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- 1. Chapter 29 The Aggregate Expenditures Model Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
- 2. 29-2 Learning outcomes LO1. Explain how sticky prices relate to the AE model. LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier. LO6. Explain how economists integrate the international sector (exports & imports) into AE model LO7. Explain how economists integrate the public sector (government & taxes) into the AE model.
- 3. 29-3 Madam, what is aggregate? a whole formed by combining several (typically disparate) elements. ooo..hehe..nak tanya lagi, so what is aggregate expenditures model? Aggregate expenditure (AE) is the sum of consumption, investment, government purchases, and net export. Understand ? Hello ? …..understand or not ? Haiihh ! Tido la tu! BUDAK MAKRO ATW108 Last seen online 12.31am
- 4. 29-4 Learning outcomes LO1. Explain how sticky prices relate to the AE model. (DIY) LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier.
- 5. 29-5 Assumptions and Simplifications • Keynes developed this model in 1930s • Help explain how modern economies adjust to economic shocks/sudden crisis. • To simplify, ignore the government role first. • Assuming economy only has private sector; • Household & business • Also assume economy has no international interaction = closed economy (no intl trade) • Also, assume saving is personal. • So, this economy has its GDP = DI LO1
- 6. 29-6 Consumption and Investment randi(percent) Investment (billions of dollars) ID 20 8 Real domestic product, GDP (billions of dollars) 20 Investment(billionsofdollars) Ig (a) Investment Demand Curve (b) Investment Schedule 20 Investment demand curve Investment schedule 20 LO2 Investment is determined by real ir
- 7. 29-7
- 8. 29-8 Learning outcomes LO1. Explain how sticky prices relate to the AE model. (DIY) LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier.
- 9. 29-9 This table shows equilibrium GDP using the expenditures-output approach for a private, closed economy Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy (1) Possible Levels of Employment , Millions (2) Real Domestic Output (and Income) (GDP = DI),*Billio ns (3) Consumption (C), Billions (4) Saving (S), Billions (5) Investment (Ig), Billions (6) Aggregate Expenditure (C+Ig), Billions (7) Unplanned Changes in Inventories , (+ or -) (8) Tendency of Employment, Output, and Income (1) 40 $370 $375 $-5 $20 $395 $-25 Increase (2) 45 390 390 0 20 410 -20 Increase LO3 shows 10 possible levels that producers are willing to offer, assuming their sales would meet the output planned “ we will produce $370 bill o.p if we can receive at least $370bil revenue” shows the amount of consumption and planned gross investment spending (C + Ig) at each output level Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output
- 10. 29-10 This table shows equilibrium GDP using the expenditures-output approach for a private, closed economy Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy (1) Possible Levels of Employment , Millions (2) Real Domestic Output (and Income) (GDP = DI),*Billio ns (3) Consumption (C), Billions (4) Saving (S), Billions (5) Investment (Ig), Billions (6) Aggregate Expenditur e (C+Ig), Billions (7) Unplanned Changes in Inventories , (+ or -) (8) Tendency of Employment, Output, and Income (1) 40 $370 $375 $-5 $20 $395 $-25 Increase (2) 45 390 390 0 20 410 -20 Increase (3) 50 410 405 5 20 425 -15 Increase (4) 55 430 420 10 20 440 -10 Increase (5) 60 450 435 15 20 455 -5 Increase (6) 65 470 450 20 20 470 0 Equilibrium (7) 70 490 465 25 20 485 +5 Decrease (8) 75 510 480 30 20 500 +10 Decrease (9) 80 530 495 35 20 515 +15 Decrease (10) 85 550 510 40 20 530 +20 Decrease * If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP LO3
- 11. 29-11 Learning outcomes LO1. Explain how sticky prices relate to the AE model. (DIY) LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier.
- 12. 29-12 figure graphically illustrates equilibrium GDP in a private closed economy (want to find where is i. Aggregate expenditure, ii) equilibrium GDP ) C Ig = $20 billion AE C = $450 billion C + Ig (C + Ig = GDP) Equilibrium point LO3 Default 45 degree
- 13. 29-13 Learning outcomes LO1. Explain how sticky prices relate to the AE model. (DIY) LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier.
