Lec- Week 3

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Department
Economics for Management Studies
Course
MGEA06H3
Professor
Iris Au
Semester
Winter

Description
1 ECMA06 – Aggregate Expenditure Aggregate Expenditure – The Simplest Short-Run Model Outline • Why do we want to develop a model that determines GDP. • Build a simple model that determines equilibrium national income. • The simple model consists of consumption and investment only (will take into account of the government and the foreign sector next week). • Discuss the adjustment mechanism. • Consider how does a change in exogenous variable affect national income (we will also discuss the multiplier). www.notesolution.com 2 Why Do We Want to Develop a Model that Determines National Income? • Question: Does demand (planned expenditure) always equal to supply (actual expenditure)? • Answer: Not necessary! But why? ⇒ (Aggregate) Demand (AD) = desired expenditure (what we intended to spend): AD = C + Iintended investment)+ G + X – IM. ⇒ (Aggregate) Supply = actual expenditure = actual national income: GDE = C + I + G + X – IM. ⇒ The key difference is investment (I) inludes unintended change in inventories (something happens that takes the firms by surprise [unexpected change in inventories]while investment (I) in AD includes only intended investment. www.notesolution.com 3 ECMA06 – Aggregate Expenditure • 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. • 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 Exogenous Variables vs. Endogenous Variables • Any model must consists 2 types of variables – exogenous variables and endogenous variables. • Exogenous variables – these 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. • Endogenous variables – the values are determined within the model (i.e., you need to solve for them) The Underlying Model • The underlying model is given by: AE = AE + c Y 0 Y where AE = aggregate expenditure = aggregate demand cY= = = constant = marginal propensity to spend out of GDP Y = GDP = output = income cYtells how much AE will change for a unit change in Y. It is greater than 0 and less than 1. Solving for Equilibrium • Question: What level of Y gives us the equilibrium? • Answer: The equilibrium level of Y, Y*, is the level o f Y that generates enough AE to buy itself. Equilibrium: Y = AE Y = AE 0 c Yy (1 – y )Y = AE0 Y* = AE /0(1 – c y Example: Suppose AE = 100 (AE ) 0 + (c Y Y. Find the equilibrium level of Y. Equilibrium: Y = AE Y = 100 + 2/3 Y 1/3 Y= 100 Y* = 300 A Simple Macro Model Assumptions of a Simple Macro Model www.notesolution.com 4 • Our simple model assume: ⇒ No government: Taxes (T) = 0 Transfer (TR) = 0 Government spending (G) = 0 ⇒ Closed economy (no foreign sector): Exports (X) = 0 Imports (IM) = 0 • In our simple model, AE only consists of consumption (C) and investment (I). www.notesolution.com 5 ECMA06 – Aggregate Expenditure Consumption Function • A simple consumption function: C = C(DI), where DI = disposable income = Y – T + TR CY= & 1 > c Y 0 • Consumption is positively related to DI. • Consumers spend a fraction of their DI on final goods and services. • Note: If T = 0 & TR = 0, then DI = Y. www.notesolution.com 6 Investment Function • Assumption: The return on investment is predetermined. • A simple investment function: I = I(r), where r = real interest rate d = = constant d tells us how much investment will change for a unit change in real interest • Investment is inversely related to the interest rate. Why? - Real interest rate capture the opportunity cost of undertaking investment (the cost of borrowing) - When R increases, the cost of borrowing increases o Undertaking investment becomes less profitable o Investment decreases • Note: In the meantime, we will assume r is fixed to keep our model simple! We will relax this assumption several weeks later. www.notesolution.com 7 ECMA06 – Aggregate Expenditure Example: Suppose C = 10 + DI, 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 (G=0, closed economy) + X (X=0) – IM (IM=0) AE = (10 + 2/3 DI) + [90 – 3(0.06 – 0.06)] - Since T = TR = 0, DI = Y AE = (10 + 2/3Y) + 90 = 100 + 2/3Y • Solve for Y: Equilibrium: Y = AE = 100 + 2/3 Y 1/3Y = 100 Y* = 300 • Graphically (Keynesian Cross Diagram) AE Y = AE (Equilibrium) Slope = 1 AE = 100 + 2/3 Y AE Slope = 2/3 100 -- 45 Y www.notesolution.com 8 Adjustment Mechanism – How Does the Economy End Up in Its Equilibrium • In this section, we will discuss the adjustment mechanism, i.e., what happens in the economy if the initial level of Y does not equal to Y*. • Recall, the model does not include government (T = TR = G = 0) and foreign sector (X = IM = 0): C = 10 + Y I = 90 – 3(r – 0.06), r = 0.06 ⇒I = 90 (constant) AE = C + I = 100 + Y www.notesolution.com 9 ECMA06 – Aggregate Expenditure Case 1 – Initial Y < Y* (= 300) Suppose initial Y = 270: • What is the level of AE if Y = 270? AE = 100 + (2/3)(270) = 280 AE Y = AE AE = 100 + 2/3 Y A 280 C Excess 270 Demand B 45° Y 270 Y* = 300 Adjustment mechanism: - At Y = 270, AE = 280 > Y = 270 - There is excess demand (ED) - Firms find their inventories decrease unexpectedly o Y increases - This process continues until Y increase to Y*=300 (point A is the equilibrium) Case 2 – Initial Y > Y* (= 300) Suppose initial Y = 360: • What is the
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