AE Model: Private Closed Economy: Videos & Practice Problems

The aggregate expenditures model in a private closed economy focuses on the relationship between consumption and investment without government influence or international trade. In this model, aggregate expenditures equal GDP at equilibrium, represented graphically where the aggregate expenditures line intersects the 45-degree line. The consumption function starts at a base level, increasing with the marginal propensity to consume (MPC). Investment remains constant, leading to a simplified equilibrium where total spending is solely from consumption and investment, highlighting the importance of these components in determining economic output.

Private Closed Economy

The aggregate expenditures model in a private closed economy focuses on the relationship between spending and production, specifically in a context without government influence or international trade. In this simplified model, the economy consists solely of consumption and investment, as there are no government purchases or net exports. This means that all economic activity is driven by consumer spending and business investments.

In this model, the aggregate expenditures (AE) are equal to the Gross Domestic Product (GDP) at equilibrium. The consumption function plays a crucial role, starting with a base level of consumption that exists regardless of income, reflecting essential needs such as food and shelter. As income increases, consumption rises according to the marginal propensity to consume (MPC), which indicates the portion of additional income that is spent on consumption. For instance, if the MPC is 0.5, then for every additional unit of GDP, consumption increases by half that amount.

Investment is treated as a constant in this model, contributing to total spending alongside consumption. The total aggregate expenditures can be expressed as:

AE = C + I

where C represents consumption and I represents investment. In a graphical representation, the consumption function begins at a point above zero, reflecting the base consumption level, and slopes upward based on the MPC. The investment line is parallel to the consumption line but shifted upward, indicating the total aggregate expenditures.

To find the macroeconomic equilibrium, one looks for the point where the aggregate expenditures line intersects the 45-degree line on a graph, which represents where total spending equals total production. In this case, equilibrium occurs when aggregate expenditures equal 6, meaning that at this level, consumption plus investment matches the GDP of 6.

This simplified model effectively illustrates how spending in a private closed economy is determined solely by consumption and investment, providing a clear understanding of the dynamics at play in such an economic environment.

Here’s what students ask on this topic:

What is the aggregate expenditures model in a private closed economy?

The aggregate expenditures (AE) model in a private closed economy examines the relationship between total spending (aggregate expenditures) and production (GDP) without government influence or international trade. In this simplified model, aggregate expenditures equal GDP at equilibrium. The model includes only two components of spending: consumption (C) and investment (I). The consumption function starts at a base level and increases with the marginal propensity to consume (MPC). Investment remains constant. Graphically, equilibrium is found where the AE line intersects the 45-degree line, indicating that total spending equals total production.

How is the consumption function represented in a private closed economy?

In a private closed economy, the consumption function represents the relationship between consumption and disposable income. It starts at a base level of consumption, which occurs even when income is zero, to account for essential spending on necessities. The function is typically expressed as:

$C=C{0}_{}+\mathrm{MPC}\times Y{d}_{}$

where $C{0}_{}$ is the base level of consumption, $\mathrm{MPC}$ is the marginal propensity to consume, and $Y{d}_{}$ is disposable income. As income increases, consumption increases by a fraction determined by the MPC.

What is the significance of the 45-degree line in the aggregate expenditures model?

The 45-degree line in the aggregate expenditures model is significant because it represents points where aggregate expenditures (AE) equal GDP. This line helps identify the macroeconomic equilibrium, where total spending matches total production. At equilibrium, the AE line intersects the 45-degree line, indicating that the economy is in balance with no unplanned changes in inventories. This graphical representation simplifies the analysis of economic output and spending in a private closed economy.

How does investment affect the aggregate expenditures model in a private closed economy?

In a private closed economy, investment (I) is a crucial component of aggregate expenditures (AE). Unlike consumption, which varies with income, investment is typically assumed to be constant. The total aggregate expenditures are the sum of consumption (C) and investment (I), expressed as:

$\mathrm{AE}=C+I$

Investment shifts the AE line upward by a constant amount, reflecting the additional spending from firms. This shift helps determine the new equilibrium level of GDP, where the AE line intersects the 45-degree line, indicating that total spending equals total production.

What is the macroeconomic equilibrium in a private closed economy?

Macroeconomic equilibrium in a private closed economy occurs where aggregate expenditures (AE) equal GDP. This is graphically represented by the intersection of the AE line and the 45-degree line. At this point, total spending (consumption plus investment) matches total production, indicating no unplanned changes in inventories. The equilibrium condition can be expressed as:

$\mathrm{AE}=\mathrm{GDP}$

In this simplified model, equilibrium highlights the balance between spending and production, driven solely by consumption and investment without government or international trade influences.