AE Model: Graphing Macroeconomic Equilibrium: Study with Video Lessons, Practice Problems & Examples

The aggregate expenditures model illustrates the relationship between total spending (aggregate expenditures) and production (GDP). Aggregate expenditures consist of consumption, investment, government purchases, and net exports. The equilibrium occurs where aggregate expenditures equal GDP, represented graphically by the intersection of the aggregate expenditures line and the 45-degree line. Key components include the marginal propensity to consume, which affects consumption based on disposable income. Understanding this model is crucial for analyzing macroeconomic stability and the impact of fiscal policy on economic output.

Graphing Macroeconomic Equilibrium

Alright. Now let's take what we've learned about the aggregate expenditures model and put it on the graph. So what we're going to do now is find our macro numerical approach. The aggregate expenditures model, as we discussed, describes the relationship between spending in the economy, which is our aggregate expenditures, and our production, which is our GDP, real GDP. So, AE equals our spending and GDP equals our production, right? We're trying to find that balance where spending equals production, defining our spending. Aggregate expenditures include consumption plus investment spending, plus government purchases, plus net exports, as we originally defined GDP based on what was being spent in the economy, what was being consumed, invested, government purchases, net exports. So, we're going to find that level of GDP that equals our aggregate expenditures.

When we define these terms, we said consumption would have some base number. Even with no income, there's still going to be some consumption like food purchase and shelter. We'll denote this constant amount as $a$. As we earn more income, we spend more money. Our marginal propensity to consume is the slope of the line, the amount for each extra dollar we have, amounting to consumption based on our disposable income, $y_d$. The more disposable income we have, the more we're consuming. We're going to keep all the other components constant: there's going to be some constant level of investment, government purchases, and net exports. These can be affected by the multiplier, which we'll get to in future videos, but for now, we'll focus on how we find our macroeconomic equilibrium on the graph.

Let's graph our consumption line. Our base amount of consumption is 2 (could be 2,000,000,000), and for every extra dollar that is earned, half of it is spent, and half is saved, giving us a marginal propensity to consume of 0.5. We've got these constant levels of investment, government purchases, and net exports—firm spending of 1,000,000,000, government purchases of half a 1,000,000,000, and net exports of half a 1,000,000,000 as well.

On the graph, in the aggregate expenditures model, we'll have our expenditures, our spending on the y-axis and our GDP on the x-axis. We're looking for a place where these are equal, and I've drawn a line here across the middle called our 45-degree line. This line is a very important part of this graph because all the points along this line indicate macroeconomic equilibrium.

When graphing just consumption, we have $2+0.5y$. If there's no income, GDP, consumption still occurs because people need to live. As we add income, let's say $2,000,000,000$ of GDP, then consumption would be $2+0.5\times 2=3$. As we add investment to it, our equation becomes $2+0.5y+1$, increasing our y-intercept to 3, meaning our consumption plus investment would be 3 when there's no GDP, and it would increase at the same rate. These lines are parallel because the slope is the same. Adding government purchases and net exports continues to shift the line upward, but the slope remains the same.

Our final aggregate expenditures equation is $c+i+g+nx=2+0.5y+1+0.5+0.5=4+0.5y$. This line, our aggregate expenditures line, is what we build up to. We add each component just to shift the consumption function up. The last thing left is to find our macroeconomic equilibrium, where aggregate expenditures cross the 45-degree line. That point tells us the correct level of GDP in equilibrium based on the level of consumption, investment, government purchases, and net exports, illustrating the macroeconomic equilibrium where spending and production are equal.

Now that we've got our macroeconomic equilibrium on the graph, we can move to the next part of our discussion.

Here’s what students ask on this topic:

What is the aggregate expenditures model in macroeconomics?

The aggregate expenditures (AE) model in macroeconomics illustrates the relationship between total spending in an economy and its production, measured as Gross Domestic Product (GDP). Aggregate expenditures consist of four main components: consumption (C), investment (I), government purchases (G), and net exports (NX). The model seeks to find the equilibrium point where total spending equals total production, represented graphically by the intersection of the AE line and the 45-degree line. This equilibrium is crucial for understanding macroeconomic stability and the effects of fiscal policy on economic output.

How do you graph the macroeconomic equilibrium using the AE model?

To graph the macroeconomic equilibrium using the AE model, follow these steps: First, plot the 45-degree line, which represents points where aggregate expenditures equal GDP. Next, construct the AE line by summing the components: consumption (C), investment (I), government purchases (G), and net exports (NX). The AE line will shift upward as each component is added. The equilibrium occurs where the AE line intersects the 45-degree line, indicating the level of GDP where total spending equals total production. This intersection point represents the macroeconomic equilibrium.

What is the significance of the 45-degree line in the AE model?

The 45-degree line in the AE model is significant because it represents all points where aggregate expenditures (AE) equal Gross Domestic Product (GDP). This line serves as a reference to identify the macroeconomic equilibrium. When the AE line intersects the 45-degree line, it indicates that total spending in the economy matches total production, signifying equilibrium. This intersection helps economists and policymakers understand the balance between spending and production, which is crucial for analyzing economic stability and the impact of fiscal policies.

How does the marginal propensity to consume (MPC) affect the AE model?

The marginal propensity to consume (MPC) affects the AE model by determining the slope of the consumption function. MPC represents the fraction of additional disposable income that households spend on consumption. In the AE model, consumption (C) is a function of disposable income (Y_d), and the MPC dictates how much consumption increases with an increase in income. A higher MPC means a steeper consumption function, leading to a higher aggregate expenditures line. This, in turn, affects the equilibrium level of GDP, as higher consumption boosts total spending in the economy.

What components make up aggregate expenditures in the AE model?

Aggregate expenditures (AE) in the AE model are composed of four main components: consumption (C), investment (I), government purchases (G), and net exports (NX). Consumption includes household spending on goods and services. Investment refers to business expenditures on capital goods. Government purchases encompass government spending on goods and services. Net exports are calculated as exports minus imports. Together, these components represent the total spending in an economy, and their sum determines the aggregate expenditures line used to find the macroeconomic equilibrium.