ECMA06 – Aggregate Expenditure 1
Aggregate Expenditure – The Simplest Short-Run Model
Develop a simple model that determines equilibrium
national income, the model consists of consumption and
Discuss the adjustment mechanism.
Consider the effect of change in exogenous variable on
Discuss the concept of the multiplier.
Exogenous Variables vs. Endogenous Variables
Any model must consist 2 types of variables, and they are:
1)Exogenous variables – the values are given (i.e., they are
constants and we do not need to solve for them).
External factors/shocks can change the values of these
2)Endogenous variables – the values are determined within
the model (i.e., we need to solve for them). ECMA06 – Aggregate Expenditure 2
Why Do We Want to Develop a Model that Determines
Just like any market, the equilibrium level of income is
determined by supply and demand.
However, demand (desired/planned expenditure) is not
always equal to supply (actual expenditure). Why?
Aggregate Demand (AD) = desired (or planned)
expenditure (what we intended to spend):
AD = C + (intended) I + G + X – IM.
Aggregate Supply = actual expenditure = actual national
Y = GDE = C + (actual) I + G + X – IM.
The key difference is investment (I) in GDE includes
unintended change in inventories while investment (I)
in AD includes only intended investment. ECMA06 – Aggregate Expenditure 3
It is certainly true that every act of production generates
income for us; however, not all of that income gets
translated into demand for the output of firms.
We want a model that has some positive relationship
The income generated by production
The demand that exists for that production ECMA06 – Aggregate Expenditure 4
The Underlying Aggregate Expenditure (AE) Model
The underlying model is given by:
AE = AE +0c YY
where AE = aggregate expenditure = planned expenditure
AE 0 autonomous expenditure
cY= AE = marginal propensity to spend out of
Y = GDP = output = income
Solving for Equilibrium
The equilibrium level of output, Y*, is the level of Y such
that planned expenditure equals to actual expenditure. ECMA06 – Aggregate Expenditure 5
A Simple AE Model
Assumptions of the Simple AE Model
It is a closed economy (i.e., no foreign sector).
Exports (X) = 0 & Imports (IM) = 0.
There is no government.
Taxes (T) = 0, Transfer (TR) = 0, & Government
spending (G) = 0.
The model only consists of consumption & investment.
Assumption: Households spend a fraction of their disposable
income (DI) on final goods and services Consumption is
positively related to DI.
A simple consumption function:
C = C(DI), where DI = Y – T + TR
C = C 0 c D1, where C 0 autonomous consumption
c1= DI & 1 > c1> 0
Note: If T = 0 & TR = 0, then DI = Y. ECMA06 – Aggregate Expenditure 6
Assumption: The return on investment is predetermined.
An investment function:
I = 0 – d(r – ), where I =0autonomous investment
r = real interest rate
d = r = constant
Investment is inversely related to the interest rate since real
interest rate represents the opportunity cost of undertaking
Note: In the meantime, we will assume r is fixed to keep
our model simple! We will relax this assumption several
weeks later. ECMA06 – Aggregate Expenditure 7
Example: Suppose C = 10 + ⅔DI, where DI = Y – T + TR
I = 90 – 3(r – 0.06), r = 0.06
Solve for the equilibrium level of output for a closed economy
with no government.
Get the AE equation: AE = C + I + G + X – IM
Solve for Y:
Graphically (Keynesian Cross Diagram)
AE Y = AE
Y ECMA06 – Aggregate Expenditure 8
Adjustment Mechanism – How Does the Economy End Up
in Its Equilibrium
Discuss the adjustment mechanism, i.e., what brings Y back
Recall, the model does not include government (T = TR = G
= 0) and foreign sector (X = IM = 0):
C = 10 + ⅔Y
I = 90 – 3(r – 0.06), r = 0.06 I = 90 (constant)
AE = C + I = 100 + ⅔Y ECMA06 – Aggregate Expenditure 9
Case 1 – Initial Y < Y* (= 300)
Suppose the initial Y = 270:
When Y = 270, the level o