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Chapter 11 - The Aggregate Expenditures Model
11-1
Chapter 11 The Aggregate Expenditures Model
QUESTIONS
1. What is an investment schedule and how does it differ from an investment demand curve? LO1
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? LO1
Answer: The reason why equilibrium occurs when real GDP equals C + Ig in a private
closed economy is because it is at this level of output where production creates total
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. LO2
Answer: Saving is like a leakage from the flow of aggregate consumption expenditures
because saving represents income not spent. Planned investment is an injection because
Chapter 11 - The Aggregate Expenditures Model
11-2
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? LO3
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.
Answer: (a) This will increase interest-sensitive consumer purchases and investment,
causing GDP to increase.
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? LO3
Answer: Consider the following numerical example. If the slope of the aggregate
expenditures schedule were .8, then the MPC = .8 and the MPS = .2. Therefore, the
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? LO4
Chapter 11 - The Aggregate Expenditures Model
11-3
Answer: Like consumption and investment, exports create domestic production,
income, and employment for a nation. Although U.S. goods and services produced for
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. LO4
Answer: Figures 28.5 and 28.6 show how to do this. Graphs and answers will differ
8. What is a recessionary expenditure gap? An inflationary expenditure gap? Which is associated
with a positive GDP gap? A negative GDP gap? LO5
Answer: A recessionary expenditure gap is the amount by which aggregate expenditures
at the full employment GDP fall short of those required to achieve the full employment
9. 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.
Answer: Say’s law states “supply creates its own demand.” People work in order to earn
income to, and plan to, spend the income on output – why else would they work?
Chapter 11 - The Aggregate Expenditures Model
11-4
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? LO1
Feedback: Consider the following example. 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?
Chapter 11 - The Aggregate Expenditures Model
11-5
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.
Chapter 11 - The Aggregate Expenditures Model
11-6
Possible levels
of employment
(millions)
Real domestic
output
(GDP=DI)
(billions)
Consumption
(billions)
Saving
(billions)
Investment
(billions)
Aggregate
Expenditures
(billions)
40
45
$240
260
$244
260
$ -4
0
$16
16
$260
276
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? LO2
Feedback: Consider the following example (same as problem 1 example). 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?
Chapter 11 - The Aggregate Expenditures Model
11-7
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.
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? LO3
Feedback: Consider the following example. By how much will GDP change if firms
increase their investment by $8 billion and the MPC is .80? If the MPC is .67?
First, we need to find the expenditure multiplier. The expenditure multiplier can be
Chapter 11 - The Aggregate Expenditures Model
11-8
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? LO3
Answer: $360
Feedback: Consider the following example. 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?
First, we need to find the expenditure multiplier. The expenditure multiplier can be
5. The data in columns 1 and 2 in the accompanying table are for a private closed economy: LO4
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 11 - The Aggregate Expenditures Model
Feedback: Consider the following example. The data in columns 1 and 2 in the
accompanying table are for a private closed economy:
Part a:
a. Use columns 1 and 2 to determine the equilibrium GDP for this hypothetical economy.
Equilibrium for this economy occurs where Aggregate Expenditures for the Private
Closed Economy equals Real Gross Domestic Product. Thus, equilibrium is $400 billion.
Chapter 11 - The Aggregate Expenditures Model
11-10
(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
$240
$20
$30
-$ 10
$ 230
(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
$240
$280
$20
$20
$40
$40
-$ 20
-$ 20
$ 220
$ 260
Part d:
d. What is the multiplier in this example?
Chapter 11 - The Aggregate Expenditures Model
11-11
To find the multiplier for this example we could use the standard approach using the
6. Assume that, without taxes, the consumption schedule of an economy is as follows: LO4
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.
Feedback: Consider the following example. Assume that, without taxes, the
consumption schedule of an economy is as follows:
Refer to Figures 27.1, 27.2, and 28.6 for the graphs for (a) and (b) respectively.
Chapter 11 - The Aggregate Expenditures Model
11-12
Chapter 11 - The Aggregate Expenditures Model
11-13
Chapter 11 - The Aggregate Expenditures Model
11-14
Part a:
a. Graph this consumption schedule and determine the MPC.
Part b:
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.
GDP, Billions
Consumption
before Tax
Tax
Consumption
after Tax
$100
$120
$10
$112
200
200
10
192
300
280
10
272
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? LO4
Chapter 11 - The Aggregate Expenditures Model
11-15
Feedback: Consider the following example. 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?
(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
$240
$280
$20
$20
$30
$30
-$ 10
-$ 10
$ 230
$ 270
(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.
LO4
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 11 - The Aggregate Expenditures Model
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Feedback: Consider the following example. 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.
9. Refer to the accompanying table in answering the questions that follow: LO5
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?
Chapter 11 - The Aggregate Expenditures Model
11-17
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?
Feedback: Consider the following example. Refer to the accompanying table in
answering the questions that follow:
Part a:
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?
The equilibrium in this economy is at $600 billion, real domestic output equals aggregate
Part b:
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?
Chapter 11 - The Aggregate Expenditures Model
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Again, the equilibrium in this economy is at $600 billion, real domestic output equals
(note the changes are negative in this case)
Part c:
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?
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
10. Answer the following questions, which relate to the aggregate expenditures model: LO5
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: Consider the following example. Answer the following questions, which
relate to the aggregate expenditures model:
Part a:
a. If C is $100, Ig is $50, Xn is –$10, and G is $30, what is the economy’s equilibrium
GDP?
Equilibrium occurs where real output (Y) equals aggregate expenditures (AE), where AE
Part b:
Chapter 11 - The Aggregate Expenditures Model
11-19
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?
If real GDP is $200, aggregate expenditures of $170 will result in positive unplanned
Part c:
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?
Here we can use the same approach as in part (a)
