Question

Explain graphically the determination of equilibrium GDP for a private economy through the aggregate expenditures model. Now add government purchases (any amount you choose) to your graph, showing its impact on equilibrium GDP. Finally, add taxation (any amount of lump-sum tax that you choose) to your graph and show its effect on equilibrium GDP. Looking at your graph, determine whether equilibrium GDP has increased, decreased, or stayed the same given the sizes of the government purchases and taxes that you selected.

Short answer

Equilibrium GDP changes depend on the balance between government purchases and taxes. Increase if purchases > taxes, decrease if taxes > purchases, unchanged if equal.

Step-by-step solution

Understanding Equilibrium GDP

In the aggregate expenditures model, Equilibrium GDP is determined where aggregate expenditures equal total output (GDP). This point ensures that all output produced by firms is purchased, leading to no unplanned changes in inventory.

Graphing Aggregate Expenditures Model

Construct a graph with GDP on the x-axis and aggregate expenditures on the y-axis. Plot the 45-degree line, which represents all points where GDP equals aggregate expenditures. Now plot the aggregate expenditures line for a private economy, which will typically slope upwards due to consumption and investment.

Adding Government Purchases

Introduce government purchases into the model by drawing a new aggregate expenditures line that shifts upwards by the amount of the government spending. This shows that with government purchases, the total expenditures at each level of GDP are higher, potentially leading to a higher equilibrium GDP.

Introducing Lump-Sum Taxation

Incorporate a lump-sum tax by shifting the aggregate expenditures line downwards due to the reduction in disposable income available for consumption. This shift will partially offset the upward shift caused by government purchases, depending on the size of the tax relative to the government spending.

Finding New Equilibrium

With both government purchases and taxes included, determine the new equilibrium GDP by finding where the post-tax aggregate expenditures line intersects the 45-degree line. This point shows the level of GDP where aggregate expenditures once again match total output.

Conclusion with Graph Interpretation

If government purchases are greater than taxes, the equilibrium GDP increases. If taxes exceed government purchases, the equilibrium GDP decreases. If they are equal, equilibrium GDP remains unchanged. Check the relative shifts in your graph to determine the exact change in equilibrium GDP.

Key concepts

Aggregate Expenditures Model

The Aggregate Expenditures Model is a fundamental concept in macroeconomics. It helps to determine the equilibrium GDP, which is the level of GDP where the total amount of goods and services produced by an economy is equal to the total spending on them. In this model, aggregate expenditures include consumption, investment, government purchases, and net exports. But initially, we consider just the private economy, where expenditure is primarily from consumption and investment.

To find the equilibrium GDP in this model, we look for the level of GDP at which planned spending equals actual output. When the economy is at this point, there are no unplanned changes in inventory, meaning that businesses sell exactly what they produce. Essentially, the aggregate expenditures line on a graph should intersect with the 45-degree line, which represents all the points where GDP equals aggregate expenditures.

Government Purchases

Government purchases refer to the spending by the government on goods and services. In the context of the Aggregate Expenditures Model, introducing government purchases shifts the aggregate expenditures line upward by the amount of government spending. This is because government purchases add directly to the total demand in the economy.

Adding this component means total expenditures at any given level of GDP increase, thus potentially raising the equilibrium GDP. When the government increases its purchases, it injects additional spending into the economy, which can stimulate further economic activity. The increase in demand from government spending can lead to higher production and potentially increase the overall GDP.

Lump-Sum Taxation

Lump-Sum Taxation is a fixed amount of tax that individuals and businesses are required to pay, irrespective of their income or profit levels. In the aggregate expenditures model, lump-sum taxes influence disposable income, which is the income households have available to spend after taxes.

When a lump-sum tax is applied, it reduces the disposable income of consumers and hence, their consumption. This leads to a downward shift in the aggregate expenditures line because there is less spending at any given level of GDP. The extent of this downward shift depends on the size of the tax relative to the original level of consumption and investment. This reduction in consumption can potentially negate some of the positive effects on equilibrium GDP from government purchases.

45-Degree Line

The 45-Degree Line in economic graphs is a critical tool for understanding equilibrium in the aggregate expenditures model. This line represents all the points where the level of GDP is equal to the level of aggregate expenditures. It acts as a reference to determine equilibrium in the economy.

When you plot the 45-degree line on a graph alongside the aggregate expenditures line, the intersection point signifies the equilibrium GDP. This is the point where total output matches total spending. Therefore, if changes such as government purchases or lump-sum taxes are introduced, economists look for new intersections between the adjusted aggregate expenditures line and the 45-degree line to find the new equilibrium GDP.