978-1259723223 Chapter 31

Chapter 31 – The Aggregate Expenditures Model

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Chapter 31 – The Aggregate Expenditures Model

McConnell Brue Flynn 21e

DISCUSSION QUESTIONS

1. What is an investment schedule and how does it differ from an investment demand curve? LO2

2. Why does equilibrium real GDP occur where C + Ig = GDP in a private closed economy? What

happens to real GDP when C + Ig exceeds GDP? When C + Ig is less than GDP? What two

expenditure components of real GDP are purposely excluded in a private closed economy? LO3

3. Why is saving called a leakage? Why is planned investment called an injection? Why must

saving equal planned investment at equilibrium GDP in the private closed economy? Are

unplanned changes in inventories rising, falling, or constant at equilibrium GDP? Explain. LO4

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4. Other things equal, what effect will each of the following changes independently have on the

equilibrium level of real GDP in the private closed economy? LO4

a. A decline in the real interest rate.

b. An overall decrease in the expected rate of return on investment.

c. A sizeable, sustained increase in stock prices.

5. Depict graphically the aggregate expenditures model for a private closed economy. Now show

a decrease in the aggregate expenditures schedule and explain why the decline in real GDP in

your diagram is greater than the decline in the aggregate expenditures schedule. What is the term

used for the ratio of a decline in real GDP to the initial drop in aggregate expenditures? LO5

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6. Assuming the economy is operating below its potential output, what is the impact of an

increase in net exports on real GDP? Why is it difficult, if not impossible, for a country to boost

its net exports by increasing its tariffs during a global recession? LO6

7. What is a recessionary expenditure gap? An inflationary expenditure gap? Which is associated

with a positive GDP gap? A negative GDP gap? LO6

8. LAST WORD What is Say’s Law? How does it relate to the view held by classical economists

that the economy generally will operate at a position on its production possibilities curve (Chapter

1)? Use production possibilities analysis to demonstrate Keynes’ view on this matter.

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REVIEW QUESTIONS

1. True or False: The aggregate expenditures model assumes flexible prices. LO1

2. If total spending is just sufficient to purchase an economy’s output, then the economy is: LO3

a. In equilibrium.

b. In recession.

c. In debt.

d. In expansion.

3. True or False: If spending exceeds output, real GDP will decline as firms cut back on

production. LO3

4. If inventories unexpectedly rise, then production ________ sales and firms will respond by

________ output. LO3

a. Trails; expanding.

b. Trails; reducing.

c. Exceeds; expanding.

d. Exceeds; reducing.

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Feedback: If inventories unexpectedly rise, then production exceeds sales and firms will

respond by reducing output. This is true because if inventories rise unexpectedly, firms

will know that they are producing output faster than people want to buy it. That will

cause firms to cut back on production, as it hurts firm profits to produce more output than

people want to purchase. That is true because every unit of output is costly to produce. So

if a firm makes too much output and piles up units in inventory, it will be incurring large

costs without getting back any revenue (because unsold units sitting in inventory produce

no revenue).

5. If the multiplier is 5 and investment increases by $3 billion, equilibrium real GDP will increase

by: LO5

a. $2 billion.

b. $3 billion.

c. $8 billion.

d. $15 billion.

e. None of the above.

6. A depression abroad will tend to ________ our exports, which in turn will _________ net

exports, which in turn will ________ equilibrium real GDP. LO6

a. Reduce; reduce; reduce.

b. Increase; increase; increase.

c. Reduce; increase; increase.

d. Increase; reduce; reduce.

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7. Explain graphically the determination of equilibrium GDP for a private economy through the

aggregate expenditures model. Now add government purchases (any amount you choose) to your

graph, showing its impact on equilibrium GDP. Finally, add taxation (any amount of lump-sum

tax that you choose) to your graph and show its effect on equilibrium GDP. Looking at your

graph, determine whether equilibrium GDP has increased, decreased, or stayed the same given

the sizes of the government purchases and taxes that you selected. LO7

8. The economy’s current level of equilibrium GDP is $780 billion. The full employment level of

GDP is $800 billion. The multiplier is 4. Given those facts, we know that the economy faces

________ expenditure gap of ________. LO8

a. An inflationary; $5 billion.

b. An inflationary; $10 billion.

c. An inflationary; $20 billion.

d. A recessionary; $5 billion.

e. A recessionary; $10 billion.

f. A recessionary; $20 billion.

