Aggregate Expenditure Model

The key idea of the aggregate expenditure model is that in any particular year, the level of real
GDP is determined mainly by the level of aggregate expenditure.

A macroeconomic model that focuses on the short-run relationship between total spending

and real GDP, assuming that the price level is constant.

Aggregate expenditure (AE): Total spending in the economy:

the sum of

1. consumption, Spending by households on goods and services.

2. planned investment, Planned spending by firms on capital goods, and by households
on new homes.
3. government purchases, Spending on all levels of government on goods and services.
4. net exports. The value of exports minus the value of imports.

Short-run determination of total output in an economy

AE = C + I + G + NX

Planned Investment vs. Actual Investment

This aggregate expenditure model uses planned investment, rather than actual
investment; in this way, the definition of aggregate expenditures is slightly different
from GDP.
The difference is that planned investment spending does not include the build-up of
inventories: goods that have been produced but not yet sold:

Planned investment =

Actual investment – unplanned change in inventories

- For the economy as a whole, we can say that actual investment spending will
be greater than planned investment spending when there is an unplanned
increase in inventories. Actual investment spending will be less than planned
investment spending when there is an unplanned decrease in inventories.
Therefore, actual investment will equal planned investment only when there is
no unplanned change in inventories.

The Important Role of Inventories

When planned aggregate expenditure is less than real GDP, firms will experience unplanned
increases in inventories.

During other years, total spending in the economy increases more than total production. In
these years, firms will increase their production and hire more workers in order to meet the
demands of consumers. Sometimes, however, the increase in total spending in the economy is
less than total production. As a result, firms reduce their production and potentially lay off a
few workers, which can trigger a slowdown in other sectors of the economy—potentially
leading to a recession.

For the economy as a whole, macroeconomic equilibrium occurs where total spending, or
planned aggregate expenditure, equals total production, or GDP:1

Planned aggregate expenditure = GDP

Getting to Macroeconomic Equilibrium

Components of Real Aggregate Expenditure

1. Consumption
2. Planned Investment
3. Government Spending
4. Net experts

1. What affects the level of consumption?

• Current disposable income: We measure this by personal income, minus personal

income taxes, plus government transfer payments such as Social Security.

• Household wealth: its assets (like homes, stocks and bonds, and bank accounts) minus
its liabilities (mortgages, student loans, etc.).

• Expected future income: Most people prefer to keep their consumption fairly stable
from year to year, a process known as consumption-smoothing.

• The price level: As prices rise, household wealth falls.

• The interest rate: Higher real interest rates encourage saving rather than spending; so
they result in lower spending, especially on durable goods.

How strong is the relationship between income and consumption?

As the graphs demonstrate, the answer is “very strong”. A straight line (called the
consumption function) describes this relationship very well, suggesting that
households spend a consistent fraction of each extra dollar of real disposable
income on consumption.

. The consumption that takes place even when disposable income is zero is called
autonomous consumption. It’s called autonomous because it occurs automatically
or isn’t linked to income at all.

marginal propensity to consume: the amount by which consumption spending

changes when disposable income changes.
This marginal propensity to consume (MPC) is the slope of the consumption
function, the relationship between consumption spending and disposable income.

MPC= 0.764
So if incomes rose $10 000, we estimate consumption would rise by $10 000 ×
0.764 = $7640.

The distinction between national income and GDP is relatively minor; for this simple
model, we will assume they are equal, and use the terms interchangeably.

Income, Consumption, and Saving

Marginal Propensity to Save

the marginal propensity to consume plus the marginal propensity to save must
equal 1. This is because part of any increase in income is consumed, and the rest
is saved.

Saving= Difference Y (Real gdp) - C (consumption)

MPC= 60/100= 0.6

MPS= 40/100= 0.4
 Show that MPC plus MPS equals 1. At every level of national income, the MPC is 0.6 and
MPS is 0.4. Therefore, the MPC plus MPS is always equal to 1.

