CHAPTER OVERVIEW - Mr Clotzman at Uni High Macroeconomics/Chap010.doc · Web viewIncorporate government into the table by assuming that it plans to tax and spend $20 billion at each

The Aggregate Expenditures Model

CHAPTER TENTHE AGGREGATE EXPENDITURES MODEL

CHAPTER OVERVIEWWe have seen in Chapter 9 three basic relationships: how income relates to consumption and saving, how the interest rate affects investment spending, and how changes in spending work through the system to create larger changes in output. In this chapter we build the more theoretically rigorous explanation for these relationships – the Aggregate Expenditures (AE) Model.

The chapter begins with the simple version of the AE model, that of a closed, private economy. Equilibrium GDP is determined and multiplier effects are briefly reviewed. The simplified “closed” economy is then “opened” to show how it would be affected by exports and imports. Government spending and taxes are brought into the model to include the “public” aspects of the system. Finally, the model is applied to two historical periods in order to consider some of the model’s deficiencies. The price level is assumed constant in this chapter unless stated otherwise, so the focus is on real GDP.

The Last Word traces briefly the historical development of the AE theory.

WHAT’S NEWChapters 10 through 12 are now organized into Part 3, a unit titled “Macroeconomic Models and Fiscal Policy.” This slight restructuring reflects primarily the changes to Chapters 9 and 10, and otherwise does not represent a significant change in coverage.

This chapter develops the aggregate expenditures (AE) analysis in its entirety. Instructors that prefer to bypass the AE model can proceed directly to Chapter 11 (Aggregate Demand / Aggregate Supply) without students missing the key underlying concepts. In the previous edition the model was covered in Chapters 9 and 10; now it is in Chapter 10 only.

Discussion of the balanced budget multiplier has been replaced with a brief discussion of the “differential impacts” of government purchases (G) and taxes (T).

New applications of recessionary gaps (recession of 2001) and inflationary gaps (late 1980s) have replaced previous edition references to the Great Depression, Vietnam War inflation, and Japan’s 1990s recession.

The closing section, “Limitations of the Model,” now includes “It does not allow for ‘self-correction’.”

The “Last Word” on “Say’s Law, the Great Depression, and Keynes” replaces the multiplier piece that appeared in the previous edition and now appears in Chapter 9.

End-of-chapter and web-based questions have been revised and edited.

There is no “Consider This” box in this chapter, but there are two potentially useful “Concept Illustrations” that appear in the COMMENTS AND TEACHING SUGGESTIONS.

INSTRUCTIONAL OBJECTIVESAfter completing this chapter, students should be able to

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1. Identify the simplifying assumptions of the Aggregate Expenditures (AE) model.

2. Explain the relationship between the investment demand curve and the investment schedule.

3. Use the consumption and investment schedules to determine the equilibrium level of GDP.

4. Explain verbally and graphically the equilibrium level of GDP.

5. Explain why above-equilibrium or below-equilibrium GDP levels will not persist.

6. Explain the basics of the classical view that the economy would generally provide full employment levels of output.

7. Trace the changes in GDP that will occur when there is a discrepancy between saving and planned investment.

8. Use the multiplier to find changes in GDP resulting from changes in spending.

9. Define the net export schedule.

10. Explain the impact of positive (or negative) net exports on aggregate expenditures and the equilibrium level of real GDP.

11. Explain the effect of increases (or decreases) in exports on real GDP.

12. Explain the effect of increases (or decreases) in imports on real GDP.

13. Describe how government purchases affect equilibrium GDP.

14. Describe how personal taxes affect equilibrium GDP.

15. Explain why an equal amount of government purchases and taxes will have a differential impact on GDP.

16. Identify a recessionary gap and explain how it relates to the U.S. recession of 2001.

17. Identify an inflationary gap and explain how it relates to the inflationary experience of the late 1980s.

18. List five limitations of the aggregate expenditures model.

19. Explain how the aggregate expenditures model emerged as a critique of Classical economics and in response to the Great Depression.

20. Define and identify terms and concepts listed at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS1. As stated earlier, some instructors may choose to skip this chapter. However, students could still

benefit from the Last Word for Chapter 10.

2. Note that net exports are kept as independent of the level of GDP to keep the analysis simple. You may want to note in passing that, in fact, there tends to be a direct relationship between import spending and the level of GDP.

3. The Last Word for this chapter provides a historical backdrop for Keynesian theory. Impress upon students that Keynes developed the theory that emphasizes the importance of aggregate demand for economic performance. You may want to point out that his theory changed the way economists viewed the modern capitalist system and that he has been credited with the development of macroeconomics as a separate field. Stress that debate still lingers over whether the system is self-correcting during periods of unemployment or inflation.

4. Data to update Figure 9-1 may be found in the most recent issue of Survey of Current Business or Economic Indicators. Web-based questions at the end of the chapter also point to sources.

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5. The following “Concept Illustration” may be useful in conveying the leakages-injections approach to equilibrium GDP.

Concept Illustration … Leakages and Injections

A bathtub analogy is useful in illustrating the injections-leakages approach to equilibrium real domestic output and income (real GDP) in the private, closed economy. A tub’s faucet enables an inflow of water and the tub’s drain allows an outflow of water. The level of water in the tub remains constant when the inflow from the faucet equals the outflow from the drain. If the inflow exceeds the outflow, the level of water rises. If the inflow is less than the outflow, the level of water level recedes.