9. If an economy has an inflationary expenditure gap, the government could attempt to bring the

economy back toward the full-employment level of GDP by ________ taxes or ________

government expenditures. LO8

a. Increasing; increasing.

b. Increasing; decreasing.

c. Decreasing; increasing.

d. Decreasing; decreasing.

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Feedback: The correct answer is that the government could try to bring the economy

back toward the full-employment level of GDP by increasing taxes or decreasing

spending. Increasing taxes would reduce households’ after-tax income. With less after-

tax income, households would reduce their consumption spending. That would reduce

aggregate expenditures and shift the aggregate expenditures curve down, thereby leading

to a smaller level of equilibrium GDP. Decreasing government expenditures would

reduce aggregate expenditures directly, by reducing the size of G. The reduction in

aggregate expenditures would shift the aggregate expenditures curve down and thereby

lead to a smaller level of equilibrium GDP. Finally, please note that the government

could of course implement both policies at the same time. It could simultaneously raise

taxes and reduce government expenditures as a way of fighting the inflationary

expenditure gap.

PROBLEMS

1. Assuming the level of investment is $16 billion and independent of the level of total output,

complete the accompanying table and determine the equilibrium levels of output and employment

in this private closed economy. What are the sizes of the MPC and MPS? LO3

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Feedback: The savings column is found by subtracting Consumption from Real

Domestic Output (disposable income) for each row. The answers are reported in the

savings column below. We can also find aggregate expenditures by adding consumption

and investment, which is reported in the last column in the table below. We can find

equilibrium two ways. First, we can find the level of output and employment where

Investment equals Savings. Second, we can find the level of output and employment

where aggregate expenditures equal real output. Either of these approaches give us the

equilibrium level of output of $340 billion and a level of employment 65 million.

The marginal propensity to consume can be found by dividing the change in consumption

Possible levels

of employment

(millions)

Real domestic

output

(GDP=DI)

(billions)

Consumption

(billions)

Saving

(billions)

Investment

(billions)

Aggregate

Expenditures

(billions)

40

45

50

55

60

65

70

75

80

$240

260

280

300

320

340

360

380

400

$244

260

276

292

308

324

340

356

372

$ -4

0

4

8

12

16

20

24

28

$16

16

$260

276

292

308

324

340

356

372

388

2. Using the consumption and saving data in problem 1 and assuming investment is $16 billion,

what are saving and planned investment at the $380 billion level of domestic output? What are

saving and actual investment at that level? What are saving and planned investment at the $300

billion level of domestic output? What are the levels of saving and actual investment? In which

direction and by what amount will unplanned investment change as the economy moves from the

$380 billion level of GDP to the equilibrium level of real GDP? From the $300 billion level of

real GDP to the equilibrium level of GDP? LO4

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Answer: At $380 billion level, saving = $24 billion; planned investment = $16 billion.

Actual saving = $24 billion; actual investment is $24 billion

At the $300 billion level, saving = $8 billion; planned investment = $16 billion. Actual

saving = $8 billion; actual investment is $8 billion

Unplanned inventories fall -8 billion

Unplanned inventories rise 8 billion

Feedback: At the $380 billion level of GDP, saving = $24 billion; planned investment =

$16 billion (from the question). This deficiency of $8 billion of planned investment

causes an unplanned $8 billion increase in inventories. Actual investment is $24 billion

(= $16 billion of planned investment plus $8 billion of unplanned inventory investment),

matching the $24 billion of actual saving.

At the $300 billion level of GDP, saving = $8 billion; planned investment = $16 billion

(from the question). This excess of $8 billion of planned investment causes an unplanned

$8 billion decline in inventories. Actual investment is $8 billion (= $16 billion of

planned investment minus $8 billion of unplanned inventory disinvestment) matching the

actual of $8 billion.

When unplanned investments in inventories occur, as at the $380 billion level of GDP,

businesses revise their production plans downward and GDP falls. When unplanned

disinvestments in inventories occur, as at the $300 billion level of GDP; businesses revise

their production plans upward and GDP rises. Equilibrium GDP—in this case, $340

billion—occurs where planned investment equals saving.

