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Lecture

EC140 1.docx

10 Pages
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Department
Economics
Course Code
EC140
Professor
Justin Smith

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EC140 January 22 – 31 2013 Chapter 27 Expenditure Multipliers: The Keynesian Model Fixed Prices and Expenditure Plans  Keynesian model describes the economy in the very short run when prices are fixed  Because each firm’s price is fixed, for the economy as a whole: 1. The price level is fixed (aggregate supply curve is horizontal) 2. Aggregate demand determines real GDP  What determines aggregate expenditure plans? Expenditure Plans - Aggregate planned expenditure equals planned consumption expenditure plus planned investment plus planned government purchases plus net exports - Households demand GDP - The components of aggregate expenditure sum to real GDP - That is, o Planned AE = Planned C + Planned I + Planned G + Planned NX - Short Run Equilibrium o When Y = Planned AE = Actual Expenditures - Two of the components of aggregate expenditure, consumption and imports, are influenced by real GDP - So there is a two-way link between aggregate expenditure and 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 Consumption and Savings Plans - Consumption expenditure is influenced by many factors but the most direct one is disposable income (allows households to determine how much they can buy) - Disposable income: aggregate income or real GDP, Y, minus net taxes, T - Call disposable income YD - The equation for disposable income is YD = Y – T - Disposable income, YD, is either spent on consumption of goods and services, C, or is saved, S - YD = C + S - The relationship between consumption expenditure and disposable income, other things equal, is the consumption function 1 EC140 January 22 – 31 2013t - 45 degree line: YD=C (consumption expenditures = income -> no savings) - Savings are determined residually - As incomes increase, savings increase - People plan to spend money even if they don’t have any income (they must consume in order to stay alive) – autonomous consumption (amount of consumption when income is zero) - Induced consumption: increased consumption induced by increase of income - As income increases, planned consumption expenditures increase - The Marginal Propensity to Consume (MPC) is the fraction of a change in disposable income spent of consumption - It is calculated as the change in consumption expenditure, divided by the change in disposable income that brought it about - The figure on the left shows that the MPC is the slope of the consumption function - Along the consumption function, when disposable income increases by $200 billion, consumption expenditure increases by $150 billion - The MPC is 0.75 - The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved - It is calculated as the change in savings divided by the change in disposable income that brought it about - The figure on the right shows that the MPS is the slope of the saving function - Along the saving function, when disposable income increases by $200 billion, saving increases by $50 billion - The MPS is 0.25 - MPC plus MPS always equals 1 2 EC140 January 22 – 31 2013 Consumption as Function of Real GDP - Disposable income changes when either real GDP changes or net taxes change - If tax rates don’t change, real GDP is the only influence on disposable income, so consumption expenditure is a function of real GDP - We use this relationship to determine read GDP when the price level is fixed - C = a + bYD where a is autonomous consumption and c is MPC C = a + b(YD) C = a + b (1 – t)Y YD = Y – T , T = tY  YD = y – tY YD = (1 – t)Y a = autonomous consumption C = MPC T= total tax revenue (%) YD= disposable income Ex. If b = 0.6 and t = 0.1 - For every $1 change in disposable income, consumption will change by 60 cents Import Function - In the short run, Canadian imports are influenced primarily by Canadian real GDP - The marginal propensity to import is the fraction of an increase in real GDP spent on imports - In an increase in real GDP of $100 billion increases imports by $25 billion, the marginal propensity to import is 0.25 (it’s always between 0 and 1) - M = mY where m is the marginal propensity to import (MPI) (if Y is 0, imports will also be 0; total imports completely depends on income and GDP) - When the price level is fixed, aggregate demand is determined by aggregate expenditure plans - Aggregate planned expenditure is planned consumption expenditure plus planned investment plus planned exports minus planned imports - Planned consumption expenditure and planned imports are influenced by real GDP - When real GDP increases, planned consumption expenditure and planned imports increase - Planned investment plus planned government expenditure plus planned exports are not influenced by real GDP. They are considered autonomous (independent) Aggregate Planned Expenditure - The relationship between aggregate planned expenditure and real GDP can be described by an aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each level of GDP - The relationship can also be described by an aggregate expenditure curve, which is a graph of the aggregate expenditure schedule 3 EC140 January 22 – 31 2013t - I + G + X line is horizontal because none of those things are dependent on aggregate income or GDP (autonomous expenditure) - But consumption increases when income increases and when real GDP increases (induced expenditure) - Imports depend on income (more income = more imports) - AE curve = I + G + X – M AE = C + I + G + (X – M) C = a + bYD, YD = Y – T, T = tY, YD = (1 – t)Y C = a + b (1 – t) Y M = mY AE = a + b(1 – t)Y + I + G + X – mY AE = (a + I + G + X) + b(1 – t) – mY AE = (a + I + G + X) + [b(1 – t) – m]Y Autonomous AE Slope of AE Change in AE Change in Y = b(1 – t) – m = slope of AE - Consumption expenditure minus imports, which varies with real GDP, is an induced expenditure - The sum of investment, government expenditure, and exports, which does not vary with GDP (or income), is an autonomous expenditure - Consumption, tax, and imports can have an autonomous component - Circular system- when income increases, consumption increases, causing income to increase Actual Expenditure, Planned Expenditure, and Real GDP - Actual aggregate expenditure is always equal to real GDP
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