Unit 5: Chapter 31
The Aggregate Expenditures Model
(Closed Economy)
Assumptions & Simplifications
Use of the Keynesian aggregate expenditure model
Extreme version of the Sticky Price model
Prices are fixed
Production decisions are made in response to unexpected changes in inventory levels
Unexpected rises – firms cut back production
Unexpected falls – firms increase production
Gross Domestic Product = Disposable Income
(GDP =DI)
Current Relevance
Many prices are inflexible downward over relatively short periods of time
Helps us understand how economy is likely to adjust to various economic shocks over short periods of time
Economy Types
Private Closed Economy – Households and businesses, no international trade or government
Private Open Economy – Households, businesses, and international trade, no government
Mixed Economy – Households, businesses, international trade, and government
Consumption & Investment Schedules
The investment demand curve is based upon and determined by the real rate of interest
The amounts that business firms collectively intend to invest at each level of GDP is called their planned investment
Assume that planned investment is independent of the level of current disposable income/real output
Private closed economy – two components of aggregate expenditures are consumption and gross investment
The investment schedule is the amount of investment forthcoming at each level of GDP
The level of investment spending by firms is based upon the real interest rate together with the investment demand curve
Equilibrium
Equilibrium GDP is where GDP = Consumption + Gross Investment
The total quantity of goods produced (GDP) equals the total quantity of goods purchased (C + Ig)
Disequilibrium
No level of GDP other than the equilibrium level of GDP can be maintained
GDP < Equilibrium – spending exceeds GDP, business increase output
GDP > Equilibrium –GDP exceeds spending, businesses reduce output
Other Features of Equilibrium GDP
Saving equals planned investment
Saving is a leakage of spending
Investment is an injection of spending
No unplanned changes in inventory
Firms do not change production
Slope of aggregate expenditures line, know as the Marginal Propensity to Consume (MPC)
Equilibrium level occurs at intersection of MPC and 45-degree line