Difficulty: Intermediate | Prerequisites: GDP measurement (Part 1) and basic labour/price concepts (Part 2)
Big picture: This is where macroeconomics moves from measuring the economy to modelling how it works. The AE model shows how planned spending determines short-run output. The multiplier explains why small changes in spending can have outsized effects. The AD-AS model then brings the price level into the picture and shows how the economy adjusts back to long-run equilibrium after shocks. These models are the analytical backbone of Exam 2.
The aggregate expenditure (AE) model determines short-run output at the point where planned spending equals actual output, with inventories acting as the adjustment mechanism. The spending multiplier amplifies any change in autonomous spending by a factor of 1 / (1 - MPC). The AD-AS model adds the price level, showing how demand and supply shocks move the economy in the short run and how wage adjustments bring it back to potential output in the long run.
Aggregate Expenditure (AE)
Total planned spending in the economy: AE = C + I + G + NX. In the simplest closed-economy model without government, AE = C + I.
Consumption Function
C = a + bY_d, where a is autonomous consumption (spending that happens regardless of income), b is the marginal propensity to consume (MPC), and Y_d is disposable income. Think of it as the rule that describes how much households spend at any given income level.
Marginal Propensity to Consume (MPC)
The fraction of each additional dollar of income that is spent on consumption. If MPC = 0.8, then for every extra dollar earned, 80 cents are spent.
Marginal Propensity to Save (MPS)
The fraction of each additional dollar of income that is saved. MPS = 1 - MPC.
Autonomous Consumption
The level of consumption that occurs even when income is zero. Financed by savings, borrowing, or transfers.
Planned Investment
Investment spending that firms intend to make, often treated as a fixed (exogenous) amount in simple AE models.
45-Degree Line
A line on the AE diagram where AE = Y (planned spending equals actual output). Equilibrium is where the AE curve crosses this line.
Equilibrium Output (Y)*
The level of output where planned aggregate expenditure equals actual output: AE(Y) = Y. At this point, there is no unintended change in inventories.
Unintended Inventory Change
The difference between what firms produce and what is actually purchased. It is the signal that tells firms to adjust production.
Spending Multiplier
The factor by which a change in autonomous spending is amplified into a larger change in equilibrium output. In the simplest model: Multiplier = 1 / (1 - MPC). Think of it as the ripple effect: one person's spending becomes another person's income, who then spends part of it, and so on.
Leakages
Money that exits the spending stream at each round: saving (MPS), taxes (MPT), and imports (MPM). Leakages reduce the multiplier.
Aggregate Demand (AD)
The relationship between the overall price level and the total quantity of real GDP demanded. The AD curve slopes downward.
Wealth Effect
When the price level falls, the real value of people's financial assets rises, so they spend more. One reason the AD curve slopes down.
Interest Rate Effect
When the price level falls, the demand for money drops, interest rates fall, and investment rises. Another reason AD slopes down.
Exchange Rate Effect
When the price level falls, domestic interest rates drop, the currency depreciates, and net exports rise. The third reason AD slopes down.
Short-Run Aggregate Supply (SRAS)
Upward-sloping curve showing that firms produce more when the price level rises, because some input costs (especially wages) are sticky in the short run, so higher prices mean higher profit margins.
Long-Run Aggregate Supply (LRAS)
Vertical line at potential output (Y_n). In the long run, the economy's output is determined by its factors of production and technology, not by the price level.
Recessionary Gap
The amount by which actual output falls short of potential output (Y_n - Y). Associated with unemployment above the natural rate.
Expansionary Gap
The amount by which actual output exceeds potential output (Y - Y_n). Associated with upward pressure on wages and inflation.
Stagflation
A situation where the price level rises while output falls, typically caused by a negative supply shock (SRAS shifting left).
The AE model determines short-run equilibrium output. In its full open-economy form:
AE = C + I + G + NX
The consumption function in its simplest version is C = a + bY_d, where a is autonomous consumption and b is the MPC. Planned investment is typically treated as exogenous (a fixed number). The AE curve, plotted against income (Y), has a slope equal to MPC when taxes and imports are ignored.
Equilibrium output (Y*) is the point where planned spending equals actual output: AE(Y) = Y.
On a graph, you plot the AE line and the 45-degree line (where every point satisfies AE = Y). The intersection is equilibrium. To the left of that point, AE > Y, meaning people want to buy more than is being produced. To the right, AE < Y, meaning production exceeds planned spending.
Inventories are the adjustment mechanism:
If AE > Y: inventories fall unexpectedly. Firms see shelves emptying and increase production. Output rises until AE = Y.
If AE < Y: inventories pile up unexpectedly. Firms see unsold goods and cut production. Output falls until AE = Y.
