Graphing Exercise: Changes in GDP

An economy will tend towards that level of GDP at which total desired spending is equal to the amount produced.  In other words, in equilibrium, GDP equals aggregate expenditures of consumption, gross investment, government spending, and net exports.  This implies that equilibrium GDP will change whenever there are changes in any of these spending components.  By implication, GDP need not reach equilibrium at a level consistent with full employment of its resources.  For example, if there is too little desired spending by consumers or businesses, GDP will fall short of its full employment level, creating a recessionary gap.

Exploration: How do changes in aggregate expenditures affect GDP?


The left side of the window shows the current level of taxes as well as the levels of each of the components of aggregate expenditures – C, Ig, G, and Xn – as they are related to the level of GDP.  The right side of the window illustrates how these expenditures are combined to form the aggregate expenditures relationship.  The consumption graph is drawn such that the marginal propensity to consume is 0.6 while investment, government spending, taxes, and net exports are each assumed to be independent of the level of GDP.  To use the graph, click on and adjust any of the sliders adjacent to Investment (I), Government expenditure (G), Net exports (Xn), Consumption expenditure (C), or Lump-sum taxes (T) graphs. These actions will be reflected in the graph as autonomous changes in Aggregate Expenditures.  Click on the Adjust Income button to bring the economy to its equilibrium GDP level; click the Reset button to restore all spending components to their original values.

  1. Total production is currently $5000 billion.  What are the current levels of Consumption, Investment, Government expenditure, taxes, and net exports?  What is the current equilibrium level of GDP? 
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  2. By how much does equilibrium GDP change if desired investment spending increases by $400 billion?  What is the value of the multiplier?  What is the value of the MPC?
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  3. Suppose the government decides to increase spending by $200 billion.  What impact will this have on equilibrium GDP?  How does this compare with a $200 billion decrease in taxes?
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  4. In 2007 and 2008, housing prices declined substantially and many people’s wealth, in the form of the value of their homes, was substantially reduced.  How might this have affected equilibrium GDP?
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  5. Suppose the economy is at equilibrium at the full employment level of GDP of $5000 billion, labeled as Y* in the graph.  Further suppose that a fall in consumer confidence dropped consumption spending by $400 billion.  How large a recessionary expenditure gap would be created?  What policies might restore the economy to full employment?
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  6. Experiment on your own.  What conclusions can you draw about the relationship between levels of the components of aggregate expenditure and equilibrium GDP?
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