Fixed Prices and Expenditure Plans
Keynesian model explains fluctuations in aggregate demand at a fixed price level by identifying expenditure plans.
In a Keynesian model, all firms set their prices and sell the quantities that their customers are willing to buy. Only if
firms persistently sell greater or lesser quantities do they change the price.
Because prices for firms are fixed, for the whole economy:
o The price level is fixed
o Aggregate demand determines real GDP
Aggregate expenditure is composed of consumption expenditure, investment, government expenditure and net exports.
Aggregate planned expenditure: Sum of planned levels of expenditure consumption, government expenditure on goods
and services, and exports minus imports.
o Consumption expenditure and imports change with income, and therefore depend on real GDP
o An increase in real GDP increases aggregate expenditure
o An increase in aggregate expenditure increases real GDP
Consumption and saving plans:
o Influenced by: Disposable income (aggregate income – taxes + transfer payments)
Aggregate income equals real GDP, so disposable income depends on real GDP
Households only spend disposable income on consumption or save it, so planned consumption
expenditure plus planned savings equal disposable income.
Consumption function: Relationship between consumption expenditure and disposable income
Consumption expenditure in y-axis and disposable income in x-axis
Autonomous consumption: Amount of consumption expenditure that would take place in the
short-run even if people had no current income (possibility to have disposable income at 0
and consumption expenditure more than 0)
Induced consumption: Consumption expenditure that by an increase in disposable income
45% degree line:
At points on the 45% degree line, consumption expenditure = disposable income
Points below this line is ‘dissaving’ (negative saving) and points above this line is ‘saving’
Savings function: Relationship between saving and disposable income
o Also influenced by real interest rate & wealth & expected future income (but assumed constant for now)
Marginal propensity to consume (MPC): Fraction of a change in disposable income that is spent on consumption
o Calculated as the change in consumption expenditure, divided by change in disposable income
Marginal propensity to save: Fraction of a change in disposable income that is saved
o Calculated as the change in savings divided by the change in disposable income
o ⁄ Due to increase in disposable income being spent on consumption or saved, MPC + MPS equals 1.
o ⁄ ⁄
Marginal propensity to import: Fraction of an increase in real GDP that is spent on imports.
o Calculated as a change imports divided by the change in real GDP, other things remaining the same.
o In Canada, real GDP has a large influence on Canadian short-run imports.
Consumption expenditure changes with disposable income changes, so it also depends on real GDP, and this link can
be used to determine equilibrium expenditure.
Real GDP with a Fixed Price Level
To calculate aggregate planned expenditure, add together:
o Planned consumption at each level of real GDP
o Investment (independent of the level of real GDP and dependent on real interest rate and expected profit)
o Government expenditure (independent of the level of real GDP)
o Exports (independent of the level of real GDP. Dependent on events in the rest of the world, prices of foreing
goods and services in relation to Canadian ones)
o (-) Imports (dependent on real GDP)
To calculate aggregate expenditure, subtract imports from I + G + X + C
Induced expenditure: Consumption expenditure minus imports (varying with real GDP)
Autonomous expenditure: Sum of investment, government expenditure and exports (not varying with real GDP)
Actual aggregate expenditure:
o Always equal to real GDP, however, planned aggregate expenditure is not.
o People carry out consumption expenditure plans, governments implement their planned expenditure on goods
and services, and firms carry out their plans to purchase fixed assets.
o However, if aggregate planned expenditure is less than real GDP, firms sell less than planned, and end up with
more inventories, and if aggregate planned expenditure is more than real GDP, firms sell more than planned.
Equilibrium expenditure: Level of aggregate expenditure when aggregate planned expenditure equals real GDP
o A level of aggregate expenditure and real GDP at which spending plans are fulfilled.
o When aggregate planned expenditure and actual aggregate expenditure are unequal, there is a convergence
towards equilibrium. However, since equilibrium expenditure determines real GDP, real GDP adjusts.
o When aggregate expenditure lie above the 45’ line, aggregate planned expenditure exceeds real GDP
o When aggregate expenditure lie below the 45’ line, aggregate planned expenditure is less than real GDP
Convergence to equilibrium:
o From below:
Given planned expenditure is more than actual expenditure and real GDP,
Firms increase production by hiring more labour to increase production to match real GDP by the
amount of difference. However, planned expenditure continues to increase as real GDP increases, and the process continues
until real GDP matches planned expenditure.
o From a