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02.04 - Demand Determined Model.docx

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ECON 102
Lanny Zrill

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Demand Determined Model of National Income 02-04-2013 The AD-AS Model: A Theoretical Model of National Income (Y) and the Price Level (P)  Describe the demand side of the economy by constructing a model of aggregate expenditure  Describe the supply side of the economy by hypothesizing the typical behavior of firms  Bring the two sides together in an aggregate supply and demand framework in order to analyze economic shocks and policy Desired Aggregate Expenditure Consider the theoretical counterpart to our measure of Real GDP from Chapter 20, the Desired Aggregate Expenditure (AE) function:  AE = C + I + G + NX  Total amount that all parties (households, firms, government) want to spend  Just like quantity demanded but for all goods Types of Expenditure: Two Types  Induced expenditure – purchases of goods and services that depend on the level of national income  Autonomous expenditure – purchases of goods and services that do not depend on the level of national income  This distinction is important for evaluating quantitative effects of government policy (ex. The Multiplier) Desired Consumption  Consumption function – relates the level of desired consumption to disposable income  Assume all disposable income not used for consumption is saved  Level of desired consumption also depends on: o Wealth o Interest rates o Expectations about the future Consider a generic consumption function: C = a + b(Yd)  Consumption is a linear function of disposable income  a = autonomous consumption  b = slope; Marginal Propensity to Consume (MPC) o MPC – tells you what fraction of each additional dollar of disposable income consumers wish to spend o MPC = ΔC / Δ Yd Shifts in the Consumption Function  What is the effect of a stock-market crash?  At all levels of disposable income, desired consumption expenditure is lower Desired Investment  Recall: Investment only includes: o Changes in inventory o New plant and equipment o New Residential housing  Depends on: o Real interest rate o Business confidence  Assume: Desired Investment is Autonomous o Ex. I = 75  Government Purchases  Government purchases (G) does not include transfer payments o Transfer payments enter the equation through Net Taxes (T)  T = tY o t = net tax rate o Y = national income  Net taxes includes taxes collected minus transfer payments  Net taxes includes all types of taxes (income, sales, international tariffs, property tax, etc.) from all levels of government (Federal, Provincial, Municipal)  Captures both directions – to the government and away from the government  Theoretical model. Assumption: relation between net tax rate and income (not situation in real life) Budget Balance  Budget balance = Net tax Revenues (T) – Government Purchases (G) o Surplus: T-G > 0 o Deficit: T-G < 0 International Trade  Assume: Exports (X) are autonomous and Imports (IM) are induced  IM = mY o M = marginal propensity to import  Thus, net exports (NX) is given by: o NX = X – mY  Net exports depend on: (must know for the exam) o Changes in foreign income  Only affects exports o Changes in price level  Affects exports and imports o Changes in exchange rate  Graph: Intercept = X o Slope = m Shifts in Net Exports  What is the effect on Net Exports of a relative decrease in the US Price Level (relative to Canadian Price Level)?  US goods and services are not relatively cheaper than they were before  First: Expect exports to fall – parallel shift of net exports function  Now, Canadians also want to buy more US goods  Second: Increase in imports – increase in marginal propensity to import o When you increase m (slope) – function bec
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