Planned Investment
Recessions can cause investment to fall rapidly.
What affects the level of investment?
1. Expectations of future profitability: Investment goods, such as factories, office
buildings, machinery, and equipment, are long-lived. Firms build more of them
when they are optimistic about future profitability. Recessions reduce
confidence in future profitability, hence during recessions, firms reduce planned
investment.
Purchases of new housing are included in planned investment. In recessions,
households have reduced wealth, and less incentive to invest in new housing.
2. Interest rate: A higher real interest rate results in less investment spending, and
a lower real interest rate results in more investment spending.
3. Taxes: Higher corporate income taxes on profits decrease the money available
for reinvestment and decrease incentives to invest by diminishing the expected
profitability of investment.
Similarly, investment tax incentives tend to increase investment.
4. Cash flow: Firms often pay for investments out of their own cash flow, the
difference between the cash revenues received by a firm and the cash
spending by the firm.
The largest contributor to cash flow is profit. During recessions, profits fall for most
firms, decreasing their ability to finance investment.
 Government Purchases
• Include all levels, federal, provincial and local. This category does not include
transfer payments; only purchases for which the government receives some
good or service.
Government purchases generally increase, exceptions include the early 1990s and the
early 2010s as the federal government made cuts to balance the budget.
Net exports
equals exports minus imports.
The value of net exports is affected by:
• Price level in Canada vs. the price level in other countries
• Canadian growth rate vs. growth rate in other countries
• Canadian dollar exchange rate
• Net exports have been negative for over 10 years.

If Canadian price levels, GDP or dollar rise more or faster, relative to the rest of the
world, exports will DECREASE. Demand for import rises due to the higher cost of
Canadian products. Foreign investors are discouraged by the higher cost.

If Canadian price levels, GDP or dollar Fall or slow down, relative to the rest of the
world, exports will INCREASE. Demand for export rises due to the attractiveness of low
costs in comparison. Demand for imports fall.
The 45°-Line Diagram
We can apply this model to a real economy, with real national income (GDP) on the x-
axis, and real aggregate expenditure on the y-axis.
This model is also known as the Keynesian cross, because it is based on the analysis.
Only points on the 45° line can be a macroeconomic equilibrium, with planned
aggregate expenditure equal to GDP.

• The resulting consumption function tells us how much consumers will spend
(real expenditure) when they have a particular income (real GDP).
This will determine Consumption (C) in the equation
Y = C + I + G + NX
Macroeconomic equilibrium simply means the left side (real GDP) must equal
the right side (planned aggregate expenditure).
Adjustment to Macroeconomic Equilibrium
In this economy, macroeconomic equilibrium occurs at $1.6 trillion.
What if real GDP were lower, say $1.2 trillion?
• Aggregate expenditure would be higher than GDP, so inventories would fall.
• This would signal firms to increase production, increasing GDP.

The economy is in recession when the aggregate expenditure line intersects the 45°
line at a level of GDP that is below potential GDP

Recession on the 45°-Line Diagram

Macroeconomic equilibrium can occur anywhere on the 45° line. Ideally, we
would like it to occur at the level of potential GDP.
If equilibrium occurs at this level, unemployment will be low—at the natural
rate of unemployment, or the full employment level.
But for various reasons, this might not occur. For example, maybe firms are
pessimistic and reduce investment spending.
• Then the equilibrium will occur below potential GDP—a recession.

Inventories play a critical role in this model of the economy.

When planned aggregate expenditure is less than real GDP, firms will
experience unplanned increases in inventories.
Then even if spending returns to normal levels, firms have excess inventories to
sell before they can return to producing at normal levels.

As real GDP changes, consumption changes but planned investment,

government purchases, and net exports do not change with GDP.

The Multiplier Effect

Autonomous and Induced Expenditures (1 of 2)
 A small change in planned aggregate expenditure causes a larger change in
equilibrium real GDP.

planned investment, government purchases, and net exports are autonomous

expenditures: their level does not depend on the level of GDP.

• But consumption has both an autonomous and induced effect. So its level does
depend on the level of GDP, and this produces the upward-sloping AE line.
• An increase in an autonomous expenditure shifts the aggregate expenditure
line upward.

real GDP increases by more than the change in autonomous expenditures; this is the
multiplier effect.
 • The multiplier = value of the increase in equilibrium real GDP divided by the
increase in autonomous expenditures (planned investment).

With a multiplier of 5, each $1 increase in planned investment (or any other

autonomous expenditure) eventually increases equilibrium real GDP by $5.

Formula for the Multiplier

1
1  MPC

MPC = 0.8; so the multiplier is

1/(1-0.8) = 5
80 billion increase in investment eventually results in a $400 billion increase in
equilibrium real GDP

Summarizing the Multiplier Effect

1. The multiplier effect occurs both for an increase and a decrease in planned
aggregate expenditure.
2. Because the multiplier is greater than 1, the economy is sensitive to changes in
autonomous expenditure. The multiplier effect means a decline in spending in
one sector will cause declines in spending and production in other sectors of
the economy.
3. The larger the MPC, the larger the value of the multiplier. The larger the MPC,
the more additional consumption takes place after each rise (or fall) in the
multiplier process.
4. Our model is somewhat simplified, omitting some real-world complications. For
example, as real GDP changes, imports, inflation, interest rates, and income
taxes will change.
The last point generally means that the value we estimate for the multiplier, from the
MPC

