Principles of Macroeconomics / Unit 9 MAC 0835 review, 2 to 3 minutes
Where Is the Price Level
The idea
The expenditure model has no price level and no supply curve in it. That is a deliberate simplification and it creates a trap, which is worth walking into on purpose. Read the model literally and it says output can be pushed to any level at all, because raising the expenditure line far enough puts the crossing anywhere you like. That reading is wrong, and the reason it is wrong is that the supply side binds: there are only so many workers, so much capital, so much technology and so much institutional capacity. The model cannot say so, because none of those things appear in it. So an inflationary gap should not be read as a prediction that output will reach that level. It should be read as a measure of how far spending exceeds what is needed to reach potential, and that excess comes out as a higher price level rather than as extra goods.
In practice
Worked example: take the course's economy at potential, 7,000 billion, and add another 200 billion of autonomous spending. The arithmetic puts the new crossing at 7,500. Unit eight's diagram says what actually happens: the economy is at potential, so it sits in the steep zone of the short-run supply curve, aggregate demand shifts right, and most of the movement lands on the price level rather than on output. The expenditure model has given a correct measure of excess demand and an incorrect forecast of output, and both come from the same missing piece.
Where people slip
Two cautions worth carrying forward. First, inflation is present in this model implicitly, through the gap, even though the price level never appears in the equation, so a model can carry a variable it never names. Second, the model that omits the price level and the model that features it are answering different questions, and the skill is knowing which one to reach for: the expenditure model for the size of a spending change, the demand and supply model for what that change does to output and prices together.
Your place on the trail
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