This is “Review and Practice”, section 28.4 from the book Economics Principles (v. 2.0).
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This chapter presented the aggregate expenditures model. Aggregate expenditures are the sum of planned levels of consumption, investment, government purchases, and net exports at a given price level. The aggregate expenditures model relates aggregate expenditures to the level of real GDP.
We began by observing the close relationship between consumption and disposable personal income. A consumption function shows this relationship. The saving function can be derived from the consumption function.
The time period over which income is considered to be a determinant of consumption is important. The current income hypothesis holds that consumption in one period is a function of income in that same period. The permanent income hypothesis holds that consumption in a period is a function of permanent income. An important implication of the permanent income hypothesis is that the marginal propensity to consume will be smaller for temporary than for permanent changes in disposable personal income.
Changes in real wealth and consumer expectations can affect the consumption function. Such changes shift the curve relating consumption to disposable personal income, the graphical representation of the consumption function; changes in disposable personal income do not shift the curve but cause movements along it.
An aggregate expenditures curve shows total planned expenditures at each level of real GDP. This curve is used in the aggregate expenditures model to determine the equilibrium real GDP (at a given price level). A change in autonomous aggregate expenditures produces a multiplier effect that leads to a larger change in equilibrium real GDP. In a simplified economy, with only consumption and investment expenditures, in which the slope of the aggregate expenditures curve is the marginal propensity to consume (MPC), the multiplier is equal to 1/(1 − MPC). Because the sum of the marginal propensity to consume and the marginal propensity to save (MPS) is 1, the multiplier in this simplified model is also equal to 1/MPS.
Finally, we derived the aggregate demand curve from the aggregate expenditures model. Each point on the aggregate demand curve corresponds to the equilibrium level of real GDP as derived in the aggregate expenditures model for each price level. The downward slope of the aggregate demand curve (and the shifting of the aggregate expenditures curve at each price level) reflects the wealth effect, the interest rate effect, and the international trade effect. A change in autonomous aggregate expenditures shifts the aggregate demand curve by an amount equal to the change in autonomous aggregate expenditures times the multiplier.
In a more realistic aggregate expenditures model that includes all four components of aggregate expenditures (consumption, investment, government purchases, and net exports), the slope of the aggregate expenditures curve shows the additional aggregate expenditures induced by increases in real GDP, and the size of the multiplier depends on the slope of the aggregate expenditures curve. The steeper the aggregate expenditures curve, the larger the multiplier; the flatter the aggregate expenditures curve, the smaller the multiplier.
Suppose the following information describes a simple economy. Figures are in billion of dollars.
|Disposable personal income||Consumption|
The graph below shows a consumption function.
For the purpose of this exercise, assume that the consumption function is given by C = $500 billion + 0.8Yd. Construct a consumption and saving table showing how income is divided between consumption and personal saving when disposable personal income (in billions) is $0, $500, $1,000, $1,500, $2,000, $2,500, $3,000, and $3,500.
The graph below characterizes a simple economy with only two components of aggregate expenditures, consumption and investment.
Explain and illustrate graphically how each of the following events affects aggregate expenditures and equilibrium real GDP. In each case, state the nature of the change in aggregate expenditures, and state the relationship between the change in AE and the change in equilibrium real GDP.
The equations below give consumption functions for economies in which planned investment is autonomous and is the only other component of GDP. Compute the marginal propensity to consume and the multiplier for each economy.
Assume an economy in which people would spend $200 billion on consumption even if real GDP were zero and, in addition, increase their consumption by $0.50 for each additional $1 of real GDP. Assume further that the sum of planned investment plus government purchases plus net exports is $200 billion regardless of the level of real GDP.