Chapter 31: The aggregate expenditure model

Investment Schedule

To complete the analysis of aggregate expenditures, the book discusses the need to construct an investment schedule. This schedule represents the planned investment by business firms at different levels of GDP (Gross Domestic Product). It is similar to the consumption schedule but focuses on the investment plans of businesses.

T or F Equilibrium GDP is determined when total spending in the economy equals total output or GDP. In this case, it is described as C + I = GDP, where "C" represents consumption and "I" represents planned investment by firms.

True

What did Keynes think was responsible for the large amount of idle labor and capital during the Great Depression?

Unplanned inventory increases

When the current production level of goods and services leads to output levels below equilibrium GDP, it results in

a reduction of goods in inventory and too low a production rate

When the current production level of goods and services leads to output levels below equilibrium GDP, it results in ______.

a reduction of goods in inventory and too low a production rate

GDP Blank______ is the desired level of output because total spending is just sufficient to purchase total output.

at equilibrium

The two components of aggregate expenditures in a private closed economy are

consumption and gross investment

The aggregate expenditure schedule in a private closed economy is the sum of ______ plus planned ______

consumption; investment

Impact of Exports

create domestic production, income, and employment in a country. Even though the goods and services are sent abroad, foreign spending on these goods and services benefits the domestic economy. Therefore, exports are included as a component of a nation's aggregate expenditures.

Multiplier Effect

A concept that describes how an initial change in spending can have a greater impact on real output (GDP). The formula for the multiplier is: Multiplier = Change in Real GDP / Initial Change in Spending In this context, it's important to note that the size of the multiplier is inversely related to the Marginal Propensity to Consume (MPS), which is the fraction of additional income that individuals choose to spend. The formula for the multiplier in terms of MPS is: Multiplier = 1 / MPS

Exchange Rate Effects

A depreciation of the currency can boost exports and decrease imports, potentially increasing GDP. Conversely, an appreciation of the currency can have the opposite effect.

Model Building Stages

A plan to build up the Aggregate Expenditures Model in stages. It starts by examining aggregate expenditures and equilibrium GDP in a closed economy without international trade and government. It then introduces these factors and analyzes the effects of government expenditures and taxes. It also assumes that real GDP equals disposable income until taxes are introduced.

If GDP is below equilibrium, where is the aggregate expenditure schedule located on the graph?

Above the 45° line

When GDP is above equilibrium, firms will ______ the rate of production.

decrease

When the level of GDP is above the equilibrium level, businesses will respond to the unintended accumulation of unsold goods by

decreasing the rate of production

The level of GDP at which the total quantity of goods produced equals the total quantity of goods purchased is known as

equilibrium output

The level of GDP at which the total quantity of goods produced equals the total quantity of goods purchased is known as ______.

equilibrium output

In a private closed economy, consumption and gross private investment are the components of aggregate ______

expenditures

How did Keynes describe the relationship between labor, capital, and inventory during the Great Depression?

firms acted predictably to unexpected inventory levels.

planned investment

form of spending that injects money back into the economy.

A private open economy is a private economy that includes international trade but not ______ spending.

government

When the level of GDP is below the equilibrium level, businesses will respond to the unplanned decline in business inventories by

increasing output and employment

Net Exports Schedule

net exports schedule lists the amount of net exports at different levels of GDP. It can be positive (exports exceed imports) or negative (imports exceed exports). The schedule is independent of GDP in the example.

When there is overproduction of goods leading to output levels above equilibrium GDP, this results in a

piling up of unsold goods and a cutback in production rates

The amount that firms intend to invest is known as

planned investment

The amount that firms intend to invest is known as ______.

planned investment

The amounts that business firms collectively intend to invest at each level of GDP is called their

planned investment

Stuck Price Model

prices cannot change, and this assumption reflects the economic conditions prevailing during the Great Depression when prices were not declining as much as expected.

The aggregate expenditure model can be used to explain short-run adjustments in

private and public spending

Firms will produce at a given level of output if their sales _____ exceeds their production ______

revenue; cost

___ represents money withdrawn from the circular flow of income, which can potentially reduce consumption and total output

saving

Firms are willing and able to produce any level of output as long as ______.

the costs of producing the output are lower than the revenues from selling the output Reason: While this may not occur at MR=MC, firms will still realize profits (though not maximum), so long as total revenue exceeds total costs.

Equilibrium GDP:

the level of output at which total spending is exactly equal to the total production. In other words, it's the level where the economy-wide spending precisely matches the amount needed to clear the shelves of goods. In your textbook, this equilibrium is reached at $470 billion of GDP.

The level of investment spending by firms and the investment demand curve are based upon

the real interest rate Reason: Recall that the price of investment spending is the interest rate or cost of money. Just as consumer spending is driven by the price of goods and services, so is the level of investment spending given by the real interest rate, also known as the interest rate adjusted for inflation.

