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University of Toronto St. George
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Economics
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ECO102H1
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Michael Ho
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Lecture

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Economics

ECO102H1

Michael Ho

Fall

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Chapter 21: The simplest short run Macroeconomics
21.1 Desired aggregate expenditure
The national accounts divide actual GDP into its components: - Ca, a , a,and NXa.
Total desired expenditure is divided into the same categories:
desired consumption, C
desired investment, I
desired government purchases, G
desired net exports, NX
Desired aggregate expenditure (AE): the sum of desired or planned spending of domestic by households, firms,
government, and foreigner.
The sum is called desired aggregate expenditure: AE = C + I + G + NX
Desired expenditure need not equal actual expenditure, either in total or in any individual category. Sometimes
in cases actual expenditure can exceed the desired expenditure.
National income accounts measure actual expenditures in each of the four expenditure categories. National
income theory deals with desired expenditure in each of these four categories.
Two types of expenditures:
Autonomous vs. Induced expenditure:
Autonomous expenditure: elements of expenditure that do not change systematically with national income.
Autonomous expenditure can and do a change , but such changes do not occur systematically in response to
changes in national income.
Induced expenditure: any component of expenditure that is systematically and related to national income
Important simplifications:
In order to develop the simplest possible model of national income determination, this chapter will focus on
only consumption and investment, which is two of four components of desired aggregate expenditure
Closed economy: economy that has no foreign trade in goods and services or assets.
A close economy also had no government and that the price level is constant.
Desired consumption expenditure
Disposable income is the amount of income households receive after deducting what they pay in taxes and
adding what they have received in transfer
Two possible uses of disposable income: - consumption (C) or saving (S)
In the simplest theory, consumption is determined primarily by current disposable income (Y )Dwhich equals to
national income, Y.
Saving: all disposable income that is not spent on the consumption
By definition, there are only two possible uses of disposable incomeconsumption and saving. When the
household and decides how much to put to one use, it has automatic team decided how much to put to the
other use.
The graph below shows the time series for real per capita consumption and disposable income in Canada. It is
clear that the two variables tend to move together over time, although the relationship is not exact. The vertical
distance between the two a lines is the amount of saving down by households Factors that influence what determines the amount of disposable income that households decide to consume
and save is consumption function and the saving function
The consumption function: the relationship between into side consumption expenditure and all the variables
that determine it; and the simplest case, the relationship between inside consumption expenditure and
disposable income.
The key factors influencing desired consumption are assumed to be: disposable income, wealth, interest rates,
and expectations about the future.
Holding constant other and determinates of desired consumption, an increase in disposable income is
assumed to lead an increase in a desired consumption
Desired consumption is positively related to current disposable income is a good approximation of the behavior
of the average household and therefore is suitable for explaining and aggregate behaviour
The simple consumption function is written as: C = a + bY D
The graph above (i) illustrates a hypothetical consumption function.
The first graph is showing a positive relationship between desired consumption C associated with each value of
disposable income Yd. The figure plots these points and connects them with the smooth line. In this hypothetical
economy, the equation of consumption function is: C= 30 + 0.8 Yd. In other words this equation says that in
disposable income is zero, desired aggregate consumption will be 30 billion and that every $1.00 increase in Yd,
decide consumption rises by 80.The 30 billion is said to be autonomous consumption because it is autonomous
of level of income. The 0.8Yd is called in Yd as consumption because it is induced by a change in income.
Autonomous part of desired consumption is the vertical intercept of the consumption function in the first graphs.
The induced part of consumption occurs as disposable income changes as we move along the consumption
function (line C).
The second graph shows the relationship between decides saving and disposable income. Line S which plots the
data about desired saving (S) . The vertical distance between C and 45 degree line in first graph is by definition
the height of line S graphs that is that any level of disposable income must be either consumed for saved.
Average and marginal propensities to consume:
Average propensity to consume (APC): designed consumption divided by the level of disposable income. APC =
C/Yd
Average propensity to consume falls as disposable income rises
Marginal propensity to consume (MPC): the change in desired consumption divided by the change in disposable
income that brought it about. MPC= delta C/ Delta Yd
MPC will always equal to the slope of desired consumption expenditure line
The slope of the consumption function:
The consumption function slope is the marginal propensity to consume. The positive slope of the consumption
function shows that the MPC is positive increase in income lead to increase in desires consumption expenditure.The constant slope of the consumption function shows that the MPC is the same at any level of disposable
income.
The 45 degree line:
The line and constructed by connecting all the points where desired consumption (vertical axis) equals to
disposable income (horizontal axis). Because both axes are given in the same units, this line has a positive slope
equal to 1 that is it forms an angle of 45 degree with the axes called the 45 degree line
When the consumption function cuts the 45 degree line at what is called the break-even level of income.
When the consumption function is about the 45 degree line, desired consumption exceeds disposable income.
In this case, decide saving must be negative; households are financing their consumption either by spending out
of their accumulated saving or by borrowing funds.
When the consumption function is above the 45 line, decide consumption is less than disposable income and so
desires saving is positive; households are paying back debt or its accumulating assets.
At the break-even level of disposable income, designed consumption eggs that the aequals disposable income
and so desired saving is zero.
The saving function:
Once we know relationship between desired consumption and disposable income, we automatically know the
relationship between a desired saving and disposable income.
There are 20 saving concepts that are exactly parallel to the consumption concepts:
Average propensity to save (APS): the desired saving divided by disposable income. APC = S/Yd
Marginal propensity to save: the change in desired saving divided by the change in disposable income that
bought is about. MPS = delta S/ Delta Yd
There is a single relationship between the saving and consumption propensities. APS and APC must sum to 1.
And MPC and MPS must also sum to 1. Because all disposable income is either spend or save

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