This is a short-run story. Prices are assumed to be fixed in the basic AE model.
When autonomous spending changes (say, the government increases G), the effect on equilibrium output is larger than the initial change. This is the multiplier effect.
In a simple closed economy with no taxes:
Multiplier = 1 / (1 - MPC)
If MPC = 0.8, the multiplier is 1 / (1 - 0.8) = 5. A $100 increase in G would raise equilibrium output by $500.
The logic: the government spends $100, which becomes $100 of income for someone. That person spends $80 (MPC = 0.8), which becomes income for someone else, who spends $64, and so on. The chain converges to $500.
With taxes and imports, the multiplier shrinks because there are more leakages at each round:
Multiplier = 1 / (MPS + MPT + MPM)
where MPS = marginal propensity to save, MPT = marginal tax rate, MPM = marginal propensity to import.
The general result: change in equilibrium output = Multiplier x change in autonomous spending.
Demand shocks: a change in C, I, G, or NX shifts the AE curve up or down. Through the multiplier, the effect on Y is amplified.
Supply shocks (e.g., an oil price spike) typically affect aggregate supply rather than AE. They can cause stagflation (falling output and rising prices).
Permanent vs. transitory shocks: permanent changes shift planned investment and expectations more than one-off events, potentially producing different multiplier dynamics.
Graphing: on the AE/45-degree diagram, a positive demand shock shifts the AE line up. The new equilibrium is where the shifted AE line intersects the 45-degree line.
The AD curve shows the relationship between the price level (P) and the quantity of real GDP demanded (Y). It slopes downward for three reasons:
Wealth effect: lower P raises the real value of financial assets, so consumers spend more
Interest rate effect: lower P reduces money demand, which lowers interest rates and boosts investment
Exchange rate effect: lower P and lower domestic interest rates cause the currency to depreciate, making exports cheaper and boosting net exports
Shifters of AD include changes in consumer confidence, investment spending, government purchases, net exports, and money supply.
Two curves represent supply at different time horizons:
SRAS (short-run): upward sloping. When prices rise, firms earn higher margins because wages and some input costs are sticky. They produce more.
LRAS (long-run): vertical at potential output (Y_n). In the long run, all prices and wages adjust. Output depends on the economy's productive capacity (labour, capital, technology), not on the price level.
The economy self-corrects through wage and price adjustments:
AD shifts right (positive demand shock): in the short run, both P and Y rise, creating an expansionary gap (Y > Y_n). Over time, wages and input costs rise in response to higher prices and tight labour markets. SRAS shifts left until Y returns to Y_n at a higher price level.
AD shifts left (negative demand shock): in the short run, P and Y fall, creating a recessionary gap (Y < Y_n). Over time, wages fall due to unemployment and slack. SRAS shifts right until Y returns to Y_n at a lower price level.
SRAS shifts left (negative supply shock): prices rise and output falls (stagflation). The long-run adjustment depends on whether policy intervenes or wages eventually adjust.
The key mechanism: SRAS moves, LRAS stays fixed at potential output.
Recessionary gap = Y_n - Y (actual output below potential). Unemployment is above the natural rate. The self-correcting mechanism is downward pressure on wages, which shifts SRAS right until the economy returns to Y_n.
Expansionary gap = Y - Y_n (actual output above potential). There is upward pressure on wages and inflation. The self-correcting mechanism is rising wages shifting SRAS left until the economy returns to Y_n.
On a graph: draw LRAS as a vertical line at Y_n. Show AD intersecting SRAS to the left of Y_n (recessionary) or to the right (expansionary). Then show SRAS shifting to close the gap over time.
Consumption function: C = a + bY_d (a = autonomous consumption, b = MPC)
AE equilibrium condition: AE(Y) = Y (graphically, where AE crosses the 45-degree line)
Simple spending multiplier (closed economy, no taxes): Multiplier = 1 / (1 - MPC)
Multiplier with leakages: Multiplier = 1 / (MPS + MPT + MPM)
Change in equilibrium output: Delta Y = Multiplier x Delta A (where Delta A is the change in autonomous spending)
AD slopes down because of: Wealth effect, interest rate effect, exchange rate effect
Self-correction: Recessionary gap: SRAS shifts right over time (wages fall) Expansionary gap: SRAS shifts left over time (wages rise) LRAS stays at Y_n throughout
The multiplier is central to debates about fiscal stimulus. During a recession, governments increase G precisely because the multiplier means the effect on GDP is larger than the spending itself. The size of the multiplier in practice is hotly debated and depends on leakages, the state of the economy, and how monetary policy responds.