- 14. 29-14 Other Features of Equilibrium GDP • Saving = planned investment, at equilibrium GDP • Saving is a ‘leakage’ of spending, causing C to be lesser than GDP. LO4 C < GDP S C C C How to replace outflows caused by spending leakage? Find/inject investment
- 15. 29-15 Other Features of Equilibrium GDP If AE < GDPe (think it as when ur spending is lesser than income) -business will have unplanned inventory (think it as terlebih inventory in store) If AE > GDPe (think it as when ur spending is lesser than income) -Business will have no inventory & need to invest to have more inventory -Business will have –ve unplanned inventory. LO4
- 16. 29-16 Learning outcomes LO1. Explain how sticky prices relate to the AE model. (DIY) LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier.
- 17. 29-17 Changes in Equilibrium GDP Increase in investment (C + Ig)0 Decrease in investment (C + Ig)2 (C + Ig)1 LO5 Increase the GDPe Decrease the GDPe
- 18. 29-18 The extent of the changes in equilibrium GDP will depend on the size of the multiplier, which, in this case, is 4. The multiplier = 1 / MPS
- 19. 29-19 Learning outcomes LO1. Explain how sticky prices relate to the AE model. LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier. LO6. Explain how economists integrate the international sector (exports & imports) into AE model LO7. Explain how economists integrate the public sector (government & taxes) into the AE model.
- 20. 29-20 Adding International Trade LO6 + GDP - GDP+ + GDP EXPANSI ONARY - - CONTRA CTIONAR Y
- 21. 29-21 The Net Export Schedule Two Net Export Schedules (in Billions) (1) Level of GDP (2) Net Exports, Xn1 (X > M) (3) Net Exports, Xn2 (X < M) $370 $+5 $-5 390 +5 -5 410 +5 -5 430 +5 -5 450 +5 -5 470 +5 -5 490 +5 -5 510 +5 -5 530 +5 -5 550 +5 -5 LO6
- 22. 29-22 Net Exports and Equilibrium GDP Aggregate expenditures with positive net exports C + Ig Aggregate expenditures with negative net exports C + Ig+Xn2 C + Ig+Xn1 Xn1 Xn2 Positive net exports Negative net exports 450 470 490 LO6
- 23. 29-23 International Economic Linkages • Prosperity abroad • Can increase U.S. exports • Exchange rates • Depreciate the dollar to increase exports • A caution on tariffs and devaluations • Other countries may retaliate • Lower GDP for all LO6
- 25. 29-25 Learning outcomes LO1. Explain how sticky prices relate to the AE model. LO2. Explain how an economy’s investment schedule is derived from the investment demand curve & an interest rate. LO3a. Illustrate how u can combine C & I to depict an AE schedule LO3b. How AE schedule can be used to determine the equilibrium level of output. LO4. Discuss 2 other ways to characterize the equilibrium level. LO5. Analyze how changes in equilibrium real GDP can occur in AE model & describe how those changes relate to multiplier. LO6. Explain how economists integrate the international sector (exports & imports) into AE model LO7. Explain how economists integrate the public sector (government & taxes) into the AE model. DIY
- 26. 29-26 Adding the Public Sector • Government purchases and equilibrium GDP • Government spending is subject to the multiplier • Taxation and equilibrium GDP • Lump sum tax • Taxes are subject to the multiplier • DI = GDP LO7