The inflow, outflow, and level of water in the tub are analogous to investment (Ig), saving (S), and real GDP, respectively, in a private, closed economy. Equilibrium real GDP occurs where the investment injection (inflow) just equals the saving leakage (drain). If the investment injection exceeds the saving leakage, real GDP expands until saving increases sufficiently to equal the level of investment. If the investment injection is less than the saving leakage, real GDP declines until saving falls sufficiently to equal investment. In both cases equilibrium is achieved where investment equals saving.

In the economy represented in Table 9-4, equilibrium real GDP is $470 billion. In view of the bathtub analogy, it is not surprising to discover that investment and saving flows are each $20 billion.

6. After learning the AE model, students may reach the conclusion that increasing saving is bad because of the contractionary impact it has on consumption and, by extension, aggregate spending. This is, of course, the famous “paradox of thrift,” and if you choose to include such a discussion in your course, you may find the following “Concept Illustration” useful.

Concept Illustration … The Paradox of Thrift

In Chapter 2 we said that a higher rate of saving is good for society because it frees resources from consumption uses and directs them toward investment goods. More machinery and equipment means a greater capacity for the economy to produce goods and services.

But implicit within this “saving is good” proposition is the assumption that increased saving will be borrowed and spent for investment goods. If investment does not increase along with saving, a curious irony called the paradox of thrift may arise. The attempt to save more may simply reduce GDP and leave actual saving unchanged.

Our analysis of the multiplier process helps explain this possibility. Suppose an economy that has a MPC of .75, a MPS of .25, and a multiplier of 4, decides to save an additional $200 billion. From the social viewpoint, a penny saved that is not invested is a penny not spent and therefore a decline in someone’s income. Through the multiplier process, the $200 billion of reduced consumption spending lowers real GDP by $800 billion (4 x $200 billion).

The $800 billion decline of real GDP, in turn, reduces saving by $200 billion (= MPS of .25 x $800 billion), which completely cancels the initial $200 billion increase of saving. Here, the attempt to increase saving is bad for the economy: it creates a recession and leaves saving unchanged.

For increased saving to be good for an economy, greater investment must accompany greater saving. If investment replaces consumption dollar-for-dollar, aggregate expenditures stay constant and the higher level of investment raises the economy’s future growth rate.

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STUDENT STUMBLING BLOCKS1. When introducing the investment, net export, and government purchases schedules, be sure to

emphasize that the graphs are horizontal because of the exogenous nature of the variables, not because the values are unchanging.

2. When the model is complete (GDP = C + Ig + Xn + G), students may confuse the equilibrium equation with the accounting identity presented in Chapter 7. You may need to visually separate planned and unplanned investment in the equation to help them see the difference between the two equations.

3. Some students will need to be reminded that in the AE model, unplanned inventory build-ups or depletions are corrected by adjusting production, not by altering prices.

LECTURE NOTES

I. Introduction—What Determines GDP?

A. This chapter focuses on the aggregate expenditures model. We use the definitions and facts from previous chapters to shift our study to the analysis of economic performance. The aggregate expenditures model is one tool in this analysis. Recall that “aggregate” means total.

B. As explained in this chapter’s Last Word, the model originated with John Maynard Keynes (pronounced “Canes”).

C. The focus is on the relationship between income and consumption and savings.

D. Investment spending, net exports, and government purchases, important parts of aggregate expenditures, are also examined.

E. Finally, these spending categories are combined to explain the equilibrium levels output and employment in at first a private (no government), domestic (no foreign sector) economy. Therefore, GDP = NI = PI = DI in this very simple model.

F. The revised model adds realism by including the foreign sector and government in the aggregate expenditures model.

G. Applications of the new model include two U.S. historical periods (the 2001 recession and the late 1980s inflation).

II. Simplifying Assumptions for the Private Closed-Economy model

A. We first assume a “closed economy” with no international trade.

B. Government is ignored.

C. Although both households and businesses save, we assume here that all saving is personal.

D. Depreciation and net foreign income are assumed to be zero for simplicity.

E. There are two reminders concerning these assumptions.

1. They leave out two key components of aggregate demand (government spending and foreign trade), because they are largely affected by influences outside the domestic market system.

2. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.

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III. Tools of Aggregate Expenditures Theory: Consumption and Investment Schedules

A. The theory assumes that the level of output and employment depend directly on the level of aggregate expenditures. Changes in output reflect changes in aggregate spending.

B. In a closed private economy the two components of aggregate expenditures are consumption and gross investment.

C. The consumption schedule was developed in Chapter 9 (see Figure 9-2a).

D. In addition to the investment demand schedule, economists also define an investment schedule that shows the amounts business firms collectively intend to invest at each possible level of GDP or DI.

1. In developing the investment schedule, it is assumed that investment is independent of the current income. The line Ig (gross investment) in Figure 10-1b shows this to be graphically related to the level determined by Figure 10-1a.