The AD-AS framework is how economists and central banks think about inflation and output trade-offs. A supply shock like an oil price spike forces policymakers to choose: stimulate demand (which worsens inflation) or fight inflation (which deepens the output decline). Stagflation in the 1970s was a real-world example of this dilemma.
Students often think the multiplier means the government "creates money." It does not. The multiplier describes how one person's spending becomes another person's income, creating successive rounds of spending from a single initial injection.
The AE model holds prices fixed. Students sometimes try to apply price-level reasoning within the AE model. Price changes belong in the AD-AS model.
LRAS is vertical. Students sometimes draw it with a slope. In the long run, output is determined by productive capacity, not by the price level.
A leftward shift of SRAS is a negative supply shock, not a decrease in demand. Students mix these up. A supply shock raises prices and lowers output simultaneously (stagflation). A demand shock moves prices and output in the same direction.
Multiplier calculations are near-certain on the exam. Given MPC and a change in G (or I or C), compute the multiplier and the change in Y. Double-check that you are using (1 - MPC) in the denominator, not MPC.
Know how to draw the AE/45-degree diagram and show equilibrium. Be ready to shift the AE line for a demand shock and find the new Y*.
The three reasons AD slopes downward (wealth, interest rate, exchange rate effects) are a common multiple-choice or short-answer question.
Be able to distinguish SRAS from LRAS on a graph. SRAS is upward sloping, LRAS is vertical at Y_n.
The self-correction mechanism (how SRAS shifts to close recessionary and expansionary gaps) is a frequent essay or diagram question. Know the direction of the SRAS shift and what happens to the price level.
Stagflation (SRAS shifting left) is a favourite exam scenario because it produces the counterintuitive combination of rising prices and falling output.
Fill in the blank: Equilibrium in the AE model occurs where AE = ________. (Y, i.e. planned spending equals actual output.)
True or false: If AE > Y, inventories are piling up. (False, inventories are falling. Firms produce less than people want to buy.)
Fill in the blank: The simple spending multiplier equals 1 / (1 - ________). (MPC.)
True or false: LRAS is upward sloping. (False, LRAS is vertical at potential output.)
Fill in the blank: A recessionary gap means actual output is ________ potential output. (Below.)
Q: MPC = 0.8. The government increases G by 100. What is the multiplier and the change in equilibrium output?
A: Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5. Delta Y = 5 x 100 = 500.
Q: MPC = 0.75. What is the multiplier? If autonomous investment falls by 50, what happens to equilibrium output?
A: Multiplier = 1 / (1 - 0.75) = 4. Delta Y = 4 x (-50) = -200. Equilibrium output falls by 200.
Q: In the AE model, if AE < Y, what happens to inventories and how do firms respond?
A: Inventories accumulate (firms produced more than people bought). Firms respond by reducing production. Output falls until AE = Y.
Q: Name the three reasons the AD curve slopes downward.
A: The wealth effect (lower prices raise real wealth, increasing consumption), the interest rate effect (lower prices reduce money demand, lowering interest rates and boosting investment), and the exchange rate effect (lower prices and interest rates depreciate the currency, boosting net exports).
Q: AD shifts left, creating a recessionary gap. Describe the self-correction mechanism that returns the economy to long-run equilibrium.
A: With output below potential, unemployment rises above the natural rate. This puts downward pressure on wages. As wages fall, firms' costs decrease and SRAS shifts right. The economy moves back towards Y_n at a lower price level.
Q: An oil price shock shifts SRAS to the left. What happens to the price level and real GDP in the short run?
A: The price level rises and real GDP falls. This combination is called stagflation.
The multiplier depends on MPC, which ties back to the consumption function and the income approach to GDP from Part 1. The AD-AS model's treatment of unemployment connects to the labour market indicators in Part 2: a recessionary gap corresponds to an unemployment rate above the natural rate, and an expansionary gap to one below it. The CPI biases from Part 2 matter here too, because when CPI overstates inflation, policymakers using the AD-AS framework may overreact to what looks like a larger price-level increase than is really occurring.
Aggregate expenditure, AE model, consumption function, MPC, MPS, autonomous consumption, planned investment, 45-degree line, Keynesian cross, equilibrium output, unintended inventory, spending multiplier, multiplier effect, leakages, marginal propensity to consume, marginal propensity to save, marginal tax rate, marginal propensity to import, aggregate demand, AD curve, aggregate supply, SRAS, LRAS, short-run aggregate supply, long-run aggregate supply, wealth effect, interest rate effect, exchange rate effect, potential output, natural rate of output, recessionary gap, expansionary gap, self-correction, wage adjustment, stagflation, demand shock, supply shock, AD-AS model, ECO2013, macroeconomics, University of Florida, Exam 2