Macroeconomics chapter 11 highlights PDF

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In the aggregate expenditure model, it is assumed that investment does not change when real GDP changes. This is represented in Figure 11.1 (b). The level of investment spending is determined by the real interest rate together with the investment demand curve. This is displayed in Figure 11.1 (a). When the real interest rate increases (decreases), the investment demand curve would stay the same but the amount of investment in the economy would decline (rise). Therefore, the investment schedule would shift down (up). Prices in the economy are assumed to be fixed in the aggregate expenditures model. The two components of the aggregate expenditures model in a private-closed economy are consumption spending and planned investment spending, aka gross investment. See Figure 11.2. When the private closed-economy is in equilibrium then the amount of planned investment equals saving. A leakage is defined as a withdrawal of spending from the economy’s circular flow of income and expenditures. For instance, saving is considered a leakage. An injection is defined as an addition of spending to the economy’s circular flow of income and expenditures. Investment would be considered an injection. Actual investment = Planned investment + unplanned changes in inventories

At any point in Table 11.2, actual investment is equal to saving. This is true only for a private closed-economy. Note that at the equilibrium point in Table 11.2 on page 224 in our textbook, there is no unplanned change in inventories and therefore actual and planned investment are the same. Whenever aggregate expenditures are greater (less) than GDP, employment, output, and income will increase (decrease) in the economy. Please review Table 11.2 Please review Figure 11.2. If the expected rate of return increases or the interest rate decreases then investment spending in the economy would rise. Therefore, aggregate expenditures, that is, C + Ig, in a closed-economy, would increase and therefore GDP would increase, since GDP = C + Ig, in a private closed-economy. Similarly, when the interest rate declines, borrowing by households would increase, and therefore current consumption would raise. That would shift the consumption schedule upward. Therefore, aggregate expenditures, that is, C + Ig, in a closed-economy, would increase and therefore GDP would increase, since GDP = C + Ig, in a private closed-economy. See Figure 11.2 Note that the slope of the aggregate expenditures (AE) line is the same as MPC since the AE-line is parallel to the consumption schedule. Therefore, when can actually find the size of the multiplier through

computing the slope of the AE-line first (change in AE over change in GDP) and then use the multiplier formula. An increase (decrease) in investment spending would shift the AE-line upward (downward) and therefore increase (decrease) GDP. The size of the change in GDP would depend on the size of the multiplier in the economy. For instance, if the multiplier is equal to 4, an increase in investment spending by $5 billion would lead to a $20 billion increase in output and income. See Figure 11.3 An open-economy includes trade with other nations. That is, imports and exports are included in the aggregate expenditures model. When net exports are positive (negative), equilibrium GDP increases (decreases). The size of the multiplier continues to determine the change in the size of the GDP due to a change in net exports. In other words, suppose net exports are +$5 (-$5) billion and multiplier is equal to 4 then equilibrium GDP would increase (decrease) by $20 billion. Thus, an increase in an economy’s exports will increase domestic aggregate expenditures and therefore increase its equilibrium GDP. See Figure 11.4 Determinants of net exports are (i) prosperity abroad – a rising level of 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, (ii) exchange rates – depreciation (appreciation) of the dollar relative to other currencies enables people to obtain more (less) dollars with each unit of their own currencies.

Thus, the price of U.S. goods in terms of those currencies will fall (rise), stimulating (upsetting) purchases of U.S. exports, (iii) Tariffs & devaluations – tariffs are taxes on imported goods. Therefore, increasing tariffs do increase net exports. However, other nations retaliate with their own tariffs and that may, in fact, reduce net exports. Similarly, devaluations of domestic currency do boost net exports. However, other nations retaliate with devaluating their own currency and that in fact reduce net exports. If a nation imposes tariffs on foreign products, what would be the immediate effect on domestic production and employment? If a nation imposes tariffs on foreign products, the immediate effect will be an increase in domestic output and employment. The government spending component of the aggregate expenditures model is also subject to the multiplier. Therefore, say, the economy’s multiplier is equal to 2 and there is a $10 billion decrease (increase) in government expenditures. This will cause equilibrium GDP to decrease (increase) by $20 billion. See Table 11.4 & Figure 11.5 A decrease (increase) in taxes will increase equilibrium GDP less than an increase (decrease) in government spending since a portion of the tax cut (rise) will be saved. See Table 11.5 Higher (lower) taxes lead to lower (higher) consumption. How much consumption will change in response to a change in taxes depends on marginal propensity to consume (MPC). Similarly, how much saving

will change in response to a change in taxes depends on marginal propensity to save (MPS). Suppose, MPC is equal to 0.75. A tax collection of $20 billion will reduce consumption by $15 billion (= 0.75 × $20 billion). Since the MPS = 0.25 (remember. MPS+MPC = 1), saving will drop by $5 billion (= 0.25 × $20 billion). Thus, both consumption and saving schedules will shift downward. If there is equal increases in government spending and lump-sum taxes will shift the aggregate expenditures line upward. See Figure 11.6 Further examples of injections are investment, exports, & government expenditures whereas further examples of leakages are saving, imports, & taxes. An inflationary expenditure gap is the amount by which aggregate expenditures exceed the full-employment level of GDP whereas a recessionary expenditure gap refers to the amount by which the full-employment GDP exceeds the level of aggregate expenditures. Suppose the MPS = 0.25 and the economy has a recessionary gap of $10 billion, then equilibrium GDP is $40 billion [= (1/.25) × $10] below the full-employment GDP. See Figure 11.7 The policy option to fix a recessionary expenditure gap is to (i) increase government spending and/or (ii) decrease taxes, while the policy option to fix an inflationary expenditure gap is to (i) reduce government spending and/or (ii) raise taxes.

See page 236 on our textbook regarding numerical examples....