Chapter 28: The Aggregate
Expenditures Model
Keynes – “In the long run, we are all dead.”
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Textbook Graphs and Tables Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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
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