The Aggregate Expenditures Model Part II

Net Exports and Equilibrium GDP The aggregate expenditures schedule labeled C + Ig in Figure 31.4b reflects the private closed economy. o It shows the combined consumption and gross investment expenditures occurring at each level of GDP.  With no foreign sector, the equilibrium GDP is $470 billion. But in the private open economy, net exports can be either positive or negative. o Let’s see how each of the net export schedules in Figure 31.4a affects equilibrium GDP. Positive Net Exports o Suppose the net export schedule is Xn1.  We account for the $5 billion of additional net export expenditures by the rest of the world by adding that $5 billion to the C + Ig schedule in Figure 31.4b. Aggregate expenditures at each level of GDP are then $5 billion higher than C + Ig alone. o The aggregate expenditures schedule for the open economy thus becomes C + Ig + Xn1.  As a result, the equilibrium shifts to where C + Ig + Xn1 intersects the 45degree line. In this case, international trade increases equilibrium GDP from $470 billion in the private closed economy to $490 billion in the private open economy. o Adding net exports of $5 billion has increased GDP by $20 billion, in this case implying a multiplier of 4. o Generalization:  Other things equal, positive net exports increase aggregate expenditures and GDP beyond what they would be in a closed economy. Negative Net Exports o Next, suppose that net exports are a negative $5 billion, as shown by Xn2 in Figure 31.4a.  In that case, our hypothetical economy is importing $5 billion more of goods than it is exporting. The aggregate expenditures schedule shown as C + Ig in Figure 31.4b therefore overstates the expenditures on domestic output at each level of GDP. o We must reduce the sum of expenditures by the $5 billion net amount spent on imported goods.  We do that by subtracting the $5 billion of net imports from C + Ig. o The relevant aggregate expenditures schedule in Figure 31.4b becomes C + Ig + Xn2 and equilibrium GDP falls from $470 billion to $450 billion.  Again, a change in net exports of $5 billion has produced a fourfold change in GDP, reminding us that the multiplier in this example is 4. o We therefore have a corollary to our first generalization:  Other things equal, negative net exports reduce aggregate expenditures and GDP below what they would be in a closed economy. When imports exceed exports, the contractionary effect of the larger amount of imports outweighs the expansionary effect of the smaller amount of exports, so equilibrium real GDP decreases. International Economic Linkages Our analysis of net exports and real GDP suggests how circumstances or policies abroad can affect U.S. GDP. Prosperity Abroad o A rising level of real output and income among U.S. foreign trading partners enables the United States to sell more goods abroad, thus raising U.S. net exports and increasing U.S. real GDP (assuming initially there is excess capacity).  There is good reason for Americans to be interested in our trading partners’ prosperity. Their good fortune enables them to buy more U.S. exports, increasing our income and enabling us in turn to buy more foreign imports. o These imported goods are the ultimate benefit of international trade.  Trade transfers foreign prosperity to Americans. Exchange Rates o Depreciation (a decrease in the value) of the dollar relative to other currencies enables people abroad to obtain more dollars with each unit of their own currencies.  The price of U.S., customers will find they need more dollars to buy foreign goods and, consequently, will reduce their spending on imports. If the economy has available capacity, the increased exports and decreased imports will increase U.S. net exports and expand the nation’s GDP. o To check your understanding, think through the effects of an appreciation (increase in value) of the dollar on net exports and equilibrium GDP. A Caution of Tariffs and Devaluations o Because higher net exports increase real GDP, countries often look for ways to reduce imports and increase exports during recessions or depressions.  Thus, a recession might tempt the U.S. federal government to increase tariffs and devalue the international value of the dollar (for instance, by supplying massive amounts of dollars in the foreign exchange market). Increasing net exports, the thinking goes, would expand domestic production, reduce domestic unemployment, and help the economy recover. o But this interventionist thinking is too simplistic.  Suppose that the United States imposes high tariffs on foreign goods to reduce imports and thus increase our domestic production and employment. Our imports, however, are our trading partners’ exports. o So, when we restrict our imports, we depress our trading partners’ economies.  They are likely to retaliate against us by imposing tariffs on our products. If they do so, our exports will decline, and our net exports may in fact fall. o Thus, imposing tariffs may decrease, not increase, our net exports. o That unfortunate possibility became a sad reality during the Great Depression of the 1930s, when various nations, including the United States, imposed trade barriers in an attempt to reduce their own domestic unemployment levels.  The result was many rounds of retaliation that throttled world trade, worsened the depression, and increased domestic unemployment. Adding to the problem were some nations’ attempts to increase their net exports by devaluing their currencies. o Other nations then retaliated by devaluing their own currencies.  