Chapter 1. Aggregate Expenditures

Good job! The aggregate expenditures model explores the relationship between a country’s income and total spending. In this model, macroeconomic equilibrium is achieved where the total income line crosses the total spending line. It was initially developed by the British economist, John Maynard Keynes, and is hence referred to as the Keynesian Cross.

Incorrect. This model explores the relationship between a country’s income and total spending. Also, consider the economist who put forward this model.

Right answer! The aggregate expenditure model provides economists and policy makers with a tool to understand how various fiscal policy actions might assist in dealing with fluctuations in the economy.

Incorrect. Consider what a model that aggregates expenditure will be used to study.

Good job! A macroeconomic equilibrium is achieved when the economy’s total spending (AE in the figure) equals total income (Y in the figure). This means the economy is spending what it earns and not incurring debt or accumulating savings.

Incorrect. Macroeconomics is the study of aggregates in an economy. Consider the curves depicted in this model.

Correct. Marginal propensity to consume explains how much consumption increases with an increase in consumer income. This concept also helps us understand the extent to which one person’s spending translates into another person’s income.

Incorrect. Consider the source of funds to support consumption expenditures.

Right answer! These are the components of gross domestic product (GDP) when measured from the spending side of the economy.

Incorrect. What are the major elements of macroeconomic activity?

Right answer! Because consumption expenditures represent 70% of aggregate expenditures, it is the focus of simulative fiscal policies when the economy is experiencing a downturn or contractionary actions when the economy is overheating. This area provides policy makers the biggest bang for the buck.

Incorrect. Consider the relative sizes of the various components of aggregate expenditures.

Correct! The multiplier effect means that an initial change in spending results in a multiple effect on income, and the size of the effect is based on the marginal propensity to consume (MPC). If MPC is 80%, income grows by 5 times the initial growth in spending. The multiplier effect works to magnify the impact of both an initial growth in spending and an initial contraction in spending.

Incorrect. Consider that one person’s spending is another person’s income.

Right answer! In the aggregate expenditures model, the equilibrium occurs at a point where aggregate expenditure equals aggregate income. Hence, there is no income devoted to savings (which would reduce potential spending), or new debt being incurred (which would increase potential spending).

Incorrect. In the aggregate expenditures model, the equilibrium occurs at a point where aggregate expenditure equals aggregate income. Hence, there is no income devoted to savings (which would reduce potential spending), or new debt being incurred (which would increase potential spending).

Good job! The multiplier effect works both to expand and to contract the economy. While initial increases in spending cause greater increases in income, this phenomenon also works to decrease income by a larger amount than the initial reductions in spending due to an economic downturn.

Incorrect. The multiplier effect works both to expand and to contract the economy. While initial increases in spending cause greater increases in income, initial decreases in spending can also cause reductions in income that amount to more than the decrease in spending. The latter effect is observed during economic downturns.

Correct! Because each dollar of spending is a dollar of income for someone else, the change in aggregate expenditures due to a change in spending is determined by proportion of that income the recipient spends. In formula terms,Spending Multiplier =1/((1-MPC)), where MPC is the marginal propensity to consume.

Incorrect. Because each dollar of spending is a dollar of income for someone else, the change in aggregate expenditures due to a change in spending is determined by the proportion of that income the recipient spends. In formula terms, pending Multiplier =1/((1-MPC)) , where MPC is the marginal propensity to consume. Hence, greater the MPC, greater is the multiplier effect.

Government stimulus spending has the effect of raising the aggregate expenditures line in the aggregate expenditures model. Due to the multiplier effect, this initial increase in spending has the effect of increasing income by a greater amount that the initial increase in government spending. The increase in income counteracts to some extent the income reducing effect of the downturn.

Lower-income people have a higher marginal propensity to consume (spend rather than save), especially during periods of economic stress. Government programs, such as unemployment benefits and targeted tax cuts, that direct funds to this segment of the population have a higher multiplier than if the funds were directed at people with a lower marginal propensity to consume (save rather than spend). As a result, programs directed at low-income people have a greater impact on aggregate expenditures than if the funds were directed at another segment of the population.

When a government increases spending or reduces taxes, deficits are likely to increase. This requires the government to issue more debt. Issuing more government debt increases the ongoing interest rates. Higher interest rates make it more expensive for businesses to borrow, causing some potential investments to be financially infeasible. Hence, when Government borrowing displaces private investment by making it more expensive, it is referred to as the crowding out effect. By retarding business investment, this phenomenon has the effect of reducing the aggregate expenditures, counteracting (at least in part) the stimulating effects of government spending.