ECON1102 Lecture Notes - Lecture 4: Xm Satellite Radio, Menu Cost, Exogeny
4 – Income-Expenditure Model of GDP
Keynesian Model
• Key assumption (of friction):
Prices of goods are fixed sticky’)
(a) Firms do not change prices in response to a change in demand for their
product
(b) Instead, they fix their price and then meet the demand by varying their level
of production
• In the short-run, firms will:
Accommodate a cut in demand by reducing output and employment, not by
reducing prices
Accommodate a rise in demand by increasing output and employment, not by
increasing prices
• Deeper assumptions
Firms have some ability to set prices (not perfectly competitive world)
Firms face some cost to changing prices (menu costs)
• In the long-run:
Sustained or persistent changes in demand will eventually lead firms to change
their prices and cause production to return to normal capacity
Frictionless view of the world
• Fluctuations in demand will be accommodated by flexible prices and wages without
changes in output and employment
• There will never be excess production because firms will cut prices to sell it
• There will never be persistent unemployment because workers will cut their wages
to keep and get jobs
Expenditure measure of GDP
• Y = C + I + G + NX
Planned aggregate expenditure
• (Keynesian) assumption is that firms meet demand by changing production
• Implies:
Aggregate output (or production) will be determined by the total level of desired
(or planned) spending
PAE – total planned spending on domestically produced final goods and services
(a) Planned / desired spending
Difference between actual and planned expenditure = (unplanned) changes in
inventories
Y = PAE + uplaed ∆ietories
Could be an unplanned fall in inventories if PAE > Y
Two concepts:
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2
• Aggregate expenditure: Y = C + I + G + (X – M)
• Planned aggregate expenditure: PAE = C + IP + G + (X – M)
Equilibrium and disequilibrium
• Equilibrium condition: Y = PAE
Two equivalent decisions: I = IP
(a) uplaed ∆ietories =
No tendency for real GDP to change
• Disequilibrium: Y < PAE or Y > PAE
In both cases, there will be some tendency for the level of GDP to change
Income-expenditure model assumes level of planned or desired aggregate expenditure
will determine the level of aggregate output
• PAE = C + IP + G + (X – M)
Two-sector model
• Assumptions (no simplifying):
No government sector (G = T = 0)
No foreign sector (i.e. a closed economy) (X = M = 0)
• Planned aggregate expenditure: PAE = C + IP
Planned investment – IP = I0
(a) Assumed to be autonomous / exogenous variable
(b) Determined by factors other than GDP (Y)
• Household consumption:
Non-durable goods
Durable goods
Services
Model of consumption expenditure
• Hypothesise that a key influence on consumption spending by households is current
disposable income (= Y – T)
Y = national income or GDP
T = taxes (TA) – transfers (TR) – interest on government debt (INT)
Assume retained earnings (RE = 0)
• Consumption function: C = C0 + c (Y – T)
Linear relationship
Household consumption depends on:
(a) A constant C0, and
(b) Disposable income (Y – T)
C0 is exogenous (or autonomous) consumption
(a) Factors (other than disposable income) that could affect consumption, e.g.
wealth, real interest rates
(b) The value of an exogenous variable is determined outside of the model under
consideration
c (Y – T) captures the effect of disposable income on consumption (sometimes
called induced consumption)
(a) c = marginal propensity to consume (parameter)
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Document Summary
Accommodate a cut in demand by reducing output and employment, not by reducing prices. Accommodate a rise in demand by increasing output and employment, not by increasing prices: deeper assumptions. Firms have some ability to set prices (not perfectly competitive world) Firms face some cost to changing prices (menu costs) Sustained or persistent changes in demand will eventually lead firms to change their prices and cause production to return to normal capacity. Expenditure measure of gdp: y = c + i + g + nx. Planned aggregate expenditure (keynesian) assumption is that firms meet demand by changing production. Aggregate output (or production) will be determined by the total level of desired (or planned) spending. Pae total planned spending on domestically produced final goods and services (a) planned / desired spending. Difference between actual and planned expenditure = (unplanned) changes in inventories. Could be an unplanned fall in inventories if pae > y.