Aggregate Expenditures Model and Macroeconomic Equilibrium - Online Tutor, Practice Problems & Exam Prep

The aggregate expenditures model (AE model) illustrates the relationship between total spending (aggregate expenditures) and production (GDP) in an economy. Key components of aggregate expenditures include consumption, investment, government purchases, and net exports. In equilibrium, aggregate expenditures equal real GDP, emphasizing that spending drives production. The marginal propensity to consume (MPC) indicates how much of additional income is spent. Changes in investment or government purchases can trigger the multiplier effect, impacting overall GDP. Understanding these concepts is crucial for analyzing economic fluctuations and policy implications.

Aggregate Expenditures Model and Macroeconomic Equilibrium

Alright. So let's take what we've learned about GDP and apply it to the aggregate expenditures model. This is an important one for this class, so let's get into it. Alright. So, aggregate expenditures. When I say aggregate expenditures, remember "aggregate" means total, right? The total amount of expenditures. It represents the total spending in an economy. Aggregate expenditures, total spending, is just a synonym there. So we're going to use the acronym AE for aggregate expenditures. The aggregate expenditures model is the AE model. Okay?

So when we talk about the aggregate expenditures model, what are we looking at? We're going to be looking at spending, right? So we're going to be taking the relationship between the spending, so the money being spent in an economy, and what's being produced, so production. Okay? So it's not always necessarily true that what gets spent in an economy was produced that year, right? Maybe some of the production came from other years or during this year. So the spending and production don't necessarily have to line up.

So when we talk about the aggregate expenditures model, we're making this key assumption that prices are sticky. We've used this idea of sticky prices before, and that just means that they're fixed; they're not going to be moving. So we're not going to worry about prices when we deal with this model.

The key idea here is that in any particular year, the level of GDP, how much is going to be produced in that year, is going to be determined by the amount of spending, right? If there's a lot of money being spent by consumers, by businesses, by government, well, then there's going to be needed production to keep up with that spending. That's the idea of this model. The production has to keep up with our spending. Cool?

So when we learn about GDP, remember our formula here? Consumption plus investment plus government purchases plus net exports. That's how we define GDP when we first studied it. Right? And if that's not sticking with you, you'll definitely need to go back and refresh yourself on GDP because it's going to be important throughout this discussion.

Alright. So, aggregate expenditures, guess what? We're going to say that aggregate expenditures, the money spent, is going to be the same thing: Consumption plus investment plus government purchases plus net exports. Those are going to be the components here of aggregate expenditures.

So, you're asking how there is a difference here? What's the difference between aggregate expenditures and GDP? They look like the same exact thing. Well, guess what? When we're in equilibrium, when the economy is in equilibrium, the spending and the production are going to be the same, so, aggregate expenditures equals GDP in equilibrium. Okay?

And when we talk about GDP, we're talking about real GDP. Right? Because we're not going to let prices get in the way. And real GDP is just, we're keeping prices constant when we use real GDP. So AE equals GDP. That is the key point we're going to be looking for on a lot of these graphs. The amount of spending during a period is equal to the production during the period.

So, when we're looking at this model, I want you to think of aggregate expenditures as the spending and GDP as the production. Okay. So when we're looking for equilibrium, we want these to be equal. And when we discuss aggregate expenditures, we're going to have our four components. Right? Aggregate expenditures equals consumption plus investment plus government purchases plus net exports, just like we discussed above.

Well, let's go ahead and define these terms a little more. Remember when we discussed the consumption function? The consumption function was just that we have our, our base level of consumption. We'll just say 'a' is some base level of consumption that we have if we had no income, right? And remember what we've discussed about consumption: as we have more money, we're going to consume more, right? The more disposable income we have, the more we're going to consume.

The marginal propensity to consume tells us that for each extra dollar we have, how much of that dollar are we going to spend and how much are we going to save? So, let's say the marginal propensity to consume was 0.8. That would mean that if you had one more dollar, you'd spend 80 cents out of that dollar and save 20 cents of that dollar. So what we do is the marginal propensity to consume times our disposable income, which we'll say is \( YD \), disposable income.

