aggregate expenditures model for closed economy
(excludes international trade and public sector)
(Chapter 31, pages 624 – 632) 🏁
formulated by John Maynard Keynes
use the Keynesian aggregate expenditure model
what determines the level of GDP, given a nation’s productive capacity? what causes real GDP to rise in one period and fall in the next?
Assumptions and Simplifications
"Keynesian cross" model states that the amount of goods and services produced in an economy and the level of employment depends directly on total spending (aggregate expenditures)
Prices are fixed: main assumptions of the aggregate expenditure model is that prices in the economy are fixed
GDP=DI (Disposable income, National income, Personal income are all the same )
In a private closed economy, the 2 components of aggregate expenditure are consumption (C) and Gross Investment (Ig)
Investment demand curve
r (rate of return) and i (real interest rate) (percent) vertical
Investment (billions of dollars) horizontal
Negative relationship: As interest rates decrease, borrowing demand increases
Used to derive
Investment schedule:
Investment (billions of dollars) Vertical
Real Domestic product GDP Horizontal
Add Investment schedule (Ig) and consumption (C) to get the Aggregate expenditure curve
Keynes created the aggregate expenditure model in the middle of the Great Depression hoping to explain why the Great Depression had happened and how it might be ended
"Stuck Price" model. Aggregate expenditures model is an extreme version of a sticky price model because the price level cannot change at all
Reason is prices has not declined sufficiently during the Great Depression to boost spending and main output and employment at per-Depression levels. Macroeconomics theories popular before the Great Depression has predicted prices would fall to equate quantity supplied and quantity demanded.
Unplanned inventory adjustments: Other key assumption is that production decisions are made in response to unexpected changes in inventory levels to achieve equilibrium
Current relevance: Model remains relevant because many prices in modern economy are inflexible downwards over relatively short periods of time
Why?
This is before taxes
For every $1 output produced, households receive $1
the presence of excess production capacity and unemployed labor implies that an increase in aggregate expenditure will increase real output and employment without raising price level
This means that firms will spend $20billion on investment goods at both low and high levels of GDP (The investment schedule line Ig is horizontal, at the $20billion mark on the INVESTMENT vertical axis)
Tabular analysis
(Row#) (Column 1) Possible levels of employments Milllions (Column 2) Real Domestic Output (and income) GDP=DI $ Billions (Column 3) Consumption C
(Column 4) Savings S $Billions (Column 5) Investment Ig $Billions (Column 6) Aggregate expenditure C+Ig $Billions
(Column 7) Unplanned changes in Inventories $Billions (Column 8) Tendencies of Employment Output and Income
(1) 40 | 370 | 375 | -5 | 20 | 395 | -25 | Increase
(2) 45 | 390 | 390 | 0 | 20 | 410 | -20 | Increase
(3) 50 | 410 | 405 | 5 | 20 | 425 | -15 | Increase
(4) 55 | 530 | 420 | 10 | 20 | 440 | -10 | Increase
(5) 60 | 450 | 435 | 15 | 20 | 455 | -5 | Increase
(6) 65 | 470 | 450 | 20 | 20 | 470 | 0 | Equilibrium
(7) 70 | 490 | 465 | 25 | 20 | 485 | +5 | Decrease
(8) 75 | 510 | 480 | 30 | 20 | 500 | +10 | Decrease
(9) 80 | 530 | 495 | 35 | 20 | 515 | +15 | Decrease
(10) 85 | 550 | 510 | 40 | 20 | 530 | +20 | Decrease
Real Domestic Output
Column 2 list the various possible levels of total output of real GDP that private sector might produce as long as revenue >= costs of producing it
These Costs are the factor payments needed to obtain the required amount of land, labour, capital and entrepreneurship
Aggregate Expenditures
In private closed econmoy aggregate expenditures consists of consumption (col 3) plus investments (col 5) with the sum in (col 6)
aggregate expenditures schedule
A table of numbers showing the total amount spent on final goods and final services at different levels of real gross domestic product (real GDP).
Planned investment (column 5) - amount that firms PLAN or INTEND to invest, not amounts they actually will invest if there are unplanned changes in inventories
Equilibrium GDP
The equilibrium is the output whose production creates total spending just sufficient to purchase that output.
Equilibrium GDP is where GDP = C + Ig
At levels of GDP < equilibrium : spending exceeds GDP
At levels > equilibrium : total output fail to generate the spending needed to clear shelves of goods
Graphically, a 45 degree line is where Aggregate expenditure (C + Ig) = GDP, this a graphical representation of the equilibrium condition
At equilibrium:
GDP = C+ Ig
Planned Investments (Ig) = Savings (S)
Unplanned inventories = 0
Savings is a LEAKAGE or WITHDRAWAL of spending from the economy's circular flow of income and expenditure
Investment (purchase of capital goods) is an INJECTION of spending into the income-expenditure stream.
private closed economy: Excluded International and government spending
Keynes describe the relationship between labor, capital, and inventory during the Great Depression: Firms acted predictably to unexpected inventory levels.
If aggregate expenditure schedule line is above the 45degree line:
Then GDP is below equilibrium
If aggregate expenditure schedule line is below the 45degree line:
Then GDP is above equilibrium
equilibrium GDP:
Savings and planned investment are equal.
There are no unplanned changes in inventories.
Investment is an injection of spending into the income-expenditure stream.
Saving is a withdrawal of spending from the economy's circular flow
If saving > planned investment
then C+Ip < GDP
and is above equilibrium
real GDP decreases
If saving < planned investment
then C+Ip > GDP
and is below equilibrium
real GDP increases
Multiplier: An initial change ion spending causes a bigger change in real output through the multiplier effect
Multiplier = Change in real GDP / initial Change in spending
there is a bigger change in equilibrium GDP than the change in aggregate expenditures
Multiplier = 1 / MPS
(1 / Marginal prosperity to spend)
If real rate of return on investment decreases, or if real interest rates rises, investment spending will decline
total qty of goods products = total qty of goods purchased
aggregate expenditure model can be used to explain short-run adjustments in private and public spending
private open economy: Includes International but excludes government spending
The level of investment spending by firms is based upon the REAL interest rate together with the investment DEMAND curve
NB: Actual investment equals savings at all GDP levels: Actual investment includes unplanned changes in inventories causing savings and actual investment to be equal.
As investment increases over time, GDP increases over time
The price of investment spending is the interest rate or cost of money
An investment schedule shows amount business collectively intend to invest (planned investment) at each possible level of GDP
no unplanned inventories and no unplanned investment.
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