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LECTURE NOTES CHAPTER 11
I. Introduction—What Determines GDP?
A. Learning objectives – After reading this chapter, students should be able to:
- Explain how sticky prices relate to the aggregate expenditures model.
- Explain how an economy's investment schedule is derived from the investment demand
curve and an interest rate.
- Illustrate how economists combine consumption and investment to depict an aggregate
expenditures schedule for a private closed economy and how that schedule can be used to
demonstrate the economy's equilibrium level of output (where the total quantity of goods
produced equals the total quantity of goods purchased).
- Discuss the two other ways to characterize the equilibrium level of real GDP in a private
closed economy: saving = investment; and no unplanned changes in inventories.
- Analyze how changes in equilibrium real GDP can occur in the aggregate expenditures
model and how those changes relate to the multiplier.
- Explain how economists integrate the international sector (exports and imports) into the
aggregate expenditures model.
- Explain how economists integrate the public sector (government expenditures and taxes)
into the aggregate expenditures model.
- Differentiate between equilibrium GDP and full-employment GDP and identify and
describe the nature and causes of recessionary expenditure gaps and inflationary
expenditure gaps.
B. This chapter focuses on the aggregate expenditures model. We use the definitions and facts
from previous chapters to shift our study to the analysis of economic performance. The
aggregate expenditures model is one tool in this analysis. Recall that “aggregate” means total.
C. As explained in this chapter’s Last Word, the model originated with John Maynard Keynes
(Pronounced “Canes”).
D. The focus is on the relationship between income and consumption and savings.
E. Investment spending, net exports, and government purchases, important parts of aggregate
expenditures are also examined.
F. Finally, these spending categories are combined to explain the equilibrium levels output and
employment in at first a private (no government), domestic (no foreign sector) economy.
Therefore, GDP=PI=DI in this very simple model.
G. The revised model adds realism by including the foreign sector and government in the
aggregate expenditures model.
II. Assumptions and Simplifications
A. Keynes developed the aggregate expenditures model during the Great Depression because
previous economic theory predicted that prices would fall to boost spending and move the
economy to full-employment.
- Prices did not fall sufficiently during the Great Depression.
- Keynes’ model is based on fixed prices and the adjustment of employment and GDP to
economic shocks when prices are inflexible.
B. We first assume a “closed economy” with no international trade.
C. Government is ignored.
D. Although both households and businesses save, we assume here that all saving is personal.
E. Depreciation and net foreign income are assumed to be zero for simplicity.
F. There are two reminders concerning these assumptions.
- They leave out two key components of aggregate demand (government spending and
foreign trade), because they are largely affected by influences outside the domestic market
system.
- With no government or foreign trade, GDP, personal income (PI), and disposable income
(DI) are all the same.
III. Consumption and Investment Schedules
A. The theory assumes that the level of output and employment depend directly on the level of
aggregate expenditures. Changes in output reflect changes in aggregate spending.
B. In a closed private economy the two components of aggregate expenditures are consumption
and gross investment.
C. The consumption schedule was developed in Chapter 10 (see Figure 10 .2a).
D. In addition to the investment demand schedule, economists also define an investment
schedule that shows the amounts business firms collectively intend to invest at each possible
level of GDP or DI.
- In developing the investment schedule, it is assumed that investment is independent of the
current income. The line I g
(gross investment) in Figure 11.1b shows this graphically
related to the level determined by Figure 11.1a.
- The assumption that investment is independent of income is a simplification, but will be
used here.
- Figure 11.1a shows the investment schedule from GDP levels given in Table 8.1.
IV. Equilibrium GDP: C+Ig = GDP
A. Look at Table 11.2, which combines data of Tables 10.1 and 11.1.
B. Real domestic output in column 2 shows ten possible levels that producers are willing to offer,
assuming their sales would meet the output planned. In other words, they will produce $
billion of output if they expect to receive $370 billion in revenue.
C. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount
of consumption and planned gross investment spending (C + I g
) forthcoming at each output
level.
- Recall that consumption level is directly related to the level of income and that here income
is equal to output level.
- Investment is independent of income here and is planned or intended regardless of the
current income situation.
D. Equilibrium GDP is the level of output whose production will create total spending just
sufficient to purchase that output. Otherwise there will be a disequilibrium situation.
- In Table 11.2, this occurs only at $470 billion.
- At $410 billion GDP level, total expenditures (C + I g
) would be $425 = $405(C) + $20 (I g
and businesses will adjust to this excess demand (revealed by the declining inventories) by
stepping up production. They will expand production at any level of GDP less than the
$470 billion equilibrium.
- The “initial change” represented in the text and Figure 11.3 is in planned investment
spending. It could also result from a non-income-induced change in consumption.
- The multiplier in Figure 11.3 is 4 (=1/MPS)
B. Figure 11.3 shows the impact of changes in investment. Suppose investment spending rises
(due to a rise in profit expectations or to a decline in interest rates).
- Figure 11.3 shows the increase in aggregate expenditures from (C + I g
) 0 to (C + I g
) 1. In
this case, the $5 billion increase in investment leads to a $20 billion increase in equilibrium
GDP.
- Conversely, a decline in investment spending of $5 billion is shown to create a decrease in
equilibrium GDP of $20 billion to $450 billion.
VII. International Trade and Equilibrium Output
A. Net exports (exports minus imports) affect aggregate expenditures in an open economy.
Exports expand and imports contract aggregate spending on domestic output.
- Exports (X) create domestic production, income, and employment due to foreign spending
on Canadian produced goods and services.
- Imports (M) reduce the sum of consumption and investment expenditures by the amount
expended on imported goods, so this figure must be subtracted so as not to overstate
aggregate expenditures on Canadian produced goods and services.
B. The net export schedule (Table 11.3):
- Shows hypothetical amount of net exports (X - M) that will occur at each level of GDP
given in Table 11.2.
- Assumes that net exports are autonomous or independent of the current GDP level.
- Figure 11.4b shows Table 11.3 graphically.
a. Xn1 shows a positive $5 billion in net exports.
b. Xn2 shows a negative $5 billion in net exports.
C. The impact of net exports on equilibrium GDP is illustrated in Figure 11.4a.
- Positive net exports increase aggregate expenditures beyond what they would be in a closed
economy and thus have an expansionary effect. The multiplier effect also is at work. In
Figure 11.4a we see that positive net exports of $5 billion lead to a positive change in
equilibrium GDP of $20 billion (to $490 from $470 billion). This comes from Table 11.
and Figure 11.3.
- Negative net exports decrease aggregate expenditures beyond what they would be in a
closed economy and thus have a contractionary effect. The multiplier effect also is at work
here. In Figure 11.4a we see that negative net exports of $5 billion lead to a negative
change in equilibrium GDP of $20 billion (to $450 from $470 billion).
D. Global Perspective 11.1 shows 2012 net exports for various nations.
E. International economic linkages:
- Prosperity abroad generally raises our exports and transfers some of their prosperity to us.
(Conversely, recession abroad has the reverse effect.)
- Tariffs on Canadian products may reduce our exports and depress our economy, causing
us to retaliate and worsen the situation. Trade barriers in the 1930s contributed to the Great
Depression.
- Depreciation of the dollar lowers the cost of Canadian goods to foreigners and encourages
exports from Canada while discouraging the purchase of imports in Canada. This could
lead to higher real GDP or to inflation, depending on the domestic employment situation.
Appreciation of the dollar could have the opposite impact.
VIII. Adding the Public Sector
A. Simplifying assumptions are helpful for clarity when we include the government sector in our
analysis. (Many of these simplifications are dropped in Chapter 11, where there is further
analysis on the government sector.)
- Simplified investment and net export schedules are used. We assume they are independent
of the level of current GDP.
- We assume government purchases do not impact private spending schedules.
- We assume that net tax revenues are derived entirely from personal taxes so that GDP, NI,
and PI remain equal. DI is PI minus net personal taxes.
- We assume tax collections are independent of GDP level (a lump-sum tax )
- The price level is assumed to be constant unless otherwise indicated.
B. Table 11.4 gives a tabular example of including $20 billion in government spending and Figure
11.5 gives the graphical illustration. Note that the previous section’s net export information
has also been included.
- Increases in government spending boost aggregate expenditures.
- Government spending is subject to the multiplier.
C. Table 11.5 and Figure 11.6 show the impact of a tax increase.
- Taxes reduce DI and, therefore, consumption and saving at each level of GDP.
- An increase in taxes will lower the aggregate expenditures schedule relative to the 45-
degree line and reduce the equilibrium GDP.
- Table 11.5 confirms that, at equilibrium GDP, the sum of leakages equals the sum of
injections. Saving + Imports + Taxes = Investment + Exports + Government Purchases.
D. Government purchases and taxes have different impacts.
- In our example, equal additions in government spending and taxation increase the
equilibrium GDP.
a. If G and T are each increased by a particular amount, the equilibrium level of real
output will rise by that same amount.
b. In the text’s example, an increase of $ 4 0 billion in G and an offsetting increase of $ 40
billion in T will increase equilibrium GDP by $ 4 0 billion (from $470 billion to $
billion).
- The example reveals the rationale.
a. An increase in G is direct and adds $ 4 0 billion to aggregate expenditures.
b. An increase in T has an indirect effect on aggregate expenditures because T reduces
disposable incomes first, and then C falls by the amount of the tax times MPC.
c. The overall result is a rise in initial spending of $ 4 0 billion minus a fall in initial
spending of $30 billion (.75X $ 3 0 billion), which is a net upward shift in aggregate
expenditures of $ 10 billion. When this is subject to the multiplier effect, which is 2
in this example, the increase in GDP will be equal to 2X $ 20 billion or $ 4 0 billion,
which is the size of the change in G.
IX. Equilibrium revisited
A. As demonstrated earlier, in a closed private economy equilibrium occurs when saving (a
leakage) equals planned investment (an injection).
F. The Great Depression of the 1930s was worldwide. GDP fell by 30 percent in Canada and the
unemployment rate rose to nearly 20 percent (when most families had only one breadwinner).
The Depression seemed to refute the classical idea that markets were self-correcting and would
provide full employment.
G. John Maynard Keynes in 1936 in his General Theory of Employment, Interest, and Money,
provided an alternative to classical theory, which helped explain periods of recession.
- Not all income is always spent, contrary to Say’s law.
- Producers may respond to unsold inventories by reducing output rather than cutting prices.
- A recession or depression could follow this decline in employment and incomes.
H. The modern aggregate expenditures model is based on Keynesian economics or the ideas that
have arisen from Keynes and his followers since. It is based on the idea that saving and
investment decisions may not be coordinated, and prices and wages are not very flexible
downward. Internal market forces can therefore cause depressions and government should
play an active role in stabilizing the economy.
