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# ECON 209 Chapter 21.docx

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McGill University

Economics (Arts)

ECON 209

Paul Dickinson

Winter

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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

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