Question

Depict graphically the aggregate expenditures model for a private closed economy. Now show a decrease in the aggregate expenditures schedule and explain why the decline in real GDP in your diagram is greater than the decline in the aggregate expenditures schedule. What term is used for the ratio of a decline in real GDP to the initial drop in aggregate expenditures?

Short answer

The graphical illustration of the aggregate expenditure model for a private closed economy is as follows:

A decline in aggregate expenditure schedule impacts the aggregate expenditure curve in the following manner:

The decline in the GDP from Y to Y’ is greater than the decline in the aggregate expenditure because of the multiplier effect.

The ratio for the decline in the real GDP to an initial fall in spending is referred to as the multiplier effect.

Step-by-step solution

Step 1. Graphical analysis aggregate expenditure

In a private closed consumption expenditure and gross investment, expenditure generates aggregate expenditure. The aggregate expenditure model studies the relationship between aggregate expenditure and the output of an economy.

In the above graph, the aggregate expenditure increases as real domestic output increases. The aggregate expenditure makes equilibrium with the GDP as the AE curve intersects the 45˚ line at the Y level of Real GDP.

Step 2. The decline in aggregate expenditure

When aggregate expenditure decreases, the AE curve shifts downward, making a new equilibrium with the real domestic output at Y’ level.

The fall in GDP is greater than the fall in aggregate expenditure due to the multiple effects initiated by initial reduced spending.

For example, a fall in consumption reduces the demand for goods, which reduces the demand for investment and thus leads to a reduction in investment expenditure as well. The effect increases further, and the fall in final GDP is higher than the initial fall in consumption spending.

Step 3. The ratio of change in GDP to changes in aggregate expenditure

It can be concluded from the above graph that a change in initial total spending induced a larger change in real GDP.

$k=\frac{∆realGDP}{∆initialspending}$

This is called the multiplier effect (k).