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Chapter 13.docx

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University of Manitoba
ECON 1010
Sarrah Vakili

Chapter 13: Purchasing power - differences in the cost of living between countries Data on relative standards of living is normally adjusted to reflect estimates of purchasing power parity to take account of differences in the cost of living – so that each unit of currency has (approximately) the same purchasing power. One Euro of income in each country may not have the same real purchasing power because of differences in the average cost of living. Limitations of the purchasing power parity adjustment At any given time, the current exchange rate for a country is unlikely to be at PPP levels. Currency speculation or other factors may have driven the exchange rate above or below its estimated PPP level. The PPP calculation/estimation is also constrained by the fact that: o Not all output is traded internationally – some goods and services are produced only for domestic consumption and do not find their way onto international markets o Price differences in different countries may reflect product differentiation o Differences in degree of competition in local and national markets affect relative prices – for example the high level of new car prices in the UK compared to most other countries in the EU is partly a result of oligopoly power among leading UK car retailers o Local indirect taxes and tariffs cause differences in the cost of living o Central bank intervention in the currency markets can take the actual exchange rate out of PPP alignment because they are trying to manage the value of the currency The consumption function The consumption function is simply a theoretical relationship between income and consumer expenditure. The Keynesian theory describes a consumption function where household spending is directly linked to people’s disposable income. A simplified consumption function diagram is shown below. The standard Keynesian consumption function is written as follows: C = a + c (Yd) - where  C is total consumer spending  a is autonomous spending  And c (Yd) is the propensity to spend out of disposable income Autonomous spending (a) is consumption which does not depend on the level of income. For example people can fund some of their spending by using their savings or by borrowing money from banks and other lenders. A change in autonomous spending would in fact cause a shift in the consumption function leading to a change in consumer demand at all levels of income. The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer sp
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