Country B is a closed economy with no government and a fixed aggregate price level. There are only two sources of aggregate demand, consumer spending and investment spending. In country B, we have that aggregate disposable income Yd, equals GDP. Write down the income-expenditure equilibrium and explain why the over time the economy moves back to the income-expenditure equilibrium.
What will be an ideal response?
Ans:
AEPlanned = C+ IPlanned , Thus GDP=AE+Iunplanned, if GDP> AEPlanned, this implies that Iunplanned is positive, the inventories of firms increase, and this acts as a signal to firms to decrease their production. When GDP< AEPlanned. this implies that Iunplanned is negative, the inventories of firms decrease, and this acts as a signal to firms to increase their production. When GDP=AEPlanned, there is no incentive to change production. Therefore, over time the economy moves back to the income-expenditure equilibrium.
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