The Aggregate Expenditures Model Part I

The Aggregate Expenditures Model What determines a country’s GDP, given its production capacity? What causes a real GDP to rise in one period and to fall in another? o To more thoroughly answer these two questions, we construct the aggregate expenditures model, which originated in the 1936 writings of British economist John Maynard Keynes (pronounced “Canes”).  The basic premise of the aggregate expenditures model – also known as the “Keynesian cross” model – is that the amount of goods and services produced and the level of employment depend directly on the level of aggregate expenditures (total spending). Businesses will produce only a level of output that they think they can profitably sell. o They will idle their workers and machinery when there are no markets for their goods and services. Assumptions and Simplifications Keynes created the aggregate expenditures model in the middle of the Great Depression, hoping to explain both why the Great Depression had happened and how it might be ended. A “Stuck Price” Model The simplifying assumptions underpinning the aggregate expenditures model reflect the economic conditions that prevailed during the Great Depression. o The most important assumption is that prices are fixed.  The aggregate expenditures model is an extreme version of a sticky price model. In fact, it is a stuck-price model because the price level cannot change at all. Keynes made this simplifying assumption because he had observed that prices had not declined sufficiently during the Great Depression to boost spending and maintain output and employment at their preDepression levels. o Macroeconomic theories popular before the Great Depression had predicted that prices would fall to equate quantity supplied and quantity demanded.  But actual prices did not fall sufficiently during the Great Depression, and the economy sank far below its potential output. U.S. real GDP declined by 27 percent from 1929 to 1933, and the unemployment rate rose to 25 percent. o Thousands of factories sat idle, gathering dust and producing nothing because there was insufficient demand for their output. Unplanned Inventory Adjustments To Keynes, the Great Depression’s massive unemployment of labor and capital was caused by firms reacting in a predictable way to unplanned increase in inventory levels. o Recall that inventory consists of goods that have been produced but which have not yet been sold.  Firms may stock up on inventory in anticipation of rapid future sales. They may also intentionally decrease inventory levels if they believe that demand will decline in the future. o But sometimes life does not go as planned.  Sometimes inventories either rise or fall more intended because demand is either unexpectedly high or unexpectedly low. The Great Depression took everyone by surprise. o Households and businesses unexpectedly reduced their spending, which caused inventories of unsold goods to unexpectedly surge.  Unable or unwilling to slash their prices, firms could not sell output fast enough to prevent inventories from continuing to pile up. So they greatly reduced their rates of production, in some cases shutting down factories completely until inventory levels declined. o Reduced production brought with it discharged workers, idle factory lines, and, in come cases, shuttered factories gathering dusts.  Keynes thought that economics needed a new model to explain these events. So, he created the aggregate expenditures model that we study in this chapter The model’s other key assumption – the one that allows it to achieve equilibrium – is that production decisions are made in response to unexpected changes in inventory levels. o If inventories are unexpectedly rising (because sales unexpectedly lag production) firms will cut back on production so as to balance production with sales and prevent inventory levels from exceeding warehouse capacity.  If inventories are unexpectedly falling (because sales unexpectedly exceed production) firms will increase production so as to take advantage of an unexpectedly good selling environment. Current Relevance The Keynesian aggregate expenditures model remains relevant today because many prices in the modern economy are inflexible downward over relatively short periods of time, as we discussed in Chapter 26. o The aggregate expenditures model therefore helps us understand how the modern economy is likely to adjust to various economic shocks over shorter periods of time.  For example, it provides insight into several aspects of the severe 2007-2009 recession, explaining why unexpected initial declines in spending caused even larger declines in real GDP. It also illuminates the thinking underlying the federal government’s stimulus programs (tax cuts, government spending increases, lower interest rates) during the recession. A Preview We will build up the aggregate expenditures model in stages. o As a first step, we examine aggregate expenditures and equilibrium GDP in a private closed economy that lacks both international trade and government.  