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MGEA06H3
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Iris Au
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Economics for Management Studies

MGEA06H3

Iris Au

Winter

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23 January 2013
CHAPTER 21: AGGREGATED EXPENDITURE [CONT’D]
Case 2: Initial Y > Y* (= 300)
Suppose the initial Y = 360:
When Y = 360, the level of AE = 100 + 2/3 (360) = 340
The adjustment mechanism when the
output is less than 300:
At Y = 360, there is excess supply (ES).
Firms find their inventory has increased
unexpectedly. The firms will then reduce
production by reducing the amount of
workers, and when the firms reduce
production, income will also decrease. As
workers lose their jobs, their income is 0.
To calculate economy as a whole, we
factor everyone’s income. The process
continues until Y drops to 300.
If Y < Y* Excess Demand Production ↑ Y↑ to Y*
If Y > Y* Excess Supply Production ↓Y↓ to Y*
The initial level of Y DOES NOT matter, the economy will always adjust itself and converge to Y*
Exogenous Change in the AE Function
Consider how an exogenous change in the AE function affects the equilibrium level of national income.
The Multiplier (M)
If AE increases by 1 unit, how much will Y* increase?
0
It depends on the size of the multiplier. The multiplier measures the change in equilibrium output or
income (Y*) that results from a unit change in autonomous expenditure (AE ) 0
M = Y* / AE O
AE = AE 0 C YY
Y* = AE 0 1 / (1 – C Y
M = Y* / AE = OY* / dAE = 1 O (1 – C ) Y
If we take the partial derivative of Y* with respect to AE , we are holding 1 / (1 – C ) constant. 1 / (1 – C )
O Y Y
is the derivative, also known as the multiplier. If the AE Oncreases by 1, then Y* increases by 1 / (1 – C ) Y
and the size of the multiplier must be greater than 1 because 1 minus a fraction is another fraction and
1 divided by any fraction must be a value greater than 1.
Since 1 > CY< 0, M > 1. The multiplier is greater than 1 because one’s expenditure = another’s income.
Suppose AE ↑ by AE :
0 0 Round Change in AE Change in Y
1 AE ↑ by AE 0 Y ↑ by AE 0
2 C ↑ by C Y AE 0
AE ↑ further by C xYAE 0 Y ↑ further by C xYAE 0
3 C ↑ by C Y C xYAE 0
AE ↑ further by C xYAE 0 Y ↑ further by C xYAE 0
First Round
For whatever reason you decided to spend a little bit more in the economy (AE ↑) by $10 (AE 0. 0
Buying coffee at Starbucks, it is true that you are spending $10 but through the Starbuck owner’s
perspective it is their income, so his income goes up by $10; thus the total economy’s income (Y) has
gone up by $10 (AE ). 0
Second Round
The Starbucks owner understands their income has gone up by $10. The owner decides to spend a
portion of his income on a book at Chapters (C). We assume households always spend a fraction of their
income. The marginal propensity to spend on disposable income is 0.8 (C ). This means wYen the
Starbucks owner receives the $10 (AE ), he 0pends $8 (C x AE ) oY books 0t Chapters. Through the
perspective of Chapters the $8 (C x AE ) spent on the book is their income (Y).
Y 0
Third Round
The Chapters owner understands their income has gone up by $8. The owner decides to spend a portion
of his income on a MacDonald

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