AE Model: Private Closed Economy - Online Tutor, Practice Problems & Exam Prep

The aggregate expenditures model in a private closed economy focuses on the relationship between consumption and investment without government influence or international trade. In this model, aggregate expenditures equal GDP at equilibrium, represented graphically where the aggregate expenditures line intersects the 45-degree line. The consumption function starts at a base level, increasing with the marginal propensity to consume (MPC). Investment remains constant, leading to a simplified equilibrium where total spending is solely from consumption and investment, highlighting the importance of these components in determining economic output.

Private Closed Economy

So let's talk about a simplified version of the aggregate expenditures model in a private closed economy. Let's see what that means. So, remember, the aggregate expenditures model, we're linking up the relationship between spending and what's the other side? Production, right? Production. So, spending and production in a private closed economy. This is when we say a private economy means no government. And a closed economy means no trade. Okay. So, it's a country that does not have government or international trade. We're still going to use the same model of aggregate expenditures equals GDP at the equilibrium. So, aggregate expenditures being our spending and GDP being our production. Well, this is actually just easier because in this economy, there's no government purchases and no net exports. So all of this is gone. There's no government purchases, no net exports. All we have is consumption and investment, right? That's all of our spending in the economy either comes from consumption from our consumers or investment from firms basically, right?

So we're going to have very similar to what we've been doing. We have our consumption function that's going to have some base amount of consumption regardless of income, there's gotta be some consumption to survive, right? There's gotta be food, shelter, things like that. And then as we make more money, MPC, right, times Y_d. So just like we've discussed with our consumption function. And investment, well, we're gonna keep that constant still. It's always gonna be constant in these in these in these, topics here. Alright? So remember that this can be affected by the multiplier effect, which we will discuss in further videos. Let's go ahead and see how this simplified model of the aggregate expenditures where there's no government, no net exports, how this looks like on the graph.

So just like before, we're going to be looking for our macroeconomic equilibrium. Just in this case, well, there are no government purchases and there are no net exports. So all we have is consumption and investment. So if we look at this graph, we're going to have our consumption function. Let's go ahead and graph our consumption function, which it starts here at this point 2. Right? If there's no GDP, So this is gonna be aggregate expenditures. This is GDP, which is why those are our axis here. So if there's no GDP, if there's no production in the economy, well, there's still gotta be some consumption for people to survive and that's base amount of 2. So when there's no production here at 0 production, we're going to have 2 consumption, right? 2,000,000,000 consumption we'll say and this will go up at a rate of 0.5. So the marginal propensity to consume being 0.5 times Y. So for every 2 GDP, right? For every time we go up by 2 GDP, well that goes up by 1 on the consumption function, right? Because half of it goes to consumption. So 2 GDP, if GDP was 2 here, well this would be 1. 0.5 times 2. So this would go up like this. Right? Just like we saw on the other graph. Oops. Like this. Here's 3 right here. It's 2 plus 1 plus 1 again, and we end up with a line like this. Right? So very similar to when we had our full economy with government, with everything. Right? We've still got our consumption. But the only thing we're going to add to it in this case is investment. Right? Because this is a private closed economy, we're going to end up with 3 plus 0.5Y, right? The 2 plus the 1 consumption plus investment and then we add that, the income part there. The marginal propensity to consume times the income. So all this does is it shifts us up to 3, right? Shifts this graph up from 2 to 3. But the slope stays the same so it's gonna be a parallel line to that. And this is it. We're done in the private closed economy. This is all that we all of the spending that we have is either from consumption or investment. So this is C right here, consumption. And this is our aggregate expenditures of C+I, right? Because there's no government purchases, no net exports, that's our total aggregate expenditures, C+I.

So here we go. We're ready to find our macroeconomic equilibrium. Do you remember where that's going to be? Yep. It's right there where our consumption where our aggregate expenditures line, consumption plus investment, touches the 45-degree line, right? Just right here. Consumption plus investment equals 6 in this case. So where our aggregate expenditures equals 6, our production equals 6, this is our macroeconomic equilibrium in this case. Alright? It's simple as that. Just as what we learned in the previous example, except we took out some variables. So what we have is consumption plus investment. So right here below me, macroeconomic equilibrium occurs where the AE line crosses the 45-degree line. Okay? Pretty much just what we just learned, except we took out some variables for government net exports. Exports. Cool? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the aggregate expenditures model in a private closed economy?

The aggregate expenditures (AE) model in a private closed economy examines the relationship between total spending (aggregate expenditures) and production (GDP) without government influence or international trade. In this simplified model, aggregate expenditures equal GDP at equilibrium. The model includes only two components of spending: consumption (C) and investment (I). The consumption function starts at a base level and increases with the marginal propensity to consume (MPC). Investment remains constant. Graphically, equilibrium is found where the AE line intersects the 45-degree line, indicating that total spending equals total production.

How is the consumption function represented in a private closed economy?

In a private closed economy, the consumption function represents the relationship between consumption and disposable income. It starts at a base level of consumption, which occurs even when income is zero, to account for essential spending on necessities. The function is typically expressed as:

$C=C{0}_{}+\mathrm{MPC}\times Y{d}_{}$

where $C{0}_{}$ is the base level of consumption, $\mathrm{MPC}$ is the marginal propensity to consume, and $Y{d}_{}$ is disposable income. As income increases, consumption increases by a fraction determined by the MPC.

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

The 45-degree line in the aggregate expenditures model is significant because it represents points where aggregate expenditures (AE) equal GDP. This line helps identify the macroeconomic equilibrium, where total spending matches total production. At equilibrium, the AE line intersects the 45-degree line, indicating that the economy is in balance with no unplanned changes in inventories. This graphical representation simplifies the analysis of economic output and spending in a private closed economy.

How does investment affect the aggregate expenditures model in a private closed economy?

In a private closed economy, investment (I) is a crucial component of aggregate expenditures (AE). Unlike consumption, which varies with income, investment is typically assumed to be constant. The total aggregate expenditures are the sum of consumption (C) and investment (I), expressed as:

$\mathrm{AE}=C+I$

Investment shifts the AE line upward by a constant amount, reflecting the additional spending from firms. This shift helps determine the new equilibrium level of GDP, where the AE line intersects the 45-degree line, indicating that total spending equals total production.

What is the macroeconomic equilibrium in a private closed economy?

Macroeconomic equilibrium in a private closed economy occurs where aggregate expenditures (AE) equal GDP. This is graphically represented by the intersection of the AE line and the 45-degree line. At this point, total spending (consumption plus investment) matches total production, indicating no unplanned changes in inventories. The equilibrium condition can be expressed as:

$\mathrm{AE}=\mathrm{GDP}$

In this simplified model, equilibrium highlights the balance between spending and production, driven solely by consumption and investment without government or international trade influences.