2. The assumption that investment is independent of income is a simplification, but it will be used here.

3. Figure 10-1a shows the investment schedule from GDP levels given in Table 9-1.

IV. Equilibrium GDP: Expenditures-Output Approach

A. Look at Table 10-2, which combines data of Tables 9-1 and 10-1.

B. Real domestic output in column 2 shows ten possible levels that producers are willing to offer, assuming their sales would meet the output planned. In other words, they will produce $370 billion of output if they expect to receive $370 billion in revenue.

C. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) forthcoming at each output level.

1. Recall that consumption level is directly related to the level of income and that here income is equal to output level.

2. Investment is independent of income here and is planned or intended regardless of the current income situation.

D. Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output. Otherwise there will be a disequilibrium situation.

1. In Table 10-2, this occurs only at $470 billion.

2. At $410 billion GDP level, total expenditures (C + Ig) would be $425 = $405(C) + $20 (Ig) and businesses will adjust to this excess demand (revealed by the declining inventories) by stepping up production. They will expand production at any level of GDP less than the $470 billion equilibrium.

3. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At $510 billion level, C + Ig = $500 billion. Businesses will have unsold, unplanned inventory investment and will cut back on the rate of production. As GDP declines, the number of jobs and total income will also decline, but eventually the GDP and aggregate spending will be in equilibrium at $470 billion.

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E. Graphical analysis is shown in Figure 10-2 (Key Graph). At $470 billion it shows the C + Ig schedule intersecting the 45-degree line which is where output = aggregate expenditures, or the equilibrium position.

1. Observe that the aggregate expenditures line rises with output and income, but not as much as income, due to the marginal propensity to consume (the slope) being less than 1.

2. A part of every increase in disposable income will not be spent but will be saved.

3. Test yourself with Quick Quiz 10-2.

V. Two Other Features of Equilibrium GDP

A. Savings and planned investment are equal.

1. It is important to note that in our analysis above we spoke of “planned” investment. At GDP = $470 billion in Table 10-2, both saving and planned investment are $20 billion.

2. Saving represents a “leakage” from spending stream and causes C to be less than GDP.

3. Some of output is planned for business investment and not consumption, so this investment spending can replace the leakage due to saving.

a. If aggregate spending is less than equilibrium GDP as it is in Table 10-2, line 8, when GDP is $510 billion, then businesses will find themselves with unplanned inventory investment on top of what was already planned. This unplanned portion is reflected as a business expenditure, even though the business may not have desired it, because the total output has a value that belongs to someone—either as a planned purchase or as an unplanned inventory.

b. If aggregate expenditures exceed GDP, then there will be less inventory investment than businesses planned as businesses sell more than they expected. This is reflected as a negative amount of unplanned investment in inventory. For example, at $450 billion GDP, there will be $435 billion of consumer spending, $20 billion of planned investment, so businesses must have experienced a $5 billion unplanned decline in inventory because sales exceed that expected.

B. In equilibrium there are no unplanned changes in inventory.

1. Consider row 7 of Table 10-2 where GDP is $490 billion; here C + Ig is only $485 billion and will be less than output by $5 billion. Firms retain the extra $5 billion as unplanned inventory investment. Actual investment is $25 billion, or $5 billion more than the $20 billion planned. So $490 billion is an above-equilibrium output level.

2. Consider row 5, Table 10-2. Here $450 billion is a below-equilibrium output level because actual investment will be $5 billion less than planned. Inventories decline below what was planned. GDP will rise to $470 billion.

C. Quick Review: Equilibrium GDP is where aggregate expenditures equal real domestic output.

1. C + planned Ig = GDP

2. A difference between saving and planned investment causes a difference between the production and spending plans of the economy as a whole.

3. This difference between production and spending plans leads to unintended inventory investment or unintended decline in inventories.

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4. As long as unplanned changes in inventories occur, businesses will revise their production plans upward or downward until the investment in inventory is equal to what they planned. This will occur at the point that household saving is equal to planned investment.

5. Only where planned investment and saving are equal will there be no unintended investment or disinvestment in inventories to drive the GDP down or up.

VI. Changes in Equilibrium GDP and the Multiplier

A. As developed in Chapter 9, an initial change in spending will be acted on by the multiplier to produce larger changes in output.

1. The “initial change” represented in the text and Figure 10-3 is in planned investmentspending. It could also result from a nonincome-induced change in consumption.

2. The multiplier in Figure 10-3 is 4 (=1/MPS)

B. Figure 10-3 shows the impact of changes in investment. Suppose investment spending rises (due to a rise in profit expectations or to a decline in interest rates).

1. Figure 10-3 shows the increase in aggregate expenditures from (C + Ig)0 to (C + Ig)1. In this case, the $5 billion increase in investment leads to a $20 billion increase in equilibrium GDP.

2. Conversely, a decline in investment spending of $5 billion is shown to create a decrease in equilibrium GDP of $20 billion to $450 billion.

VII. International Trade and Equilibrium Output

A. Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports expand and imports contract aggregate spending on domestic output.

1. Exports (X) create domestic production, income, and employment due to foreign spending on U.S. produced goods and services.

2. Imports (M) reduce the sum of consumption and investment expenditures by the amount expended on imported goods, so this figure must be subtracted so as not to overstate aggregate expenditures on U.S. produced goods and services.