3. By how much will GDP change if firms increase their investment by $8 billion and the MPC is

.80? If the MPC is .67? LO5

4. Suppose that a certain country has an MPC of .9 and a real GDP of $400 billion. If its

investment spending decreases by $4 billion, what will be its new level of real GDP? LO5

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Feedback: First, we need to find the expenditure multiplier. The expenditure multiplier

can be found by dividing one by one minus the marginal propensity to consume.

Expenditure multiplier = 1/(1-MPC)

For our value, we have an expenditure multiplier of 10 (= 1/(1-0.9)).

Second, to find the change in GDP we take the expenditure multiplier and multiply this

value by the change in investment.

Change in GDP = 10 x (-$4) = –$40

Third, to find the new level of real GDP we add the change to the original level of real

GDP (note, when investment decreases the change is negative).

New level of real GDP = $400 +(-$40) = $400 – $40 = $360

5. The data in columns 1 and 2 in the accompanying table are for a private closed economy: LO6

a. Use columns 1 and 2 to determine the equilibrium GDP for this hypothetical economy.

b. Now open up this economy to international trade by including the export and import figures of

columns 3 and 4. Fill in columns 5 and 6 and determine the equilibrium GDP for the open

economy. What is the change in equilibrium GDP caused by the addition of net exports?

c. Given the original $20 billion level of exports, what would be net exports and the equilibrium

GDP if imports were $10 billion greater at each level of GDP?

d. What is the multiplier in this example?

Chapter 31 – The Aggregate Expenditures Model

Feedback: Part a:

6.

(1)

Real

domestic

output

(GDP=DI)

billions

(2)

Aggregate

Expenditures,

private closed

economy,

billions

(3)

Exports,

billions

(4)

Imports,

billions

(5)

Net

exports,

private

economy

(6)

Aggregate

expenditures,

open

billions

$200

$250

$300

$350

$400

$450

$500

$550

$240

$280

$320

$360

$400

$440

$480

$520

$20

$30

-$ 10

$ 230

$ 270

$ 310

$ 350

$ 390

$ 430

$ 470

$ 510

Equilibrium for this economy occurs where Aggregate Expenditures for the Private Open

Economy equals Real Gross Domestic Product. Thus, equilibrium is $350 billion. The

change in equilibrium GDP is a decrease of $50.

Part c:

If Imports were $10 billion greater at each level of GDP we would have the following

table.

(1)

Real

domestic

output

(GDP=DI)

billions

(2)

Aggregate

Expenditures,

private closed

economy,

billions

(3)

Exports,

billions

(4)

Imports,

billions

(5)

Net

exports,

private

economy

(6)

Aggregate

expenditures,

open

billions

$200

$250

$300

$350

$400

$450

$500

$550

$240

$280

$320

$360

$400

$440

$480

$520

$20

$40

-$ 20

$ 220

$ 260

$ 300

$ 340

$ 380

$ 420

$ 460

$ 500

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Equilibrium for this economy occurs where Aggregate Expenditures for the Private Open

Economy equals Real Gross Domestic Product. Thus, equilibrium is $300 billion.

Part d:

To find the multiplier for this example we could use the standard approach using the

marginal propensity to consume or using the change in real GDP that results from the

6. Assume that, without taxes, the consumption schedule of an economy is as follows: LO7

a. Graph this consumption schedule and determine the MPC.

b. Assume now that a lump-sum tax is imposed such that the government collects $10 billion in

taxes at all levels of GDP. Graph the resulting consumption schedule and compare the MPC and

the multiplier with those of the pretax consumption schedule.

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Feedback:

Refer to below figures for the graphs for (a) and (b) respectively.

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Part a:

Use the values in the table above for graph. The size of the MPC is 80/100 or .8 because

consumption changes by 80 when GDP changes by 100.

tax). The other $2 billion will come from a reduction in saving.

The new level of consumption after the tax equals the original level of consumption

minus the reduction above. These values are reported in column 4 below.

