AGGREGATE EXPENDITURE—THE SIMPLEST SHORT-RUN MODEL
x Build a simple model that determines equilibrium national income.
x Simple model consists of consumption and investment only (will take into account of government and foreign sector next week).
x Discuss the adjustment mechanism.
x 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?
x Question: Does demand (planned expenditure) always equal to supply (actual expenditure)?
x 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
x 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.
x We want a model that has some positive relationship between
The income generated by production
The demand that exists for that production
Model of the Macro Economy
x The underlying model is given by:
AE = AE0 + cY
where AE = aggregate expenditure = aggregate demand
AE0 = autonomous expenditure = constant
Y = d AE / d Y = constant, 0 < cY < 1
Y = GDP = output = income
x cY basically says that every time income increases by $1 that amount will be divided between spending and saving. cY is the amount
that will be spent. So, if cY is 0.85, then 85 cents will be spent for every $1 increase in income.
x In Canada, the cY rate is about 0.7 right now. This means that for every $1 income, 70 cents are spent for consumption.
Start with a Simple Macro Model
x We will start with a simple model first so that you have a feel what the model looks like.
x When we make the model more detailed later on, we will have:
** AE = C + I + G+ X – IM **
x FOR NOW, we assume I, G, and X are exogenous variables.
o 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.
x FOR NOW, we assume C and IM are endogenous variables.
o Endogenous variables—the values are determined within the model (i.e., you need to solve for them).
x 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
x We know AE = AE0 + cYY
x AE0 is always a positive number, even if income is 0.
x Question: What level of Y gives us the equilibrium?
x Answer: The equilibrium level of Y, Y*, is the level of Y that generates enough AE to buy itself.
*** Equilibrium: supply = demand Æ Y = AE Æ Y = AE0 + cYY Æ (1 – cY) Y = AE0 Æ Y* = AE0 / (1 – cY)
Suppose AE = 100 + 2/3Y. Find the equilibrium level of Y.
100 = AE0, 2/3 = cY
Equilibrium: Y = AE
Y = 100 + 2/3Y
1/3Y = 100
Y* = 300
In this economy, the equilibrium level of output or the equilibrium level of income is equal to 300.
Building the Model
x Question: Where does this kind of model come from?
x Start with a simple world
o No government: Taxes (T) = 0
Transfer (TR) = 0
Government spending (G) = 0
Transfer—CPP, EI, Child Care Benefit, so on (negative tax—something government pays people)