Now, investment, government purchases, and net exports, they're not going to have this kind of upward slope. They're just going to be constants. Okay? There's going to be a constant amount of investment, a constant amount of government purchases, and a constant amount of net exports. At least in this class, right? We're not going to make it more complicated than that. We're just going to be given a number. This is the amount of investment, this is the amount of government purchases, this is the amount of net exports.

Consumption is going to go up as there's more income, as there's more GDP, right? The more GDP there is, well there's more income being made, right? Because there's more production, there's more people being hired, more income. So consumption is related to GDP. As GDP goes up, well, consumption goes up with it. Okay? And we're going to keep the other ones constant.

Now, what happens if we have a change in one of these other ones, investment, government purchases, or net exports? We're going to have the multiplier effect, and we're going to talk about that more in other videos where we're going to see how they can be affected by the multiplier effect where a change in investment or a change in government purchases, say like a boost of $5,000,000 in investment, well, that's going to have a multiplier effect on the amount of GDP that comes out of it. Alright. We'll talk about how that looks in further videos. But for now, let's just know that those are going to be affected by the multiplier. Consumption is going to have that linear equation, and the other ones are just constants. Cool?

So this is the basics of the aggregate expenditures model, right? We're going to be looking at spending and production. Okay? So let's go ahead and look at an example, a kind of numerical example, and then we'll discuss this in more detail in the next video. Cool? Let's keep going.

Numerical Aggregate Expenditures

Alright. So let's try this numerical example of our aggregate expenditures model. So what we're going to notice here is that we've got our real GDP and we're solving for our aggregate expenditures. Notice it gives us consumption, investment, government purchases, and net exports at different levels of GDP. So why is there going to be different levels of consumption, at these different levels of GDP? Notice that the other 3 are staying constant, right? Investment, just like I said, we're going to keep these constant: investment, government purchase, and net exports are staying constant at different levels of GDP. But what about consumption? Remember, as there's more production being produced, there are more goods being produced in the economy; well, we need to hire more people. There's going to be more people making money, right? So what we're seeing is that wages are there's more income being made as GDP goes up because we're producing more stuff. So people have to be earning that money. And what did we learn about consumption? As we learn more as we earn more money, we spend more money, right? That's the consumption idea that we learned with the consumption function and that has to do with that marginal propensity to consume. So, notice here, when we went up from 16,000 to 18,000 in GDP, there was this $2,000 increase in GDP. Well, it didn't totally go up by 2,000. It didn't go from 12,400 to 14,400. No, because we earned more money, but we didn't spend it all. We saved some as well and we spent some. So that's the idea is this consumption is going to be going up but not as fast as the GDP because there's going to be some of it being saved as well.

