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Class Notes
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Canada
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Wilfrid Laurier University
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Economics
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EC140
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Justin Smith
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Lecture

Description

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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