B. The net export schedule (Table 10-3):

1. Shows hypothetical amount of net exports (X - M) that will occur at each level of GDP given in Table 10-2.

2. Assumes that net exports are autonomous or independent of the current GDP level.

3. Figure 10-4b shows Table 10-3 graphically.

a. Xn1 shows a positive $5 billion in net exports.

b. Xn2 shows a negative $5 billion in net exports.

C. The impact of net exports on equilibrium GDP is illustrated in Figure 10-4a.

1. Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and thus have an expansionary effect. The multiplier effect also is at work. In Figure 10-4a we see that positive net exports of $5 billion lead to a positive change in equilibrium GDP of $20 billion (to $490 from $470 billion). This comes from Table 10-2 and Figure 10-3.

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2. Negative net exports decrease aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary effect. The multiplier effect also is at work here. In Figure 10-4a we see that negative net exports of $5 billion lead to a negative change in equilibrium GDP of $20 billion (to $450 from $470 billion).

D. Global Perspective 10-1 shows 2001 net exports for various nations.

E. International economic linkages:

1. Prosperity abroad generally raises our exports and transfers some of their prosperity to us. (Conversely, recession abroad has the reverse effect.)

2. Tariffs on U.S. products may reduce our exports and depress our economy, causing us to retaliate and worsen the situation. Trade barriers in the 1930s contributed to the Great Depression.

3. Depreciation of the dollar (Chapter 6) lowers the cost of American goods to foreigners and encourages exports from the U.S. while discouraging the purchase of imports in the U.S. This could lead to higher real GDP or to inflation, depending on the domestic employment situation. Appreciation of the dollar could have the opposite impact.

VIII. Adding the Public Sector

A. Simplifying assumptions are helpful for clarity when we include the government sector in our analysis. (Many of these simplifications are dropped in Chapter 12, where there is further analysis on the government sector.)

1. Simplified investment and net export schedules are used. We assume they are independent of the level of current GDP.

2. We assume government purchases do not impact private spending schedules.

3. We assume that net tax revenues are derived entirely from personal taxes so that GDP, NI, and PI remain equal. DI is PI minus net personal taxes.

4. We assume that tax collections are independent of GDP level (a lump-sum tax)

5. The price level is assumed to be constant unless otherwise indicated.

B. Table 10-4 gives a tabular example of including $20 billion in government spending and Figure 10-5 gives the graphical illustration. Note that the previous section’s net export information has also been included.

1. Increases in government spending boost aggregate expenditures.

2. Government spending is subject to the multiplier.

C. Table 10-5 and Figure 10-6 show the impact of a tax increase. (Key Question 12)

1. Taxes reduce DI and, therefore, consumption and saving at each level of GDP.

2. An increase in taxes will lower the aggregate expenditures schedule relative to the 45-degree line and reduce the equilibrium GDP.

3. Table 10-5 confirms that, at equilibrium GDP, the sum of leakages equals the sum of injections. Saving + Imports + Taxes = Investment + Exports + Government Purchases.

D. Government purchases and taxes have different impacts.

1. In our example, equal additions in government spending and taxation increase the equilibrium GDP.

a. If G and T are each increased by a particular amount, the equilibrium level of real output will rise by that same amount.

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b. In the text’s example, an increase of $20 billion in G and an offsetting increase of $20 billion in T will increase equilibrium GDP by $20 billion (from $470 billion to $490 billion).

2. The example reveals the rationale.

a. An increase in G is direct and adds $20 billion to aggregate expenditures.

b. An increase in T has an indirect effect on aggregate expenditures because T reduces disposable incomes first, and then C falls by the amount of the tax times MPC.

c. The overall result is a rise in initial spending of $20 billion minus a fall in initial spending of $15 billion (.75 x $20 billion), which is a net upward shift in aggregate expenditures of $5 billion. When this is subject to the multiplier effect, which is 4 in this example, the increase in GDP will be equal to $4 x $5 billion or $20 billion, which is the size of the change in G.

IX. Injections, Leakages, and Unplanned Changes in Inventories – Equilibrium revisitedA. As demonstrated earlier, in a closed private economy equilibrium occurs when saving (a

leakage) equals planned investment (an injection).

B. With the introduction of a foreign sector (net exports) and a public sector (government), new leakages and injections are introduced.

1. Imports and taxes are added leakages.

2. Exports and government purchases are added injections.

C. Equilibrium is found when the leakages equal the injections.

1. When leakages equal injections, there are no unplanned changes in inventories.

2. Symbolically, equilibrium occurs when Sa + M + T = Ig + X + G, where Sa is after-tax saving, M is imports, T is taxes, Ig is (gross) planned investment, X is exports, and G

is government purchases.

X. Equilibrium vs. Full-Employment GDP

A. A recessionary gap exists when equilibrium GDP is below full-employment GDP. (See Figure 10-7a)

1. A recessionary gap of $5 billion is the amount by which aggregate expenditures fall short of those required to achieve the full-employment level of GDP.

2. In Table 10-5, assuming the full-employment GDP is $510 billion, the corresponding level of total expenditures there is only $505 billion. The gap would be $5 billion, the amount by which the schedule would have to shift upward to realize the full-employment GDP.