So let's go ahead and use our consumption investment, government purchases, and net exports to calculate our aggregate expenditures. Remember, we're defining aggregate expenditures as the sum of these 4. Real GDP is what's being produced and we're worried about what's being spent. Remember, when we define GDP previously, we used an expenditures approach where we defined it as everything that's being spent, consumption, investment, government purchases, net export. So those are our aggregate expenditures in our economy. So what we want to do is find that balance between how much we should produce in the economy and how much is being spent in the economy at that level of production. So let's go ahead and check this out. Let's go ahead and calculate aggregate expenditures at these different levels. So let me grab my calculator here. And by calculator, I mean cellphone. So let's go ahead and do the first one here. At a level of real GDP of 16,000, well, there's this much consumption. 12,400 plus our investment, 3,510 plus government purchases, 3,210 minus 1,000 net exports gets us to 18,100. So notice our aggregate expenditures and real GDP are not in equilibrium here, right? They don't equal each other. There's more spending in the economy than there is production. So if we increase the production to 18,000, well, there's going to be a little more consumption because there's more money being made and we're keeping the other things constant here. So let's go ahead and see at a level of 18,000, do we reach our equilibrium? 13,700 in consumption, plus 3,510 plus 3,210 minus 1,000. That gets us to aggregate expenditures of 19,400 here. Right? 19,400. So we're still not in equilibrium. There's still more spending than there is production. So we up production again. Let's see what happens when there's $20,000 of production. We're going to have 15,000 in consumption plus 3,510 plus 3,210 minus 1,000. That gets us to 20,700. We're getting close here. Right? 20,700, but it's a little more. There's still a little more spending than there is production in the economy. Remember, we're thinking of real GDP as our production in the economy, what's being produced, and aggregate expenditures as what is being spent in the economy. Alright? So we want to match these up. Let's go ahead and try the next one. 22,000. 16,300 in consumption, +3,510, plus 3,210, minus 1,000. Well, what do you know? Eventually, it works out. How come these numbers work so well for us? Who knows? Well, this is what we got. We've got an equilibrium here at 22,000 of production. We have our equilibrium amount of aggregate expenditures as well. Okay? So, real GDP and aggregate expenditures are equal at this state. So what does that mean? Everything produced during this year at a level of 22,000 will be purchased, right, with 22,000 of spending. So, let's go ahead and round out our table here with the last one. At real GDP of 24,000, well, there's 17,600 in consumption plus 3,510 plus 3,200 minus 1,000. That's 23,300. Notice in this case, well, there's less spending, right? Now, we're at a point where there's less spending than there is production. So there are things being produced that are not being purchased. So what's happening in these first years where we're spending more than we're producing? Well, what's happening is we're digging into our inventories. Maybe in previous years, we had produced things that we hadn't sold. Well, we're going to start selling those things that had been produced previously not produced this year, produced previously, but are being sold this year. So, what's happening to our inventories? These are called unplanned changes in inventory because we didn't expect this to happen. Right? So they're unplanned changes, meaning the spending was 18,100 when real GDP was 16,000. Right? We didn't we didn't we would have produced everything that we would sell. Right? A business wants to produce just as much as they would sell. They don't want to overproduce or under-produce. They want to have just the right amount. So this would be an unplanned change and this would be minus 2,100, right? This would be the 18,100 minus what's produced of 16,000. 18,100 minus 16,000 is 2,100 that's coming out of inventories, where only 18,000 was produced. So we have an unplanned change of inventory of 1,400 in this case, right? 1,400 worth of goods are being pulled out of inventories and in the next case, what we're still spending more than we're producing. So again, we're pulling out of inventory 700. Now, in our equilibrium, look what happens. We bought everything that was produced this year, So there's no change in inventory. We're in equilibrium. We're selling everything that was produced. And finally, in the final case, well, they're producing more than they're spending. Right? The production is more than the spending. So they produce things that were not sold. So those things that were not sold are going to be in our inventories now. So there's an unplanned increase in inventories in this case. So what does that matter? How does this idea of the inventory, the unplanned changes of these inventories, how does that work into this model? Well, let's think about our equilibrium first. When we're in equilibrium down here, if Aggregate Expenditures equals GDP, right? Our equilibrium, Well, this means that inventories do not change, right? Just like we saw there in our example, everything produced is sold and the economy is in equilibrium. But if we're not in equilibrium, we're going to be moving towards our equilibrium. Things are going to start adjusting in the economy to try and make our way to equilibrium. So in this first case, if aggregate expenditures are less than GDP. So what's happening in this situation? Remember, aggregate expenditures are spending and this is production. Right? So production is more, right? That what we purchased is not everything that was produced like in this final case where there's 24,000 produced, 23,300 spent. Right? So there's more being produced. Well, inventories increase in this case, right? Because not everything was sold. So what happens if these inventories increase? Well, in future years, we're not going to need to produce that inventory. Right? It's already being produced this year. So what's going to happen to GDP and employment? Well, they're going to decrease in future years. In future years, the economy is gonna start to adjust and it we're gonna lay people off. We're like, hey, we've got too much inventory. We don't need people producing more stuff. We've already got inventories left over. So, there'll be less employment, less GDP leading to a decrease trying to find that equilibrium level, right? Because the economy is always going to be adjusting to find equilibrium there. So in this case, the purchases are less than production, right? So the opposite happens in these first few examples, 16,000, 18,000. In these cases, the spending is more than GDP, right? The spending is more than what's being produced. So in these cases, the inventories decrease, right? We're pulling things that were produced in previous years and we're selling them this year. So in this case, let me get out of the way. So in this case, what's going to happen to GDP and employment? Well, we're going to see the firms are seeing that their inventories are falling. There's a bunch of purchases being made. They're going to increase their production. And when they increase their production, they're increasing GDP. And to do that, they're going to need to hire more people. Right? So in those cases, it's increasing while we're finding our equilibrium GDP. So purchases in this case are more than production. I wrote less than then production. So purchases are less than production. Purchases are more than production in that case. Okay. So this is how the aggregate expenditures model works. We're trying to find the equilibrium between what's being produced in the economy and what's being purchased, right? The spending in the economy, those aggregate expenditures. Cool? So 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 macroeconomics?

The aggregate expenditures model (AE model) in macroeconomics illustrates the relationship between total spending (aggregate expenditures) and production (GDP) in an economy. It emphasizes that the level of GDP in any given year is determined by the amount of spending by consumers, businesses, and the government. The key components of aggregate expenditures are consumption, investment, government purchases, and net exports. In equilibrium, aggregate expenditures equal real GDP, meaning that the total spending in the economy matches the total production. This model helps in understanding economic fluctuations and the impact of fiscal policies.

How do you calculate aggregate expenditures?

Aggregate expenditures (AE) are calculated using the formula:

$\mathrm{AE}=C+I+G+\mathrm{NX}$

where:

• $C$ is consumption
• $I$ is investment
• $G$ is government purchases
• $\mathrm{NX}$ is net exports (exports minus imports)

These components together represent the total spending in an economy. In equilibrium, aggregate expenditures equal real GDP, indicating that the total spending matches the total production in the economy.

What is the marginal propensity to consume (MPC) and how does it affect aggregate expenditures?

The marginal propensity to consume (MPC) is a measure of how much additional income is spent on consumption. It is defined as the change in consumption divided by the change in disposable income:

$\mathrm{MPC}=\frac{\mathrm{\Delta C}}{\mathrm{\Delta Y}}$

where $\mathrm{\Delta C}$ is the change in consumption and $\mathrm{\Delta Y}$ is the change in disposable income. A higher MPC means that a larger portion of additional income is spent, which increases aggregate expenditures. This relationship is crucial in the AE model, as higher consumption leads to higher total spending, driving production and GDP.

What is the multiplier effect in the context of the aggregate expenditures model?

The multiplier effect refers to the phenomenon where an initial change in spending (such as investment or government purchases) leads to a larger overall change in GDP. This occurs because the initial spending creates income for others, who then spend a portion of that income, creating further income and spending in a virtuous cycle. The size of the multiplier is determined by the marginal propensity to consume (MPC) and is calculated as:

$\mathrm{Multiplier}=\frac{1}{1-\mathrm{MPC}}$

For example, if the MPC is 0.8, the multiplier would be 5, meaning that an initial $1 increase in spending would ultimately increase GDP by $5.

How do changes in government purchases affect the aggregate expenditures model?

Changes in government purchases directly affect the aggregate expenditures (AE) in the economy. An increase in government purchases raises total spending, which, according to the AE model, leads to an increase in GDP. This is because higher government spending creates income for businesses and individuals, who then spend a portion of that income, further increasing aggregate expenditures. This process is amplified by the multiplier effect, where the initial increase in spending leads to a larger overall increase in GDP. Conversely, a decrease in government purchases would reduce total spending and GDP.