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.