Then we will open the closed economy to exports and imports. We will also convert our “private” economy that has only private actors (businesses and households) into a more realistic “mixed” economy that includes the government sector. o Doing so will allow us to analyze the effects of government expenditures and taxes. Until we introduce taxes, we will assume that real GDP equals disposable income (DI). o For instance, if $500 billion of output is produced as GDP, households will receive exactly $500 billion is disposable income that they can then consume or save. Finally, unless specified otherwise, we will assume (as Keynes did) that the presence of excess production capacity and unemployed labor implies that an increase in aggregate expenditures will increase real output and employment without raising the price level. Consumption and Investment Schedules In the private closed economy, the two components of aggregate expenditures are consumption, C, and grows investment, Ig. o Because we examined the consumption schedule in the previous chapter, there is no need to repeat that analysis here.  But to add to the investment decisions of businesses to the consumption plans of households, we need to construct an investment schedule showing the amounts of business firms collectively intend to invest – their planned investment – at each possible level of GDP. Such a schedule represents the investment plans of businesses in the same way the consumption schedule represents the consumption plan of households. o In developing the investment schedule, we will assume that planned investment is independent of the level of current disposable income or real output. Equilibrium GDP: C + Ig = GDP Now let’s combine the consumption schedule of Chapter 30 with the investment schedule of the previous section to explain the equilibrium levels of output, income, and employment in the private closed economy. Tabular Analysis Real Domestic Output o Column 2 in Table 31.2 lists the various possible levels of total output – of real GDP – that the private sector might produce.  Firms are willing to produce any one of these 10 levels of output just as long as the revenue that they receive from selling any particular amount of output equals or exceeds the costs of producing it. Those costs are the factor payments needed to obtain the required amounts of land, labor, capital, and entrepreneurship. o For example, firms are willing to produce $370 billion of output if the costs of production (wages, rents, interest, and the nominal profit needed to attract entrepreneurship) do not exceed the $370 billion in revenue that they will get from selling the output. Aggregate Expenditures o In the private closed economy of Table 31.2, aggregate expenditures consist of consumption (column 3) plus investment (column 5).  Their sum is shown in column 6, which along with column 2 makes up the aggregate expenditures schedule for the private closed economy. This schedule shows the amount (C + Ig) that will be spent at each possible output or income level. o At this point we are working with planned investment – the data in column 5 of Table 31.2.  These data show the amounts that firms plan or intend to invest, not the amounts they actually will invest if there are unplanned changes in inventories. Equilibrium GDP o Of the 10 possible levels of GDP in Table 31.2, which is the equilibrium level?  Which total output is the economy capable of sustaining? o The equilibrium output whose production creates total spending just sufficient to purchase that output.  In other words, the equilibrium GDP occurs where the total quantity of goods produced (GDP) equals the total quantity of goods purchased (C + Ig): C + Ig = GDP o If you look at the domestic output levels in column 2 and the aggregate expenditures levels in column 6, you will see that this equality exists only at $470 billion of GDP (row 6).  That is the only output at which economywide spending precisely equals the amount needed to move that output off the shelves. At $470 billion of GDP, annual production and spending are in balance. o There is no overproduction, which would result in excess inventories and consequently cutbacks in production.  Nor is there an excess of total spending, which would draw down inventories of goods and prompt increases in production. In short, there is no reason for businesses to alter this rate of production; $470 billion is the equilibrium GDP. Disequilibrium o No level of GDP other than the equilibrium level of GDP can be sustained.  At the levels of GDP less than equilibrium, spending always exceeds GDP. If, for example, firms produced $410 billion of GDP, they would find it would yield $405 billion in consumer spending. o Supplemented by $20 billion of planned investment, aggregate expenditures (C + Ig) would be $425 billion.  The economy would provide an annual rate of spending more than sufficient to purchase the $410 billion of annual production. Because buyers would be taking goods off the shelves faster than firms could produce them, an unplanned decline in business inventories of $15 billion would occur if this situation continued. o But businesses can adjust to such an imbalance between aggregate expenditures and real output by stepping up production. o Greater output will increase employment and total income.  