The Paradox of Thrift

Recall the savings identity: savings equals investment.
But consider what happens in the short-term if people save more: consumption
decreases, which causes aggregate expenditure to fall and… potentially pushes the
economy into recession.
• John Maynard Keynes referred to this as the paradox of thrift: what appears to
be favorable in the long-run may be counterproductive in the short-run.
• Economists debate whether this paradox of thrift really exists; increasing
savings decreases the real interest rate; the consequent increase in investment
spending may offset the decrease in consumption spending.

The Price Level and Aggregate Expenditure

 As demand for a product rises, two things are likely to occur: production
increases, and so does the product’s price.
increases in the price level will cause aggregate expenditure to fall, and decreases in
the price level will cause aggregate expenditures to rise.

How does the Price Level Affect Aggregate Expenditure?

1. Rising price levels decrease the real value of household wealth, causing
consumption to fall.
2. If the price level in the Canada rises faster than in other countries, Canadian
exports fall and imports rise, causing net exports to fall.
3. When prices rise, firms and households need more money to finance buying
and selling. If the supply of money doesn’t change, the interest rate must rise;
this will cause investment spending to fall.
4. Each effect works in the same direction; so rising price levels decrease
aggregate expenditure, while falling price levels increase aggregate
expenditure.

The Effect of a Change in Price Level on Real GDP

a. Increases in the price level cause AE and real GDP to fall.
b. Decreases in the price level cause AE and real GDP to rise.

There is an inverse relationship between the price level and real GDP.
Aggregate demand (AD) curve: A curve that shows the relationship between the price
level and the level of planned aggregate expenditure in the economy, holding constant
all other factors that affect aggregate expenditure.
Common Misconceptions to Avoid
• In the 45°- line diagram, it becomes very important to distinguish income (real
GDP) from expenditure (aggregate expenditure); although these are equal in
macroeconomic equilibrium, they are not conceptually identical.
• Similarly, consumption spending is only a part (albeit the largest part) of
aggregate expenditure.

Equilibrium GDP = Autonomous expenditure × Multiplier

The paradox is sometimes observed at the beginning of recessions. Households that expect
negative economic times reduce their spending in case they lose their jobs, and thus their
incomes. As households switch from spending to saving, the aggregate expenditure in the
economy falls. Firms respond to the fall in aggregate spending by reducing their production. A
reduction in production means laying off workers. In some cases, people trying to protect
themselves from a recession end up contributing to one.

In this chapter, we examined a key macroeconomic idea: In the short run, the level of GDP is
determined mainly by the level of aggregate expenditure. When economists forecast changes
in GDP, they do so by forecasting changes in the four components of aggregate expenditure.
We constructed an aggregate demand curve by asking what would happen to the level of
aggregate expenditure when the price level changes.

We saw that sales of snowmobiles are linked to changes in the economy.

Based on this linkage, do you think BRP pays attention to the Consumer
Confidence Index? Why or why not?
The Consumer Confidence Index is a good predictor of household spending in Canada. The link
between spending and expected future income is supported by Andy Kwan and
John Cotsomitis's study. They find spending increases when consumers are more confident
about the future and falls when they are less confident. Therefore, using the detailed consumer
confidence data of the Consumer Confidence Index can help the owner of small business to
forecast his future level of sales and prevent unplanned inventory investments.
The Consumer Confidence Index is a good predictor of household spending in Canada. There is
a link between spending and expected future income: spending increases when consumers are
more confident about the future and falls when they are less confident. The Consumer
Confidence Index fell sharply in 2008 as the global recession began to hit Canadians.
Confidence also fell throughout most of the early part of 2015. Consumers gained a lot of
confidence between November 2015 and December 2018. Sudden drops in the Consumer
Confidence Index are seldom a good sign, but don't always indicate a recession. So far, BRP
can use this index to predict slowdowns in the Canadian economy that cause a decrease in
demand for snowmobiles.

 What is the value of the MPC?

 What is the value of equilibrium real GDP?

960 -60

1040 -40

1120 -20
920

1200 0
1000

1080 1280 +20

Unplanned change in inventories: Real GDP (Y) – AE aggregate expenditure

AE = C + I+ G + Nx

MPC= change consumption/ change in GDP

= 80/ 100 = 0.8
Equilibrium= 1200
 100

125 075

150 0.75

175 0.75

200 0.75

75/100