The Keynesian Aggregate Expenditure Model

The Keynesian Aggregate Expenditure Model

Related to Current American Economics

The Keynesian Aggregate Expenditure Model

Related to Current American Economics

Much of today's news focuses on global economic recession, global economic recovery, bailout spending, employment and our struggle to reach a better economic situation. In Europe and the United States, Keynesian economics has generated a greater interest. This paper attempts to relate current developments in American economics to the Keynesian aggregate expenditure model by responding to the following questions:

1. Who was Keynes and what is his basic aggregate expenditure model?

2. How does Keynes relate gross domestic product (GDP) to aggregate spending?

3. How can this be related back to American Economics?

John Maynard Keynes was a British economist that developed an aggregate expenditure model in the 1930s in efforts to search for causes and solutions to the Great Depression. There are several underlying assumptions to the aggregate expenditure model established by Keynes. Keynes described real gross domestic product formulaically as:

GDP = C + I + G + NX

In this formula, GDP (planned spending, or aggregate expenditures) equals the sum of C (planned consumption), I (planned investment), G (government spending), and NX (net exports). Consumption, government spending, and exchange through imports and exports always occur, but planned investment would vary and could not always be assumed to occur.

Keynes noted that companies upon completing inventories would find that they had a larger amount of unsold goods than expected, and would attribute this to sales in the economy not being strong enough to support the sale of their merchandise. Other times, there would be an unexpected depletion of their merchandise, and firms reasoned that sales were stronger than anticipated. These periodic inventory inspections gave firms clues to enable them to plan for upcoming quarters. When sales were strong, companies would hire more workers and increase production. When sales were weak, companies would cut back production and lay workers off.

Keynes was able to use these observations and assumtions to develop a simple model, with the premise that price levels remained constant, not just sticky, but stuck. Keynes simple model also does not assume a full level of employment.

The basic or simple Keynesian model is below:

Keynes drew a 45 degree line between the vertical axis representing aggregate (total) spending and the horizontal axis, representing real GDP. At every point along this line, spending always occurred, and real GDP (the output of a nation) was equal to what was spent by citizens at home and abroad. This line (in green above) represented an "ideal" situation. When Keynes researched economic patterns in the United States and Great Britain, Keynes saw that the patterns were more realistically represented by another line (C + I + G + NX), starting higher on the Y axis and with a much gentler slope.

Keynes proposed a condition of equilibrium where the 45 degree "ideal" crossed the line formed by (C + I + G + NX). At that point of equilibrium, aggregate expenditures would equal GDP. This is considered a truer ideal.

As shown above by the red dashed lines in the diagram above, when GDP is diminished to lower than equilibrium, there is greater spending than output. Going back to the scenario of businesses taking inventory, stocks would be depleted faster than anticipated. Firms observing this pattern would ideally hire more workers to increase production.

When GDP is greater than equilibrium, as shown in the diagram above, planned spending is less than total output. More is being produced than is demanded. Merchandise is not sold as much as anticipated. Companies reduce production, reduce work hours, and lay workers off. When this happens, real GDP falls, moving the economy back to a state of equilibrium.

Also important in Keynesian economics is the marginal propensity to save (ΔS/ΔDI) versus the marginal propensity to consume (ΔC/ΔDI). When funds are injected into the market as an increase in investment spending (stimulus spending, as has