This process will continue until the equilibrium level of GDP is reached. o The reverse is true at all levels of GDP greater than the $470 billion equilibrium level.  Businesses will find that these total outputs fail to generate the spending needed to clear the shelves of goods. Being unable to recover their costs, businesses will cut back on production. o But businesses can adjust to this unintended accumulation of unsold goods by cutting back on the rate of production.  The resulting decline in output would mean fewer jobs and a decline in total income. Graphical Analysis We can demonstrate our analysis graphically. o In Figure 31.2, the 45 degree line we developed in Chapter 30 takes on increased significance.  At any point on this line, the value of what is measured on the horizontal axis (here, GDP) equals the value of what is measured on the vertical axis (here, aggregate expenditures, or C + Ig). Having discovered in our tabular analysis that the equilibrium level of domestic output occurs where C + Ig equals GDP, we can say that the 45 degree line in Figure 31.2 is a graphical representation of that equilibrium condition. Now we must graph the aggregate expenditures schedule onto Figure 31.2. o To do so, we duplicate the consumption schedule C in Figure 30.2a and add to it vertically the constant $20 billion amount of investment Ig from Figure 31.1b.  This $20 billion is the amount that firms plan to invest at all levels of GDP. Or, more directly, we can plot the C + Ig data in column 6. In Figure 31.2, the aggregate expenditures line C + Ig shows that total spending rises with income and output (GDP), but not as much as income rises. o That condition holds true because the marginal propensity to consume – the slope of line C – is less than 1.  A part of any increase in income will be saved rather than spent. And because the aggregate expenditures line C + Ig is parallel to the consumption line C, the slope of the aggregate expenditures line also equals the MPC for the economy and is less than 1. o For our particular data, aggregate expenditures rise by $15 billion for every $20 billion increase in real output and income because $5 billion of each $20 billion increment is saved.  Therefore, the slope of the aggregate expenditures line is 0.75 (=$15/$20). The equilibrium level of GDP occurs at the intersection of the aggregate expenditures schedule and the 45 degree line. o This intersection locates the only point at which aggregate expenditures (on the vertical axis) are equal to GDP (on the horizontal axis).  Because Figure 31.2 is based on the data in table 31.2, we once again find that equilibrium output is $470 billion. Observe that consumption at this output is $450 billion, and investment is $20 billion. It is evident from Figure 31.2 that no levels of GDP above the equilibrium level are sustainable because at those levels C + Ig falls short of GDP. o In those situations, the aggregate expenditures schedule lies below the 45 degree line.  At the $510 billion GDP level, for example, C + Ig is only $500 billion. This underspending causes inventories to rise, prompting firms to adjust production downward, toward the $470 billion output level Conversely, at levels of GDP below $470 billion, the economy wants to spend in excess of what businesses are producing. o Therefore, C + Ig exceeds total output.  Graphically, the aggregate expenditures schedule lies above the 45 degree line. At the $410 billion GDP level, for example, C + Ig totals $425 billion. o This excess spending causes inventories to fall below their planned level, prompting firms to adjust production upward, toward the $470 billion output level.  Once production reaches that level, it will be sustained there indefinitely unless there is some change in the location of the aggregate expenditures line. Other Features of Equilibrium GDP We have seen that C + Ig = GDP at equilibrium in the private closed economy. o A closer look at Table 31.2 reveals two more characteristics of equilibrium GDP:  Saving and planned investment are equal (S =Ig)  There are no unplanned changes in inventories. Saving Equals Planned Investment As row 6 in Table 31.2 shows, saving and planned investment are both $20 billion at the $470 billion equilibrium level of GDP. Saving is a leakage, or a withdrawal, of spending from the economy’s circular flow of income and expenditures. o Saving causes consumption to be less than total output or GDP.  Because of saving, consumption by itself is insufficient to remove domestic output from the shelves, apparently setting the stage for a decline in total output. However, firms do not intend to sell their entire output to consumers. o Some of that output will be capital goods sold to other businesses.  Investment – that is, purchases of capital goods – is therefore an injection of spending into the incomeexpenditures stream. As an addition to consumption, investment is thus a potential replacement for the leakage of saving If the leakage of saving at a certain level of GDP exceeds the injection of investment, then C + Ig will be less than GDP and that level of GDP cannot be sustained. o Any GDP for which saving exceeds investment is an aboveequilibrium GDP.  