- 27. 29-27 Government Purchases and Eq. GDP The Impact of Government Purchases on Equilibrium GDP (1) Real Domestic Output and Income (GDP=DI), Billions (2) Consumption (C), Billions (3) Saving (S), Billions (4) Investment (Ig), Billions (5) Net Exports (Xn), Billions (6) Governmen t Purchases (G), Billions (7) Aggregate Expenditures (C+Ig+Xn+G), Billions (2)+(4)+(5)+(6) Exports (X) Imports (M) (1) $370 $375 $-5 $20 $10 $10 $20 $415 (2) 390 390 0 20 10 10 20 430 (3) 410 405 5 20 10 10 20 445 (4) 430 420 10 20 10 10 20 460 (5) 450 435 15 20 10 10 20 475 (6) 470 450 20 20 10 10 20 490 (7) 490 465 25 20 10 10 20 505 (8) 510 480 30 20 10 10 20 520 (9) 530 495 35 20 10 10 20 535 (10) 550 510 40 20 10 10 20 550 LO7
- 28. 29-28 Government Purchases and Eq. GDP C Government spending of $20 billion C + Ig + Xn C + Ig + Xn + G LO7
- 29. 29-29 Taxation and Equilibrium GDP Determination of the Equilibrium Levels of Employment, Output, and Income: Private and Public Sectors (1) Real Domestic Output and Income (GDP=DI), Billions (2) Taxes (T), Billions (3) Disposabl e Income (DI), Billions, (1)-(2) (4) Consump- tion (C), Billions (5) Saving (S), Billions (6) Invest- ment (Ig), Billions (7) Net Exports (Xn), Billions (8) Govern- ment Pur- chases (G), Billions (9) Aggregate Expendi- tures (C+Ig+Xn +G), Billions (4)+(6)+(7) +(8) Export s (X) Import s (M) (1) $370 $20 $350 $360 $-10 $20 $10 $10 $20 $400 (2) 390 20 370 375 -5 20 10 10 20 415 (3) 410 20 390 390 0 20 10 10 20 430 (4) 430 20 410 405 5 20 10 10 20 445 (5) 450 20 430 420 10 20 10 10 20 460 (6) 470 20 450 435 15 20 10 10 20 475 (7) 490 20 470 450 20 20 10 10 20 490 (8) 510 20 490 465 25 20 10 10 20 505 (9) 530 20 510 480 30 20 10 10 20 520 (10) 550 20 530 495 35 20 10 10 20 535 LO7
- 30. 29-30 Taxation and Equilibrium GDP 45° 490 550 Real domestic product, GDP (billions of dollars) Aggregateexpenditures(billionsofdollars) $15 billion decrease in consumption from a $20 billion increase in taxes Ca + Ig + Xn + G C + Ig + Xn + G LO7
- 31. 29-31 Equilibrium versus Full-Employment • Recessionary expenditure gap • Insufficient aggregate spending • Spending below full-employment GDP • Increase G and/or decrease T • Inflationary expenditure gap • Too much aggregate spending • Spending exceeds full-employment GDP • Decrease G and/or increase T LO8
- 32. 29-32 Equilibrium versus Full-Employment Real GDP (a) Recessionary expenditure gap Aggregateexpenditures (billionsofdollars) 530 510 490 45° 490 510 530 AE0 AE1 Full employment Recessionary expenditure gap = $5 billion LO8
- 33. 29-33 Equilibrium versus Full-Employment AE0 AE2 Full employment Inflationary expenditure gap = $5 billion LO8
- 34. 29-34 Application: The Recession of 2007- 09 • December 2007 recession began • Aggregate expenditures declined • Consumption spending declined • Investment spending declined • Recessionary expenditure gap LO8
- 35. 29-35 Application: The Recession of 2007- 09 • Federal government undertook Keynesian policies • Tax rebate checks • $787 billion stimulus package LO8
- 36. 29-36 Say’s Law, Great Depression, Keynes • Classical economics • Say’s Law • Economy will automatically adjust • Laissez-faire • Keynesian economics • Cyclical unemployment can occur • Economy will not correct itself • Government should actively manage macroeconomic instability
Editor's Notes
- The chapter begins with the simple version of the AE model: that of a closed, private economy. The equilibrium GDP is determined and multiplier effects are briefly reviewed. The simplified “closed” economy is then “opened” to show how it would be affected by exports and imports. Government spending and taxes are brought into the model to include the “public” aspects of the system. The price level is assumed constant in this chapter unless stated otherwise, so the focus is on real GDP.