3. Graphically, the recessionary gap is the vertical distance by which the aggregate expenditures schedule (Ca + Ig + Xn + G)1 lies below the full-employment point on the 45-degree line.

4. Because the multiplier is 4, we observe a $20-billion differential (the recessionary gap of $5 billion times the multiplier of 4) between the equilibrium GDP and the full-employment GDP. This is the $20 billion GDP gap we encountered in Chapter 8’s Figure 8-3.

B. An inflationary gap exists when aggregate expenditures exceed full-employment GDP.

1. Figure 10-7b shows that a demand-pull inflationary gap of $5 billion exists when aggregate spending exceeds what is necessary to achieve full employment.

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2. The inflationary gap is the amount by which the aggregate expenditures schedule must shift downward to realize the full-employment noninflationary GDP.

3. The effect of the inflationary gap is to pull up the prices of the economy’s output.

4. In this model, if output can’t expand, pure demand-pull inflation will occur (Key Question 10).

XI. Historical Applications

A. The U.S. recession of 2001 provides a good illustration of a recessionary gap.

1. U.S. overcapacity and business insolvency resulted from excessive expansion by businesses in the 1990s, a period of prosperity.

2. Internet-related companies proliferated during the 1990s, despite their lack of profitability, but fueled by speculative interest in the stocks of these start-up firms.

3. Consumer debt grew as people borrowed against their expectations of rising wealth in financial markets.

4. Fraud by executives and accountants led to speculative excesses and set up firms to fail.

5. Beginning in 2000, a dramatic drop in stock market values occurred, causing pessimism and highly unfavorable conditions for acquiring additional investment funds.

6. In March 2001 aggregate expenditures declined and the economy fell into its 9 th

recession since 1950.

7. The terrorist attacks on September 11, 2001, further undermined consumer confidence and contributed to the downturn.

8. Unemployment has remained high (by the standards of the last decade), at or above 6%, despite other signs pointing toward recovery. As of summer 2003, the upturn was still being referred to as a “jobless recovery,” where output rises, but labor market conditions remain weak.

B. U.S. Inflation in the late 1980s provides an example of an inflationary gap period.

1. Strong economic growth in the late 1980s gave way to increasing rates of inflation.

2. Inflation rose from 1.9% in 1986 and to 3.6, 4.1, and 4.8% in the years that followed.

3. Inflationary pressure subsided with the 1990-91 recession and the recessionary gap that emerged.

XII. Limitations of the Model

A. The aggregate expenditures model has five limitations.

1. The model can account for demand-pull inflation, but it does not indicate the extent of inflation when there is an inflationary gap. It doesn’t measure inflation.

2. It doesn’t explain how inflation can occur before the economy reaches full employment (premature demand-pull inflation).

3. It doesn’t indicate how the economy could produce beyond full-employment output for a time.

4. The model does not address the possibility of cost-push type of inflation.

5. It doesn’t allow for “self-correction,” built-in features of the economy that tend to ameliorate recessionary and inflationary gaps.

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B. In Chapter 11, these deficiencies are remedied with a related aggregate demand-aggregate supply model.

XIII. Last Word: Say’s Law, The Great Depression, and Keynes

A. Until the Great Depression of the 1930, most economists going back to Adam Smith had believed that a market system would ensure full employment of the economy’s resources except for temporary, short-term upheavals.

B. If there were deviations, they would be self-correcting. A slump in output and employment would reduce prices, which would increase consumer spending; would lower wages, which would increase employment again; and would lower interest rates, which would expand investment spending.

C. Say’s law, attributed to the French economist J. B. Say in the early 1800s, summarized the view in a few words: “Supply creates its own demand.”

D. Say’s law is easiest to understand in terms of barter. The woodworker produces furniture in order to trade for other needed products and services. All the products would be traded for something, or else there would be no need to make them. Thus, supply creates its own demand.

E. Reformulated versions of these classical views are still prevalent among some modern economists today.

F. The Great Depression of the 1930s was worldwide. GDP fell by 40 percent in U.S. and the unemployment rate rose to nearly 25 percent (when most families had only one breadwinner). The Depression seemed to refute the classical idea that markets were self-correcting and would provide full employment.

G. John Maynard Keynes in 1936 in his General Theory of Employment, Interest, and Money, provided an alternative to classical theory, which helped explain periods of recession.

1. Not all income is always spent, contrary to Say’s law.

2. Producers may respond to unsold inventories by reducing output rather than cutting prices.

3. A recession or depression could follow this decline in employment and incomes.

H. The modern aggregate expenditures model is based on Keynesian economics or the ideas that have arisen from Keynes and his followers since. It is based on the idea that saving and investment decisions may not be coordinated, and prices and wages are not very flexible downward. Internal market forces can therefore cause depressions and government should play an active role in stabilizing the economy.

ANSWERS TO END-OF-CHAPTER QUESTIONS

10-1 What is an investment schedule and how does it differ from an investment demand curve?

An investment schedule shows the level of investment spending for a given level of GDP. An investment demand curve shows how expected rates of profit and real interest rates determine the level of investment spending. In the simple AE model, investment spending is assumed to be independent of the level of real GDP.

