Question

According to the income-expenditure model, at any level of GDP is below potential, changes in total expenditure affect real GDP, but the ________ remains level.

a) aggregate price level
b) spending level
c) GDP
d) inflation rate

Answer 1

In the income-expenditure model, when GDP is below potential, changes in total expenditure affect real GDP but the aggregate price level stays the same, assuming there is excess capacity in the economy.

Step-by-step explanation:

According to the income-expenditure model, at any level of GDP that is below potential, changes in total expenditure affect real GDP, but the aggregate price level remains level. This is because, in the short run, when there is a recessionary gap, a rightward shift in the aggregate demand curve leads to a higher level of real GDP without a change in the aggregate price level if the economy is operating with excess capacity or slack.

For instance, if the aggregate expenditure line in the income-expenditure model intersects the 45-degree line at a point below potential GDP, this indicates that the economy is not at full employment. In this case, an increase in aggregate expenditure can result in a higher level of output and employment without putting upward pressure on the price level, thus reducing the recessionary gap. This scenario is consistent with the Keynesian perspective that, when there is unemployment, increases in spending can lead to increases in output without a corresponding rise in inflation.