- Keynes developed this model during the depression of the 1930s and it can help explain how modern economies adjust to economic shocks. This is used today to provide insight regarding current economic conditions. Government is ignored, so the economy just consists of the private sector: households and businesses. Assume a “closed economy”, one with no international trade. Although both households and businesses save, we assume here that all saving is personal. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same.
- This figure reflects (a) the investment demand curve and (b) the investment schedule. (a) The level of investment spending (here, $20 billion) is determined by the real interest rate (here, 8 percent) together with the investment demand curve, ID. (b) The investment schedule, Ig, relates the amount of investment ($20 billion) determined in (a) to the various levels of GDP.
- This table shows equilibrium GDP using the expenditures-output approach for a private, closed economy. Real domestic output in column 2 shows ten possible levels that producers are willing to offer, assuming their sales would meet the output planned. In other words, they will produce $370 billion of output if they expect to receive $370 billion in revenue. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) at each output level. Recall that the consumption level is directly related to the level of income and that here income is equal to output. Investment is independent of income and is planned or intended regardless of the current income situation. Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output. Otherwise, there will be a disequilibrium situation. In the table, equilibrium occurs only at $470 billion. At $410 billion GDP level, total expenditures (C + Ig) would be $425 = $405(C) + $20 (Ig) and businesses will adjust to this excess demand (revealed by the declining inventories) by stepping up production. They will expand production at any level of GDP less than the $470 billion equilibrium. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At the $510 billion level, C + Ig = $500 billion. Businesses will have unsold, unplanned inventory investment and will cut back on the rate of production. As GDP declines, the number of jobs and total income will also decline, but eventually the GDP and aggregate spending will be in equilibrium at $470 billion. No level of GDP other than the equilibrium level of GDP can be sustained.
- This table shows equilibrium GDP using the expenditures-output approach for a private, closed economy. Real domestic output in column 2 shows ten possible levels that producers are willing to offer, assuming their sales would meet the output planned. In other words, they will produce $370 billion of output if they expect to receive $370 billion in revenue. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) at each output level. Recall that the consumption level is directly related to the level of income and that here income is equal to output. Investment is independent of income and is planned or intended regardless of the current income situation. Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output. Otherwise, there will be a disequilibrium situation. In the table, equilibrium occurs only at $470 billion. At $410 billion GDP level, total expenditures (C + Ig) would be $425 = $405(C) + $20 (Ig) and businesses will adjust to this excess demand (revealed by the declining inventories) by stepping up production. They will expand production at any level of GDP less than the $470 billion equilibrium. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At the $510 billion level, C + Ig = $500 billion. Businesses will have unsold, unplanned inventory investment and will cut back on the rate of production. As GDP declines, the number of jobs and total income will also decline, but eventually the GDP and aggregate spending will be in equilibrium at $470 billion. No level of GDP other than the equilibrium level of GDP can be sustained.
- This figure graphically illustrates equilibrium GDP in a private closed economy. The aggregate expenditures schedule, C + Ig, is determined by adding the investment schedule, Ig, to the upsloping consumption schedule, C. Since investment is assumed to be the same at each level of GDP, the vertical distances between C and C + Ig do not change. Equilibrium GDP is determined where the aggregate expenditures schedule intersects the 45 degree line, in this case at $470 billion.
- Savings and planned investment are equal at equilibrium GDP. It is important to note that in our analysis above we spoke of “planned” investment. Saving represents a “leakage” from the spending stream and causes C to be less than GDP. Some of the output is planned for business investment and not consumption, so this investment spending can replace the leakage due to saving. If aggregate spending is less than equilibrium GDP, then businesses will find themselves with unplanned inventory investment on top of what was already planned. This unplanned portion is reflected as a business expenditure, even though the business may not have desired it, because the total output has a value that belongs to someone—either as a planned purchase or as unplanned inventory. If aggregate expenditures exceed GDP, then there will be less inventory investment than businesses planned as businesses sell more than they expected. This is reflected as a negative amount of unplanned investment in inventory.
