682 CHAPTER 28 EXPENDITURE MULTIPLIER
MOST FIRMS are like your local supermarket. They set their prices, advertise their products and services, and sell the quantities their customers are willing to buy. If they persistently sell a greater quantity that they plan to and are constantly running out of inventory, they eventually raise their prices. And if they persistently sell a smaller quantity than they plan to and have inventories piling up, they eventually cut their prices. But in the very short term their prices are sticky. They hold the prices they have set, and the quantities they sell depend on demand, not supply.
Sticky prices have two immediate implications for the economy as a whole:
So to understand the fluctuations in real GDP when the price level is sticky, we must understand aggregate demand fluctuations. The aggregate expenditure model explains fluctuations in aggregate demand by identifying the forces that determine expenditure plans.
The components of aggregate expenditure are:
These four components of aggregate expenditure sum to real GDP (see Chapter 23, pp. 547-549).
Aggregate planned expenditure is equal to plannedconsumption expenditure plusplanned investment plus planned government purchases plus planned exports minus planned imports. Chapter 26 describes the influences on these expenditure plans and explains how in the long run, when real GDP equals potential GDP, expenditure plans determine the real interest rate. Chapter 27 combines aggregate demand, which is based on aggregate expenditure plans, with aggregate supply and explains how in the short run, real GDP deviates from potential GDP. Here, we look at expenditure plans on a much shorter-term horizon.
In the very short term, planned investment, .planned government purchases, and planned exports are fixed. But planned consumption expenditure and planned imports are not fixed. They depend on the level of real GDP itsel£
Because real GDP influences consumption expenditure and imports, and because consumption expenditure and imports are components of aggregate expenditure, there is a two~way link between aggregate expenditure and GDP Other things remaining the same,
You are going to learn how this two-way link between aggregate expenditure and real GDP determines real GDP when the price level is sticky. The starting point is to consider the first piece of the twoway link: the influence of real GDP on planned consumption expenditure and saving.