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Chapter 31 - The Aggregate Expenditures Model
31-1
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
Chapter 31 - The Aggregate Expenditures Model
31-2
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
Chapter 31 - The Aggregate Expenditures Model
31-3
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.
Chapter 31 - The Aggregate Expenditures Model
31-4
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.
Chapter 31 - The Aggregate Expenditures Model
31-5
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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.
Chapter 31 - The Aggregate Expenditures Model
31-6
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.
Chapter 31 - The Aggregate Expenditures Model
31-7
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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
Chapter 31 - The Aggregate Expenditures Model
31-8
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
16
16
16
16
16
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
Chapter 31 - The Aggregate Expenditures Model
31-9
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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
Chapter 31 - The Aggregate Expenditures Model
31-10
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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
$20
$20
$20
$20
$20
$20
$20
$30
$30
$30
$30
$30
$30
$30
$30
-$ 10
-$ 10
-$ 10
-$ 10
-$ 10
-$ 10
-$ 10
-$ 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
$20
$20
$20
$20
$20
$20
$20
$40
$40
$40
$40
$40
$40
$40
$40
-$ 20
-$ 20
-$ 20
-$ 20
-$ 20
-$ 20
-$ 20
-$ 20
$ 220
$ 260
$ 300
$ 340
$ 380
$ 420
$ 460
$ 500
Chapter 31 - The Aggregate Expenditures Model
31-12
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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.
Chapter 31 - The Aggregate Expenditures Model
31-13
Feedback:
Refer to below figures for the graphs for (a) and (b) respectively.
Chapter 31 - The Aggregate Expenditures Model
31-14
Chapter 31 - The Aggregate Expenditures Model
31-15
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
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
$20
$20
$20
$20
$20
$20
$20
$30
$30
$30
$30
$30
$30
$30
$30
-$ 10
-$ 10
-$ 10
-$ 10
-$ 10
-$ 10
-$ 10
-$ 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?
Chapter 31 - The Aggregate Expenditures Model
31-17
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?
Chapter 31 - The Aggregate Expenditures Model
31-18
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
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).
Chapter 31 - The Aggregate Expenditures Model
31-19
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:
