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Unit 5: The Aggregate Expenditures Model - Coggle Diagram
Unit 5: The Aggregate Expenditures Model
Assumptions and Simplifications
Keynes created the aggregate expenditures model in the middle of the Great Depression, hoping to explain both why the Great Depression had happened and how it might be ended.
Unplanned Inventory Adjustments
The Great Depression’s massive unemployment of labor and capital was caused by firms reacting in a predictable way to unplanned increases in inventory levels.
Households and businesses unexpectedly reduced their spending, which caused inventories of unsold goods to unexpectedly surge.
Firms could not sell output fast enough to prevent inventories from continuing to pile up. So they greatly reduced their rates of production, in some cases shutting down factories completely until inventory levels declined.
Reduced production brought with it discharged workers, idle factory lines, and, in some cases, shuttered factories gathering dust.
The model’s other key assumption—the one that allows it to achieve equilibrium—is that production decisions are made in response to unexpected changes in inventory levels.
Current Relevance
The Keynesian aggregate expenditures model remains relevant today because many prices in the modern economy are
inflexible downward
over relatively short periods of time.
The aggregate expenditures model therefore helps us understand how the modern economy is likely to adjust to various economic shocks over shorter periods of time.
It illuminates the thinking underlying the federal government’s stimulus programs (tax cuts, government spending increases, lower interest rates) during the recession.
A “Stuck Price” Model
The most important assumption is that prices are fixed. It is a stuck-price model because the price level cannot change at all.
The simplifying assumptions underpinning the aggregate expenditures model reflect the economic conditions that prevailed during the Great Depression.
Keynes made this simplifying assumption because he had observed that
prices had not declined sufficiently
during the Great Depression
to boost spending and maintain output and employment
at their pre-Depression levels.
Thousands of factories sat idle, gathering dust and producing nothing because there was insufficient demand for their output.
Consumption and Investment Schedules
In the private closed economy, the two components of aggregate expenditures are consumption, C, and gross investment, Ig.
To add the investment decisions of businesses to the consumption plans of households, we need to construct an investment schedule showing the amounts business firms collectively intend to invest—their
planned investment
—at each possible level of GDP.
A investment schedule represents the investment plans of businesses in the same way the consumption schedule represents the consumption plans of households.
When developing the investment schedule, we will assume that planned investment is independent of the level of current disposable income or real output.
The investment schedule shows the amount of investment forthcoming at each level of GDP.
The interest rate and investment demand curve together determine the Gross Investment (Ig) level.
Equilibrium GDP: C + Ig = GDP
Real Domestic Output
The various possible levels of total output—of real GDP—that the private sector might produce.
Firms are willing to produce output just as long as the revenue that they receive from selling any particular amount of output equals or exceeds the costs of producing it.
Those costs are the factor payments needed to obtain the required amounts of land, labor, capital, and entrepreneurship.
Aggregate Expenditures
In the private closed economy, aggregate expenditures consist of consumption plus investment.
Their sum, along with the Real Domestic Output column makes up the
aggregate expenditures schedule
for the private closed economy. This schedule shows the amount (C + Ig) that will be spent at each possible output or income level.
Equilibrium GDP
The equilibrium output is the output whose production creates total spending just sufficient to purchase that output. The equilibrium GDP occurs where the total quantity of goods produced (GDP) equals the total quantity of goods purchased (C + Ig):
C + Ig = GDP
Disequilibrium
No level of GDP other than the equilibrium level of GDP can be sustained.
At levels of GDP less than equilibrium, spending always exceeds GDP. But businesses can adjust to such an imbalance between aggregate expenditures and real output by stepping up production.
At all levels of GDP greater than the equilibrium level, businesses will find that these total outputs fail to generate the spending needed to clear the shelves of goods. Being unable to recover their costs, businesses will cut back on production.