How Aggregate Expenditure Models Work in Economics

Aggregate expenditure is a macroeconomic tool used to measure and evaluate the total amount of economic activity or total output within a country. Similarly to gross domestic product (GDP) and national income, aggregate expenditure evaluates the total spending of a country at a given time. Aggregate expenditure is the total value of all final goods and services in a country’s economy.

The aggregate expenditure function is AE = C + I + G + NX, which includes four main components.

1. 1. Household consumption spending (C): This determinant encompasses the total level of consumption of individuals in a household. This consumption function is determined by two types of consumer spending: autonomous consumption (also known as autonomous expenditure) and induced consumption. The autonomous consumption expenditure is considered independent of disposable income (basic living expenses, for example), while induced consumption rises as income increases.
2. 2. Investment spending (I): Investment expenditures are the total amount of money investors spend on business capital goods, including unplanned and planned investments.
3. 3. Government spending (G): Also known as government expenditure, this determinant includes government purchases at the federal, state, and local levels.
4. 4. Net exports (NX): Net exports are the difference between a country’s total exports and total imports.

The aggregate expenditure model, also known as the Keynesian cross diagram, was created by British economist John Maynard Keynes. The aggregate expenditure model centers around the short-run relationship between total spending and real GDP at a given price level. In the aggregate expenditure model, there is an aggregate expenditure curve that falls on a graph with the vertical axis, or x-axis, representing aggregate expenditures while the horizontal axis, or y-axis, represents the real GDP. Real GDP is essentially nominal GDP with adjustments for price changes and inflation.

The aggregate expenditure model includes two lines that act as guides: the 45-degree line and the potential GDP. The 45-degree line is a diagonal line that depicts the equilibrium GDP, or equilibrium level of real GDP, representing an equal level of output and expenditures. The potential GDP is a vertical line that represents an estimate of a country’s level of output if it were operating at full employment. The equilibrium point occurs where a third line representing aggregate expenditure meets with the 45-degree line.

Aggregate expenditure is a tool used to identify recessionary gaps, inflationary gaps, expectations for future interest rates, changes to the national income, and total consumption. Aggregate expenditure is also used within the aggregate demand–aggregate supply (AD/AS) model, which examines the relationship of real GDP, price level, and output.

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