Chapter 29: The Aggregate Expenditures Model

Private Sector is composed of Households (Consume) and Firms (Invest).

Actual Investment and Planned Investment:

𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃𝑙𝑎𝑛𝑛𝑒𝑑 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑈𝑛𝑝𝑙𝑎𝑛𝑛𝑒𝑑

Investment planned refers to the addition to capital stock and inventories that are planned by
firms.
Unplanned Investment is the unexpected change in inventories.

Types of economies that we are going to deal with:

- Private Closed Economy.
- Mixed Closed Economy (With Government).
- Open Economy.

Private Closed Economy:

- No government and no trade.

- Disposable Income = Y (Income) in the absence of taxes.
- All investments are planned (I is constant).

Equilibrium in a Private Closed Economy is under 3 conditions:

I. 𝑌 = 𝐴𝐸 and 𝐴𝐸 = 𝐶 + 𝐼 because in a Private Closed Economy we do not have

government expenditures (G) and net exports (𝑋𝑛 ).

II. This condition of equilibrium holds if and only if

𝑃𝑙𝑎𝑛𝑛𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Which means that 𝑈𝑛𝑝𝑙𝑎𝑛𝑛𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 0.

At disequilibrium: (𝒀 ≠ 𝑨𝑬):

- 𝑌 > 𝐴𝐸, Output > Spending; therefore, Unplanned Investment increases.

- 𝑌 < 𝐴𝐸 , Output < Spending; therefore, Unplanned Investment decreases and firms will
increase their production.

III. We know that 𝑌 = 𝐶 + 𝑆

At equilibrium 𝑌 = 𝐴𝐸 and 𝐴𝐸 = 𝐶 + 𝐼; therefore, 𝐶 + 𝑆 = 𝐶 + 𝐼 as a result 𝑆 = 𝐼

Leakage Injection

At equilibrium 𝑌 = 𝐴𝐸:
If Investment increases, 𝐴𝐸 increases; therefore, 𝑌 < 𝐴𝐸. 𝑌 has to increase by how much to
reach equilibrium again? We use the Multiplier.

∆𝑌 1
=
∆𝐼 𝑀𝑃𝑆
1
In which is the multiplier.
𝑀𝑃𝑆

Algebraic derivation of the multiplier:

𝐶 = 𝑎 + 𝑏𝑌
At equilibrium 𝑌 = 𝐴𝐸; therefore, 𝑌 = 𝐶 + 𝐼 (𝐼 is a constant)
1
As a result 𝑌 = 𝑎 + 𝑏𝑌 + 𝐼 → 𝑌 − 𝑏𝑌 = 𝑎 + 𝐼 → 𝑌(1 − 𝑏) = 𝑎 + 𝐼 → 𝑌 = 𝑎 + 𝐼 × (1−𝑏)

∆𝐼
∆𝐼
As a result ∆𝑌 = (1−𝑏) where 𝑏 is the MPC.
Equilibrium in a Mixed Closed Economy (With Government) is under 3 conditions:

I. 𝑌 = 𝐴𝐸 and 𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 because in a Mixed Closed Private Economy we have

Government Spending (𝐺) but we do not have net exports (𝑋𝑛 ),and 𝑌𝑑 = 𝑌 − 𝑇 and
𝑌𝑑 = 𝐶 + 𝑆; therefore, 𝑌 = 𝐶 + 𝑆 + 𝑇
II. This condition of equilibrium holds if and only if
𝑃𝑙𝑎𝑛𝑛𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Which means that 𝑈𝑛𝑝𝑙𝑎𝑛𝑛𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 0.

At disequilibrium: (𝒀 ≠ 𝑨𝑬):
- 𝑌 > 𝐴𝐸, Output > Spending; therefore, Unplanned Investment increases.
- 𝑌 < 𝐴𝐸 , Output < Spending; therefore, Unplanned Investment decreases and firms will
increase their production.

