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Aggregate Expenditure Model (Closed Economy - Coggle Diagram
Aggregate Expenditure Model (Closed Economy
Key question: what determines the level of a country's GDP, given its productive capacity
The model explains fluctuations in aggregate demand at a fixed price level by identifying the forces that determine expenditure plans (M Parkin et al Economics (8th ed, European Edition) Chapter 27 pg 638)
Aggregate planned expenditure = to the sum of the planned levels of: (1) consumption expenditure; (2) investment; (3) government expenditure on goods and services; and (4) exports minus imports
Consumption expenditure & imports change when income changes; therefore they depend on real GDP
Expenditure plans determine real GDP when the price level is fixed
Aggregate Expenditure Schedule
This schedule lists aggregate planned expenditure generated at each level of real GDP
Aggregate Expenditure Curve
Key assumption: prices are fixed (stuck-price model)
Keynes made this assumption because during 1930 prices did not decline sufficiently to boost spending & maintain output and employment at their pre-depression levels
Before Keynes' model, macroeconomics theories (classical economics theory) had said that prices would fall to equate to quantity supplied and quantity demanded. However, actual prices did not fall during the Great Depression, economy depressed way below its potential output. US real GDP declined sharply and unemployment rose to 25%. Factories were idle and gathered dust
Unplanned Inventory Adjustments: Firms react in a predictable way to unplanned increases in inventory levels. If demand unexpectedly falls, inventories will will rise more than intended
Other assumption: If inventories are unexpectedly rising, firms will cut back on production to balance production with sales and prevent inventory levels from exceeding warehouse capacity. If inventories unexpectedly fall, firms will increase production to take advantage of an unexpected good selling environment
Model developed to explain economic conditions prevailing during the Great Depression
In 1929: (1) economy was booming and there was full employment; (2) then the stock market crash happened sending businesses into a panic; (3) "animal spirits" went from bullish to bearing; (4) businesses cut back seriously on investment and production; (5) spooked consumers cut back sharply on consumption and "marginal propensity to save" rose substantially
Simplifying assumptions underlying the AE model reflect the economic conditions that prevailed during the Great Depression
Refined by the writings of Alvin H Hansen (1950's) & Paul Samuelson
Amount of Goods and services produced in an economy and the level of employment depends directly on total spending
AE Model helps us understand how the modern economy is likely to adjust to various economic shocks over shorter periods. Helps explain the 2007-2008 financial crisis led recession and 2020 Covid-19 induced recession globally
Stages of the AE Model: (1) examine aggregate expenditures and equilibrium GDP in a private closed economy (i.e. exclude both international trade and government); (2) then open the economy to exports and imports
If you exclude taxes: (1) assume that real GDP equals disposable income (DI). Also assume, that the presence of excess production capacity and unemployed labour implies an increase in aggregate expenditures will increase real output and employment without raising the price level
Consumption and Investment Schedules
Derive an economy's investment schedule from the investment demand curve and an interest rate
In private closed economy, components on aggregate expenditure: (a) consumption (C) and (b) gross investment (Ig)
Investment schedule: shows the amount business firms collectively plan to invest at each possible level of GDP
Investment demand curve: (a) current real interest rate and (b) rate of return. (Y-axis comprise expected rate of return and real interest rate (both expressed in % terms). X-axis comprise investment
Investment schedule: (a) y-axis comprise investment and (b) x-axis comprise real domestic product (GDP)
Equilibrium GDP: Consumption schedule plus investment schedule
Sum of consumption plus investment makes up aggregate expenditure schedule for the private closed economy. The schedule shows the amount (C + Ig) that will be spent at each possible output or income level
Equilibrium GDP = level of output whose production creates total spending just sufficient to purchase that output. Put differently, equilibrium GDP occurs where total quantity of goods produced (GDP) equals total quantity of goods purchased
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Originates from British economist, John Maynard Keynes ( 1936 book titled "General Theory of Employment, Interest and Money"
Also called: (1) Keynesian cross model; (2) multiplier model; or (3) aggregate expenditure-aggregate production model