AE Model: Private Open Economy: Videos & Practice Problems

The aggregate expenditures model in a private open economy illustrates the relationship between spending and production without government influence. Key components include consumption, investment, and net exports, with the absence of government purchases. The equilibrium occurs where aggregate expenditures equal GDP, represented graphically by the intersection of the aggregate expenditures line and the 45-degree line. The consumption function can be expressed as $C=2+0.5Y$, while aggregate expenditures are calculated as $\mathrm{AE}=C+I+\mathrm{NX}$.

Private Open Economy

The aggregate expenditures model in a private open economy illustrates the relationship between spending and production, similar to a private closed economy but without government involvement. In this context, a private open economy engages in trade, investment, and consumption, while the absence of government means there are no government purchases influencing the economy.

In this model, aggregate expenditures (AE) consist of consumption (C), investment (I), and net exports (NX). The consumption function can be expressed as:

$$C = A + MPC \cdot Y$$

where A is a constant representing autonomous consumption, MPC is the marginal propensity to consume, and Y is the national income or GDP. In this scenario, consumption starts at a base level (e.g., 2) and increases with GDP at a rate determined by the MPC (e.g., 0.5). Thus, as GDP increases, consumption rises accordingly.

Investment and net exports also contribute to aggregate expenditures, leading to the equation:

$$AE = C + I + NX$$

For example, if investment is represented as 1, the total aggregate expenditures can be simplified to:

$$AE = (2 + 1) + 0.5Y = 3 + 0.5Y$$

This indicates that the intercept of the aggregate expenditures line is at 3, with a slope of 0.5, reflecting the same rate of increase as consumption.

To find macroeconomic equilibrium, we look for the point where aggregate expenditures equal GDP, represented graphically by the intersection of the aggregate expenditures line and the 45-degree line. This equilibrium occurs when total spending matches total production, such as when both aggregate expenditures and GDP are at 7, indicating a balanced economy where $7,000,000,000 worth of goods are produced and consumed.

In summary, the private open economy model emphasizes the significance of consumption, investment, and net exports in determining aggregate expenditures, while highlighting the absence of government influence. Understanding this model is crucial for analyzing economic performance and equilibrium in a trade-involved environment.

Here’s what students ask on this topic:

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

The aggregate expenditures (AE) model in a private open economy describes the relationship between spending and production without government influence. Key components include consumption (C), investment (I), and net exports (NX). The model excludes government purchases. The equilibrium occurs where aggregate expenditures equal GDP, represented graphically by the intersection of the AE line and the 45-degree line. The consumption function can be expressed as $C=2+0.5Y$, while aggregate expenditures are calculated as $\mathrm{AE}=C+I+\mathrm{NX}$.

How is equilibrium determined in a private open economy using the AE model?

In a private open economy, equilibrium is determined where aggregate expenditures (AE) equal GDP. This is graphically represented by the intersection of the AE line and the 45-degree line. The AE line includes consumption (C), investment (I), and net exports (NX), but excludes government purchases. The equilibrium point indicates that the total spending in the economy matches the total production, ensuring that there is no unplanned inventory accumulation or depletion. Mathematically, equilibrium is found where $\mathrm{AE}=\mathrm{GDP}$.

What components are included in the aggregate expenditures in a private open economy?

In a private open economy, the components of aggregate expenditures (AE) include consumption (C), investment (I), and net exports (NX). Government purchases are excluded since the model assumes no government influence. The formula for aggregate expenditures in this context is $\mathrm{AE}=C+I+\mathrm{NX}$. Consumption is typically expressed as a function of GDP, such as $C=2+0.5Y$, where Y is GDP.

How does the multiplier effect work in a private open economy?

In a private open economy, the multiplier effect refers to the amplification of initial changes in spending on GDP. When investment (I) or net exports (NX) change, it leads to a multiplied impact on GDP due to the consumption function. For example, an increase in investment increases income, which in turn increases consumption, leading to further increases in income and consumption. The size of the multiplier depends on the marginal propensity to consume (MPC). The formula for the multiplier is $\frac{1}{1-\mathrm{MPC}}$.

What is the consumption function in a private open economy?

The consumption function in a private open economy represents the relationship between consumption (C) and GDP (Y). It is typically expressed as $C=2+0.5Y$, where 2 is the autonomous consumption (consumption when GDP is zero) and 0.5 is the marginal propensity to consume (MPC). This function indicates that for every additional unit of GDP, consumption increases by 0.5 units.