Fundamental Questions

1. What does equilibrium mean in macroeconomics?

2. How do aggregate expenditures affect income or real GDP?

3. What are the leakages from and injections to spending?

4. Why does equilibrium income change by a multiple of a change in autonomous expenditures?

5. What is the spending multiplier?

6. What is the relationship between the GDP gap and the recessionary gap?

7. How does international trade affect the size of the multiplier?

8. Why does the aggregate expenditures curve shift with changes in the price level?

Teaching Objectives

The primary purpose of this chapter is to explain the income-expenditure model. This model is the foundation of modern macroeconomics.

The unique feature of this chapter is the income-expenditure model, which shows how aggregate expenditures determine the level of real GDP and employment. The concept of macroeconomic equilibrium-a condition in which leakages equal injections and aggregate expenditures equal real GDP-is also presented. This chapter also discusses the concept of the multiplier. The appendix to this chapter shows an algebraic income-expenditures model that is solved for equilibrium real GDP and for the multiplier.

An area that requires special attention is the process by which the economy achieves equilibrium. You should begin with a level of real GDP below equilibrium and explain how the economy moves to equilibrium. Then ask the students to do the same when beginning from a point above equilibrium.

The material in this chapter links with the aggregate demand curve that was developed in Chapter 9. It also stands on its own as an introduction to the Keynesian perspective on the macroeconomy.

Key Term Review

spending multiplier
recessionary gap

Lecture Outline and Teaching Strategies

1. Equilibrium Income and Expenditures

Equilibrium is a point from which there is no tendency to move.

1.a. Expenditures and income: The AE function represents planned expenditures at different levels of incomes. When expenditures are less than real GDP, inventories are accumulated, which leads business to reduce production. When expenditures exceed real GDP, inventories are depleted, which leads business to increase production. The equilibrium level of income is where AE = NI (Y).

1.b. Leakages and injections: Leakages reduce autonomous aggregate expenditures. For equilibrium to occur, leakages must be offset by corresponding injections. When saving, taxes, and imports are equal to investment, government spending, and exports, leakages equal injections and the economy is in equilibrium.

Teaching Strategy: The leakages and injections concept is often the easiest way for students to understand how macroeconomic equilibrium is reached. This is often referred to as the "Bathtub Theorem," and students often benefit from a visual drawing of a leaking bathtub which also has a dripping faucet. In order for the water level to remain constant, the leakages must equal the injections. If injections > leakages, NI rises, just as the water level rises. If leakages > injections, NI falls, just as the water level would fall.

2. Changes in Equilibrium Income and Expenditures

Changes in autonomous expenditures shift the aggregate expenditures function and lead to changes in income.

Point out that the aggregate expenditure model describes how changes in spending affect the economy in the short run, before prices start changing.

Point out that the aggregate expenditure model developed in this section illustrates the case where demand creates its own supply.

2.a. The spending multiplier: The multiplier is the change in equilibrium income that results from a change in autonomous spending. When AE is increased, Y increases by more than a 1:1 ratio.

Teaching Strategy: It is important to explain the multiplier clearly. Work through an example of the multiplier process step by step.

2.b. The spending multiplier and equilibrium: The recessionary gap is the amount that aggregate expenditures must increase, given the multiplier, to close the GDP gap. Recall that the GDP gap = potential real GDP - actual real GDP. Recessionary gap = GDP / multiplier.

Teaching Strategy: When you discuss the determinants of the multiplier, change the values of the marginal propensity to spend and marginal propensity to import and show the effects on the value of the multiplier. You can also show how these changes affect the slope of the aggregate expenditures function. Then show how, in graphic form, a change in aggregate expenditures leads to a larger change in real GDP. By developing the numerical, algebraic, and graphic approaches to the multiplier, you will provide your students with more ways to understand this crucial concept.

2.c. Real-world complications

2.c.1. Foreign repercussions of domestic imports: Because of foreign repercussions, the multiplier underestimates true multiplier effects. Price changes and taxes cause the simple multiplier to overestimate the true multiplier.

Teaching Strategy: Economists and policymakers are often concerned about the impact of foreign economic policy on the domestic economy. Pay attention to current examples of this in the news and bring it into your lecture.

2.c.2. Multiplier estimates: Many models are used to analyze current economic developments and forecast future ones.

3. Aggregate Expenditures and Aggregate Demand

Point out that the Keynesian model is best used to analyze what happens in the short-run, before prices begin to change. Remind students that the Keynesian model assumes that the supply of goods and services adjusts to AE, and, therefore, there is no need for price changes.

3.a. Aggregate expenditures and changing price levels: The AE curve will shift with changes in the price level because of the wealth effect, interest rate effect, and international trade effect.

3.b. Deriving the aggregate demand curve: The AD curve is derived from the AE curve.

3.c. A fixed-price AD-AS model: The Keynesian model of fixed-price equilibrium is a special case.