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Aggregate Expenditure Model - John Maynard Keynes (Keynesian Cross) -…
Aggregate Expenditure Model - John Maynard Keynes (Keynesian Cross)
The amount of goods and services produced and the level of employment depend directly on the level of aggregate expenditure (total spending)
Assumptions & Simplifications
A "Stuck-Price" Model
Assuming all prices are fixed. Price level
CANNOT
change
During the Great depression factories sat idle and produced nothing as their were insufficient demand for their products.
Unplanned Inventory Adjustments
Inventory consists of good being produced but which have not yet been sold.
Firms may rapdily increase or decrease their inventory in anticipation of a rapid increase or decline in furture sales respectively
Sometimes inventory rise or falls more than intended because demand is unexpectedly high or unexpectedly low
Key assumption - to achieve equilibrium: Production decisions are made in response to unexpected changes in inventory levels
Current Relevance
Many prices in the modern economy are inflexible downward over relatively short periods of time
Preview
Aggregate expenditures and Equilibrium GDP in a private closed economy lacks both international trade and government
Mixed economy includes the government sector
Until we introduce taxes we assume that real GDP equals Disposable Income (DI)
We will assume that the presence of excess production capacity and unemployed labor implies that an increase in aggregate expenditure will increase real output and employment without raising the price level
Consumptions & Investment Schedules
Private closed economy - 2 components of aggregate expenditure = 1.
Consumption - C
2.
Gross Investment - Ig
Planned investment
: The amount firms plan or intend to invest
Planned investment is independent of the level of current disposable income or real output
Investment Schedule:
A curve or schedule that shows the amounts that firms plan to invest at various possible values of real gross domestic product (real GDP)
Level of investment spending is determined by the real interest rate together with the investment demand curve
If total spending is unexpectedly low in the economy, inventories will unexpectedly rise, causing firms to cut back on production. If total spending is unexpectedly high, inventories will unexpectedly fall, causing firms to increase production
Equilibrium GDP: C + Ig = GDP
Combine the investment schedule with the consumption schedule to explain equilibrium levels of output, income and employment in the private closed economy
Aggregate Expenditures
Private closed economy = consumption + investment (C + Ig)
Aggregate expenditure schedule: A table of numbers showing the total amount spent on final goods and final services at different levels of real GDP
Working with planned investment - amounts that firms intent or plan to invest not the amounts that they will actually invest if there are unplanned changes in inventories
Disequilibrium
No level of GDP other than the equilibrium level can be sustained
At all levels of GDP smaller than equilibrium level - business can adjust to such an imbalance between aggregate expenditure and real output by stepping up production. Greater output will increase employment and total income
At all levels of GDP greater than equilibrium level - Total outputs fail to generate the spending to clear the shelves of goods, unable to recover costs, businesses will cut back on production. The resulting decline in output would mean fewer jobs and a decline in total income
This process will continue until equilibrium level of GDP is reached
This process will continue until equilibrium level of GDP is reached
Real Domestic Output
Firms are willing to produce any level of output as long as the revenue that they receive from selling any particular amount of output equals or exceeds the cost of producing it
Costs are the factor payments needed to obtain the required amounts of land, labor, capital and entrepreneurship
Equilibrium GDP
The gross domestic product at which the total quantity of final goods and final services purchased is equal to the total quantity of final goods and services produced; the real domestic output at which the aggregate demand curve intersects the aggregate supply curve
C + Ig = GDP
Annual production and spending are in balance
Graphical analysis
45 degree line is a graphical representation of the equilibrium condition
Aggregate expenditure schedule is determined by adding the investment schedule to the up-sloping consumption schedule. Equilibrium GDP is determined where the aggregate expenditure schedule intersects the 45 degree line