## Consumption and the Aggregate Expenditures Model

Read this chapter to examine consumption and its determinants within the aggregate expenditures model. Consumption is the largest component of Aggregate Demand the United States, therefore, the factors that determine consumption, also determine the success of the economy.

### 13.2 The Aggregate Expenditures Model

#### The Aggregate Expenditures Model in a More Realistic Economy

Four conclusions emerge from our application of the aggregate expenditures model to the simplified economy presented so far. These conclusions can be applied to a more realistic view of the economy.

1. The aggregate expenditures function relates aggregate expenditures to real GDP. The intercept of the aggregate expenditures curve shows the level of autonomous aggregate expenditures. The slope of the aggregate expenditures curve shows how much increases in real GDP induce additional aggregate expenditures.
2. Equilibrium real GDP occurs where aggregate expenditures equal real GDP.
3. A change in autonomous aggregate expenditures changes equilibrium real GDP by a multiple of the change in autonomous aggregate expenditures.
4. The size of the multiplier depends on the slope of the aggregate expenditures curve. The steeper the aggregate expenditures curve, the larger the multiplier; the flatter the aggregate expenditures curve, the smaller the multiplier.

These four points still hold as we add the two other components of aggregate expenditures – government purchases and net exports – and recognize that government not only spends but also collects taxes. We look first at the effect of adding taxes to the aggregate expenditures model and then at the effect of adding government purchases and net exports.

#### Taxes and the Aggregate Expenditure Function

Suppose that the only difference between real GDP and disposable personal income is personal income taxes. Let us see what happens to the slope of the aggregate expenditures function.

As before, we assume that the marginal propensity to consume is 0.8, but we now add the assumption that income taxes take ¼ of real GDP. This means that for every additional $1 of real GDP, disposable personal income rises by$0.75 and, in turn, consumption rises by $0.60 (= 0.8 ×$0.75). In the simplified model in which disposable personal income and real GDP were the same, an additional $1 of real GDP raised consumption by$0.80. The slope of the aggregate expenditures curve was 0.8, the marginal propensity to consume. Now, as a result of taxes, the aggregate expenditures curve will be flatter than the one shown in Figure 13.7 "Plotting the Aggregate Expenditures Curve" and Figure 13.9 "Adjusting to Equilibrium Real GDP". In this example, the slope will be 0.6; an additional $1 of real GDP will increase consumption by$0.60.

Other things the same, the multiplier will be smaller than it was in the simplified economy in which disposable personal income and real GDP were identical. The wedge between disposable personal income and real GDP created by taxes means that the additional rounds of spending induced by a change in autonomous aggregate expenditures will be smaller than if there were no taxes. Hence, the multiplied effect of any change in autonomous aggregate expenditures is smaller.

#### The Addition of Government Purchases and Net Exports

Suppose that government purchases and net exports are autonomous. If so, they enter the aggregate expenditures function in the same way that investment did. Compared to the simplified aggregate expenditures model, the aggregate expenditures curve shifts up by the amount of government purchases and net exports. An even more realistic view of the economy might assume that imports are induced, since as a country's real GDP rises it will buy more goods and services, some of which will be imports. In that case, the slope of the aggregate expenditures curve would change.

Figure 13.11 "The Aggregate Expenditures Function: Comparison of a Simplified Economy and a More Realistic Economy" shows the difference between the aggregate expenditures model of the simplified economy in Figure 13.8 "Determining Equilibrium in the Aggregate Expenditures Model" and a more realistic view of the economy. Panel (a) shows an AE curve for an economy with only consumption and investment expenditures. In Panel (b), the AE curve includes all four components of aggregate expenditures.

Figure 13.11 The Aggregate Expenditures Function: Comparison of a Simplified Economy and a More Realistic Economy

Panel (a) shows an aggregate expenditures curve for a simplified view of the economy; Panel (b) shows an aggregate expenditures curve for a more realistic model. The AE curve in Panel (b) has a higher intercept than the AE curve in Panel (a) because of the additional components of autonomous aggregate expenditures in a more realistic view of the economy. The slope of the AE curve in Panel (b) is flatter than the slope of the AE curve in Panel (a). In a simplified economy, the slope of the AE curve is the marginal propensity to consume (MPC). In a more realistic view of the economy, it is less than the& MPC because of the difference between real GDP and disposable personal income.

There are two major differences between the aggregate expenditures curves shown in the two panels. Notice first that the intercept of the AE curve in Panel (b) is higher than that of the AE curve in Panel (a). The reason is that, in addition to the autonomous part of consumption and planned investment, there are two other components of aggregate expenditures – government purchases and net exports – that we have also assumed are autonomous. Thus, the intercept of the aggregate expenditures curve in Panel (b) is the sum of the four autonomous aggregate expenditures components: consumption (Ca), planned investment (IP), government purchases ( G), and net exports (Xn). In Panel (a), the intercept includes only the first two components.

Second, notice that the slope of the aggregate expenditures curve is flatter for the more realistic economy in Panel (b) than it is for the simplified economy in Panel (a). This can be seen by comparing the slope of the aggregate expenditures curve between points A and B in Panel (a) to the slope of the aggregate expenditures curve between points A′ and B′ in Panel (b). Between both sets of points, real GDP changes by the same amount, $1,000 billion. In Panel (a), consumption rises by$800 billion, whereas in Panel (b) consumption rises by only \$600 billion. This difference occurs because, in the more realistic view of the economy, households have only a fraction of real GDP available as disposable personal income. Thus, for a given change in real GDP, consumption rises by a smaller amount.

Let us examine what happens to equilibrium real GDP in each case if there is a shift in autonomous aggregate expenditures, such as an increase in planned investment, as shown in Figure 13.12 "A Change in Autonomous Aggregate Expenditures: Comparison of a Simplified Economy and a More Realistic Economy". In both panels, the initial level of equilibrium real GDP is the same, Y1. Equilibrium real GDP occurs where the given aggregate expenditures curve intersects the 45-degree line. The aggregate expenditures curve shifts up by the same amount – ΔA is the same in both panels. The new level of equilibrium real GDP occurs where the new AE curve intersects the 45-degree line. In Panel (a), we see that the new level of equilibrium real GDP rises to Y2, but in Panel (b) it rises only to Y3. Since the same change in autonomous aggregate expenditures led to a greater increase in equilibrium real GDP in Panel (a) than in Panel (b), the multiplier for the more realistic model of the economy must be smaller. The multiplier is smaller, of course, because the slope of the aggregate expenditures curve is flatter.

Figure 13.12 A Change in Autonomous Aggregate Expenditures: Comparison of a Simplified Economy and a More Realistic Economy

In Panels (a) and (b), equilibrium real GDP is initially Y1. Then autonomous aggregate expenditures rise by the same amount, ΔIP. In Panel (a), the upward shift in the AE curve leads to a new level of equilibrium real GDP of Y2; in Panel (b) equilibrium real GDP rises to Y3. Because equilibrium real GDP rises by more in Panel (a) than in Panel (b), the multiplier in the simplified economy is greater than in the more realistic one.