The aggregate expenditures model illustrates the relationship between total spending in the economy and the production of goods and services, represented by real GDP. The goal is to identify the macroeconomic equilibrium, where aggregate expenditures (AE) equal GDP. Aggregate expenditures are calculated as the sum of consumption (C), investment (I), government purchases (G), and net exports (NX), which can be expressed as:
AE = C + I + G + NX
Consumption is influenced by disposable income (YD) and is characterized by a base level of consumption (A) plus a marginal propensity to consume (MPC), which indicates the fraction of additional income that is spent. The consumption function can be represented as:
C = A + MPC × YD
In this model, even without income, there is a baseline consumption level. As income increases, consumption rises proportionally based on the MPC. For example, if the base consumption is 2 and the MPC is 0.5, then for every additional dollar earned, half is spent on consumption.
To graph the aggregate expenditures model, the vertical axis represents aggregate expenditures, while the horizontal axis represents GDP (Y). A crucial element of this graph is the 45-degree line, which indicates points where aggregate expenditures equal GDP. Any point along this line signifies macroeconomic equilibrium.
When plotting the consumption function, the initial point starts at the base consumption level. As income increases, the consumption line rises, reflecting the MPC. Adding investment, government purchases, and net exports shifts the consumption line upward, creating a new aggregate expenditures line. Each component contributes to the total spending in the economy without altering the slope of the line, which remains constant due to the MPC.
The final aggregate expenditures line is determined by the equation:
AE = (A + I + G + NX) + MPC × Y
To find the macroeconomic equilibrium, one must identify where the aggregate expenditures line intersects the 45-degree line. This intersection indicates the level of GDP at which total spending matches production. For instance, if the intersection occurs at a GDP of 8,000,000,000, this signifies that at this level of spending, the economy is in equilibrium, with both aggregate expenditures and GDP equal to 8,000,000,000.
In summary, the aggregate expenditures model provides a framework for understanding how various components of spending interact to determine the overall economic equilibrium, emphasizing the importance of the 45-degree line as a visual representation of balance between spending and production.
