Economics –Unit 3 Test Corrections (Almost Done) -{Not Answered: 4,5,9,10,11,15,18,19,21,24,25}

#	Topic	Correct Answer/Why is it Correct?	Why Missed
1.	Aggregate Supply	E= A schedule indicating the level of real output that will be produced at each possible price level A-D are obviously incorrect as they deal with purchasing (D), expenditures (A), inflation and unemployment (C), and inputs (B). Supply indicates production	Not enough studying Never understood Stupid Mistake Did not miss
2.	Aggregate Demand Curve	C= Consumer wealth Energy prices (A) would not effect demand. The prices of inputs (D) would not effect demand. Productivity rates (B) would not effect demand. How much it costs of how quickly a product is made is not going to change how much the product is demanded. What you are left with if either consumer wealth or prices. While a change in prices might effect the demand curve, consumer wealth is what will cause it to shift. The more money the consumer have the more they will purchase, increasing demand	Not enough studying Never understood Stupid Mistake Did not miss
3.	Short-Run Aggregate Supply Curve	C=Prices of inputs decrease The graph set up with real output on the X axis and interest rates on the Y axis. When the prices of inputs decrease we will have in increase in output as we purchase more materials needed for our output, moving the curve to the right.	Not enough studying Never understood Stupid Mistake Did not miss
4.	Aggregate Demand Curve vs. Aggregate Supply Curve	C= Employment increase & Price level has no change	Not enough studying Never understood Stupid Mistake Did not miss
5.	Capital Stock	D=Long-run aggregate supply curve to shift rightward	Not enough studying Never understood Stupid Mistake Did not miss
6.	Inflationary gap	B=Increase in money supply Inflationary gaps can be depleted with the usage of contractionary fiscal policy or minimizing the money supply.	Not enough studying Never understood Stupid Mistake Did not miss
7.	Effect on GDP and Price Level	B= Real GDP increase & Price Level Decrease With an increase in labor GDP would increase since you would now not only be producing more but there would be more individuals with a source on income and that income would then be used for purchases. Price level would decrease because you are now producing more and therefore have an excess supply of the product, so price levels would drop.	Not enough studying Never understood Stupid Mistake Did not miss
8.	Marginal Propensity	A=Consume is 0.8 The problem gives you the information to find the marginal propensity to consume. The equation is: MPC=Change in consumption/change in income x=40/50 x=0.8	Not enough studying Never understood Stupid Mistake Did not miss
9.	Keynesian Aggregate-Expenditure Model	D= $24 billion	Not enough studying Never understood Stupid Mistake Did not miss
10.	Keynesian Aggregate-Expenditure Model	B=The change in real GDP by the initial change in spending	Not enough studying Never understood Stupid Mistake Did not miss
11.	Change in Consumption Schedule	D= An expectation of future shortages of essential consumer goods	Not enough studying Never understood Stupid Mistake Did not miss
12.	Investment Demand Curve	C=Businesses becoming more optimistic with respect to future business conditions The investment demand curve lies on a graph with the Y axis being represented by the rate of return and interest while the X axis is represented by investment. The curve would move to the right along the X axis as investment increases. Investment would increase as a result of 'businesses becoming more optimistic'	Not enough studying Never understood Stupid Mistake Did not miss
13.	Automatic Stabilizers	D=I & II only Congressional action is not included in the list of automatic stabilizers because it requires the action of the government and takes time for any actions discussed by congress to be approved and put to work in the economy. Income tax and unemployment compensation are built into our economy to keep the money supply under control.	Not enough studying Never understood Stupid Mistake Did not miss
14.	Automatic Stabilizers	B= Decrease & Increase Automatic stabilizers really work for the economy during extreme periods such as during recessions and inflationary times. During a recession we need taxes to decrease so not as much money is being taken out of circulation. During inflationary periods we need taxes to increase to get some of the dollars out of the hands of consumer. Depleting the money supply will bring the economy back to equilibrium	Not enough studying Never understood Stupid Mistake Did not miss