- Savings and planned investment are equal at equilibrium GDP. It is important to note that in our analysis above we spoke of “planned” investment. Saving represents a “leakage” from the spending stream and causes C to be less than GDP. Some of the output is planned for business investment and not consumption, so this investment spending can replace the leakage due to saving. If aggregate spending is less than equilibrium GDP, then businesses will find themselves with unplanned inventory investment on top of what was already planned. This unplanned portion is reflected as a business expenditure, even though the business may not have desired it, because the total output has a value that belongs to someone—either as a planned purchase or as unplanned inventory. If aggregate expenditures exceed GDP, then there will be less inventory investment than businesses planned as businesses sell more than they expected. This is reflected as a negative amount of unplanned investment in inventory.
- This figure demonstrates changes in the aggregate expenditure schedule and the multiplier effect. An upward shift of the aggregate expenditure schedule from (C plus Ig)0 to (C plus Ig)1 will increase the equilibrium GDP. Conversely, a downward shift from (C plus Ig)0 to (C plus Ig)2 will lower the equilibrium GDP. The extent of the changes in equilibrium GDP will depend on the size of the multiplier, which, in this case, is 4. The multiplier is equal to 1 divided by MPS
- Net exports (exports minus imports) affect aggregate expenditures in an open economy. Exports (X) create domestic production, income, and employment due to foreign spending on U.S. produced goods and services. Imports (M) reduce the sum of consumption and investment expenditures by the amount expended on imported goods, so this figure must be subtracted so as not to overstate aggregate expenditures on U.S. produced goods and services. Positive net exports increase aggregate expenditures beyond what they would be in a closed economy and thus have an expansionary effect. Negative net exports decrease aggregate expenditures beyond what they would be in a closed economy and thus have a contractionary effect.
- In this table, column Xn1 shows that exports exceed imports by $5 billion at each level of GDP. Column Xn2 shows imports exceed exports by $5 billion at each level of GDP. Since the net exports are constant at all GDP levels, we are assuming that net exports are independent of GDP. This data will be represented graphically in the figure on the next slide.
- This figure illustrates the impact of net exports and equilibrium GDP. Positive net exports, such as that shown by the net export schedule Xn1 in (b), elevate the aggregate expenditures schedule in (a) from the closed-economy level of C + Ig to the open-economy level of C + Ig + Xn1. Negative net exports, such as that depicted by the net export schedule Xn2 in (b), lower the aggregate expenditures schedule in (a) from the closed-economy level of C + Ig to the open-economy level of C + Ig + Xn2.
- Prosperity abroad generally raises our exports and transfers some of their prosperity to us. (Conversely, a recession abroad has the reverse effect.) Depreciation of the dollar lowers the cost of American goods to foreigners and encourages exports from the U.S., while discouraging the purchase of imports in the U.S. This could lead to higher real GDP or to inflation, depending on the domestic employment situation. Appreciation of the dollar could have the opposite impact. Tariffs on U.S. products may reduce our exports and depress our economy, causing us to retaliate and worsen the situation. For example, trade barriers in the 1930s contributed to the Great Depression.
- This Global Perspective shows the net exports of goods for selected nations in 2012.
- Simplifying assumptions are helpful for clarity when we include the government sector in our analysis. We simplified investment and net export schedules that are used by assuming that they are independent of the level of current GDP. We assume government purchases do not impact private spending schedules. We assume that net tax revenues are derived entirely from personal taxes so that GDP, NI, and PI remain equal. DI is PI minus net personal taxes. We assume tax collections are a constant amount and independent of the GDP level (a lump-sum tax). An increase in taxes has an indirect effect on aggregate expenditures because taxes reduce disposable incomes first, and then C falls by the amount of the tax times the MPC. With the addition of government to aggregate expenditures, the economy is now a mixed, open economy.
