sg11 - 11 The Income-Expenditure Model Chapter Summary The...

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11 The Income-Expenditure Model Chapter Summary The model we develop in this chapter is called the income-expenditure model, sometimes referred to as the Keynesian cross . The model was developed by the economist John Maynard Keynes in the 1930s. This chapter will primarily use graphical tools to explain the income-expenditure model. An appendix to this chapter provides an algebraic treatment of the model and shows how some of the key formulas are derived. Here are the main points of the chapter: In the income-expenditure model, the level of output in the economy will adjust to equal the level of planned expenditures. This level of output is called equilibrium output. Consumption spending consists of two parts. One part is independent of income, but can be influenced by changes in wealth or consumer sentiment. The other part depends on the level of income. Increases in planned expenditures by households, the government, or the foreign sector lead to increases in equilibrium output. Because of the multiplier, the final increase in equilibrium output is larger than the initial increase. Policy makers can use multipliers to calculate the appropriate size of economic policies. Higher tax rates, by reducing the multiplier, can reduce fluctuations in GDP. Increases in exports lead to increases in equilibrium output; increases in imports lead to decreases in equilibrium output. The income-expenditure model can be used to derive the aggregate demand curve. Applying the Concepts After reading this chapter, you should be able to answer these four key questions: 1. How do increases in the value of homes affect consumer spending? 2. Why does real GDP typically increase after natural disasters? 3. How influential a figure was John Maynard Keynes? 4. Why do foreign countries like U.S. growth? 11.1 A Simple Income-Expenditure Model To determine equilibrium output, we need to understand the behavior of firms. Figure 11.1 illustrates the behavior of firms with a 45° line from the origin. In the income-expenditure model, the 45° line represents where planned expenditure equals actual output. Because firms are willing to supply whatever

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156 Chapter 11 is demanded without raising prices very much, demand is the key factor in determining the level of output, or GDP. As we consider demand, we will focus on consumption spending ( C ) and investment spending ( I ). Total demand or planned expenditures in this model will be C + I . In the income-expenditure model, the level of output in the economy will adjust to equal the level of planned expenditures. The level of output is called the equilibrium output . The following equation shows this relationship: ; Key Equation Equilibrium output = y * = C + I = planned expenditures Figure 11.2 can help us understand how the level of equilibrium output, or GDP, in the economy is determined. On the expenditure-output graph, we draw the line representing planned expenditures, C + I , which is a horizontal line, because both C and I are fixed amounts. The intersection of the 45° line with
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sg11 - 11 The Income-Expenditure Model Chapter Summary The...

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