15.	Long & Short Run Graph	C= An increase in wages	Not enough studying Never understood Stupid Mistake Did not miss
16.	Short-Run Aggregate Supply	B=Decrease in price level & decrease in unemployment When you have an increase in supply price will drop as there is now excess of a product that needs to be get rid off. Unemployment will also decrease because an increase in supply means that there are more employees are needed to create this increase of produce	Not enough studying Never understood Stupid Mistake Did not miss
17.	Aggregate Supply Curve	A=Increase in price level & increase in real GDP Real GDP would increase because of the excess governmental spending. Price level would decrease because _______	Not enough studying Never understood Stupid Mistake Did not miss
18.	Total Income	E= II & III only	Not enough studying Never understood Stupid Mistake Did not miss
19.	Full-Employment GDP	C= $50 billion	Not enough studying Never understood Stupid Mistake Did not miss
20.	Crowding Out	C=Higher interest rates decrease private sector investment Crowding out is defined as a rise in interest rates and a resulting decrease in planned investment caused by the Federal government's increased borrowing in the money market	Not enough studying Never understood Stupid Mistake Did not miss
21.	Fiscal Policy	B=$25 billion decrease in government & $25 billion increase in taxes spending	Not enough studying Never understood Stupid Mistake Did not miss
22.	Fiscal Policy	D= I & III only During an inflation we want to implement contractionary fiscal policy. Therefore, we want to reduce government spending to help decrease the money supply and to increase income taxes, once again, to get some of the money out of the hands of the consumers	Not enough studying Never understood Stupid Mistake Did not miss
23.	Classical Economics	A=A market economy is self-correcting and thus will not remain in a recession indefinitely Classical, unlike Keynesian, supports a self correcting economy and a government that gives gentle nudges here and there, but over all leaves the economy to straighten itself. Classical economists believe that the economy is self-correcting and won't stay, permanently in a recession and inflation.	Not enough studying Never understood Stupid Mistake Did not miss
24.	Short & Long-Run Supply and Production Possibilities Curves	C=Decrease in S-R Supply, Decrease in L-R Supply, and inward shift in Production Possibilities Curve	Not enough studying Never understood Stupid Mistake Did not miss
25.	Personal Income Taxes	B= II only	Not enough studying Never understood Stupid Mistake Did not miss
26.	Phillips Curve	D=Low unemployment rates When the actual rate of inflation is higher than expected, profits temporarily rise and the unemployment rate temporarily falls	Not enough studying Never understood Stupid Mistake Did not miss
27.	Personal Income Taxes	D=A Decrease in consumption of $67 and an increase in savings of $33 We currently consume two-thirds of what we have available. With the new income tax we have $100 less available for consumption or savings. Therefore there is a decrease in consumption by $67, which is two-thirds of the $100 lost, and a decrease in savings by $33, which is the remain third of the $100.	Not enough studying Never understood Stupid Mistake Did not miss
28.	Personal Income Taxes	A=Decrease in real GDP & decrease in Price level With a rise in incomes taxes we have less money available to consume. Less to consume means a lower GDP. Also with less money available we will not only be consuming less, but also producing less which less lower the price level.	Not enough studying Never understood Stupid Mistake Did not miss
29.	Automatic Stabilizers in Fiscal Policy	D=Go into effect without passage of new legislation Automatic stabilizers are a good thing to have built into the economy since they go into effect almost immediately without any new legislation needed. Should they require a new legislation being passed by congress it would require a great deal of time. The immediate reaction of the built-stabilizers is what gives them a major advantage.	Not enough studying Never understood Stupid Mistake Did not miss
30.	Marginal Propensity to Consume/GDP	D=It could increase by up to $9 billion Equation for finding the marginal propensity to consume: MPC= Change in consumption/change in income. $0.9Billion=$1Billion/x .9x=1 x=1.1111	Not enough studying Never understood Stupid Mistake Did not miss

Econ Unit 3 Study Guide

Study Guide: Unit 3

1. Consumption Schedule

a. What is it?

Consumption Schedule: A schedule showing the amounts households plan to spend for consumer goods at different levels of disposable income.

B. What will cause it to shift?

Schedule Shifts: changes in wealth, expectations, interest rates, and household debt will shift the consumption schedule in one direction and the saving schedule in the opposite direction

~A tax increase shifts both schedules downward, and vice versa

C. Know when the consumption schedule is at equilibrium.

45° Line: a reference line; each point on it is equidistant from the two axes

C = DI

(consumption equals disposable income)

2. Investment Demand Curve

A. What is it?

Investment Demand Curve: shows the amount of investment forthcoming at each real interest rate; the level of investment depends on the expected rate of return and the real interest rate

B. What will cause it to shift?

Expected Rate of Return on Investment:

~Acquisition, Maintenance, and Operating Costs

~Business Taxes

~Technological Change

~Stock of Capital Goods on Hand

3. MPC & MPS

A. What are they?

Marginal Propensity to Consume (MPC): the fraction of any change in income consumed

Marginal Propensity to Save (MPC): the fraction of any change in income saved

B. Be able to find someone's MPS & MPC if I tell you their new income and spending habits

MPC = change in consumption

change in income

MPS = change in saving

change in income

MPC + MPS = 1

4. Multiplier

A. Be able to determine the total change in spending if given the initial change in spending.

Multiplier = change in real GDP

initial change in spending

Change in GDP = multiplier X initial change in spending

B. Know the 3 ways to calculate the multiplier

Multiplier = 1/(1-MPC) = 1/(APC - 1) = change in real GDP/ initial change in spending

5. Aggregate Supply and Aggregate Demand

A. What are the determinants of each?

Determinants of Aggregate Supply

1.) Change in input prices

~Domestic resource prices

~Prices of imported resources

~Market Power

2.) Change in Productivity

3.) Change in legal-institutional environment

~Business taxes and subsidies

~Government regulations

Determinants of Aggregate Demand

1.) Change in Consumer Spending

~Consumer wealth

~Consumer expectations

~Household indebtedness

~Taxes

2.) Change in Investment Spending

~Interest Rates

~Expected Returns

-Expected future business conditions

-Technology

-Degree of excess capacity

-Business taxes

3.) Change in Government Spending

4.) Change in Net Export Spending

~National income abroad

~Exchange rates

B. When they shift, what happens to the price level and Q of GDP?

Aggregate Demand Curve: is downward sloping; inverse relationship between price level and the quantity demanded of Real GDP

~As price level rises, the quantity of Real GDP falls and vice versa

~Slopes downward because of:

-Wealth Effect: an increase in the price level decreases purchasing power (and vice versa)

-Interest-Rate Effect: an increase in price level increases the demand for money, thus increasing interest rates and reducing expenditures (and vice versa)

-Foreign Purchases Effect: an increase in the U.S. price level will reduce U.S. exports and increase U.S. imports (and vice versa)

Aggregate Supply Curve: up sloping; indicates a direct relationship between the price level and the amount of real output that firms will offer for sale

~As price level rises, so does GDP and vice versa

i. Because of this change in GDP, what happened to the employment level?

Aggregate Supply: a decrease in aggregate supply means a decrease in employment (and vice versa)

Aggregate Demand: an increase in demand means an increase in employment (and vice versa)

C. Know the SRAS and LRAS.

i. Why is the LRAS vertical?

In the long run, wages and other input prices rise and fall to match changes in the price level

~Price-level changes do not affect firms' profits and thus they create no incentive for firms to alter their output

ii. Understand the effect that an eventual increase in wages has on the AD, LRAS, and SRAS equilibrium

Aggregate Demand: an increase in wages will increase demand

Short Run Aggregate Supply: an increase in wages will increase supply

Long Run Aggregate Supply: no effect; wages match changes in the price level

D. Know how changes in the LRAS is similar to shifts in the PPC

The LRAS can only shift to the right if more resources are found or new technology invented, the PPC is the alternative combinations of two goods that an economy can produce with existing resources and technology in a given time period

6. Fiscal Policy

A. What are the different types (discretionary and non-discretionary/ contractionary and expansionary?) Know what they are and be able to identify examples of each.

Discretionary Fiscal Policy: policy in which the government has to take action for it to be implemented

Non-Discretionary Fiscal Policy: automatic stabilizers in the economy

~Progressive Tax: the more you make the larger percentage of your income you pay in taxes

Contractionary Fiscal Policy: causes a budget surplus

~The government has decreased spending and started taking in more money in tax revenues so the government has a surplus

Expansionary Fiscal Policy: causes a budget deficit

~The government is spending more but not taking in extra money in tax revenues so the government has a deficit

B. What type of fiscal policy should be implemented to eliminate an inflationary or recessionary gap?

Recessionary Gap: expansionary fiscal policy

Inflationary Gap: contractionary fiscal policy

7. Crowding out Effect

A. What is it?

Crowding-out Effect: a rise in interest rates and a resulting decrease in planned investment

B. What causes it?

Caused by the Federal government's increased borrowing in the money market

8. Basic Classical economic theory

Value Theory

~Labor Theory of Value: natural prices were the sum of natural rates of wages, profits (including interest on capital and wages of superintendence) and rent

