Question

Derive the aggregate demand curve from an aggregate expenditures diagram. Explain how aggregate demand relates to aggregate expenditures.

Short answer

Answer: Aggregate demand and aggregate expenditures are closely related, as changes in aggregate expenditures directly influence the equilibrium level of real GDP, which in turn affects the aggregate demand curve. When aggregate expenditures increase (due to an increase in any of the components: C, I, G, or NX), the equilibrium level of real GDP will increase, causing a shift in the aggregate demand curve to the right. Conversely, when aggregate expenditures decrease, the aggregate demand curve will shift to the left. Thus, the aggregate demand curve can be derived from the aggregate expenditures model, and any changes in aggregate expenditures will affect the position of the aggregate demand curve.

Step-by-step solution

Understand the Aggregate Expenditures Model

The aggregate expenditures model is used to understand the relationship between total spending in an economy, primarily made up of four components: consumption (C), investment (I), government spending (G), and net exports (NX). The aggregate expenditure equation can be represented as: AE = C + I + G + NX Next, let's analyze each component of aggregate expenditures.

Analyze Consumption (C)

Consumption refers to the spending by households on goods and services. The consumption function (C) in the aggregate expenditures model is primarily determined by disposable income and the marginal propensity to consume (MPC). C = C_o + (MPC × DisposableIncome) Where: C_o is the autonomous consumption or the consumption amount when disposable income is zero MPC is the marginal propensity to consume (fraction of extra income spent on consumption).

Analyze Investment (I)

Investment spending, denoted by "I," refers to businesses purchasing capital goods or investing in new projects. Investment spending can be affected by factors like interest rates, expectations about the future, and the overall economic climate. In the aggregate expenditures model, we typically treat investment as a fixed value and don't specifically model its determinants.

Analyze Government Spending (G) and Net Exports (NX)

Government spending (G) refers to expenditures by the government on goods and services. In the aggregate expenditures model, government spending is also treated as a fixed value. Net exports (NX) represent the difference between the value of goods and services exported and the value of goods and services imported. Net exports can be influenced by factors like exchange rates, domestic and foreign incomes, and trade policies. For simplicity, we generally treat both government spending (G) and net exports (NX) as fixed values in the aggregate expenditures model.

Deriving the Aggregate Demand Curve

When the economy reaches equilibrium, the total spending or aggregate expenditures (AE) is equal to the total output or real GDP (Y). Equilibrium: AE = Y Substitute the aggregate expenditures components into the equation: Y = C + I + G + NX From step 2, we know that: C = C_o + (MPC × DisposableIncome) So we can substitute this into the aggregate demand function to obtain: Y = (C_o + (MPC × DisposableIncome)) + I + G + NX This equation represents the aggregate demand curve in terms of its components. The curve shows the relationship between the price level and the quantity of real GDP demanded when the economy is in equilibrium.

Relationship between Aggregate Demand and Aggregate Expenditures

The aggregate demand curve shows the quantity of goods and services demanded when the economy is in equilibrium, while aggregate expenditures represent the total spending in the economy. Both terms are closely related, as changes in aggregate expenditures directly influence the equilibrium level of real GDP, which in turn affects the aggregate demand curve. When aggregate expenditures increase (due to an increase in any of the components: C, I, G, or NX), the equilibrium level of real GDP will increase, causing a shift in the aggregate demand curve to the right. Conversely, when aggregate expenditures decrease, the aggregate demand curve will shift to the left. Thus, the aggregate demand curve can be derived from the aggregate expenditures model, and any changes in aggregate expenditures will affect the position of the aggregate demand curve.

Key concepts

Aggregate Expenditures Model

At the heart of macroeconomic analysis is the aggregate expenditures model. This model encapsulates the total amount of spending by various sectors within an economy. It considers consumer spending, investments by businesses, government expenditures, and the net effect of exports and imports (net exports). The equation is given by:

AE = C + I + G + NX

Where AE represents aggregate expenditures, C is consumption by households, I is investment by businesses, G is government spending, and NX is net exports.The beauty of the aggregate expenditures model lies in its simplicity and power in explaining economic output and employment levels. By examining each component, economists can dissect the complex web of economic activity to understand how changes in spending behavior impact overall economic performance. For instance, a rise in government spending can stimulate the economy by increasing AE, while a decline in consumer confidence might decrease consumption and AE, leading to a contraction.

Consumption Function

The consumption function is a keystone within the aggregate expenditures model. It expresses the idea that household consumption is dependent on disposable income. Notably, the relationship can be articulated with the formula:

C = C_o + (MPC \times DisposableIncome)

In this context, \(C_o\) stands for autonomous consumption, which is the level of expenditure that would occur even if households had no disposable income. The term MPC, or marginal propensity to consume, is pivotal here. It's a ratio that indicates what fraction of additional income will be spent on consumption. For example, if MPC is 0.8, then for every extra dollar of income, 80 cents will go toward consumption.Understanding the consumption function helps in predicting how changes in income levels affect consumer spending patterns. This is crucial for businesses in planning their production and for governments in crafting fiscal policy.

Marginal Propensity to Consume

Delving deeper into consumer behavior, we encounter the marginal propensity to consume (MPC). This measure is vital for grasping how households are likely to adjust spending with changes in income. Defined simply, MPC is the portion of additional income that is spent on consumption rather than being saved.

Consider an example where if an individual receives an extra \(100, and they spend \)70 on new goods and services, the MPC would be 0.7. It's important to note that MPC varies across different income levels, societies, and over time. An understanding of MPC is not only academically interesting but has practical implications in predicting consumer behavior in response to policies like tax cuts or cash transfers from the government. Economically, a high MPC indicates a greater likelihood of increased aggregate demand with rising incomes, driving economic growth.