III. When government is included we know that 𝑌 = 𝐶 + 𝑆 + 𝑇 because taxes are included.
At equilibrium 𝑌 = 𝐴𝐸 where 𝐴𝐸 = 𝐶 + 𝐼 + 𝐺; therefore, 𝐶 + 𝑆 + 𝑇 = 𝐶 + 𝐼 + 𝐺
As a result 𝑆 + 𝑇 = 𝐼 + 𝐺

Leakage Injection

We have 3 types of taxes:

- Lump-sum Tax is fixed and a person would pay regardless of the income.
- Proportional Tax is expressed as a proportion of income and doesn’t vary with income.
- Progressive Tax is a tax that increases as income increases.
Fiscal policy at work:

- Expansionary Fiscal Policy is when Government Spending (𝐺) increases or Taxes (𝑇)
decrease in which it aims to expand output (𝑌).
- Contractionary Fiscal Policy is when Government Spending (𝐺) decreases or Taxes (𝑇)
increase in which it aims to contract or reduce output (𝑌).

There are 3 different tools or policies (Multipliers):

- Government Spending Multiplier (when Government Spending (𝐺) is changed alone).

- Tax Multiplier (when Tax (𝑇) is changed alone).
- Balanced-Budget Multiplier (when Government Spending (𝐺) and Tax (𝑇) change by the
same amount).

Government Spending Multiplier:

You can only change 𝐺 to increase 𝑌.

𝐺 is a component if 𝐴𝐸 and 𝐴𝐸 = 𝐶 + 𝐼 + 𝐺

Therefore, if 𝐺 increases 𝐴𝐸 will increase and as a result 𝐴𝐸 > 𝑌, and inventories will decrease
and firms will produce more.

How much will 𝑌 have to increase to retain equilibrium?

∆𝑌 = 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 ∆𝐴𝐸 × 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟, in this case the ∆𝐴𝐸 is equal to the ∆𝐺 and the multiplier is
1
.
𝑀𝑃𝑆

As a result ∆𝐺and ∆𝐼 have the same effect on ∆𝑌, for 𝑌 to retain equilibrium it will have to
1
increase by .
𝑀𝑃𝑆

1
The final equation is ∆𝑌 = ∆𝐺 × 𝑀𝑃𝑆.
Tax Multiplier:

Taxes are not a component of 𝐴𝐸; however, taxes affect 𝐴𝐸 indirectly through consumption.

We must follow two steps: First we must see the effect of taxes on consumption, second we
see the effect of consumption on 𝑌.

Example:

Assume government decides to cut taxes by $1. If taxes are cut by $1, 𝑌𝑑 increases by $1; as a
result, ∆𝑌𝑑 = ∆𝑇.

∆𝐶 ∆𝐶
We know that 𝑀𝑃𝐶 = = ; therefore, ∆𝐶 = ∆𝑇 × 𝑀𝑃𝐶.
∆𝑌𝑑 ∆𝑇

1
We have to find ∆𝑌 = ∆𝐴𝐸 × 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟, and the 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = .
𝑀𝑃𝑆

−𝑀𝑃𝐶
∆𝑌 = ∆𝑇 × 𝑀𝑃𝐶 × 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟; hence, ∆𝑌 = ∆𝑇 × .
𝑀𝑃𝑆

∆𝐶 Tax Multiplier

Balance-Budget Multiplier:

We apply the Balance-Budget Multiplier when 𝐺 and 𝑇 are changing by the same amount.

Assume the government decides to pay for its extra spending by increasing taxes by the same
amount.

Example:

𝐺 increases by $40 billion (increases 𝑌), and 𝑇 increases by $40 billion (decreases 𝑌).

We have two effects (𝑀𝑃𝐶 = 0.75).

1 1
1𝑠𝑡 , 𝐺 increases by $40 billion; therefore, ∆𝑌 = ∆𝐺 × 𝑀𝑃𝑆 → ∆𝑌 = 40 × 1−0.75 → ∆𝑌 = 160.
 −𝑀𝑃𝐶 −0.75
2𝑛𝑑 , 𝑇 increases by $40 billion; therefore, ∆𝑌 = ∆𝑇 × → ∆𝑌 = 40 × → ∆𝑌 = −120.
𝑀𝑃𝑆 0.25

The final effect on 𝑌, ∆𝑌 = 160 + (−120) → ∆𝑌 = 40.

