# ECON1002 Lecture Notes - Lecture 4: Potential Output, Consumption Function, Root Mean SquarePremium

8 pages103 viewsSpring 2017

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ECON1002 - Lecture 4 (Week 4)

Aggregate Expenditure (AE)!

-AE = C + I + G + NX!

-We are in the short run so prices and interest rates etc. are constant.!

-Output is determined by planned aggregate expenditure:!

•Actual I > planned I then inventories rise. !

•Actual I < planned I then inventories fall. !

-However, for everyone else we assume that actual spending is the same as

planned spending to allow us to show that occasionally ﬁrms make mistakes with

their investment planning. !

The Consumption Function!

-Where:!

•Cc = exogenous consumption (wealth eﬀect)!

•C = marginal propensity to consume (0 < MPC < 1)!

•Y = total income !

•T = net taxes!

1

C

Y-T

c

C

( )

where

exogenous consumption (wealth effect)

marginal propensity to consume (0<MPC<1)

total income/production

net taxes

C C c Y T

C

c

Y

T

= + −

=

=

=

=

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Wednesday, 23 August 2017

Planned Aggregate Expenditure!

-PAE = C + Ip + G + NX, if the following values are true:!

•C = 500 + 0.6(Y - T)!

•Ip = 100!

•G = 200, T = 250!

•NX = 50!

-PAE = 700 + 0.6Y where:!

•700 is the exogenous expenditure which is unrelated to income !

•0.6Y is the induced expenditure which is related to income.!

Short Run Equilibrium Output!

-In equilibrium Y = PAE.!

-Injections = I + G + X!

-Leakages = S + T + M!

-In the short run we have a 2 sector model with:!

•Households and ﬁrms (I & S)!

-There is also a 4 sector model with:!

•Households, ﬁrms, government & foreign sector (I, G, X, S, T & M)!

-Equilibrium: injections = withdrawals.!

The 2 Sector Model!

-In the 2 sector model:!

•Y = PAE = C + Ip!

•Ip =Y - C = S!

•Therefore S = I and WD = INJp!

-PAE > Y then:!

•Ip > S!

•Inventories are lower than expected.!

2

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Wednesday, 23 August 2017

•Production increases to replenish their inventories.!

•Economy grows (Y increases) until Y = PAE.!

-2 sector consumption function:!

-2 sector savings function: (S = Y - C):!

•(1 - c) is the marginal propensity to save as it is 1 minus the marginal propensity

to consume as it is a proportion. !

-Planned investment exogenous:!

•Current GDP does not inﬂuence Ip.!

•Other factors such as real interest rates etc. are more signiﬁcant.!

Components of PAE!

3

C C cY= +

( )

1S C c Y=−+−

PAE

Y

45°

C

Ip

Household planned

consumption

Firms’ planned

investment

PAE

Equilibrium

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