Class Notes (810,488)
Canada (494,139)
ECON 209 (122)

ECON 209 Chapter 21.docx

7 Pages
Unlock Document

McGill University
Economics (Arts)
ECON 209
Paul Dickinson

ECON 209 January 22, 2013 Chapter 21 – The Simplest Short-Run Macro Model 21.1 Desired Aggregate Expenditure Desired aggregate expenditure (AE): sum of desired or planned spending on domestic output by households, firms, gov’ts, and frgnrs  AE = C + I + G + (X – IM)  Need not = actual expenditure in any regard  Nat’l income accts msr actual expenditures in ea of the 4 expenditure categories; nat’l income theory deals w/ desired expenditures Autonomous vs. induced expenditure:  Autonomous expenditure: elements of aggregate expenditure that do not change systematically w/ nat’l income  Induced expenditure: any elements of expenditure that are systematically related to (vary w/) nat’l income Important simplifications: We will focus only on consumption (55-60% of GDP; largest segment of GDP and most important link btwn desired aggregate expenditure and real nat’l income) and investment (20% of GDP, volatile and therefore crucial to fluctuations in real nat’l income/business cycles)  We consider a closed econ: no frgn trade in goods, services, or assets  We assume no gov’t and constant price level Desired consumption expenditure: In our simplified model…  Savings = all disposable income not spent on consumption (savings and consumption are only possible uses of disposable income)  YD= Y (in simple model)  Consumption and disposable income tend to be (+) related (in the simplest model, holding constant other determinants of desired consumption) The consumption function: relationship btwn desired consumption expenditure and all variables that determine it; in the simplest case, the relationship btwn desired consumption expenditure and disposable income  Key factors influencing desired consumption are…  Disposable income  Wealth  Interest rates  Expectations about the future  E.g. C = 30 + 0.8D – when Y D 0, aggregate desired consumption = $30 billion, and for every $1 increase inDY , C increases by $0.80  $30 billion = autonomous aggregate consumption (changes as the production function moves along the x-axis)  0.8Y =Dinduced aggregate consumption (y-intercept of production function) Avg and marginal propensities to consume:  APC = C/Y – APC is negatively related to Y D D  MPC = ΔC/ΔY –Drelates change in desired consumption to the change in disposable income that caused it (in above ex. = 0.8) The slope of the consumption function:  MPC = ΔC/ΔY =Dslope of consumption function (positive and constant in the simple model) The 45° line: connects all pts where desired consumption = disposable income (positive slope of 1)  Consumption function cuts the 45° line at the “break-even” level on income  Desired saving = 0  When consumption function > 45° line, C > Y D  Desired savings must be (-) – spending out of savings or borrowing  When consumption function < 45°, C < Y D  Desired savings must be (+) – paying back debt or accumulating assets The saving function:  APS = S/YD  MPS ΔS/ΔY D  APC + APS = 1 (necessarily)  MPC + MPS = 1 (necessarily) …all income and increments of income must be acctd for  Saving function is (+) sloped – disposable income and desired saving are (+) related  Amt of desired saving = vertical distance btwn the consumption function and the 45° line Shifts of the consumption function: in the simple model, changes in disposable income = mvmts ALONG the consumption function; changes in wealth/interest rates/future expectations = SHIFTS of the consumption function  Change in household wealth (accumulated assets – accumulated debts):  Increase in wealth = less saving of CURRENT earnings; consumption function shifts UP and saving function shifts DOWN  Decrease in wealth = consumption function shifts DOWN and saving function shifts UP  Change in interest rates:  Household consumption = consumption of durable goods + consumption of non-durable goods  Fall in the interest rate = increase in desired consumption, esp of durable goods, for any given level of disposable income – consumption function shifts UP and saving function shifts DOWN  Rise in the interest rate = consumption function shifts down and saving function shifts UP  Future expectations:  Optimism (about the future state of the econ, future employment opportunities, etc.) = consumption function shifts UP and saving function shifts DOWN  Pessimism = consumption function shifts DOWN and saving function shifts UP  MVMTS ARE INDUCED, SHIFTS ARE AUTONOMOUS (w/ reference to the simple model) Desired investment expenditure: 3 important determinants of aggregate investment expenditure:  The real interest rate  Changes in level of sales  Business confidence Desired investment and the real interest rate (represents real opp cost of using money – either borrowed money or retained earnings – for investment purposes)  Higher real interest rate = higher opp cost of investment = lower amt of desire investment  Rise in real interest rate = reduction in amt of desired investment expenditure Relationship best seen divided into 3 categories:  Inventories: small % of private investment in a typical yr  However, it is volatile and therefore has an important influence on fluctuations in investment expenditure  Firms could lend out funds tied up in inventories at the going interest rate… higher real interest rate = higher opp cost of holding an inventory of a given size = smaller inventories will be desired  Residential construction: also volatile  B/c interest pymts are such a large part of mortgage pymts, variations in interest rates have a substantial effect on desire for housing  New plant and equipment: high interest rates make it expensive for firms to borrow money for big expenditure such as building a new plant or buying new equipment = less investment of this kind Desired investment and change in sales:  Size of inventories related to size of sales, therefore change in inventories (part of current investment) related to change in level of sales  Higher level of sales = larger desired stock of inventories… changes in rate of sales therefore cause temporary bouts of investment (or disinvestment) in inventories  Changes in sales have similar effects on investment in plant and equipment Desired investment and business confidence: investment depends on firms’ expectations about the econ – optimism leads to more desired investment, and vice versa Desired investment as autonomous expenditure: treated as such in the simple model that we are dealing w/  We assume investment to be unaffected by changes in nat’l income (investment function is a horizontal line)… this is not to say that we assume it is
More Less

Related notes for ECON 209

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.