~Price Determinants:

-The level of outputs at the level of Smith's "effectual demand"

-Technology

-Wages

*Stressed the benefits of trade

*Laissez-faire

Monetary Theory

~Monetarists and the currency school argued that banks can and should control the supply of money

-Theory: inflation is caused by banks issuing an excessive supply of money

~Theory of Endogenous Money: the supply of money automatically adjusts to the demand, and banks can only control the terms (e.g., the rate of interest) on which loans are made

9. The Phillips Curve

A. Know the relationship between inflation and unemployment on the SR Phillips curve

SR Phillips Curve: when the actual rate of inflation is higher than expected, profits temporarily rise and the unemployment rate temporarily falls

Econ -Unit 3- Chap 12 Questions

1. What is the central thrust of the Employment Act of 1946? What is the role of Council of Economic Advisers in response to this law?

Commits the Federal government to use all practicable means, consistent with the market system, it commits the Federal government to take action through momentary and fiscal policy to maintain economic stability. The council assisted and advised the president on economic matters.

2. Assume that a hypothetical economy with a MPC of .8 is experiencing a severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish the same goal.

Government spending would have to increase by $6.25 billion. A tax cut would need to be $7.81 for the same effect. There's a difference because with a tax cut there will be an increase in saving, so you have to cut it by more than your aim. A possible combination to reach the same goal would be a tax cut of $7 billion and an increase in government spending by $.65.

3. What are government's fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these fiscal policies on the price level. Which of these fiscal options do you thin might be favored by a person who wants to preserve the size of the government? A person who thinks the public sector is too large?

Options:
Decrease government spending: Preferred by those who want to preserver the size of the government
Increased taxes: Preferred by those who believe the public sector is too large


6. Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy's built-in stability?

A built-in stabilizer is anything that increases the government’s budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy makers. Which means that to some degree, government tax revenues change automatically over the course of the business cycle and in ways that stabilize the economy.

9. Some politicians have suggested that the US enact a constitutional amendment requiring that the Federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact the contractionary fiscal policy whenever the economy experienced a severe recession.

If we went into a recession, they'd have to try to stop it with contrfactionary fiscal policy to keep the budget around what it was

Econ -Unit 3- Chap 12 Notes

Aggregate Demand

• A schedule or curve that shows the amounts of real output that buyers desire to purchase at each price level
  
• Negative relation between price level and real GDP
  

  
  

  Aggregate Demand Curve
  

• When graphed it curves downward
  
  • Centered on the income and substitution effect
    
• When economy moves down the aggregate curve it moves to a lower general price
  

  
  

  Really-Balances Effect;
  

• Change in the price producing creates a real-balances effect
  

  Inetest-Rtae effect
  

• Also curves downward because of interest rate effect.
  
• We assume that the supply of money in the economy is fixed
  
• A higher price level increases the demand for money
  

  Foreign Purchase Effect
  

• Foreign purchase effect also causes a downward slope
  
• When US price levels rises relative to foreign price levels foreigners buy fewer US goods and American's buy more imports
  
• Fall in exports; rise in imports
  

  
  

  Determinants of Aggregate Demand
  

  A change in price level will change amount of aggregate spending and therefore change real GDP of economy
  

• If one of the determents of aggregates of demand changes the demand curve will shift
  
• A change in one of the determinant of demand that directly changes the amount of real GDP demanded
  
• Multiplier effect that produces a greater ultimate change in aggregate demand than the initiating change in spending
  

  Consumer Spending
  

• If consumers buy more output at each price level, the AD curve will shift to the right
  
• If they buy less the curve will shift to the left
  

  Consumer Wealth:
  

• Includes both financial assets and physical assets
  
• An increase prompts people to save less and buy more
  

  Consumer Expectation
  

• May alter spending
  
• When one thinks that their income is too rise they tend to spend more
  
• A widely held expectation of surging inflation in the near future may increase AG because consumers will want to buy before prices rise.
  

  Taxes
  

• Reduction in income tax rates raises take-home income and increase consumer purchases at each possible price level
  
• Tax cuts shift to right, Tax increases bring curve to left
  

  Investment Spending
  

• The second major determinant of AD
  
• Decline in investments = left
  
• Increase= left
  

  Real Interest Rates
  

• Increase in interest rates = lower investment spending and lower AD
  
• Increase in money supply lowers the interest rate, thereby increasing investment and AD
  

  Expected Return
  

• Expectations: If firms are positive about what will happen in the future they will more likely invest
  
• Technology: Better technology enhance expected returns on investment thus increasing AD
  
• Excess capacity: Reduce expected return on new investment and decrease AD
  
• Taxes: Increase will reduce after-tax profits and lower expected returns.
  

