Aggregate Expenditures Model

Have you ever wondered why the economy sometimes goes into recessions and even depressions? If so, you are definitely not alone. Many great economists have thought about this same question. Some of them developed the aggregate expenditures model to help answer this question. In this article, we will explain to you the different components of the aggregate expenditures model as well as its formula. Want to learn more? Keep on reading!

Aggregate Expenditures Model Definition

What is the definition of the aggregate expenditures model? Well, let's talk about what the model can do for us. The aggregate expenditures model explains what causes real GDP to rise and fall.

The amount of goods and services produced in turn has implications for the level of employment in the economy.

It is also known as the Keynesian cross model because it traces its roots to the work of the well-known British economist John Maynard Keynes.

The popular economics theory at the time said that prices would adjust accordingly and solve the problems of over-supply and under-supply. However, during the Great Depression, firms did not lower their prices sufficiently as the economy slowed. As goods started to pile up in their warehouses, firms reduced production and laid off workers. This exacerbated the over-supply problem as unemployed people had to cut back on their spending.

Keynes observed this and wanted to develop a new economic model to try to understand how the Great Depression happened. This model later became the aggregate expenditures model that we are talking about now. The most important assumption behind the model is that prices are fixed so that the market can't simply sort itself out in the event of a recession or depression.

Aggregate Expenditures Example

Here is an example that helps us better understand the idea of aggregate expenditures. Consumption, planned investment, government purchases, and net exports make up aggregate expenditures.

When the economy is in a recession, the government will try to boost aggregate expenditures to get the economy back on track. It can do this in two ways: the government can increase its own spending or it can try to get others (people or firms) to increase their spending.

Aggregate Expenditures Components

The aggregate expenditures model consists of four components: consumption, investment, net exports, and government purchases. Let's go through them one by one.

Aggregate Expenditures Components: Consumption

How much people will consume depends on how much disposable income they have. This relationship is given by the consumption schedule, shown in Figure 1 below. The consumption schedule is also called the consumption function. As you will expect, people consume more as their disposable income increases.

Fig. 1 - The consumption schedule.

But the consumption schedule is flatter than the 45-degree line, meaning that consumption doesn't increase as fast as disposable income. Think about it, we usually don't spend our entire increase in income because we would like to save some of that, as long as we have enough to satisfy our current consumption needs. To put this another way, the marginal propensity to consume is less than 1.

Aggregate Expenditures Components: Investment

The level of planned investment by firms is given by the investment demand curve, shown in Figure 2a. The investment demand curve slopes downward. Investment demand increases when the real interest rate is lower. If the current real interest rate is 2%, firms will demand $40 billion of investment goods. We assume that firms' planned investment does not depend on the level of real output (real GDP). Therefore, the investment schedule is flat in Figure 2b. Firms will spend $40 billion in investment regardless of the current real output level.

Fig. 2 - The investment demand curve and the investment schedule.

Aggregate Expenditures Components: Government Purchases and Net Exports

Let's not forget about the government sector. The government also spends money on purchasing goods and services. Think of it as consumption by the government. These government purchases are of course part of aggregate expenditures.

Net exports are another component of aggregate expenditures. Goods and services that are exported to foreign countries are produced in the home country and therefore generate jobs and incomes in the home country as well. On the other hand, imports from foreign countries are not produced in the country, and their production in foreign countries does not generate jobs and incomes at home. Therefore, when we measure aggregate expenditures, we add the value of exports and subtract the value of imports. In other words, we add the value of net exports.

Aggregate Expenditures Model Formula

The aggregate expenditure formula is:

\(C + I_p + G + NX = GDP\)

This formula gives us the equilibrium level of output. We have the total spending on goods on the left-hand side: consumption, planned investment, net exports, and government purchases. On the right-hand side, we have the real output level. So, in equilibrium, we have the total spending on goods equal to the level of real output. Makes sense!

Figure 3 below shows the equilibrium GDP in the aggregate expenditures model. The equilibrium is where the AE curve intersects with the 45-degree line. Note that the 45-degree line represents where aggregate expenditures are equal to real GDP.

Fig. 3 - Equilibrium GDP in the aggregate expenditures model.

Aggregate Expenditures Model: Multiplier

The multiplier plays a crucial role in the aggregate expenditures model. It tells us how an initial change in spending will result in a change in real GDP. We can see this by looking at Figure 4, which shows how the equilibrium GDP changes as a result of an initial increase in consumption.

Fig 4. Aggregate expenditures and the multiplier effect.

In Figure 4, we see that an initial increase of $20 billion in consumer spending shifts up the aggregate expenditures curve by this exact amount. But the increase in real GDP as a result of this initial increase in consumption is larger than $20 billion - it increases by $80 billion.

So what is the multiplier in this case? We can calculate that easily with this formula:

\(\hbox {Multiplier} = \frac {\hbox {Change in real GDP}} {\hbox {Initial change in spending}}\)

\(\hbox {Multiplier} = \frac {\hbox {\$80 million}} {\hbox {\$20 million}} = 4 \)

The multiplier is 4.

Once we know the size of the multiplier, we can also calculate the marginal propensity to save (MPS) and the marginal propensity to consume (MPC):

\(\hbox {Multiplier} = \frac {1} {MPS} = \frac {1} {1-MPC} \)

\(4 = \frac {1} {MPS} \)

\(MPS = 0.25\)

\(MPC = 1 - MPS = 1 - 0.25 = 0.75 \)

Aggregate Expenditures and Aggregate Demand

What do aggregate expenditures (AE) have to do with aggregate demand (AD)? The aggregate expenditures model tells us the equilibrium real GDP given the AE curve; the aggregate demand curve shows the relationship between real GDP and the aggregate price level. So both have to do with real GDP, and we can actually find the corresponding points if we stack the two graphs together.

Fig. 5 - An increase in AE causes the AD curve to shift outward.

In Figure 5, we see that if we hold the price level constant at P₁, an increase in aggregate expenditures will give us a higher level of real GDP. This corresponds to an outward shift of the AD curve.

On the other hand, movement along the AD curve means a change in the aggregate price level. If we hold everything else constant, when the price level increases, aggregate expenditures will decrease. This is shown in Figure 6 below. An increase in the aggregate price level causes the AE curve to shift downward.

Why is that? An increase in the price level affects three components of aggregate expenditures: consumption, planned investment, and net exports. Think about it. When inflation is higher, you are likely to consume less because your money now has less purchasing power. Inflation will increase the interest rate, causing firms to spend less on investment goods and consumers to cut back on big-item purchases because they are likely to have to borrow for these. Inflation also makes exports more expensive for foreign consumers and imports relatively cheaper for domestic consumers, therefore reducing net exports.

Fig. 6 - An increase in the price level causes the AE curve to shift downward.