As a result the effect of 𝑇 is lower than the effect of 𝐺 on 𝑌.

Note:

1 −𝑀𝑃𝐶 1 − 𝑀𝑃𝐶 𝑀𝑃𝑆

+ = = =1
𝑀𝑃𝑆 𝑀𝑃𝑆 𝑀𝑃𝑆 𝑀𝑃𝑆

It is a one-to-one relationship, and 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝐵𝑢𝑑𝑔𝑒𝑡 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 1.

Equilibrium of an Open Economy (Trade):

I. 𝑌 = 𝐴𝐸 and 𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋𝑛 because in an Open Economy we have all of the

components.
II. This condition of equilibrium holds if and only if
𝑃𝑙𝑎𝑛𝑛𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Which means that 𝑈𝑛𝑝𝑙𝑎𝑛𝑛𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 0.

At disequilibrium: (𝒀 ≠ 𝑨𝑬):
- 𝑌 > 𝐴𝐸, Output > Spending; therefore, Unplanned Investment increases.
- 𝑌 < 𝐴𝐸 , Output < Spending; therefore, Unplanned Investment decreases and firms will
increase their production.

III. When trade is included we know that 𝑌 = 𝐶 + 𝑆 + 𝑇 + 𝑀(𝐼𝑚𝑝𝑜𝑟𝑡𝑠).

At equilibrium 𝑌 = 𝐴𝐸 where 𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋(𝐸𝑥𝑝𝑜𝑟𝑡𝑠); therefore,
𝐶+𝑆+𝑇+𝑀 =𝐶+𝐼+𝐺+𝑋
As a result 𝑆 + 𝑇 + 𝑀 = 𝐼 + 𝐺 + 𝑋

Leakage Injection

Multiplier:
 1
The effect of 𝑋𝑛 has the same effect of ∆𝐺 and ∆𝐼 on 𝑌; therefore, ∆𝑌 = ∆𝑋𝑛 × 𝑀𝑃𝑆

For the graphical interpretation, Keep in mind that any increase in I, G or Xn will shift AE upward.
And when I, G and T are independent from income, the MPC would be the slope of AE too.
Equilibrium vs. Full Employment Output:

𝑌𝒆 = 490 (Equilibrium GDP).

𝑌𝑓 = 510 (𝐹𝑢𝑙𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝐺𝐷𝑃) .

In this case 𝑌𝑒 < 𝑌𝑓 (𝐴𝑐𝑡𝑢𝑎𝑙 < 𝑃𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙).

Therefore, we have a Recessionary Expenditure

Gap. This 𝐺𝐷𝑃 𝑔𝑎𝑝 = 𝑌𝑒 − 𝑌𝑓 = 490 − 510 = −20

The economy is sacrificing $20 billion of output.

If 𝑌𝑒 < 𝑌𝑓 , the GDP gap will be negative. The problem in this case is low 𝐴𝐸; therefore, 𝐴𝐸
should shift upwards to realize equilibrium at full employment. The amount by which 𝐴𝐸
should shift is the recessionary expenditure gap.

𝑌𝒆 = 530 (Equilibrium GDP).

𝑌𝑓 = 510 (𝐹𝑢𝑙𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝐺𝐷𝑃) .

In this case 𝑌𝑒 > 𝑌𝑓 (𝐴𝑐𝑡𝑢𝑎𝑙 > 𝑃𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙).

Therefore, we have an Inflationary Expenditure

Gap. This 𝐺𝐷𝑃 𝑔𝑎𝑝 = 𝑌𝑒 − 𝑌𝑓 = 530 − 510 = 20

If 𝑌𝑒 > 𝑌𝑓 , the GDP gap will be positive.

The problem in this case is that demand is way too much. The amount by which 𝐴𝐸 should shift
down to realize equilibrium at full employment is the inflationary expenditure gap.