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Lecture 8

# Economics 1022A/B Lecture Notes - Lecture 8: Consumption Function, Chapter 27, Aggregate Demand

by OC1029289

This

**preview**shows page 1. to view the full**5 pages of the document.**Several factors influence consumption expenditure and saving.

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The most direct influence is disposable income, which is real GDP or aggregate income minus net

taxes (taxes minus transfer payments).

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Planned consumption expenditure plus planned saving equals disposable income.

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The greater the disposable income, the greater is consumption expenditure and the greater is saving.

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The relationship between consumption expenditure and disposable income, other things remaining

the same, is called the consumption function.

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The relationship between saving and disposable income, other things remaining the same, is called

the saving function. 2 3

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The extent to which a change in disposable income changes consumption expenditure depends on

the marginal propensity to consume.

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The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is

consumed.

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The marginal propensity to consume is calculated as the change in consumption expenditure ΔC,

divided by the change in disposable income, ΔYD.

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MPC = ΔC ÷ ΔYD

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That is:

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The extent to which a change in disposable income changes saving depends on the marginal

propensity to save.

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The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved.

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The marginal propensity to save is calculated as the change in saving ΔS, divided by the change in

disposable income, ΔYD.

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MPS = ΔS ÷ ΔYD

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That is:

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The marginal propensity to consume plus the marginal propensity to save sum to 1.

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C + S = YD

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ΔC + ΔS = ΔYD (ΔC ÷ ΔYD) + (ΔS ÷ ΔYD) = (ΔYD ÷ ΔYD)

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MPC + MPS = 1

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You can see this from the following:

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The figure shows the MPC as the slope of the consumption function and the MPS as the slope of the

saving function.

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MPC is $150 billion ÷ $200 billion = 0.75.

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MPS is $50 billion ÷ $200 billion = 0.25.

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The marginal propensity to import is the fraction of an increase in real GDP that is spent on

imports.

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It is calculated as the change in imports divided by the change in real GDP that brought it

about, other things remaining the same.

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The relationship between imports and real GDP is determined by the marginal propensity to import.

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Fixed Prices and Expenditure Plans:

Aggregate planned expenditure equals planned consumption expenditure plus planned investment

plus planned government expenditures plus planned exports minus planned imports.

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The table on the next page sets out an aggregate expenditure schedule, together with the

components of aggregate planned expenditure.

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The figure shows the AE curve.

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It is made up from the consumption function minus the import function plus I, G, and X.

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Autonomous Expenditure

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Induced Expenditure

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The AE curve can be thought of as two parts:

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Autonomous Expenditure is the sum of investment, government expenditures, and exports, which

does not vary with real GDP

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Induced Expenditure is consumption expenditure minus imports, which varies with real GDP

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Real GDP with a Fixed Price Level

Lecture 8 - Chapter 27: Expenditure Multipliers

March 12, 2017

10:33 AM

Lecture Notes Page 1

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The figure shows equilibrium expenditure

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The 45-degree line shows actual aggregate expenditure at each level of real GDP.

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Only at point D is actual aggregate expenditure equal to aggregate planned expenditure.

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So, $1,700 billion is equilibrium real GDP.

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Below $1,700 billion, aggregate planned expenditure exceeds real GDP.

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Above $1,700 billion, aggregate planned expenditure is less than real GDP.

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The bottom figure shows the unplanned inventory changes that bring a convergence to equilibrium

expenditure.

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Below $1,700 billion, aggregate planned expenditure exceeds real GDP, so inventories fall below their

target levels.

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Firms increase production.

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Real GDP increases.

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Above $1,700 billion, aggregate planned expenditure is less than real GDP, so inventories rise above

their target levels. 7

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Firms decrease production.

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Real GDP decreases.

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At $1,700 billion, aggregate planned expenditure equals real GDP, so inventories remain at their

target levels.

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Firms do not change production.

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Real GDP remains constant.

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A change in expenditure generates a change in income.

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The change in income induces a change in consumption expenditure.

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The change in consumption expenditure increases income further.

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Where does the process end?

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The multiplier is the amount by which a change in autonomous expenditure is magnified or

multiplied to determine the change in equilibrium expenditure and real GDP.

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The figure shows equilibrium expenditure.

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The AE curve shows aggregate planned expenditure at each level of real GDP.

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By studying the schedule, you can work out the equilibrium of real GDP (Y) and aggregate

expenditure (AE)

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The Multiplier

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Lecture Notes Page 2

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