Question

Suppose price levels are fixed, what must be done, if any, so that the equlibrium expenditure (Keynesian cross) stays in the same spot?

Answer 1

The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy are equal to the amount of output produced.

The foundation of Keynesian macroeconomic theory is that prices, wages, and interest rates are fixed. Prices and wages are directly related because firms could not lower product prices if wages were not lowered. Classical economic theory suggested that high unemployment rates would lead to lower wage rates, which would lead to lower prices, which would lead to higher demand because of the increased purchasing power of existing wealth. But Keynes observed that wages were not falling (actually there was a decline in the average price level during the early 1930s but evidently not enough to matter). Keynes could not apply an economic theory to explain why those out of work were unwilling to accept a lower wage in order to get a job. He simply accepted it as an unexplained socioeconomic fact of life and built a theory around the assumption that prices and wages were rigid.

If the price level is fixed, then changes in nominal income will be equivalent to changes in real income. That is, when assuming the price level is fixed, we do not have to distinguish real variable changes from nominal variable changes. In the very short run, prices are fixed and sellers adjust output to meet the demand for goods and services. That is, the demand for output at a given price is determining how much each firm is producing and selling. The fixed price level assumption has an important implication: if demand determines the quantity of output that each firm sells, then it is aggregate demand that determines the level of real gross domestic product (RGDP) or the aggregate quantities of goods and services sold. In other words, in the Keynesian world, we must study fluctuations in aggregate demand in order to understand changes in the real gross domestic product (RGDP).

In the Keynesian model with fixed prices, we can have an equilibrium when the economy is operating below its potential of full employment. The implication during the Great Depression was that the economic depression could continue since it represents a possible equilibrium. The government must step in to force the economy to a new equilibrium at full employment.

When the economy is not in equilibrium aggregate output does not equal aggregate expenditures. Firms are producing more or fewer goods than households are buying. What we will see in a disequilibrium condition is that inventories are either building (output exceeds expenditures) or declining (output is less than expenditures). In the classical model when there is undesired inventory build or draw, firms will lower or raise prices to eliminate the imbalance. In the Keynesian model with fixed prices, firms will simply reduce or increase production without changing prices.

The Keynesian model as strictly a model of demand. The supply side is essentially ignored. Firms simply increase or reduce output to meet the level of demand at the fixed price level. The aggregate supply curve is flat at the fixed price level and only shifts in spending result in changes in aggregate economic output.

Government fiscal policy represents a change in either spending or taxes. For example, if the economy is in a recession the government could increase autonomous spending, increase transfer payments, reduce lump-sum taxes, or reduce the income tax rate.

Keynesian macroeconomics argues that the solution to a recession is an expansionary fiscal policy that shifts the aggregate demand curve to the right.

Conversely, Figure (b) shows a situation where the aggregate expenditure schedule (AE₀) intersects the 45-degree line above potential GDP. The gap between the level of real GDP at the equilibrium E₀ and potential GDP is called an inflationary gap. An economy faces some supply-side limits on how much it can produce at a given time with its existing quantities of workers, physical and human capital, technology, and market institutions.

The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment.