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Course: ECON 220
Principles of Macroeconomics
Assignment
Aggregate Expenditure Determination
on National Income

Questions
1) What is aggregate expenditure?

2) Using the Aggregate expenditure framework show how
national income equilibrium is determined for the simple,
closed and open model of an economy?
3) Illustrate and explain for each of the following the likely
impact on national income equilibrium
 A fall in investment
 An increase in government spending
 An increase in the tax rate

Aggregate expenditure
Aggregate expenditure refers to the total expenditure of output by all the economic
agents, firms, households and government and forms one of the approaches to measure
gross domestic product
...
It covers spending on enormous range of
items including durable goods for example televisions and cars and non durable goods
such as food and clothing as well as personal services such as legal advice and dental
care
...
However part of
the consumer expenditure is on imports and this represents spending by the domestic
residents on goods and services abroad
...
It consist of
capital goods such as factory building and machinery as well as additions of stock of raw
materials, semi or finished goods
...

Government expenditure (G)
Government is usually an extreme spender in the economy it consists of transfer
payments or it can also be transfers of income from tax payers to those eligible such as
social security payments and family income supplements available to assist the elderly,
sick and unemployed
...
Government expenditure represents spending on real domestic output and
contributed directly to national income
...
Due to the expansion
of world trade in recent years a great amount of spending in most countries goes towards
the purchase of goods produced abroad rather than domestically
...


The outlays in the circular flow of income represents spending which leaks from the
domestic economy to the rest of the world and is consequently treated as a negative entry
in measuring total domestic spending
...
On
the other hand, domestic spending on imports and foreign spending on exports are
combined and called net exports that can either be positive or negative
...


AE = Y
AE = C + I + G + X -M
A
E1

NI Equilibrium

45 0
Y1 GDP

Real GDP

The 45 degree line in the diagram represents the level at which income must be equal to
expenditure at all times
...
This can be determined either by the
1) Circular flow of income where output = expenditure =income
...
It comprise of
two sectors:
 It is assumed that all income is spent on goods and services and the use of income
must be exactly the same amount as consumption in which C=Y and since all
income is spent on consumption Y=C
...
This leads to C+I=Y
The model consists of households which consumes produced goods and services and
which supply labour and other productive services to firms
...
Firms pay out wages and salaries in return for labour services
Household consequently have money income that they use to pay for the produced goods
and services that flows to them from firms
...
Which could be measured at any point metering the flow any where in
the circuit
...
This is a leakage of income spending from the
system and the volume of flow would dwindle and the level of national income would
fall
...
Banks and other financial intermediaries serve as the nexus
through which savings are converted into investment spending and then returned in the
income stream of the circular flow of income
...
Therefore the only
form of expenditure with the economy is consumer expenditure and investment
expenditure and the aggregate expenditure function is represented by AE=f(C+I)

The closed model
The government is added to the simple model and makes it closed in which there is
potential for a leakage of income from the new system introduced
...
Which also
causes a potential for an injection such as income back into the circular flow of income
but in the form of government spending on produced goods and services
...
The national income or expenditure is a continuous flow which can be
measured in different ways
...

In the open model the value of export and import determines the placement line along the
aggregate expenditure to equal income for instance if exports is more than imports the
aggregate expenditure functions shows AE=C+I+G+X-M occurs above the closed model
which only shows C+I+G
...


AE = Y
D
E3

C+I+G+X-M
(Open model)
C+I+G
(closed model)

C
E2
B

C+I
(S
...
At point A it occurs if consumer expenditure is only used or where AE= C
...
In the closed model the national income

equilibrium occurs at point C where real GDP is at Y3, E2
...

The likely impact on national income equilibrium due to;

Fall in investment
A lower level of national income and therefore output will induce a lower level of
investment
...


AE = Y
B
E2

C+I

A

C

E1

450
Y1

Y2

Real GDP

From the diagram above national income equilibrium occurs at point B at Y2, E2
...
However if investment falls the aggregate expenditure functions
moves from C+I to only C
...

However a fall in investment results in a fall in expenditure from E2 to E1 and a fall in
real GDP from Y2 to Y1
...
But there are also positive
and negative effects of government spending
...


Negative effects
 Due to excessive spending can lead to high inflation and rising prices as shown in
the diagram
...
As a result of government’s increased spending the economy becomes
closed model
...


An increase in taxation

An increase in tax will lead to similar series of reduction in income
...
However there are both positive and negative effects of an increase in taxes
...

 Narrows the gap between the rich and the poor
 Safeguard health example by imposing tax on cigarette and alcohol
...

 Externalities can be controlled
...

Negative effects
 Productivity declines as taxes increases as people choose to work less
...


Expenditure
AE = Y

A

C1

E1
Pivot indicates that
B
E2

taxes increase

45

C2

Real GDP
Y2
Y1
As indicated in the diagram as taxes increase the consumption line pivoted downwards
showing that consumer had less to spend or consumption expenditure had decreased
...
as
the taxes increased the consumption line pivoted and the equilibrium point move from
point A to point B the new equilibrium of expenditure at E 2 and real GDP Y2

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