GDP, Billions

Consumption

before Tax

Tax

Consumption

after Tax

$100

$120

$10

$112

200

10

192

300

280

10

272

400

360

10

352

500

440

10

432

600

520

10

512

700

600

10

592

7. Refer to columns 1 and 6 in the table for problem 5. Incorporate government into the table by

assuming that it plans to tax and spend $20 billion at each possible level of GDP. Also assume

that the tax is a personal tax and that government spending does not induce a shift in the private

aggregate expenditures schedule. What is the change in equilibrium GDP caused by the addition

of government? LO7

Chapter 31 – The Aggregate Expenditures Model

Feedback:

(1)

Real

domestic

output

(GDP=DI)

billions

(2)

Aggregate

Expenditures,

private closed

economy,

billions

(3)

Exports,

billions

(4)

Imports,

billions

(5)

Net

exports,

private

economy

(6)

Aggregate

expenditures,

open

billions

$200

$250

$300

$350

$400

$450

$500

$550

$240

$280

$320

$360

$400

$440

$480

$520

$20

$30

-$ 10

$ 230

$ 270

$ 310

$ 350

$ 390

$ 430

$ 470

$ 510

(NOTE: Use marginal propensity to consume and multiplier found in problem 5)

Before G is added, open private sector equilibrium will be at $350. The addition of $20

billion of government expenditures and $20 billion of personal taxes increases

equilibrium GDP from $350 to $370 billion.

8. ADVANCED ANALYSIS Assume that the consumption schedule for a private open economy

is such that consumption C = 50 + 0.8Y. Assume further that planned investment Ig and net

exports Xn are independent of the level of real GDP and constant at Ig = 30 and Xn = 10. Recall

also that, in equilibrium, the real output produced (Y) is equal to aggregate expenditures: Y = C +

Ig + Xn. LO7

a. Calculate the equilibrium level of income or real GDP for this economy.

b. What happens to equilibrium Y if Ig changes to 10? What does this outcome reveal about the

size of the multiplier?

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Feedback:

Part a:

Part b:

If Investment falls from 30 to 10, we follow the same procedure (except let Ig=10).

9. Refer to the accompanying table in answering the questions that follow: LO8

a. If full employment in this economy is 130 million, will there be an inflationary expenditure gap

or a recessionary expenditure gap? What will be the consequence of this gap? By how much

would aggregate expenditures in column 3 have to change at each level of GDP to eliminate the

inflationary expenditure gap or the recessionary expenditure gap? What is the multiplier in this

example?

b. Will there be an inflationary expenditure gap or a recessionary expenditure gap if the full–

employment level of output is $500 billion? By how much would aggregate expenditures in

column 3 have to change at each level of GDP to eliminate the gap? What is the multiplier in this

example?

c. Assuming that investment, net exports, and government expenditures do not change with

changes in real GDP, what are the sizes of the MPC, the MPS, and the multiplier?

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Answer: a. Recessionary expenditure gap; 20 billion shortfall of employment; $20; 5

b. Inflationary expenditure gap; -$20; 5

c. MPC = 0.8; MPS = 0.2; multiplier = 5

Feedback:

Part a:

The equilibrium in this economy is at $600 billion, real domestic output equals aggregate

expenditures (this is where the economy will take us). Since full employment is at 130

million, this implies that full employment real domestic output is at $700 billion. Given

that aggregate expenditures is only $680 billion at this level of employment we have a

recessionary expenditure gap. That is, aggregate expenditures is $20 billion below real

Part b:

Again, the equilibrium in this economy is at $600 billion, real domestic output equals

aggregate expenditures (this is where the economy will take us). Since full employment

real domestic output is $500 billion and given that aggregate expenditures is $520 billion

at this level of real domestic output we have an inflationary expenditure gap. That is,

Part c:

To find the marginal propensity to consume (MPC) divide the change in aggregate

expenditures by the change in real domestic output (assuming that investment, net

exports, and government expenditures do not change with changes in real GDP).

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10. Answer the following questions, which relate to the aggregate expenditures model: LO8

a. If C is $100, Ig is $50, Xn is –$10, and G is $30, what is the economy’s equilibrium GDP?

b. If real GDP in an economy is currently $200, C is $100, Ig is $50, Xn is -$10, and G is $30,

will the economy’s real GDP rise, fall, or stay the same?

c. Suppose that full-employment (and full-capacity) output in an economy is $200. If C is $150,

Ig is $50, Xn is –$10, and G is $30, what will be the macroeconomic result?

Feedback:

Part a: