The Addition of Government Purchases and Net Exports

Suppose that government purchases and net exports are autonomous. If so, they enter the aggregate expenditures function in the same way that investment did. Compared to the simplified AE model, the aggregate expenditures curve shifts up by the amount of government purchases and net exports.^[1]

Figure The Aggregate Expenditures Function: Comparison of a Simplified Economy and a More Realistic Economy shows shows the difference between the AE model of the simplified economy in Figure Determining Equilibrium in the Aggregate Expenditures Model and a more realistic view of the economy. Panel (a) shows an AE curve for an economy with only consumption and investment expenditures. In Panel (b), the AE curve includes all four components of aggregate expenditures.

 

Figure The Aggregate Expenditures Function: Comparison of a Simplified Economy and a More Realistic Economy

 

There are two major differences between the aggregate expenditures curves shown in the two panels. Notice first that the intercept of the AE curve in Panel (b) is higher than that of the AE curve in Panel (a). The reason is that, in addition to the autonomous part of consumption and planned investment, there are two other components of aggregate expenditures – government purchases and net exports – that we have also assumed are autonomous. Thus, the intercept of the aggregate expenditures curve in Panel (b) is the sum of the four autonomous aggregate expenditures components: consumption (C a), planned investment (Ip), government purchases (G), and net exports (Xn). In Panel (a), the intercept includes only the first two components.

Second, notice that the slope of the aggregate expenditures curve is flatter for the more realistic economy in Panel (b) than it is for the simplified economy in Panel (a). This can be seen by comparing the slope of the aggregate expenditures curve between points A and B in Panel (a) to the slope of the aggregate expenditures curve between points A′ and B′ in Panel (b). Between both sets of points, real GDP changes by the same amount, $1,000 billion. In Panel (a), consumption rises by $800 billion, whereas in Panel (b) consumption rises by only $600 billion. This difference occurs because, in the more realistic view of the economy, households have only a fraction of real GDP available as disposable personal income. Thus, for a given change in real GDP, consumption rises by a smaller amount.

Key concepts

 

· The AE model relates aggregate expenditures to real GDP. Equilibrium in the model occurs where aggregate expenditures equal real GDP and is found graphically at the intersection of the aggregate expenditures curve and the 45-degree line.

· Economists distinguish between autonomous and induced aggregate expenditures. The former do not vary with GDP; the latter do.

· Equilibrium in the AE model implies that unintended investment equals zero.

· A change in autonomous aggregate expenditures leads to a change in equilibrium real GDP, which is a multiple of the change in autonomous aggregate expenditures.

· The size of the multiplier depends on the slope of the aggregate expenditures curve. In general, the steeper the aggregate expenditures curve, the greater the multiplier. The flatter the aggregate expenditures curve, the smaller the multiplier.

· Income taxes tend to flatten the aggregate expenditures curve.

Multiple Choice Test

1. Consumption is:

a) part of household income spent on the purchase of goods and services in the current period;

b) part of the income intended for the purchase of goods and services in the future period;

c) the balance of income accumulated in Bank accounts.

2. Savings are:

a) all accumulated household assets and household savings;

b) real cash balances of all market entities;

c) part of income invested in securities;

d) part of household income not spent in a given period of time.

3. Consumption and savings:

a) in total are equal to the amount of income;

b) are always more than income in the context of economic growth;

c) are always less than income;

4. The marginal propensity to save (MPS):

a) always less than 1;

b) always equal to 0;

c) equals 1.