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University of Toronto Scarborough
Economics for Management Studies
Iris Au

ECMA06 – Aggregate Expenditure 1 Aggregate Expenditure – The Simplest Short-Run Model Outline  Develop a simple model that determines equilibrium national income, the model consists of consumption and investment only.  Discuss the adjustment mechanism.  Consider the effect of change in exogenous variable on national income.  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 variables. 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 National Income?  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 income (GDE): 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 between The income generated by production and 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 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. Consumption Function 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 C c1= DI & 1 > c1> 0  Note: If T = 0 & TR = 0, then DI = Y. ECMA06 – Aggregate Expenditure 6 Investment Function Assumption: The return on investment is predetermined.  An investment function: I = 0 – d(r – ), where I =0autonomous investment r = real interest rate I d = r = constant  Investment is inversely related to the interest rate since real interest rate represents the opportunity cost of undertaking investment.  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 45 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 to Y*.  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
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