Question

True or False: The aggregate expenditures model assumes flexible prices.

Short answer

False. The model assumes fixed prices.

Step-by-step solution

Understanding the Aggregate Expenditures Model

The aggregate expenditures model, developed by John Maynard Keynes, is used to determine the equilibrium level of national income or output. This model is also known as the Keynesian cross model.

Recognizing Assumptions

One key assumption of the aggregate expenditures model is that prices are fixed or rigid in the short run. This means that the model does not allow for any change in the price level.

Comparing Assumption with Statement

The statement claims that the aggregate expenditures model assumes flexible prices. Since we identified that the model assumes fixed prices, the statement is opposite to the model's assumption.

Conclusion

Given the analysis, the statement is false because the aggregate expenditures model assumes fixed prices, not flexible prices.

Key concepts

Keynesian Economics

John Maynard Keynes, a renowned economist, introduced a revolutionary theory during the Great Depression. His ideas laid the groundwork for what we now call Keynesian Economics. This economic approach emphasizes the role of aggregate demand in influencing overall economic activity and highlights the need for government intervention during economic downturns.
At the core of Keynesian Economics is the belief that economies may not always self-correct to reach full employment. Instead, during periods of low demand, such as during a recession, the government should step in to boost spending and investment to stimulate the economy.
Keynesian Economics includes several key elements:

• The idea that total spending in the economy (aggregate demand) determines the economic output and employment level.
• Governments can influence economic activity by adjusting fiscal policies, such as changing tax rates and public spending.
• The importance of short-run adjustments and the recognition that economies can be stuck below full employment for extended periods.

Understanding these principles helps us grasp why equilibrium national income might need assistance when aggregate demand falters.

Fixed Prices Assumption

In the aggregate expenditures model, the fixed prices assumption is key to simplifying the analysis of economic output. It is assumed that prices do not change in the short run, meaning prices are rigid or sticky. This simplifies the model, allowing economists to focus on other variables affecting national output. The fixed prices assumption suggests that changes in demand do not immediately alter the price level. Hence, any shifts in aggregate demand directly impact the output and employment.

• This is often a reasonable assumption over shorter time periods where wages and prices don't fully adjust.
• Fixed prices allow us to isolate and better understand the direct impact of changes in expenditure on national income.

While this assumption might not hold in the real world over the long term, it provides a useful framework for analyzing short-term economic fluctuations.

Equilibrium National Income

Equilibrium national income is a central concept in the aggregate expenditures model. This is the level of national income or output where the total spending in the economy equals the total production.
When national income is at equilibrium, there is no inherent pressure for it to change, as aggregate expenditures match aggregate output. However, when there is a discrepancy between the two, the economy will adjust until equilibrium is restored. Key facts about the equilibrium in this model include:

• If aggregate expenditures exceed output, businesses will increase production to meet demand, which can raise national income.
• Conversely, if aggregate expenditures are less than output, businesses might cut back on production, leading to a decrease in national income.
• The equilibrium level is important as it helps determine the necessary level of spending to achieve full employment.

Understanding equilibrium national income is crucial for analyzing how changes in spending can affect overall economic stability and growth.