CHAPTER 11 The Aggregate Expenditures Model

Question 1

What was Keynes’ primary goal in developing the aggregate expenditures model?

Answer 1

To explain the causes of the Great Depression and provide solutions to restore the economy.

Question 2

What is the key assumption of the aggregate expenditures model?

Answer 2

Prices are fixed, making it a “stuck-price” model.

Question 3

Why did Keynes assume prices were fixed in his model?

Answer 3

During the Great Depression, prices did not fall enough to boost spending and restore output/employment.

Question 4

How much did U.S. real GDP decline during the Great Depression, and what was the unemployment rate?

Answer 4

GDP declined by 27%, and unemployment rose to 25%.

Question 5

What happens when inventories rise unexpectedly?

Answer 5

Firms cut production to align with sales.

Question 6

What happens when inventories fall unexpectedly?

Answer 6

Firms increase production to meet higher-than-expected demand.

Question 7

Why did inventories surge during the Great Depression?

Answer 7

Households and businesses reduced spending unexpectedly.

Question 8

How did firms react to unexpected surges in inventory during the Great Depression?

Answer 8

They cut production, leading to factory shutdowns and worker layoffs.

Question 9

Why is the aggregate expenditures model still relevant today?

Answer 9

Sticky prices remain common in the modern economy, especially in the short term.

Question 10

What insights does the aggregate expenditures model provide about economic shocks?

Answer 10

It explains how unexpected declines in spending can cause larger GDP declines and supports government stimulus policies.

Question 11

What are the stages of building the aggregate expenditures model?

Answer 11

1. Private closed economy (no trade or government).
2. Open economy (with trade).
3. Mixed economy (with government).

Question 12

What assumption is made about real GDP and disposable income (DI) before taxes are introduced?

Answer 12

Real GDP equals disposable income.

Question 13

What happens when aggregate expenditures increase in an economy with excess capacity and unemployment?

Answer 13

Real output and employment rise without increasing the price level.

Question 14

What are the two components of aggregate expenditures in a private closed economy?

Answer 14

Consumption (C) and gross investment (I_g).

Question 15

How is the investment schedule different from the consumption schedule?

Answer 15

The investment schedule shows planned business investment at each GDP level, while the consumption schedule shows household spending at different income levels.

Question 16

What does the investment demand curve (ID) represent?

Answer 16

It shows the relationship between investment spending and the interest rate; higher rates generally reduce investment.

Question 17

What is the key assumption regarding planned investment in the aggregate expenditures model?

Answer 17

Planned investment is independent of current disposable income or real output.

Question 18

What happens to firms’ production when total spending is unexpectedly low?

Answer 18

Inventories rise, causing firms to reduce production.

Question 19

What is the equilibrium GDP in a private closed economy?

Answer 19

It’s the level of output where total spending (C + I₉) equals GDP.

Question 20

What is the formula for determining equilibrium GDP?

Answer 20

C + I₉ = GDP, where C is consumption and I₉ is investment.

Question 21

What does the slope of the aggregate expenditures line represent?

Answer 21

The marginal propensity to consume (MPC), showing the proportion of additional income that is spent.

Question 22

What happens when investment spending increases by $5 billion in a private closed economy?

Answer 22

The investment schedule shifts upward, increasing aggregate expenditures and raising equilibrium GDP.

Question 23

How do businesses adjust when GDP levels are above equilibrium?

Answer 23

Excess inventories lead firms to cut production.

Question 24

What are leakages and injections in the income-expenditure stream?

Answer 24

Leakages include savings (S), imports (M), and taxes (T). Injections include investment (I₉), exports (X), and government purchases (G).

Question 25

What is a recessionary expenditure gap?

Answer 25

It occurs when aggregate expenditures at the full-employment level are insufficient, resulting in lower output and unemployment.

Question 26

What is an inflationary expenditure gap?

Answer 26

It occurs when aggregate expenditures exceed the level needed for full employment, leading to demand-pull inflation.

Question 27

How do exchange rates affect net exports?

Answer 27

Depreciation of the dollar boosts exports and reduces imports, increasing net exports and GDP.

Question 28

What is the impact of government purchases on equilibrium GDP?

Answer 28

Increases in government spending raise aggregate expenditures and equilibrium GDP through the multiplier effect.

Question 29

How do taxes affect equilibrium GDP?

Answer 29

Higher taxes reduce disposable income, lowering consumption, saving, and GDP.

Question 30

What is Say’s Law, and how did the Great Depression challenge it?

Answer 30

Say’s Law states that supply creates its own demand. The Great Depression showed that inadequate spending could result in persistent unemployment.