It is undesirable for GDP to be greater than the equilibrium level because it will lead to a(n)

Decline in output, jobs and total income

investment schedule

Denoted as "I sub g," represents the planned investment of business firms at different levels of Gross Domestic Product (GDP). The investment schedule is a straight horizontal line across the graph, indicating that businesses plan to invest a constant amount of $20 billion at all levels of real GDP. In other words, regardless of the GDP level, businesses intend to spend $20 billion on investment goods, as long as the real interest rate remains at 8 percent, as shown in the example provided in your textbook. The investment schedule is a graphical and tabular representation of the relationship between planned investment and GDP when other factors are held constant, like the interest rate.

Inclusion of Government Purchases

The model incorporates government spending (G) as an additional component alongside private consumption (C), investment (I), and net exports (Xn) in the calculation of aggregate expenditures. The assumption is that government purchases remain constant and independent of GDP.

Integration of International Trade

The passage explains how an open economy incorporates international trade, which includes exports (X) and imports (M). It emphasizes the importance of considering net exports (exports minus imports), which can be either positive or negative.

nternational Economic Linkages

The passage highlights the interdependence of economies and how changes in foreign economies and exchange rates can affect a nation's GDP. A prosperous foreign economy can increase a nation's net exports, while changes in exchange rates can impact exports and imports.

Equilibrium GDP:

This represents the point where aggregate supply (AS) equals aggregate demand (AD), showing the level of real GDP at which the economy is in balance.

The ______ helps to explain the situation of massive unemployment, as well as to better understand how an economy will react to such economic shocks as changes in tax rates as well as government and household spending.

aggregate expenditure model

If GDP is above equilibrium, the aggregate expenditure schedule is located on the graph in a position

below the 45° line

A fundamental assumption behind the Keynesian aggregate expenditure model is that prices in the economy are

fixed

When GDP is ____ than its equilibrium level, businesses will raise the rate of production, leading to more employment and consequently raising the levels of consumption and income.

lower

A private ______ economy is a private economy that includes international trade in its GDP.

open

It is undesirable for actual GDP to be less than the equilibrium level because there will be a(n)

unplanned decline in business inventories

Equilibrium GDP

"C + Ig = GDP," represents the equilibrium level of GDP in a private closed economy. This equation states that the total output of goods and services (GDP) in the economy is equal to the total spending, which is the sum of consumption (C) and planned investment (Ig).

***During the Recession: Aggregate expenditures declined, leading to a negative GDP gap. This resulted in a significant decline in real GDP and a rise in unemployment.

***Government Response: Policies were implemented to stimulate the economy by increasing aggregate expenditures through tax rebates and stimulus packages, aiming to close the recessionary expenditure gap and revive economic activity.

Which of the following are true at equilibrium GDP?

-Total quantity of goods produced equals the total quantity of goods purchased -there is no excess of total spending -there is no increase in inventories of goods

If saving exceeds planned investment at a particular level of GDP, it will result in a below-equilibrium GDP. In this scenario, total spending (C + I) will be less than GDP, which could lead to a decline in real GDP.

...

Saving and planned investment are equal (S = I) at equilibrium GDP. This means that the total amount of saving in the economy is equal to the total amount of planned investment.

...

Which of the following reflects the total amount that will be spent at each possible output or income level?

Aggregate expenditures schedule

Disequilibrium

At levels of GDP below the equilibrium GDP, spending exceeds GDP, leading to an unplanned increase in business inventories. In contrast, at levels of GDP above the equilibrium GDP, spending falls short of GDP, leading to unplanned declines in inventories. In both cases, businesses will adjust production levels to return to the equilibrium GDP of $470 billion.

Real Domestic Output

Column 2 in Table 31.2 lists different possible levels of real GDP that the private sector can produce. Firms are willing to produce a certain level of output if the revenue from selling that output covers the production costs. The costs include wages, rents, interest, and profits required to attract entrepreneurship.

The level of investment spending by firms is based upon the ______ interest rate together with the investment ______ curve

Real;demand

Current Relevance

The Keynesian Aggregate Expenditures Model is still relevant today because it explains how the modern economy adjusts to economic shocks over shorter periods of time. It helps understand why initial declines in spending can lead to even larger declines in real GDP. This has implications for government policies like stimulus programs, tax cuts, and government spending increases during economic downturns.

What is planned investment?

The amount that firms intend to invest.

What is planned investment?

The amounts that business firms collectively intend to invest at each level of GDP.

Independence of Planned Investment

The book assumes that planned investment is independent of the level of current disposable income or real output. In other words, business firms' investment decisions are not influenced by changes in current income or real output.

Consumption Schedule

The consumption schedule represents the spending plans of households at different levels of income and is typically represented in a graph.

Injections, Leakages, and Equilibrium

The equality between leakages (saving, imports, and taxes) and injections (investment, exports, and government spending) determines the equilibrium GDP. This equality is used to ensure that unplanned changes in inventories are minimal, thereby maintaining a stable level of GDP.

Investment Demand Curve

The investment schedule is derived from the investment demand curve (ID) which is shown in Figure 31.1a. The curve shows the relationship between the expected rate of return (r) and the real interest rate (i) at different levels of investment. This curve helps determine the amount of investment at various interest rates.

