AGGREGATE EXPENDITURETHE SIMPLEST SHORT-RUN MODEL Outline N Build a simple model that determines equilibrium national income. N Simple model consists of consumption and investment only (will take into account of government and foreign sector next week). N Discuss the adjustment mechanism. N Consider how does a change in aggregate expenditure affect national income (we will also discuss the multiplier). Why Do We Want to Develop a Model That Determines National Income? N Question: Does demand (planned expenditure) always equal to supply (actual expenditure)? N Answer: Not necessary! But why? o Supply = actual expenditure = actual national income: GDE = C + I + G + X IM o Demand (AD) = desired expenditure: AD = C + I + G + X IM except unexpected changes in inventories. o The key is investment (I) in GDE includes unintended change in inventories while investment (I) in AD includes only intended investment. N It is certainly true that every act of production generates income for Canadians; however, not all of that income gets translated into demand for the output of firms. N We want a model that has some positive relationship between The income generated by production and The demand that exists for that production Model of the Macro Economy N The underlying model is given by: AE = AE 0 + cYY where AE = aggregate expenditure = aggregate demand AE 0 autonomous expenditure = constant c = d AE d Y = constant, 0 < c < 1 Y Y Y = GDP = output = income N cY basically says that every time income increases by $1 that amount will be divided between spending andYsaving. c is the amount that will be spent. So,Yif c is 0.85, then 85 cents will be spent for every $1 increase in income. N In Canada, the c rate is about 0.7 right now. This means that for every $1 income, 70 cents are spent for consumption. Y Start with a Simple Macro Model N We will start with a simple model first so that you have a feel what the model looks like. N When we make the model more detailed later on, we will have: ** AE = C + I + G+ X IM ** N FOR NOW, we assume I, G, and X are exogenous variables. o Exogenous variablesthese are given to the model (i.e., they are constants and you do not need to solve for them). However, external factors can change the values of these variables. N FOR NOW, we assume C and IM are endogenous variables. o Endogenous variablesthe values are determined within the model (i.e., you need to solve for them). N In particular, C and IM as Y (income) changes. o C and IM are positively related to income. o If income increases, then consumption (C) increases, and imports (IM) also increase. Solving for Equilibrium N We know AE = AE + 0 Y Y N AE 0s always a positive number, even if income is 0. N Question: What level of Y gives us the equilibrium? N Answer: The equilibrium level of Y, Y*, is the level of Y that generates enough AE to buy itself. *** Equilibrium: supply = demand Y = AE Y = AE 0+ cYY (1 cY) Y = AE 0 Y* = AE 01 c Y Example Suppose AE = 100 + 23Y. Find the equilibrium level of Y. 100 = AE 0 23 = Y Equilibrium: Y = AE Y = 100 + 23Y 13Y = 100 Y* = 300 In this economy, the equilibrium level of output or the equilibrium level of income is equal to 300. Building the Model N Question: Where does this kind of model come from? N Start with a simple world o No government: Taxes (T) = 0 Transfer (TR) = 0 Government spending (G) = 0 TransferCPP, EI, Child Care Benefit, so on (negative taxsomething government pays people) www.notesolution.com

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