10-2 (Key Question) Assuming the level of investment is $16 billion and independent of the level of total output, complete the following table and determine the equilibrium levels of output and

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employment in this private closed economy. What are the sizes of the MPC and MPS?

Possible levelsof employment

(millions)

Real domesticoutput (GDP = DI)

(billions)Consumption

(billions)Saving

(billions)

404550556065707580

$240260280300320340360380400

$244260276292308324340356372

$ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____

Saving data for completing the table (top to bottom): $-4; $0; $4; $8; $12; $16; $20; $24; $28.

Equilibrium GDP = $340 billion, determined where (1) aggregate expenditures equal GDP (C of $324 billion + I of $16 billion = GDP of $340 billion); or (2) where planned I = S (I of $16 billion = S of $16 billion). Equilibrium level of employment = 65 million; MPC = .8; MPS = .2.

10-3 Using the consumption and saving data in question 2 and assuming investment is $16 billion, what are saving and planned investment at the $380 billion level of domestic output? What are saving and actual investment at that level? What are saving and planned investment at the $300 billion level of domestic output? What are the levels of saving and actual investment? Use the concept of unplanned investment to explain adjustments toward equilibrium from both the $380 and $300 billion levels of domestic output.

At the $380 billion level of GDP, saving = $24 billion; planned investment = $16 billion (from the question). This deficiency of $8 billion of planned investment causes an unplanned $8 billion increase in inventories. Actual investment is $24 billion (= $16 billion of planned investment plus $8 billion of unplanned inventory investment), matching the $24 billion of actual saving.

At the $300 billion level of GDP, saving = $8 billion; planned investment = $16 billion (from the question). This excess of $8 billion of planned investment causes an unplanned $8 billion decline in inventories. Actual investment is $8 billion (= $16 billion of planned investment minus $8 billion of unplanned inventory disinvestment) matching the actual of $8 billion.

When unplanned investments in inventories occur, as at the $380 billion level of GDP, businesses revise their production plans downward and GDP falls. When unplanned disinvestments in inventories occur, as at the $300 billion level of GDP; businesses revise their production plans upward and GDP rises. Equilibrium GDP—in this case, $340 billion—occurs where planned investment equals saving.

10-4 Why is saving called a leakage? Why is planned investment called an injection? Why must saving equal planned investment at equilibrium GDP in the private closed economy? Are unplanned changes in inventories rising, falling, or constant at equilibrium GDP? Explain.

Saving is like a leakage from the flow of aggregate consumption expenditures because saving represents income not spent. Planned investment is an injection because it is spending on capital goods that businesses plan to make regardless of their current level of income. If the two are unequal, there will be a discrepancy between spending and production that will result in

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unplanned inventory changes. Firms, not wanting inventory levels to change, will change production, implying that equilibrium can only occur when the saving leakage equals the injection of investment spending in a private closed economy.

At equilibrium GDP there will be no changes in unplanned inventories because expenditures will exactly equal planned output levels which include consumer goods and services and planned investment. Thus there is no unplanned investment including no unplanned inventory changes.

10-5 What effect will each of the changes designated in question 3 at the end of Chapter 9 have on the equilibrium level of GDP? Explain your answers.

a. A large increase in the value of real estate, including private houses.

b. A decline in the real interest rate.

c. A sharp, sustained decline in stock prices.

d. An increase in the rate of population growth.

e. The development of a cheaper method of manufacturing computer chips.

f. A sizable increase in the retirement age for collecting Social Security benefits.

g. The expectation that mild inflation will persist in the next decade.

h. An increase in the Federal personal income tax.

(a) If this means that people have become wealthier, then their consumption schedule will shift up and GDP will rise by a multiple of the increase in consumption.

(b) This will increase interest-sensitive consumer purchases and investment, causing GDP to increase.

(c) By reducing consumption (because households will feel—or be—less wealthy, or because they fear a recession) and by decreasing investment, the AE schedule will shift downward, causing the GDP to decline.

(d) This will increase AE, causing GDP to increase.

(e) Investment will increase both because of increased profitability and because of increased innovations, causing GDP to increase.

(f) The announcement will lead to an upward shift of the current saving schedule (downward shift of the consumption schedule), causing GDP to decline.

(g) An increase in the personal income tax will decrease the level of disposable income, and decrease consumer spending, which could mean a decline in aggregate expenditures. But if the government increases its purchases to the extent of the tax increase, then aggregate expenditures will actually increase, since consumer expenditures fall only by a fraction of the decline in income and government spending is more than offsetting this decline. If this happens, the equilibrium level of GDP should rise. On the other hand, if government spending does not rise, then the equilibrium level of GDP may fall as private spending falls.

10-6 By how much will GDP change if firms increase their investment by $8 billion and the MPC is .80? If the MPC is .67?

GDP will increase $40 billion if the MPC is .80. An MPC of .80 will produce a multiplier of 5. The multiplier times the $8 billion change in spending will change GDP by $40 billion.

Change in GDP = Change in Investment x (1/(1 - MPC)) $40 billion = $8 billion x (1/(1 - .8))

GDP will increase by approximately $24 billion when the MPC is .67

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$24 billion = $8 billion x (1/(1 - .67)) Note: The multiplier for an MPC of .67 is actually 3.03.