What is the equilibrium level of output?

The level of GDP at which the total quantity of goods produced equals the total quantity of goods purchased

Production Decisions

The model assumes that production decisions are made in response to unexpected changes in inventory levels. If inventories rise unexpectedly, firms cut back on production to balance it with sales. If inventories fall unexpectedly, firms increase production.

Assumption of Excess Capacity

The model assumes that the presence of excess production capacity and unemployed labor implies that an increase in aggregate expenditures will increase real output and employment without raising the price level. In other words, there is room for the economy to produce more without causing inflation.

Caution on Tariffs and Devaluations

The passage warns against the simplistic view that imposing tariffs and devaluing a country's currency will always lead to increased net exports and economic growth. It mentions the historical example of the Great Depression, where such actions led to retaliation and a collapse in international trade, worsening the economic situation.

Focus on Investment Schedule

The text emphasizes that changes in the investment schedule (I) are the main sources of instability in the economy. This means that variations in investment spending have a significant impact on the equilibrium GDP.

Graphical Analysis

The textbook also provides a graphical representation of the equilibrium using a 45° line. The intersection of the aggregate expenditures schedule (C + Ig) and the 45° line represents the equilibrium level of GDP.

Tabular Analysis

The textbook uses tables to illustrate the concepts. Columns 2 through 5 in Table 31.2 contain information about consumption, saving, and investment schedules. This data is used to calculate aggregate expenditures, which is the total amount spent by the private sector in the economy.

inflationary expenditure gap

This describes the situation where aggregate expenditures exceed what is necessary to achieve full employment GDP. Implications: If the economy attempts to produce above its full-employment level, it will likely face demand-pull inflation due to the limited supply of resources, particularly labor.

Full Employment GDP

This is the maximum level of real GDP an economy can produce when all its resources, especially labor, are utilized efficiently.

Recessionary Expenditure Gap:

This occurs when aggregate expenditures are insufficient to achieve full employment GDP, resulting in a gap between the actual and potential output of the economy. Solution: Keynes suggested that to close this gap and reach full employment, the government could increase spending or reduce taxes to stimulate aggregate demand.

planned investment

Denoted as "lg" in the text, refers to the amount of investment that business firms collectively intend to make at each possible level of Gross Domestic Product (GDP) in a private closed economy. In this context, it is assumed that planned investment is independent of the level of current disposable income or real output, meaning that businesses have a predetermined level of investment they intend to carry out, regardless of changes in income or output. In the example given in the text, it is stated that business firms plan to spend $20 billion on investment goods at both low and high levels of GDP. This $20 billion represents the planned investment, and it is constant across different levels of GDP in the specific scenario described in the text. Planned investment is an important concept in macroeconomics and is a key component of aggregate expenditures within an economy.

Calculation of Aggregate Expenditures:

For a private closed economy, aggregate expenditures are C + I (consumption and investment). However, in a private open economy, aggregate expenditures are calculated as C + 1/2*(X - M), taking into account net exports. This formula ensures that the value of domestic production is not overstated.

Aggregate Expenditures

In a private closed economy, aggregate expenditures are the sum of consumption (column 3) and planned investment (column 5). This total spending at each output or income level is shown in column 6. It represents the amount of money that will be spent in the economy at different output levels.

Components of Aggregate Expenditures

In a private closed economy, aggregate expenditures are the total spending within the economy. These expenditures are comprised of two main components: consumption (C) and gross investment (Ig).

Equilibrium GDP in a Closed Economy

In a private closed economy, the equilibrium GDP is achieved when total consumption (C) plus total investment (I) equals GDP. This equilibrium GDP can change in response to changes in the consumption schedule (C) or the investment schedule (I).

Impact of Imports

In an open economy, some income is spent on imports (goods and services produced abroad). To accurately measure aggregate expenditures for domestic goods and services, expenditures on imports must be subtracted from total spending.

Interest Rate and Investment

In the example, the current real interest rate is 8 percent. The book illustrates that at this interest rate, firms plan to spend $20 billion on investment goods at both low and high levels of GDP. This $20 billion investment is depicted as a horizontal line in the investment schedule, representing the amount of investment at each level of GDP.

Unplanned Inventory Adjustment

Keynes believed that the massive unemployment during the Great Depression was caused by firms reacting to unplanned increases in inventory levels. When households and businesses unexpectedly reduced their spending, it caused unsold goods to pile up in inventories. Firms couldn't sell their output fast enough, so they reduced production and sometimes shut down factories. This led to unemployment and reduced economic output.

Return to Equilibrium

Once the increase in income and saving occurs due to the initial change in spending, the economy returns to equilibrium. This means that total saving equals planned investment, and there are no unplanned changes in inventories.

Effect on Equilibrium GDP

Positive Net Exports: Positive net exports increase aggregate expenditures and GDP, shifting the equilibrium GDP higher. Negative Net Exports: Negative net exports reduce aggregate expenditures and GDP, causing equilibrium GDP to decrease.

Which of the following is the most fundamental assumption behind the Keynesian aggregate expenditure model?

Prices in the economy are fixed