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Lecture 3

# Lec- Week 3

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University of Toronto Scarborough

Economics for Management Studies

MGEA06H3

Iris Au

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
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• 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.
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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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