The following equations relate to an open economy with a government sector. E = aggregate expenditure on…

Analyze the question: We need the aggregate expenditure equation for an open economy with a government sector. "Open" means the economy trades with other countries, so exports and imports must appear in the equation.

Concept: Aggregate expenditure on domestically produced goods is:

E = C + I + G + (X – M)

• C = household consumption
• I = investment
• G = government spending
• X = exports, which are foreign spending on our goods and so are added
• M = imports, which are spending on foreign goods and so are subtracted, because C, I and G include some spending on imported items that is not spent on domestic output
• X – M is net exports

Checking each option:

• A. E = C + I + G leaves out the foreign sector. It describes a closed economy with a government.
• B. E = C + I + G + M – X has the signs reversed. It adds imports and subtracts exports.
• C. E = C + I + G + X – M is the correct form.
• D. E = C + I + G – T + M – X is wrong on two counts. Taxes are not a direct component of expenditure (they affect disposable income, and so consumption), and the signs on M and X are reversed again.

Exam tip: Remember that the open economy equation is E = C + I + G + (X – M). Exports come in, imports go out. Whenever you see taxes (T) in an expenditure equation, be suspicious. Taxes belong in the disposable income equation, Yd = Y – T.