10-7 Depict graphically the aggregate expenditures model for a private closed economy. Now show a decrease in the aggregate expenditures schedule and explain why the decrease in real GDP in your diagram is greater than the initial decline in aggregate expenditures. What would be the ratio of a decline in real GDP to the initial drop in aggregate expenditures if the slope of your aggregate expenditures schedule were .75?

If the slope of the aggregate expenditures schedule were .8, then the MPC = .8 and the MPS = .2. Therefore, the multiplier would be 1/(.2) = 5. The ratio of decline in real GDP to the initial drop of expenditures would be a ratio of 5:1. That is, if expenditures declined by $4 billion, GDP should decline by $20 billion. On the graph it can be seen that a one-unit decline in (C + I) leads to a five-unit decline in real GDP.

10-8 Suppose that a certain country has an MPC of .9 and real GDP of $400 billion. If its investment spending decreases by $4 billion, what will be its new level of real GDP?

The multiplier is 10 or 1/(1-.9) so 10 x -$4 billion = -$40 billion. The new GDP is $400 billion - $40 billion = $360 billion.

10-9 (Key Question) The data in columns 1 and 2 of the table below are for a private closed economy.

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(1)Real

domesticoutput

(GDP = DI)billions

(2)Aggregate

expendituresprivate closed

economy,billions

(3)

Exports,billions

(4)

Imports,billions

(5)

Netexports,private

economy

(6)

Aggregateexpenditures,

open,billions

$200$250$300$350$400$450$500$550

$240$280$320$360$400$440$480$520

$20$20$20$20$20$20$20$20

$30$30$30$30$30$30$30$30

$ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____

$ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____

a. Use columns 1 and 2 to determine the equilibrium GDP for this hypothetical economy.

b. Now open up this economy to international trade by including the export and import figures of columns 3 and 4. Fill in columns 5 and 6 to determine the equilibrium GDP for the open economy. Explain why this equilibrium GDP differs from that of the closed economy.

c. Given the original $20 billion level of exports, what would be the equilibrium GDP if imports were $10 billion greater at each level of GDP?

d. What is the multiplier in this example?

(a) Equilibrium GDP for closed economy = $400 billion.

(b) Net export data for column 5 (top to bottom); $-10 billion in each space. Aggregate expenditure data for column 6 (top to bottom): $230; $270; $310; $350; $390; $430; $470; $510. Equilibrium GDP for the open economy is $350 billion, $50 billion below the $400 billion equilibrium GDP for the closed economy. The $-10 billion of net exports is a leakage that reduces equilibrium GDP by $50 billion.

(c) Imports = $40 billion: Aggregate expenditures in the private open economy would fall by $10 billion at each GDP level and the new equilibrium GDP would be $300 billion.

(d) Since every rise of $50 billion in GDP increases aggregate expenditures by $40 billion, the MPC is .8 and so the multiplier is 5.

10-10 Assume that, without taxes, the consumption schedule of an economy is as shown below:

GDP,billions

Consumption,Billions

$100200300400500600700

$120200280360440520600

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a. Graph this consumption schedule and determine the MPC.

b. Assume now that a lump-sum tax system is imposed such that the government collects $10 billion in taxes at all levels of GDP. Graph the resulting consumption schedule, and compare the MPC and the multiplier with that of the pretax consumption schedule.

Refer to Figures 9-2 and 9-4 for the graphs for (a) and (b), respectively.

(a) The size of the MPC is 80/100 or .8 because consumption changes by 80 when GDP changes by 100.

(b) The resulting consumption schedule will be exactly $8 billion below the original at all levels of GDP (or income). After-tax income will fall by $10 billion. Given the MPC of .8, consumption therefore will fall by $8 billion at each level of GDP. The multiplier is 5 because the MPS is .2. The MPC and multiplier don’t change from of a lump-sum tax.

10-11 Explain graphically the determination of equilibrium GDP for a private economy through the aggregate expenditures model. Now add government spending (any amount that you choose) to your graph, showing its impact on equilibrium GDP. Finally, add taxation (any amount of lump-sum tax that you choose) to your graph and show its effect on equilibrium GDP. Looking at

your graph, determine whether equilibrium GDP has increased, decreased, or stayed the same in view of the sizes of the government spending and taxes that you selected.

Figures 10-5 and 10-6 show how to do this. Graphs and answers will differ depending on magnitude of changes.

10-12 (Key Question) Refer to columns 1 and 6 of the tabular data for question 9. Incorporate government into the table by assuming that it plans to tax and spend $20 billion at each possible level of GDP. Also assume that all taxes are personal taxes and that government spending does not induce a shift in the private aggregate expenditures schedule. Compute and explain the changes in equilibrium GDP caused by the addition of government.

Before G is added, open private sector equilibrium will be at $350. The addition of government expenditures of G to our analysis raises the aggregate expenditures (C + Ig +Xn + G) schedule and increases the equilibrium level of GDP as would an increase in C, Ig, or Xn. Note that changes in government spending are subject to the multiplier effect. Government spending supplements private investment and export spending (Ig + X + G), increasing the equilibrium GDP to $450.

