CHAPTER 11 The Aggregate Expenditures Model Flashcards
What was Keynes’ primary goal in developing the aggregate expenditures model?
To explain the causes of the Great Depression and provide solutions to restore the economy.
What is the key assumption of the aggregate expenditures model?
Prices are fixed, making it a “stuck-price” model.
Why did Keynes assume prices were fixed in his model?
During the Great Depression, prices did not fall enough to boost spending and restore output/employment.
How much did U.S. real GDP decline during the Great Depression, and what was the unemployment rate?
GDP declined by 27%, and unemployment rose to 25%.
What happens when inventories rise unexpectedly?
Firms cut production to align with sales.
What happens when inventories fall unexpectedly?
Firms increase production to meet higher-than-expected demand.
Why did inventories surge during the Great Depression?
Households and businesses reduced spending unexpectedly.
How did firms react to unexpected surges in inventory during the Great Depression?
They cut production, leading to factory shutdowns and worker layoffs.
Why is the aggregate expenditures model still relevant today?
Sticky prices remain common in the modern economy, especially in the short term.
What insights does the aggregate expenditures model provide about economic shocks?
It explains how unexpected declines in spending can cause larger GDP declines and supports government stimulus policies.
What are the stages of building the aggregate expenditures model?
- Private closed economy (no trade or government).
- Open economy (with trade).
- Mixed economy (with government).
What assumption is made about real GDP and disposable income (DI) before taxes are introduced?
Real GDP equals disposable income.
What happens when aggregate expenditures increase in an economy with excess capacity and unemployment?
Real output and employment rise without increasing the price level.
What are the two components of aggregate expenditures in a private closed economy?
Consumption (C) and gross investment (I_g).
How is the investment schedule different from the consumption schedule?
The investment schedule shows planned business investment at each GDP level, while the consumption schedule shows household spending at different income levels.
What does the investment demand curve (ID) represent?
It shows the relationship between investment spending and the interest rate; higher rates generally reduce investment.
What is the key assumption regarding planned investment in the aggregate expenditures model?
Planned investment is independent of current disposable income or real output.
What happens to firms’ production when total spending is unexpectedly low?
Inventories rise, causing firms to reduce production.
What is the equilibrium GDP in a private closed economy?
It’s the level of output where total spending (C + I₉) equals GDP.
What is the formula for determining equilibrium GDP?
C + I₉ = GDP, where C is consumption and I₉ is investment.
What does the slope of the aggregate expenditures line represent?
The marginal propensity to consume (MPC), showing the proportion of additional income that is spent.
What happens when investment spending increases by $5 billion in a private closed economy?
The investment schedule shifts upward, increasing aggregate expenditures and raising equilibrium GDP.
How do businesses adjust when GDP levels are above equilibrium?
Excess inventories lead firms to cut production.
What are leakages and injections in the income-expenditure stream?
Leakages include savings (S), imports (M), and taxes (T). Injections include investment (I₉), exports (X), and government purchases (G).
What is a recessionary expenditure gap?
It occurs when aggregate expenditures at the full-employment level are insufficient, resulting in lower output and unemployment.
What is an inflationary expenditure gap?
It occurs when aggregate expenditures exceed the level needed for full employment, leading to demand-pull inflation.
How do exchange rates affect net exports?
Depreciation of the dollar boosts exports and reduces imports, increasing net exports and GDP.
What is the impact of government purchases on equilibrium GDP?
Increases in government spending raise aggregate expenditures and equilibrium GDP through the multiplier effect.
How do taxes affect equilibrium GDP?
Higher taxes reduce disposable income, lowering consumption, saving, and GDP.
What is Say’s Law, and how did the Great Depression challenge it?
Say’s Law states that supply creates its own demand. The Great Depression showed that inadequate spending could result in persistent unemployment.
