Chapter 31 _ The Aggregate Expenditures Model _ ECON 2020.pdf - \u201cWhat determines the level of GDP given a nation\u2019s production capacity What causes

Chapter 31 _ The Aggregate Expenditures Model _ ECON 2020.pdf

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“What determines the level of GDP, given a nation’s production capacity? What causes real GDP to rise in one period and to fall in another? To provide more thorough answers to these two questions, we construct the aggregate expenditures model, which has its origins in 1936 in the writings of British economist John Maynard Keynes (pronounced “Caines”). The basic premise of the aggregate expenditures model—also known as the “Keynesian cross” model—is that the amount of goods and services produced and therefore the level of employment depend directly on the level of aggregate expenditures (total spending).” 31.1 [Assumptions and Simplifications]: Explain how sticky prices relate to the aggregate expenditures model. The most fundamental assumption behind the aggregate expenditures model is that prices in the economy are fixed. In the terminology of Chapter 26, the aggregate expenditures model is an extreme version of a sticky price model. In fact, it is a stuck-price model because the price level cannot change at all. Keynes made this simplifying assumption because he had observed that prices had not declined sufficiently during the Great Depression to boost spending and maintain output and employment at their pre-Depression levels. Such price declines had been predicted by macroeconomic theories that were popular before the Great Depression. The aggregate expenditures model therefore can help us understand how the modern economy is likely to initially adjust to various economic shocks over shorter periods of time. For example, it clarifies aspects of the severe 2007–2009 recession, such as why unexpected initial declines in spending caused even larger declines in real GDP. It also illuminates the thinking underlying the stimulus programs (tax cuts, government spending increases) enacted by the government during the recession. Let’s first look at aggregate expenditures and equilibrium GDP in a private closed economy —one without international trade or government. Then we will “open” the “closed” economy to exports and imports and also convert our “private” economy to a more realistic “ mixed economy that includes government purchases (or, more loosely, “government spending”) and taxes. In addition, until we introduce taxes into the model, we will assume that real GDP equals disposable income (DI). For instance, if $500 billion of output is produced as GDP, households will receive exactly $500 billion of disposable income that they can then consume or save. And finally, unless specified otherwise, we will assume (as Keynes did) 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. __________________________________________________________________ 31.2 [Consumption and Investment Schedules]: Explain how an economy’s investment schedule is derived from the investment demand curve and an interest rate.
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  • Spring '10
  • Macroeconomics, gross domestic product, government spending

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