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Chapter 27 Notes.docx

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Economics 1022A/B
Jeannie Gillmore

Chapter 27 Notes Fixed Prices and Expenditure Plans  on any given day, firms prices are fixed and the quantity they sell as depend on demand, not supply o because each firm’s price are fixed, for economy as a whole:  the price level is fixed  aggregate demand determines real GDP  the Keynesian model explains fluctuations in aggregate demand at a fixed price level by identifying the forces that determine expenditure plans Expenditure Plans  aggregate planned expenditure is equal to the sum of the planned levels of consumption expenditure, investment, government expenditure on goods and services, and net exports o consumption expenditure and imports change when income changes so they depend on Real GDP  other things remaining the same: o an increase in real GDP increases aggregate expenditure o an increase in aggregate expenditure increases real GDP  it is thus a two-way link Consumption and Saving Plans  saving is influenced by the following factors: o disposable income o real interest rate o wealth o expected future income  disposable income is aggregate income minus taxes plus transfer payments o since aggregate income equals real GDP, disposable income depends on real GDP o we focus on the relationship between disposable income and consumption expenditure when the other three factors are constant Consumption Expenditure and Saving  households can only spend their disposable income on consumption or save it, so planned consumption plus planned saving always equals income  consumption function o the consumption function is the relationship between consumption expenditure and disposable income  autonomous consumption is the amount of consumption that would take place if people had no current income  induced consumption is the amount of consumption expenditure induced by an increase in disposable income  the 45˚ line measures disposable income  saving function o the saving function is the relationship between saving and disposable income o when consumption expenditure exceeds disposable income, saving is negative (dissaving) Marginal Propensities to Consume and Save  the marginal propensity to consume (MPC) is the fraction of a change in disposable income that is spent on consumption o calculated as the change in consumption expenditure divided by the change in disposable income o in 2010, the Canadian MPC was 0.85  the marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved o calculated as the change in saving divided by the change in disposable income  the sum of MPC + MPS always equals 1 o disposable income is always spent or saved  the MPS and MPC can also be found by calculation the slope of the saving and consumption function respectively Consumption as a Function of Real GDP  consumption expenditure changes when disposable income changes and disposable income changes when real GDP changes o therefore, consumption expenditure depends also on real GDP o we use this to help determine equilibrium expenditure Import Function  an increase in Canadian real GDP increases the quantity of Canadian imports  the relationship between imports and real GDP is determined by the marginal propensity to import o calculated as the fraction of an increase in real GDP that is spent on imports Real GDP with a Fixed Price Level  aggregate planned expenditure o to calculate aggregate planned expenditure at a given real GDP, we add the expenditure components together (C + I + G + X – M) o consumption expenditure minus imports (which varies with real GDP) is called induced expenditure o the sum of investment, government expenditure, and exports (which does not vary with real GDP) is called autonomous expenditure  equals the level of aggregate planned expenditure if real GDP were zero o the aggregate expenditure curve summarizes the relationship between aggregate planned expenditure and real GDP  actual aggregate expenditure is always equal to real GDP (planned expenditure is not always equal to actual, thus not always equal to real GDP) o actual and planned expenditure can differ when firms end up with inventories that are greater or smaller than planned o people carry out their consumption expenditure plans, the government expenditure plans, and net exports are as planned  firms carry out their plans to purchase new capital (investment)  however, a firms’ inventory varies o if aggregate planned expenditure is less than real GDP, firms sell less than they planned to sell and end up with unplanned inventories o if aggregate planned expenditure exceeds real GDP, firms sell more than they planned to sell and end up with inventories that are too low Equilibrium Expenditure  equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP o is a level of aggregate expenditure and real GDP at which spending plans are fulfilled o at a given price level, equilibrium expenditure determines real GDP  convergence to equilibrium (from below) o suppose real GDP is 1000, meaning that actual expenditure is also 1000 o planned expenditure is 1100 o when people spend 1100 and firms produce 1000, inventories fall by 100  because the change in inventories is part of investment, actual investment is 100 less than planned investment  when inventories fall below a firms target, firms increase production to restore them to target level  to do this they hire additional labour and increase production  production than increases by 100, so real GDP increases by 100 to 1100  the process continues until real GDP and planned expenditure are equal, and unplanned inventory changes are zero (firms don’t change production)  convergence to equilibrium (from above) o suppose real GDP is 1400, actual aggregate expenditure is 1400, but planned expenditure is 1300 o firms inventories than rise by 100  firms cut production until real GDP reaches 1200 The Multiplier  the multiplier is the amount by which a change in autonomous expenditure is multiplied by to determine the change in equilibrium expenditure and real GDP  suppose that investment increases o the additional expenditure by business means that aggregate expenditure and real GDP increase  increase in real GDP leads to increases in disposable income, and with no income taxes, real GDP and disposable income increase by the same amount o the increase in disposable income brings an increase in consumption expenditure  adds even more to aggregate expenditure o the initial increase in investment brings an even bigger increase in aggregate expenditure because it induces an increase in consumption expenditure  the magnitude of the increase in
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