interest rate falls such that investment
spending increases, the investment schedule will
shift upward, which in turn increases AE and raises
equilibrium GDP
 If the expected rate of return on investment
decreases, or if the interest rate rises, investment
 The level of output whose production will create spending will decline, which will show as a
total spending just sufficient to purchase that output downward shift in the investment schedule, and a
 At GDP levels below equilibrium, businesses will downward shift of the AE schedule; as a result,
adjust to excess demand revealed by declining equilibrium GDP will fall
inventories by expanding production
Adding Net Exports and International Trade

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 10

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 ECON 2 PRINCIPLES OF ECONOMICS 2

 Net exports (Xn = X – M) affect aggregate Adding the Public Sector: Government Purchases
expenditures in an open private economy  Increases in government spending boost aggregate
 Exports expand and imports contract aggregate expenditures
spending on domestic output  Government spending is subject to the multiplier
 Exports (X) create domestic production, income,
and employment due to foreign spending on
domestically produced goods & services
 Imports (M) reduce the sum of consumption &
investment expenditures by the amount expended
on imported goods, so this figure must be
subtracted so as not to overstate aggregate
expenditures on domestically produced goods &
services
Impact of Net Exports on Equilibrium GDP

 Taxes reduce DI and, therefore, consumption &

saving at each level of GDP
 An increase in taxes will lower the aggregate
expenditures schedule & reduce the equilibrium
GDP
 At equilibrium GDP, the sum of leakages equals the
sum of injections
o Saving (SA) + Import (M) + Taxes (T) =
Investment (IG)+ Exports (X) + Government
Purchases (G)
 If G & T are each increased by a particular amount,
 Positive net exports increase aggregate
the equilibrium level of real output will rise by the
expenditures beyond what they would be in a closed
same amount
economy & thus have the effect of expansion
 Negative net exports decrease aggregate
expenditures beyond what they would be in a closed
economy & thus have the effect of contraction
 The multiplier effect is also at work in both
scenarios
International Economic Linkages
 Prosperity abroad generally raises our exports &
transfers some of their prosperity to us (Recession
abroad has the reverse effect)
 Tariffs on products may reduce our exports &
depress our economy, causing us to retaliate and
worsen the situation. Trade barriers in the 1930s
contributed to the Great Depression
 Depreciation of the dollar lowers the cost of
American goods to foreigners and encourages
exports from the U.S. while discouraging the Equilibrium versus Full-Employment GDP
purchase of imports in the U.S. This could lead to a  A recessionary expenditure gap exists when
higher real GDP or to inflation, depending on the equilibrium GDP is below full-employment
domestic employment situation. Appreciation of the
dollar could have the opposite impact.

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 10

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 ECON 2 PRINCIPLES OF ECONOMICS 2

 An inflationary expenditure gap exists when

aggregate expenditures exceed full-employment
GDP

INSTRUCTOR: NIÑA MAE BIANCA J. MARTIN LESSON 10

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