  Government Spending
  

• Increase will shift AD curve to the right
  
• Reduction will push curve to left
  

  New Export Spending
  

• Exports=increased foreign demand for US goods
  

  National Income Abroad
  

• Encourages foreigners to buy more products
  
• Shift graph to left
  

  
  

  Aggregate Supply
  

• A schedule or curve showing the level of real domestic output that firms will produce at each price level
  

  
  

  Aggregate Supply in the Long Run
  

• Vertical at the economy's full-employment output
  
• Changes in the price level therefore do not change real profit and there is no change in real output
  
• Long-run aggregate supply curve: vertical at economy's potential output
  

  
  

  Aggregate Supply in the Short Run
  

• Short-Run aggregate supply curve: up-sloping
  

  
  

Econ -Unit 3- Chap 3 Notes

SIMPLIFACATIONS

• Private Closed Economy (no international trade or gov.)
  
  • GDP=DI

  CONSUMPTION AND INVESTMENT SCHEDULES
  

• Two factors of aggregate expenditures are consumption (C) and gross investment (I_g)
  
• Need an investment schedule to know planned investment at each possible level of GDP
  
  • Represents investment plans of businesses in the same way consumption schedule represents consumption plans of households
    
• Investment schedule shows amount of investing forthcoming
  
• Interest rate and investment demand curve together to determine amount
  

  
  

  EQUILIBRIUM GDP: C + Ig = GDP
  

Possible Levels of Employment	Real Domestic Output	Consumption	Savings	Investment	Expenditures	Unplanned Changes in Inventories	Tendency of E,O & I
40	$370	$375	$-5	$20	$395	$-25	Increase
45	390	390	0	20	410	-20	Increase
50	410	405	5	20	425	-15	Increase
55	430	420	10	20	440	-10	Increase
60	450	435	15	20	455	-5	Increase
65	470	450	20	20	470	0	Equilibrium
70	490	465	25	20	485	5	Decrease
75	510	480	30	20	500	10	Decrease
80	530	495	35	20	515	15	Decrease
85	550	510	40	20	530	20	Decrease

Tabular Analysis

• Columns 2-5 repeat consumption and saving schedules and the investment schedule
  

  Real Domestic Output
  

• Column2= possible output levels
  

  ECT.
  

• Equilibrium=good
  
  • Total number of good produced=total number of good purchased
    
  • C+I_g
    

  Disequilibrium
  

• Not where it should be
  
• Below=economy wants to spend at higher levels
  
  • To fix: Businesses adjust by stepping up production; greater output increases employment and total income
    
• Above: Total outputs don't generate needed spending to clear shelves of goods; causing bussinesses to cut back production
  
  • To fix: Businesses adjust by cutting back on rate of production
    
    • Lower output=fewer jobs and decline in total income
      

      
      

  Graphical Analysis
  

• 45˚
  
  • Any point=value measured on X=value of what is being measured on Y (x=y)?
    
  • Graphical statement of equilibrium condition
    

    
    

  OTHER FEATURES OF EQILIBRIUM GDP
  

• 2 more characteristics of GDP:
  
  • Saving and planned investments are equal
    
  • No unplanned changes in inventories
    

    
    

  Saving Equals Planned Investment
  

• Saving=Leakage or withdrawal from spending
  
• Causes consumption to be less than total output or GDP
  
• Investment is an injection of spending into the income-expenditures stream
  
• If leakage of saving (LAS) exceeds the injection of investment then C+I_g will be less than GDP (cannot be sustained)
  
• If Injection of investment (IOI) exceeds leakage of saving then C+I_g will be greater than GDP (drives GDP up)
  

  
  

  No Unplanned Changes In Inventories
  

• No unplanned changes in inventories at equilibrium
  
• Unplanned changes in inventories act as balancing item the equates the actual amounts saved and invested
  

  
  

  CHNAGES IN EQUILIBRIUM GDP AND THE MULITPLIER
  

• Change in response to changes in either the investment schedule or the consumption schedule
  
• Expected rate of return on investment rises or the real interest rate falls=upward shift of investment schedule
  
• ^opposite=downward shift
  

  
  

  ADDING INTERNATIONAL TRADE
  

• OPEN ECONOMY!
  
