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Lecture 10 Aggregate Expenditure Model

Lecture 10 Aggregate Expenditure Model. Consumption Function. Consumption Function: It shows the relationship between disposable income and consumption. What is disposable income? If we subtract tax from total income then we get disposable income. Suppose M= Total income

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Lecture 10 Aggregate Expenditure Model

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  1. Lecture 10Aggregate Expenditure Model

  2. Consumption Function • Consumption Function: It shows the relationship between disposable income and consumption. • What is disposable income? • If we subtract tax from total income then we get disposable income. Suppose M= Total income T= Tax M-T= Disposable income =Y • So consumption function is C= f(Y) which implies that consumption is a function of disposable income. So consumption function shows how consumption changes when disposable income changes.

  3. Here the equation for consumption function is C= a + b Y where a= intercept = autonomous consumption ( the consumption we will have when we do not have any income) b= slope = MPC = ΔC/ ΔY So the slope of the consumption function (b) is called the marginal propensity to consume (MPC), which shows the change in consumption due to the change in disposable income. MPC is always between 0 and 1. So 0< MPC <1. Why? The reason is that if our income increases then we will consume some amount and save the rest. So ΔC< ΔY. This implies that MPC cannot be greater than 1.

  4. Example: • Suppose initially income is Y1=100. Now income increases to Y2=200. So the change in income is ΔY= 200-100= 100. • This increase in income causes an increase in consumption. Initially consumption was C1=80 and then with income increase it increases to C2= 160. So the change in consumption is ΔC= 160-80=80 • So MPC= ΔC/ ΔY = 80/100= 4/5

  5. Savings Function • It shows the relationship between savings and disposable income. That is it shows how savings changes as disposable income changes. • S=f(Y)

  6. Marginal Propensity to Save (MPS) • Here the equation for savings function is S= -a + d Y where -a= intercept = dissavings ( when we do not have income we still have to consume goods and services and we do this by borrowing ) d= slope = MPS = ΔS/ ΔY So the slope of the savings function (d) is called the marginal propensity to save (MPS), which shows the change in savings due to the change in disposable income. MPS is always between 0 and 1. So 0< MPS <1. Why? The reason is that if our income increases then we will consume some amount and save the rest. So change in savings will be less than change in income that is ΔS< ΔY. This implies that MPS cannot be greater than 1.

  7. Relation between MPC and MPS • We know that Y= C+ S • So we will have MPC+ MPS=1. • So we can write MPC = 1- MPS

  8. Total consumption Total savings APC = APS = Total income Total income APC and APS • Average Propensity to Consume (APC): The ratio of consumption and income is known as average propensity to consume. If we divide the total consumption by total income then we get APC. • Average Propensity to Save (APS) : The ratio of savings and income is known as average propensity to save. If we divide the total savings by total income then we get APS.

  9. (2) Consump- tion (C) (1) Disposable Income (Y) (4) Average Propensity to Consume (APC) (2)/(1) (5) Average Propensity to Save (APS) (3)/(1) (6) Marginal Propensity to Consume (MPC) Δ(2)/Δ(1) (7) Marginal Propensity to Save (MPS) Δ(3)/Δ(1) (3) Saving (S) (1-2) APC, APS, MPC and MPS • $370 • 390 • 410 • 430 • 450 • 470 • 490 • 510 • 530 • 550 $375 390 405 420 435 450 465 480 495 510 $-5 0 5 10 15 20 25 30 35 40 1.01 1.00 .99 .98 .97 .96 .95 .94 .93 .93 -.01 .00 .01 .02 .03 .04 .05 .06 .07 .07 .75 .75 .75 .75 .75 .75 .75 .75 .75 .25 .25 .25 .25 .25 .25 .25 .25 .25

  10. Aggregate Expenditure • Aggregate expenditure is the total amount the economy plans to spend in a given period. There are four components in aggregate expenditure which consumption expenditure, investment expenditure, government expenditure and net export. • AE= C+ I + G + NX

  11. Equilibrium Aggregate Output (Income) • Equilibrium occurs when there is no tendency for change. Equilibrium occurs when planned aggregate expenditure is equal to aggregate output/GDP. • In the figure below the point E shows the equilibrium where AE cuts the 45 degree line. At the equilibrium aggregate expenditure is equal to aggregate output/GDP. That is Y=AE

  12. Breaking Down Aggregate Expenditure • We start the discussion by the simplest aggregate expenditure model which is the two sector closed economy. • Two sector or private ( no govt) closed economy: In this model we just include consumption expenditure and investment expenditure. • AE= C + I • Equilibrium is at E where AE=Y ( aggregate expenditure= total income )

  13. Three sector model/ closed economy (no trade) : Here we bring government in the aggregate expenditure model. So we will consider tax ( T) and government expenditure ( G). As we have tax in the economy so we need to use disposable income instead of income. So we have the following equation: • AE= C(Y-T) + I + G where C( Y-T) shows that consumption is a function of disposable income. • Equilibrium is at E where AE=Y ( aggregate expenditure= total income )

  14. Four sector model/Open Economy: This is the complete model where we consider international trade ( export and import) and that is why this model is called open economy. So this model has four components: Consumption ( C), Investment ( I), Govt. Expenditure ( G) and Net export ( NX). So we can write • AE= C(Y –T)+ I + G + NX • Equilibrium is at E where AE=Y ( aggregate expenditure= total income )

  15. (1) Level of Output and Income (GDP=DI) (5) Net Exports (Xn) (7) Aggregate Expenditures (C+Ig+Xn+G) (2)+(4)+(5)+(6) (2) Consump- tion (C) (4) Investment (Ig) (6) Government (G) Exports (X) Imports (M) (3) Saving (S) Aggregate Expenditure Model …in Billions of Dollars 20 20 20 20 20 20 20 20 20 20 $415 430 445 460 475 490 505 520 535 550 • $370 • 390 • 410 • 430 • 450 • 470 • 490 • 510 • 530 • 550 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 $375 390 405 420 435 450 465 480 495 510 $-5 0 5 10 15 20 25 30 35 40 $20 20 20 20 20 20 20 20 20 20

  16. Aggregate Demand and Aggregate Supply • The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. • The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

  17. P P2 1. A decrease Aggregate in the price demand level . . . Y Y2 2. . . . increases the quantity of goods and services demanded. The Aggregate-Demand Curve... Price Level Quantity of 0 Output

  18. Short-run aggregate supply P P2 2. . . . reduces the quantity 1. A decrease of goods and services in the price supplied in the short run. level . . . Y2 Y The Short-Run Aggregate-Supply Curve is upward sloping Price Level Quantity of 0 Output

  19. Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Equilibrium occurs at the intersection of Aggregate Demand and Aggregate Supply curves Price Level Quantity of 0 Output

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