Unit 5: The Aggregate Expenditures Model (Closed Economy) Chapter 31 -…
Unit 5: The Aggregate Expenditures Model (Closed Economy) Chapter 31
Aggregate Expenditures Model History
written by economist John Maynard Keynes
The model also known as Keynesian cross model
Originated in the 1936 in the middle of the Great Depression
The model is that the amount of good and services produced and the level of employment depend directly on the level of aggregate expenditures (total spending).
A Stuck Price model:
The simplifying assumptions underpinning the aggregate expenditures model reflect the economic conditions that prevailed during the Great Depression.
The most important assumption is that price is fixed.
It is call this as the price level cannot change at all.
Keynes observed that prices did not decline sufficiently during the Great Depression to boost spending and maintain output and employment at their pre-depression levels.
Macroeconomic theories that were popular before this period predicted that prices would fall to equate quantity supplied and quantity demanded, however this did not happen during the Great Depression and the economy sank far below its potential output. Which called thousands of factories to sit idle, gathering dust and not producing anything as there was insufficient demand for their output.
Unplanned Inventory Adjustments
According to Keynes, the reason for the massive unemployment of labor and capital during the Great Depression was caused by firms reacting in a predictable way to unplanned increases in inventory levels.
Inventory is goods that have been produced but have not yet been sold.
A firm my stock up in anticipation of rapid future sales or decrease their inventory levels as they believe sales will decline in the future. However things don't always go to plan. Sometimes inventories rise or fall more than intended because demand is either unexpectedly high or low.
The Great Depression took everyone by surprise.
The model's other fundamental assumption allows it to achieve equilibrium: production decisions are made in response to unexpected changes in inventory levels.
If inventory unexpectedly rises firms will cut back on production so as to not exceed warehouse capacity and if inventory unexpectedly fail firms will increase production and take advantage of the good selling environment.
Current Relevance of AEM
The model is still relevant today as many prices in the modern economy are inflexible downward over a relatively short periods of time.
The model helps us understand how the modern economy is likely to adjust to various economic shocks over a shorter periods of time.
Example provides insights into the recession of 2007-2009 and why the decline in spending caused even larger declines in real GDP. As well as why governments stimulus programs such as tax cuts during a recession
Build up the aggregate expenditures model:
Examine aggregate expenditures and GDP in a private closed economy (businesses and households) that lacks both international trade and government.
Then examine closed economy to exports and imports as well as convert our private economy into a more realistic mixed economy that includes the government, doing this will allow us to analyze the effects of government expenditures and taxes.
Consumption and Investment Schedules
In a private closed economy: there are 2 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.
See the investment demand curve [Figure 31.1a] below (ID), the real interest rate is 8%. The firm spends $20 Billion on investment goods at both low and high levels of GDP. Figure 31.1b shows this graphically = the economy's investment schedule. Don't confuse this investment schedule (Ig) with the investment demand curve ID. The investment schedule shows the amount of investment forthcoming at each level of GDP. The interest rate and investment demand curve together determine this amount ($20 Billion)
Equilibrium GDP: C + Ig = GDP
Assume that depreciation and net foreign factor income are 0 , government is ignored and all saving occur in the household sector of the economy, then GDP as a measure of domestic output is equal to NI, PI and DI. This means that households receive a DI equal to the value of total output, real GDP
Real domestic output
Firms are willing to produce any one of these 10 levels 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. These costs are the factor payments needed to obtain the required amounts of land, labor, capital, and entrepreneurship. Column 2 lists possible levels of output (of real GDP) that a private sector might produce.
In the private closed economy, aggregate expenditure consists of
consumption (column 5) plus investments (column 5). Their sum is shown in column 6 which along with column 2 makes up the aggregate expenditures schedule for the private closed economy. This shows C + Ig that will be spent at each possible output or income level.
We are working with planned investment (column 5). This data shows the amounts that the firms intend to invest, not the amounts they actually invest if there are unplanned changes in inventories.
Equilibrium GDP occurs where the total quantity of goods produces (GDP) equals the total quantity of goods purchased.
C + Ig = GDP
Only at $470 of GDP does this equality exist in the below table and therefore spending is in balance, there is no overproduction nor is there excess total spending. In short there is no reason for this business to change its rate of production. $470 billion is the equilibrium GDP.
No lever of GDP other than the equilibrium level of GDP can be sustained. At levels below equilibrium spending exceeds GDP. A business can correct, adjust to such an imbalance between aggregate expenditure s and the real output by stepping up production. Greater output will increase employment and total income, this process will continue until equilibrium.
If levels are greater than equilibrium, 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 and resulting in a decline in output would mean fewer jobs and a decline in total income.
At any point on this line, the value of what is measured on the horizontal axis (GDP) equals the value of what is measured on the vertical axis (aggregate expenditure).
The 45 degree line is a representation of that equilibrium condition.
To graph the aggregate expenditures schedule, we duplicate the consumption schedule C in 30.2a and add it to it vertically the constant $20 billion amount of investment Ig from 31.1b. The $20 Billion is the amount firms plan to invest at all levels of GDP.
The Aggregate expenditures line C + Ig shows that total spending rises with income and output (GDP), but not as much as income rises. Consumption Line C is less than 1 and the aggregate expenditure line is parallel to C and equals MPC it is also less than 1. Therefore the slope of the aggregate expenditure line is 0.75 (=$15/$20)
The Equilibrium level of GDP occurs at the intersection of the aggregate expenditures schedule and the 45% line. This intersection locates the only point at which aggregate expenditure are equal to GDP. ($470 Billion)