Consider GDP of $510 billion. Households save $30 billion, but firms plan to invest only $20 billion. o This $10 billion excessive of saving over planned investment reduces total spending to $10 billion below the value of total output,  Specifically, aggregate expenditures will be $500 billion while real GDP is $510 billion. This spending deficiency will reduce real GDP. Conversely, if the injection of investment exceeds the leakage of saving, then C + Ig will be greater than GDP and drive GDP upward. o Any GDP for which investment exceeds saving is belowequilibrium GDP.  For example, at a GDP of $410 billion, households save only $5 billion, but firms invest $20 billion. So investment exceeds saving by $15 billion. o The larger injection of investment spending more than compensates for this small leakage of saving at this relatively low GDP level. Only where S = Ig – where the leakage of saving of $20 billion is exactly offset by the injection of planned investment of $20 billion – will aggregate expenditures (C + Ig) equal real output (GDP). o That C + Ig = GDP equality defines the equilibrium GDP. No Unplanned Changes in Inventories As part of their investment plans, firms may decide to increase or decrease their inventories. o But as line 6 of Table 31.2 confirms, there are no unplanned changes in inventories at equilibrium GDP.  This fact, along with C + Ig = GDP, and S = Ig, characterizes equilibrium GDP in the private closed economy. Unplanned changes in inventories play a major role in achieving equilibrium GDP. When economists say differences between investment and saving can occur and bring about changes in equilibrium GDP, they are referring to planned investment and saving. o Equilibrium occurs only when planned investment and savings are equal.  But when unplanned changes in inventories are taken into account, investment and saving are always equal, regardless of the level of GDP. Why? o Actual investment consists of planned investment and unplanned investment (unplanned changes in inventories).  Unplanned changes in inventories act as a balancing item that equates the actual amounts saved and invested in any period. Changes in Equilibrium GDP and the Multiplier In Chapter 30, we established that an initial change in spending can cause a greater change in real output through the multiplier effect. o In equation form,  Multiplier = change in real GDP/Initial change in spending The size of the multiplier depends on the size of the MPS in the economy: o Multiplier = 1/MPS In a private closed economy, C + Ig = GDP when the economy is in equilibrium. o So equilibrium GDP changes in response to changes in either the consumption schedule ( C ) or the investment schedule (Ig).  Because the changes in the investment schedule are the main sources of instability, we direct our attention toward him. Adding International Trade We now move from a private closed economy to a private open economy that incorporates exports (X) and imports (M). o We focus on net exports (exports minus imports), which may be either positive or negative. Net Exports and Aggregate Expenditures Like consumption and investment, exports create domestic production, income, and employment for a nation. o Although U.S. goods and services produced for export are sent abroad, foreign spending on those goods and services increases production and creates jobs and incomes in the United States.  We must therefore include exports as a component of U.S. aggregate expenditures. In addition, when an economy is open to international trade, it will spend part of its income on imports – goods and services produced abroad. o To avoid overstating the value of domestic production, we must subtract the amount spent on imported goods because such spending generates production and income abroad rather than at home.  So, to correctly measure aggregate expenditures for domestic goods and services, we must subtract expenditures on imports from total spending. In short, for a private closed economy, aggregate expenditures are C + Ig. o But for an open economy, aggregate expenditures are C + Ig + (X -M).  Or, recalling that net exports (Xn) equal (X-M), we can say that aggregate expenditures for a private open economy are C + Ig + Xn, The Net Export Schedule A net export schedule lists the amount of net exports that occurs at each level of GDP. o Table 31.3 shows two possible net export schedules for the hypothetical economy represented in Table 31.2.  In net export schedule Xn1 (columns 1 and 2), exports exceed imports by $5 billion at each level of GDP. Perhaps exports are $15 billion while imports are $10 billion. o In schedule Xn2 (columns 1 and 3), imports are $5 billion higher than exports.  Perhaps imports are $20 billion while exports are $15 billion. To simplify our discussion, we assume in both schedules that net exports are independent of GDP. Figure 31.4a represents the two net export schedules in Table 31.3. o Schedule Xn1 is above the horizontal axis and depicts positive net exports of $5 billion at all levels of GDP.  Schedule Xn2, which is below the horizontal axis, shows negative net exports of $5 billion at all levels of GDP.