• X=exports
  
• M=imports
  

  
  

  Net Exports and Aggregate Expenditures
  

• Exports=Domestic production, income, and employment for a nation
  
• Included in AE because increase production and creates jobs and income
  
• Open Economy= C+I_g+(X-M)
  

  
  

  The Net Export Schedule
  

• Lists amount of net exports that will occur at each level of GDP
  

  
  

  Net Exports and Equilibrium GDP
  

• In open economy next exports can be positive or negative
  

  Positive Net Exports
  

• Net export schedule= X_n1
  
• C+I_g+X_n1
  
• Other things equal positive exports increase aggregate expenditures and GDP beyond that of closed economy
  
• Exports= lower stock available and boosts real GDP (by increasing expenditures on domestically produced output
  

  Negative Net Exports
  

• Negative = X_n2
  
• C+I_g+X_n2
  
• Other things equal negative exports reduce AE and GDP (Imports add to stock of goods, but diminish GDP by reducing expenditures on domestically produced products)
  

  
  

  International Economic Linkages
  

  Prosperity Abroad
  

• Rising level of real output and income among US trading partners allows US to sell more good abroad, raising net exports
  
• They do good and they buy form us, we get more money and buy from them
  
• Prosperity abroad=prosperity here
  

  Tariffs
  

• When a foreign economy raises tariffs on imports they increase production in their economies, stimulating it; this reduces US exports and depresses our economy
  

  Exchange Rate
  

• Depreciation of dollar
  
  • enables people abroad to get more dollars in exchange for their own currency
    
  • Price of US goods in terms of that currency to fall stimulating increase in purchase of US exports
    
  • US citizens will find that they need more dollars to buy foreign goods and reduce spending on imports
    
  • INCREASES NET EXPORTS & GDP
    

    
    

  ADDING THE PUBLIC SECTOR
  

• Public open economy
  
  • Adding taxes and government purchases
    
• Gov purchases do not cause any movement in schedules
  
• Net tax revenues come from person taxes
  
• Fixed amount of taxes is collected regardless of GDP
  

  
  

  Government Purchases and Equilibrium GDP
  

• Increase in public spending shift the AE upward and produce higher equilibrium GDP
  
• C+I_g+X_n+G
  

  
  

  Taxation and Equilibrium GDP
  

• Lump-sum tax=tax of a constant amount or a tax yielding the same amount of tax revenue at each level of GDP
  
• Taxes reduce disposable income relative to GDP by the amount of taxes
  
• Decline in DI reduces consumption and saving at each level of GDP
  
• Tax increases lower the AE schedule relative to the 45˚ line and reduce the equilibrium GDP
  
• Decreases in existing taxes will raise the AE schedule
  

  
  

• C_a+I_g+X_n+G=GDP
  

  
  

  Injections, Leakages, and Unplanned Changes in Inventories
  

• Imports and taxes are added leakages
  
• Saving importing, and paying taxes=uses for income that subtract from potential consumption (PC)
  
  • Consumption is will be less than GDP (creating potential spending (PS) gap) in amount of after tax saving(S), imports(M), and taxes(T)
    
  • Exports(X), gov. purchases(G), and investments(I_g) are injections into the income expenditures stream
    
  • S_a+M+T=I_g+X+G
    
• Because AE=GDP: all goods and services produced will be purchased
  

  
  

  EQUILIBRIUM VERSUS FULL-EMPLUYMENT GDP
  

• The economy doesn't always need to produce full employment and price level stability
  

  
  

  Recessionary Gap
  

• Recessionary gap (RG) in the amount by which AE at the full employment GDP fall short of those required to meet full employment GDP
  
• Graphically the RG is the vertical distance by which the actual AE schedule lies below the hypothetical AE schedule
  

  
  

  LIMITATION OF THE MODEL
  

• Does not show price-level changes:
  
  • Can account for demand-pull inflation, but does not include how much the price level will rise when AE are excessive
    
  • Does not measure inflation
    
• Ignores premature demand-pull inflation
  
  • Does not explain why mild d-p can occur
    
• Limits real GDP to the full-employment level of output
  
  • Economy can actually expand beyond full-employment real GDP, AE model does not show this
    
• Does not deal with cost-push inflation
  
  • AE does not address
    
• Does not allot for "self-correction"
  
• AE does not contain features that may correct RG