- This table shows the impact of government purchases on equilibrium GDP. Before adding government purchases, equilibrium GDP had been at $470. Now with government purchases, equilibrium GDP rises to $550, implying a multiplier effect since the rise in GDP is greater than the $20 billion in additional aggregate expenditures.
- This figure illustrates the impact of government spending on equilibrium GDP. The addition of government expenditures, G, to our analysis raises the aggregate expenditures (C + Ig + Xn + G) schedule and increases the equilibrium level of GDP, as would an increase in C, Ig, or Xn. The multiplier is again 4 (80 divided by 20).
- This table shows the determination of the equilibrium levels of employment, output, and income with the private sector and taxes. With taxes of $20 billion at all levels of GDP, equilibrium GDP falls from $550 to $490. Again, we can see that there is a multiplier effect. The multiplier = 60 divided by 15 = 4.
- This figure reflects the impact of taxes on equilibrium GDP. If the MPC is .75, the $20 billion of taxes will lower the consumption schedule by $15 (20 x .75) billion and cause a $60 billion decline in the equilibrium GDP. In the open economy with government, equilibrium GDP occurs where Ca (after-tax income) + Ig + Xn + G = GDP. Here, that equilibrium is $490 billion.
- Expenditure gaps arise because equilibrium GDP and real GDP do not always match. A recessionary expenditure gap exists when aggregate expenditures fall short of full-employment GDP. Output falls and unemployment rises. An inflationary expenditure gap exists when aggregate expenditures exceed full-employment GDP. In this model, if output can’t expand, pure demand-pull inflation will occur. See next two slides for graphical representation.
- This graph shows the recessionary expenditure gap. The equilibrium and full-employment GDPs may not coincide. A recessionary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP fall short of those needed to achieve the full-employment GDP. Here, the $5 billion recessionary expenditure gap causes a $20 billion negative GDP gap. See the next slide for the graph of the inflationary expenditure gap.
- This graph shows the inflationary expenditure gap. The equilibrium and full-employment GDPs may not coincide. An inflationary expenditure gap is the amount by which aggregate expenditures at the full-employment GDP exceed those just sufficient to achieve the full-employment GDP. Here, the inflationary expenditure gap is $5 billion; this overspending produces demand-pull inflation.
- The recession of 2007 to 2009 was the worst recession since the Great Depression. Real GDP declined and unemployment jumped above 10 percent.
- In 2008 and 2009 the Federal government used Keynesian economics to try to end the recession. The idea was to increase aggregate expenditures, eliminating the recessionary expenditure gap and bring the economy to full-employment GDP.
- Until the Great Depression of the 1930s, most economists going back to Adam Smith had believed that a market system would ensure full employment of the economy’s resources except for temporary, short-term upheavals. If there were deviations, they would be self-correcting. A slump in output and employment would reduce prices, which would increase consumer spending; it would lower wages, which would increase employment again; and it would lower interest rates, which would expand investment spending. Say’s law, attributed to the French economist J. B. Say in the early 1800s, summarized the view in a few words: “Supply creates its own demand.” Say’s law is easiest to understand in terms of barter. The woodworker produces furniture in order to trade for other needed products and services. All of the products would be traded for something, or else there would be no need to make them. Thus, supply creates its own demand. The Great Depression of the 1930s was worldwide. GDP fell by 40 percent in the U.S. and the unemployment rate rose to nearly 25 percent (when most families had only one breadwinner). The Depression seemed to refute the classical idea that markets were self-correcting and would provide full employment. In 1936 John Maynard Keynes, in his General Theory of Employment, Interest, and Money, provided an alternative to classical theory, which helped explain periods of recession. Not all income is always spent, contrary to Say’s law. Producers may respond to unsold inventories by reducing output rather than cutting prices. A recession or depression could follow this decline in employment and incomes. The modern aggregate expenditures model is based on Keynesian economics or the ideas that have arisen from Keynes and his followers since. It is based on the idea that saving and investment decisions may not be coordinated, and prices and wages are not very flexible downward. Internal market forces can therefore cause depressions and government should play an active role in stabilizing the economy.