# Chapter 21 Simplest Short Run Macro Model.docx

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11 Apr 2012
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Chapter 21 The Simplest Short Run Macro Model
21.1 Desired Aggregate Expenditure
National accounts divide actual GDP into its components:
o GDP = Ca, Ia, Ga, and NXa
Total desired expenditure is divided into same categories:
o Desired consumption
o Desired investment
o Desired government purchases
o Desired net exports
What does “desired really mean?
o Desired expenditure is not just a list of what consumers and firms would buy if they had
no constraints on their spending it is much more realistic than that
o Desired expenditure is what consumers and firms would like to purchase, given their
real-world constraints of income and market prices
The sum is called desired aggregate expenditure
o AE = C + I + G + NX
Two types of expenditures
o Autonomous expenditures do not depend on the level of national income (expenditure
is not a function of income)
o Induced expenditures do depend on the level of national income (expenditure is a
function of income)
Desired Consumption Expenditure
In simplest theory, consumption is determined primarily by current disposable income (YD)
Disposable income: amount of income households receive after deducting what they pay in
Two possible uses of disposable income: consumption (C) or saving (S)
o Difference between disposable income and amount of consumption is the amount
saved
Key factors influencing desired consumption
o Disposable income
o Wealth
o Interest rate
In more advanced theories, individuals are forward looking and so consumption depends more
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Consumption function
Simple consumption function is written as C = a+bYD
The simple consumption function is written as: (graph 1)
o Note: the slope of this simple consumption function (b) is positive and less than one
o a = minimum consumption (autonomous consumption)
o positive slope = more income, more consumption
o BEFORE “break even” level of income above 45 degree line households spending
more than their disposable income saving is negative
o AT “break even” level of income consumption equals household income
o AFTER “break even” level of income below 35 degree line saving is positive
o Constant slope: changes in income and consumption are the same
MPC, APC, MPS, and APS
The marginal propensity to consume (MPC) relates the change in desired consumption to the
change in disposable income that beings it about
o MPC = delta C/ delta YD
MPC is slope of consumption function. What does this mean?
Average propensity to consume (APC) is equal to total consumption divided by total disposable
income
o APC = C/YD
Marginal propensity to save (MPS) relates change in desired saving to change in disposable
o MPS = delta S/delta YD
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