ECO ch 11 notes - Summary Macroeconomics PDF

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Professor James D'Angelo...

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ECO 200 Ch 11 – The Aggregate Expenditures Model 11.1 – Assumptions & Simplifications - 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 - Without taxes involved, real GDP = DI - Keynes assumed that the presence of excess production capacity & unemployed labor implies that an increase in aggregate expenditures will increase real output & employment without raising the price level 11.2 – Consumption & Investment Schedules - In the private closed economy, the two components of aggregate expenditures are consumption (C) & gross investment (Ig) - Planned Investment – the amount that firms plan or intend to invest - Investment Schedule – the tendency of competition to cause individuals & firms to unintentionally but quite effectively promote the interests of society even when each individual or firm is only attempting to pursue its own interests 11.3 – Equilibrium GDP: C + Ig = GDP - Aggregate expenditures consist of consumption plus investment, their sum makes up the aggregate expenditures model - Aggregate Expenditures Schedule – a table of numbers showing the total amount spent on final goods & final services at different levels of real GDP - Equilibrium GDP is where C + Ig = GDP ; the level at which the total quantity of goods produced (GDP) equals the total quantity of goods purchased (C + Ig) 11.4 – Other Features of Equilibrium GDP - Saving & planned investment are equal (S = Ig) when in equilibrium - There are no unplanned changes in inventory when in equilibrium - Leakage – (1) a withdrawal of potential spending from the income-expenditures stream via saving, tax payments or imports; (2) a withdrawal that reduces the lending potential of the banking system - Injection – an addition of spending into the income-expenditures stream: any increment to consumption, investment, government purchases or net exports - Unplanned Changes in Inventory – changes in inventories that firms did not anticipate; changes in inventories that occur because of unexpected increases or decrease of aggregate spending (or of aggregate expenditures) - Equilibrium occurs only when planned investment & saving are equal 11.5 – Changes in Equilibrium GDP & the Multiplier - Multiplier = change in real GDP / initial change in spending - Multiplier = 1 / MPS - An upward shift of the aggregate expenditures schedule from ( C + Ig)0 to (C + Ig)1 will increase the equilibrium GDP - A downward shift from (C + Ig)0 to (C + Ig)2 will lower the equilibrium GDP - The extent of the changes in equilibrium GDP will depend on the size of the multiplier o ex.) 1/.25 = 4 11.1 – 11.5 Review - In a private close economy, equilibrium GDP occurs where aggregate expenditures equal real domestic output (C + Ig = GDP) - At equilibrium GDP, saving equals planned investment (S = Ig) & unplanned changes in inventories are zero - Actual investment consists of planned investment plus unplanned changes in inventories (+ or -) & is always equal to saving in a private closed economy

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Through the multiplier effect, an initial change in investment spending can cause a magnified change in domestic output & income

11.6 – Adding International Trade - Exports = (X) ; imports = (M) - Net Exports – exports minus imports - For a private closed economy, aggregate expenditures are ( C + Ig) - For an open economy, aggregate expenditures are C + Ig + (X – M) - Since net exports (Xn) = (X – M), we can say that aggregate expenditures for a private open economy are C + Ig + Xn - Net exports can be positive (above horizontal axis) or negative (below horizontal axis) - Prosperity abroad transfers some of that prosperity to Americans - Higher net exports increase real GDP, so countries often look for ways to reduce imports & increase exports during recessions or depression; thus increasing tariffs & devalue the US dollar 11.6 Review - Positive net exports increase aggregate expenditures relative to the closed economy & other things equal, increase equilibrium GDP - Negative net exports decrease aggregate expenditures relative to the closed economy & other things equal, reduce equilibrium GDP - In the open economy, changes in (a) prosperity abroad, (b) tariffs, & (c) exchange rates can affect U.S. next exports & therefore U.S. aggregate expenditures & equilibrium GDP - Tariffs & deliberate currency depreciations are unlikely to increase net exports because other nations will retaliate 11.7 – Adding the Public Sector - Mixed economy means adding government purchases & taxes to the model - Private spending = ( C + Ig + Xn); adding government purchases to private spending, the equation becomes (C + Ig + Xn + G) & raises the aggregate expenditures schedule & increases the equilibrium level of GDP; conversely a decline in G will lower the aggregate expenditures schedule - Lump-Sum Tax – a tax that collects a constant amount (the tax revenue of government is the same) at all levels on GDP - Ca = after-tax consumption - In an open, mixed economy, equilibrium GDP occurs where (Ca + Ig + Xn + G) - Injections into the income-expenditures steam = leakages from the income steam for the private closed economy, S = Ig - At the equilibrium GDP, the sum of leakages = the sum of injection. Sa + M + T = Ig + X + G o Sa = after-tax savings; M = imports; T = taxes; X = exports; G = government purchases; Ig = investment 11.8 – Equilibrium versus Full-Employment GDP - Equilibrium & full-employment GDPs may not coincide o A recessionary expenditure gap is the amount by which aggregate expenditures at the fullemployment GDP fall short of those needed to achieve the full-employment GDP o An inflationary expenditure gap is the amount by which aggregat4e expenditures at the fullemployment GDP exceed those just sufficient to achieve the full-employment GDP - Recessionary Expenditure Gap – the amount by which the aggregate expenditures schedule must shift upward to increase real GDP to its full-employment, noninflationary level - When increasing aggregate expenditures, the government might increase government spending or lower taxes in pursuit to close a recessionary expenditure gap - Increasing government expenditures (G) will increase overall aggregate expenditures & the equilibrium real GDP - Government could lower taxes to close the recessionary expenditure gap & thus eliminate the negative GDP gap

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Inflationary Expenditure Gap – in the aggregate-expenditures model, the amount by which the aggregate expenditure schedule must shift downward to decrease the nominal GDP to its full-employment noninflationary level