The international exchange rate system collapsed, and world trade spiraled downward. Economic historians agree that tariffs and devaluations during the 1930s were huge policy mistakes. Adding the Public Sector Our final step in constructing the full aggregate expenditures model is to move the analysis from a private (no-government) open economy to an economy with a public sector (sometimes called a “mixed economy”). o To do so, we must add government purchases and taxes to the model. For simplicity, we assume that government purchases are independent of GDP and do not alter the consumption and investment schedules. o Also, government’s net tax revenues – entirely from personal taxes.  Finally, a fixed amount of taxes is collected regardless of the level of GDP. Government Purchases and Equilibrium GDP Suppose the government decides to purchase $20 billion of goods and services regardless of the level of GDP and tax collections. Taxation and Equilibrium GDP The government not only spends but also collects taxes. o Suppose it imposes a lump-sum tax, which is a tax of a constant amount or, more precisely, a tax yielding the same amount of tax revenue at each level of GDP. o Let’s assume this tax is $20 billion, so that the government obtains $20 billion of tax revenue at each level of GDP regardless of the level of government purchases. Injections, Leakages, and Unplanned Changes in Inventories o In the full model, it is still the case that injections into the income-expenditures stream equal leakages from the income stream.  For the private closed economy, S = Ig.  For the expanded economy, imports and taxes are added leakages. Saving, importing, and paying taxes are all uses of income that subtract from potential consumption. o Consumption will now be less than GDP – creating a potential spending gap – in the amount of after-tax saving (Sa), imports (M), and taxes (T).  But exports (X), government purchases (G), and investment (Ig), are injections into the income-expenditures stream. A the equilibrium GDP, the sum of the leakages equals the sum of injections. o In symbols:  Sa + M + T = Ig + X + G o You should use the data in Table 31.5 to confirm this equality between leakages and injections at the equilibrium GDP of $490 billion.  Also, substantiate that a lack of such equality exists at all other possible levels of GDP. o Although not directly shown in Table 31.5, the equilibrium characteristics of “no unplanned changes in inventories” will also be fulfilled at the $490 billion GDP.  Because aggregate expenditures equal GDP, all the goods and services produced will be purchased. There will be no unplanned increase in inventories, so firms will have no incentive to reduce their employment and production. o Nor will they experience an unplanned decline in their inventories, which would prompt them to expand their employment and output to replenish their inventories. Equilibrium versus Full-Employment GDP In the aggregate expenditures model, equilibrium GDP need not equal the economy’s full-employment GDP. o In fact, Keynes specifically designed the model to explain situations like the Great Depression, in which the economy appeared to be trapped in a bad equilibrium in which real GDP was far below potential output. The fact that equilibrium and potential GDP in the aggregate expenditures model need not match reveals critical insights about the causes of demand-pull inflation. o We will first examine the “expenditure gaps” that give rise to differences between equilibrium and potential GDP.  Then we will see how the model helps to explain the recession of 2007-2009 and preview the policies that the federal government used to try to halt and reverse it. Recessionary Expenditure Gap A recessionary expenditure gap is the amount by which aggregate expenditures at the full-employment level of GDP fall short of the amount required to achieve the full-employment level of GDP. o Insufficient total spending contracts or depresses the economy.  Table 31.5 shows that at the full-employment level of $510 billion (column 1), the corresponding level of aggregate expenditures is only $505 billion (column 9). The recessionary expenditure gap is thus $5 billion, the amount by which the aggregate expenditures curve would have to shift upward to realize equilibrium at the full-employment GDP. o Graphically, the recessionary expenditure gap is the vertical distance (measured at the fullemployment GDP) by which the actual aggregate expenditures schedule AE1 lies below the hypothetical full-employment aggregate expenditures schedule AE0. I  In Figure 31.7a, this recessionary expenditure gap is $5 billion. Because the multiplier is 4, there is a $20 billion differential (the recessionary expenditure gap of $5 billion times the multiplier of 4) between the equilibrium GDP and the full-employment GDP. o The $20 billion difference is a negative GDP gap. Keynes’s Solution to a Recessionary Expenditure Gap o Keynes pointed to two different policies that a government might pursue to close a recessionary expenditure gap and achieve full employment.  The first is to increase government spending. The second is to lower taxes. o Both work by increasing aggregate expenditures. o Look back at Figure 31.5, which shows how an increase in government expenditures G will increase overall aggregate expenditures and, consequently, the equilibrium real GDP.  Applying this strategy to the situation in Figure 31.7a, government could completely close the $20 billion negative GDP gap if it increased spending by the $5 billion amount of the recessionary expenditure gap. Given the economy’s multiplier of 4, the $5 billion increase in G would create a $20 billion increase in equilibrium real GDP, bringing the economy to full employment. o Government also could lower taxes to close the recessionary expenditure gap and thus eliminate the negative GDP gap.  Look back at Figure 31.6, in which an increase in taxes results in lower after-tax consumption spending and a smaller equilibrium real GDP. Keynes suggested a reversal of this process: o Because an increase in taxes lowers equilibrium real GDP, a decrease in taxes will raise equilibrium GDP.  The decrease in taxes will leave consumers with higher after-tax income, which will lead to higher consumption expenditures and an increase in equilibrium real GDP. o But a big warning is needed here:  As the economy moves closer to its potential output, it becomes harder to justify Keynes’s assumption that prices are stuck.  As the economy closes its negative GDP gap, nearly all workers are employed and nearly all factories are operating at or near full capacity. In that situation, there is no massive oversupply of productive resources to keep prices from rising. o In fact, economists know from real-world experience that as GDP rises toward potential output, prices become increasingly flexible and inflationary in the medium run and the long run. o This fact is one of the major limitations of the aggregate expenditures model, and it is the reason we will develop the ADAS model in the next chapter.  That said, the aggregate expenditures model is still very useful because even an economy operating near full employment will show sticky or stuck prices in the short run. Over that shorter time horizon, the intuitions of the aggregate expenditures model will still hold true. Inflationary Expenditure Gap Economists use the term inflationary expenditure gap to describe the amount by which an economy’s aggregate expenditures at the full- employment level of GDP exceed those just necessary to achieve the full-employment level of GDP. o In Figure 31.7b, there is a $5 billion inflationary expenditure gap at the $510 billion full-employment GDP.  This gap is shown by the vertical distance between the actual aggregate expenditures schedule AE2 and the hypothetical schedule AE0 that would be just sufficient to achieve the $510 billion full-employment GDP. Thus, the inflationary expenditure gap is the amount by which the aggregate expenditures schedule would have to shift downward to realize equilibrium at the full-employment level of GDP. Why does the name “inflationary expenditure gap” contain the word inflationary? What does the situation depicted in Figure 31.7b have to do with inflation? o The answer lies in the answer to a different question:  Can the economy achieve and maintain an equilibrium real GDP that is substantially above the full-employment output level? The unfortunate answer is no. o If such a thing were possible, then the government could make real GDP as high as it wanted by simply increasing G to an arbitrarily high number.  Graphically, it could raise the AE2 curve in Figure 31.7b as far up as it wanted, thereby increasing equilibrium real GDP as high as it wanted. Living standards would skyrocket! o But this outcome is not possible because, by definition, all the available workers in the economy are fully employed at the fullemployment output level.  Producing slightly more than the fullemployment output level for a few months might be possible if employers can convince a sizable fraction of workers to work overtime day after day. But there simply is not enough labor for the economy to produce at much more than potential output for an extended period of time. o So what does happen in situations in which aggregate expenditures are so high that the model predicts an equilibrium level of GDP beyond potential output?  The answer is twofold. First, the economy ends up producing either at potential output or just above potential output due to the limited supply of labor. Second, the economy experiences demand-pull inflation. o With the supply of output limited by the supply of labor, high levels of aggregate expenditures drive up prices.  Nominal GDP increases because of the higher price level, but real GDP does not. We will discuss this process in greater depth in the next chapter. Application: The Recession of 2007-2009 In December 2007 the U.S. economy entered the longest and deepest recession since the Great Depression of the 1930s. o We defer discussion of the underlying financial crisis until later chapters, but we can use the aggregate expenditures model to portray the ultimate effect of the crisis.  We know that the AE0 line in Figure 31.7a consists of the combined amount the after-tax consumption expenditures (Ca), gross investment expenditures (Ig), net export expenditures (Xn), and government purchases (G) planned at each level of real GDP. During the recession, both after-tax consumption and investment expenditures declined, with planned investment expenditures suffering the largest drop by far. Aggregate expenditures thus declined, as from AE0 to AE1 in Figure 31.7a. o The result was a multiple decline in real GDP, illustrated by the decline from $510 billion to $490 billion.  In the language of the aggregate expenditures model, a recessionary expenditure gap produced on of the largest negative GDP gaps since the Great Depression. Employment sank by more than 8 million people, and the unemployment rate jumped above 10 percent. o As recessions go, this was a big one! The federal government undertook various macroeconomic stimulus policies in 2008 and 2009 to try to eliminate the recessionary expenditure gap. o In 2008, the government provided $100 billion of tax rebate checks to taxpayers, hoping that recipients would use most of their checks to buy goods and services.  (They didn’t! Instead, they used substantial portions of their checks to pay off credit cards and reduce other debt). In 2009, the federal government enacted a $787 billion stimulus package designed to boost aggregate expenditures, reduce the recessionary expenditure gap, and, through the multiplier effect, increase real GDP and employment. We defer discussion and further assessment of these stimulus attempts until Chapter 33, but Figure 31.7a clearly illuminates their purpose. o If the government could drive up aggregate expenditures, such as from AE1 to AE0 the recession would come to an end and the recovery phase of the business cycle would begin.