The Income–Expenditure Model

Earlier in this chapter, we described how autonomous changes in spending—such as a fall in investment spending when a housing bubble bursts—lead to a multistage process through the actions of the multiplier that magnifies the effect of these changes on real GDP. In this section, we will examine this multistage process more closely. We’ll see that the multiple rounds of changes in real GDP are accomplished through changes in the amount of output produced by firms—changes that they make in response to changes in their inventories. We’ll come to understand why inventories play a central role in macroeconomic models of the economy in the short run as well as why economists pay particular attention to the behavior of firms’ inventories when trying to understand the likely future state of the economy.

Before we begin, let’s quickly recap the assumptions underlying the multiplier process.

  1. Changes in overall spending lead to changes in aggregate output. We assume that producers are willing to supply additional output at a fixed price level. As a result, changes in spending translate into changes in output rather than moves of the overall price level up or down. A fixed aggregate price level also implies that there is no difference between nominal GDP and real GDP. So we can use the two terms interchangeably in this chapter.

  2. The interest rate is fixed. We’ll take the interest rate as predetermined and unaffected by the factors we analyze in the model. As in the case of the aggregate price level, what we’re really doing here is leaving the determinants of the interest rate outside the model. As we’ll see, the model can still be used to study the effects of a change in the interest rate.

  3. Taxes, government transfers, and government purchases are all zero.

  4. Exports and imports are both zero.

In all subsequent chapters, we will drop the assumption that the aggregate price level is fixed. The Chapter 13 appendix addresses how taxes affect the multiplier process. We’ll explain how the interest rate is determined in Chapter 15 and bring foreign trade back into the picture in Chapter 19.