11.7 – 11.8 Review - Government purchases shift the aggregate expenditures schedule upward & raise equilibrium GDP - Taxes reduce disposable income, lower consumption spending & saving, shift the aggregate expenditures schedule downward, & reduce equilibrium GDP - A recessionary expenditure gap is the amount by which an economy’s aggregate expenditures schedule must shift upward to achieve the full-employment GDP; an inflationary expenditure gap is the amount by which the economy’s aggregate expenditures schedule must shift downward to achieve full-employment GDP & eliminate demand-pull inflation Summary: 11.1 – Explain how sticky prices relate to the aggregate expenditures model - The aggregate expenditures model views the total amount of spending in the economy as the primary factor determining the level of real GDP that the economy will produce. The model assumes that the price level is fixed. Keynes made the assumption to reflect the general circumstances of the Great Depression, in which declines in output & employment, rather than declines in prices, were the dominant adjustments made by firms when they faced huge declines in their sales 11.2 – Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate - An investment schedule shows how much investment the firms in an economy are collectively planning to make at each possible level of GDP. In this chapter, we utilize a simple investment schedule in which investment is a constant value & therefore the same at all levels of GDP. That constant value is derived from the investment demand curve by determining what quantity of investment will be demanded at the economy’s current real interest rate. 11.3 – Illustrate how economists combine consumption & investment to depict an aggregate expenditures schedule for a private closed economy & how that schedule can be used to demonstrate the economy’s equilibrium level of output (where the total quantity of goods produced equals the total quantity of goods purchased) - For a private closed economy, the equilibrium level of GDP occurs when aggregate expenditures & real output are equal or, graphically, where the C + Ig line intersects the 45-degree line. At any GDP greater than equilibrium GDP, real output will exceed aggregate spending, resulting in unplanned investment in inventories & eventual declines in output & income (GDP). At any below-equilibrium GDP, aggregate expenditures will exceed real output, resulting in unplanned disinvestment in inventories & eventual increases in GDP 11.4 – Discuss the two other ways to characterize the equilibrium level of real GDP in a private closed economy: saving = investment & no unplanned changes in inventories - At equilibrium GDP, the amount households save (leakages) & the amount businesses plan to invest (injections) are equal. Any excess of saving over planned investment will cause a shortage of total spending, forcing GDP to fall. Any excess of planned investment over saving will cause an excess of total spending, including GDP to rise. The change in GDP will in both cases correct the discrepancy between saving & planned investment - At equilibrium GDP, there are no unplanned changes in inventories. When aggregate expenditures diverge from real GDP, an unplanned change in inventories occurs. Unplanned increases in inventories are followed by a cutback in production & a decline of real GDP. Unplanned decreases in inventories result in an increase in production & a rise of GDP - Actual investment consists of planned investment plus unplanned changes in inventories & is always equal to saving

11.5 – Analyze how changes in equilibrium real GDP can occur in the aggregate expenditures model & describe how those changes relate to the multiplier - A shift in the investment schedule (caused by changes in expected rates of return or changes in interest rates) shifts the aggregate expenditures curve & causes a new equilibrium level of real GDP. Real GDP changes by more than the amount of the initial change in investment. The multiplier effect (ΔGDP / Δ Ig) accompanies both increases & decreases in aggregate expenditures and also applies to changes in net exports (Xn) & government purchases (G) 11.6 – Explain how economists integrate the international sector (exports & imports) into the aggregate expenditures model - The next export schedule in the model of the open economy relates net exports (exports minus imports) to levels of real GDP. For simplicity, we assume that the level of net exports is the same at all levels of real GDP. - Positive net exports increase aggregate expenditures to a higher level than they would if the economy were “closed” to international trade. Negative net exports decrease aggregate expenditures relative to those in a closed economy, decreasing equilibrium real GDP by a multiple of their amount. Increases in exports or decreases in imports have an expansionary effect on real GDP, while decreases in exports or increases in imports have a contractionary effect 11.7 – Explain how economists integrate the public sector (government expenditures & taxes) into the aggregate expenditures model - Government purchases in the model of the mixed economy shift the aggregate expenditures schedule upward & raise GDP - Taxation reduces disposable income, lowers consumption & saving, shifts the aggregate expenditures curve downward & reduces equilibrium GDP - In the complete aggregate expenditures model, equilibrium GDP occurs where Ca + Ig + Xn + G = GDP. At the equilibrium GDP, leakages of after-tax saving (Sa), imports (M), & taxes (T) equal injections of investment (Ig) exports (X) & government purchases (G): Sa + M + T = Ig + Xn + G. Also, there are no unplanned changes in inventories 1.8 – Differentiate between equilibrium GDP & full-employment GDP & identify & describe the nature & causes of “recessionary expenditure gaps” & “inflationary expenditure gaps”. - The equilibrium GDP & the full-employment GDP may differ. A recessionary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP fall short of those needed to achieve the full-employment GDP. The gap produces a negative GDP gap (actual GDP minus potential GDP). An inflationary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP exceed those just sufficient to achieve the fullemployment GDP. This gap causes demand-pull inflation - Keynes suggested that the solution to the large negative GDP gap that occurred during the Great Depression was for government to increase aggregate expenditures. It could do this by increasing its own expenditures (G) or by lowering taxes (T) to increase after-tax consumption expenditures (Ca) by households. Because the economy had millions of unemployed workers & massive amounts of unused production capacity, government could boost aggregate expenditures without worrying about creating inflation - The stuck-price assumption of the aggregate expenditures model is not credible when the economy approaches or attains its full-employment output. With unemployment low & excess production capacity small or nonexistent, an increase in aggregate expenditures will cause inflation along with any increase in real GDP...