Question

The following table shows some information on a hypothetical economy. The table lists real GDP, consumption (C), investment (I), government spending (G), net exports (X – M), and aggregate expenditures (AE). In this problem, assume that investment, government spending, and net exports are independent of the economy's real GDP level.

Using the numbers provided in the table, enter the correct numbers in the empty cells. Then, using the dropdown selection menus in the right-most column, indicate whether output will tend to increase, decrease, or remain in equilibrium at each level of real GDP in the table. (Note: The table uses negative numbers to indicate an unplanned inventory investment depletion and positive numbers to indicate an unplanned inventory investment accumulation.)

Real GDP	C	I	G	X – M	AE	Unplanned Inventory Investment	Direction of Real GDP and Employment
$400	$300	$50	$100	$0		-$50
$500		$50	$100	$0	$500	$0
$600	$400	$50	$100	$0		$50
$700		$50	$100	$0	$600	$100
	$500	$50	$100	$0	$650	$150

True or False: The most fundamental assumption behind the aggregate expenditures model is that prices in the economy are flexible.

When aggregate expenditures are greater than real GDP, there is an unplanned inventory investment _____ . This will prompt firms to ______ employment and production.

Answer 1

Solution:

Real GDP	C	I	G	X-M	AE= C+I+G+(X-M)	Unplanned invesntory investment= Real GDP-AE	Direction of Real GDP and employment (increase or decrease)
400	300	50	100	0	450	-50	increase
500	350	50	100	0	500	0	neither increase nor decrease
600	400	50	100	0	550	50	decrease
700	450	50	100	0	600	100	decrease
800	500	50	100	0	650	150	decrease

The statement that "The most fundamental assumption behind the aggregate expenditures model is that prices in the economy are flexible" is false. In fact the prices are fixed which is extreme case of sticky price model.

When aggregate expenditures are greater than real GDP, there is an unplanned inventory investment depletion . This will prompt firms to increase employment and production. This is done in order to match expenditure with output.