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Chapter 28: The Aggregate Expenditures Model

Keynes – “In the long run, we are all dead.”

Textbook Graphs and Tables Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Assumptions of Model

1. Prices (goods, services, and resources) are stuck.

→ In the immediate short run, prices can’t react to market changes.

Average time between price changes for 350 categories of goods was 4.3 months.

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Assumptions of Model: Prices are Stuck

• Reasons:– Most markets are not perfectly competitive, which

leads to some degree of price-setting (and sticking) by producers.

– Firms:• Know that consumers prefer stable prices.• Are afraid of competitive price wars.

– Changing prices can be costly - “changing the menu price”.

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Assumptions of Model

2. Since prices are stuck, economic feedback to firms is in the form of unplanned inventory changes.

3. The economy has excess production capacity and unemployed labor.

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Equilibrium: Private, Closed Economy

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Equilibrium: Private, Closed Economy

• Equilibrium (private, closed economy):AE = C + Ig = GDP

→ Planned spending equals total production (income)

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Equilibrium: Private, Closed Economy

• By definition, actual spending always equals GDP (income): (C + Ig + unplanned inventory changes) = GDP

• But only in equilibrium does aggregate planned spending equal GDP (income):

AE = C + Ig = GDP

→ No unplanned inventory changes in equilibrium.

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Equilibrium: Private, Closed Economy

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The Multiplier effect

Increase in investment spending = $5 billion+ Second-round increase in consumer spending = MPC × $5 billion+ Third-round increase in consumer spending = MPC2 × $5 billion+ Fourth-round increase in consumer spending = MPC3 × $5 billion• • • • • • • • • • • •Total increase in real GDP = (1 + MPC + MPC2 + MPC3 + . . .) × $5 billion

= 1/(1 – MPC) * $5 billion = 1/(1 – 0.75) * $5 billion = $20 billion

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The Multiplier effect – changes in Ig

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Two Net Exports Schedules

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Aggregate Expenditures with Net Exports

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Aggregate Expenditures with Government Purchases

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Equilibrium: Mixed, Open Economy

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Taxes and Equilibrium GDP