Chapter 21 Simplest Short Run Macro Model.docx

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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
taxes and adding what they receive in transfers
Two possible uses of disposable income: consumption (C) or saving (S)
o Difference between disposable income and amount of consumption is the amount
Key factors influencing desired consumption
o Disposable income
o Wealth
o Interest rate
o Expectations about future income
In more advanced theories, individuals are forward looking and so consumption depends more
on “lifetime” income
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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
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
o APC = C/YD
Marginal propensity to save (MPS) relates change in desired saving to change in disposable
income that brings it about
o MPS = delta S/delta YD
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