Class Notes (923,217)
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UTSC (33,026)
MGEA06H3 (176)
Iris Au (165)
Lecture 3

Lec- Week 3

21 Pages
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Department
Economics for Management Studies
Course Code
MGEA06H3
Professor
Iris Au

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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 + I (intended investment) + G + X – IM.
(Aggregate) Supply = actual expenditure = actual national income:
GDE = C + I + G + X – IM.
The key difference is investment (I) in GDE includes 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 = AE0 + cYY
where AE = aggregate expenditure = aggregate demand
cY = = = constant
= marginal propensity to spend out of GDP
Y = GDP = output = income
cY tells 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 = AE0 + cyY
(1 – cy)Y = AE0
Y* = AE0 / (1 – cy)
Example: Suppose AE = 100(AE0) + (cY)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

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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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