The addition of $20 billion of government expenditures and $20 billion of personal taxes increases equilibrium GDP from $350 to $370 billion. The $20 billion increase in G raises equilibrium GDP by $100 billion (= $20 billion x the multiplier of 5); the $20 billion increase in T reduces consumption by $16 billion at every level. (= $20 billion x the MPC of .8). This $16 billion decline in turn reduces equilibrium GDP by $80 billion ($16 billion x multiplier of 5). The net change from including balanced government spending and taxes is $20 billion (= $100 billion - $80 billion).

10-13 (Key Question) Refer to the table below in answering the questions that follow:

164


(1)Possible levels

of employment,millions

(2)Real domestic

output,billions

(3)Aggregate

Expenditures(Ca+Ig+Xn+G),

billions

90100110120130

$500550600650700

$520560600640680

a. If full employment in this economy is 130 million, will there be an inflationary gap or a recessionary gap? What will be the consequence of this gap? By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the inflationary or recessionary gap? Explain. What is the multiplier in this example?

b. Will there be an inflationary or recessionary gap if the full-employment level of output is $500 billion? Explain the consequences. By how much would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the gap? Explain. What is the multiplier in this example?

c. Assuming that investment, net exports, and government expenditures do not change with changes in real GDP, what are the sizes of the MPC, the MPS, and the multiplier?

(a) A recessionary gap. Equilibrium GDP is $600 billion, while full employment GDP is $700 billion. Employment will be 20 million less than at full employment. Aggregate expenditures would have to increase by $20 billion (= $700 billion -$680 billion) at each level of GDP to eliminate the recessionary gap. The MPC is .8, so the multiplier is 5.

(b) An inflationary gap. Aggregate expenditures will be excessive, causing demand-pull inflation. Aggregate expenditures would have to fall by $20 billion (= $520 billion -$500 billion) at each level of GDP to eliminate the inflationary gap. The multiplier is still 5 – the level of full employment GDP does not affect the multiplier.

(c) MPC = .8 (= $40 billion/$50 billion); MPS = .2 (= 1 -.8); multiplier = 5 (= 1/.2).

10-14 (Advanced analysis) Assume the consumption schedule for a private open economy is such that C = 50 + 0.8Y. Assume further that planned investment and net exports are independent of the level of income and constant at Ig = 30 and Xn = 10. Recall also that, in equilibrium, the real output produced (Y) is equal to the aggregate expenditures: Y = C + Ig + Xn.

a Calculate the equilibrium level of income or real GDP for this economy.

b What happens to equilibrium Y if Ig changes to 10? What does this tell you about the size of the multiplier?

(a)

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Real domesticoutput

(GDP = YI) C Ig Xn

Aggregateexpenditures,open economy

$ 050

100150200250300350400450500

$ 5090

130170210250290330370410450

$3030303030303030303030

$1010101010101010101010

$90130170210250290330370410450490

(b) If Ig decreases from $30 to $10, the new equilibrium GDP will be at GDP of $350, for with Ig now $10 this is where AE also equals $350. This indicates that the multiplier equals 5, for a decline in AE of $20 has led to a decline in equilibrium GDP of $100. The size of the multiplier could also have been calculated directly from the MPC of 0.8.

10-15 Answer the following questions, which relate to the aggregate expenditures model.

a. If Ca is $100, Ig is $50, Xn is -$10, and G is $30, what is the economy’s equilibrium GDP?

b. If real GDP in an economy is currently $200, Ca is $100, Ig is $50, Xn is -$10, and G is $30, will the economy’s real GDP rise, fall, or stay the same?

c. Suppose that full-employment (and full-capacity) output in an economy is $200. If Ca is $150, Ig is $50, Xn is -$10, and G is $30, what will be the macroeconomic result?

(a) Assuming that there is no unplanned inventory investment at these expenditure levels, equilibrium GDP is $170. (= Ca+Ig+Xn+G)

(b) If real GDP is $200, aggregate expenditures of $170 will result in positive unplanned inventory investment. GDP will fall as firms respond to the inventory build-up by reducing output.

(c) Assuming that the economy is in equilibrium at these expenditure levels, real GDP is $170, below the full employment level of output. There is a recessionary gap, and employment levels are lower than they would be at full employment.

10-16 (Last Word) What is Say’s law? How does it relate to the view held by classical economists that the economy generally will operate at a position on its production possibilities curve (Chapter 2). Use production possibilities to demonstrate Keynes’s view on this matter.

Say’s law states “supply creates its own demand.” People work in order to earn income and plan to spend the income on output – why else would they work? Basically, the classical economists would say that the economy will operate at full employment or on the production possibilities curve because income earned will be recycled or spent on output. Thus the spending flow is continuously recycled in production and earning income. If consumers don’t spend all their income, it would be redirected via saving to investment spending on capital goods.

The Keynesian perspective, on the other hand, suggests that society’s savings will not necessarily all be channeled into investment spending. If this occurs, we have a situation in which aggregate demand is less than potential production. Because producers cannot sell all of the output

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produced at a full employment level, they will reduce output and employment to meet the aggregate demand (consumption plus investment) and the equilibrium output will be at a point inside the production possibilities curve at less than full employment.

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