ECON1102 Study Guide - Final Guide: Permanent Income Hypothesis, Real Interest Rate, Ceteris Paribus
Aggregate Expenditure in the Short-Run
Theory Building:
Step 1: Redefinition (the
Aggregate Expenditure
Model - AEM)
• Let's redefine 'Y' (GDP) as aggregate expenditure (AE): the total
amount of spending in the economy - the sum of consumption,
planned investment, gov. purchases and net exports.
• Aggregate expenditure model - focuses on the short-run relationship
between total spending and real GDP.
Step 2: Making Simplifying
Assumptions
• AE = C + I + G + NX
• We assume that the price level is constant for a given AE curve.
Step 3: Defining Equilibrium
Conditions
• AE = Y
• (Aggregate expenditure = GDP)
Step 4: Delineating basic causal relationships for each component (C, I, G, NX).
Step 5: Further elaborate the way all the components add up into AE.
Step 6: 'Run' the AE model and see how it matches with our equilibrium condition.
i) Consumption
• The five important variables that determine level of consumption:
1. Current
Disposable
Income (YD)
• Disposable income - the amount of money that consumers have available to
devote to spending after they have paid their taxes and received transfer
payments.
• As YD goes up, consumer spending (C) will go up. As YD falls, C will fall.
2. Expected
Future Income
• If consumers expect to have more future YD than they have now, this tends to raise
consumer spending because they believe they can spend more (save less) now
because their available resources will grow later.
• Even with high current YD, consumers may cut back their spending now if they
believe that future times will be lean.
• If expected future income is fairly close to current income, then we can probably
say that the proportion of YD spent will stay fairly stable over time.
• It is only when expected future income is significantly higher or lower that this
stability may not hold.
• Permanent income hypothesis - the theory that people will spend money at a level
consistent with their expected long term average income.
3. Household
Wealth
• Wealth - the accumulation of income in the form of assets, financial and real.
• 'Wealth effect' - wealth can be drawn upon to fund spending if need be, and
ceteris paribus, higher levels of wealth will make consumers feel more comfortable
spending more in a period than lower levels of wealth.
• The wealth effect depends in part upon the liquidity of the wealth held and on the
permanence of the wealth.
4. Price Level
&
5. Real
Interest Rate
• In the short-run, price level increases have three major 'channels' that influence
spending:
a) Price inflation decreases the real value of household wealth, leading to
lowered consumption via the wealth effect.
b) Price inflation leads to an increased demand for cash since everything
costs more in nominal terms.
c) Real interest rate rises lower C (and falls raise C). A fall in the real interest
rate (r) makes money less costly and increases consumption, especially
that financed by debt.
The Consumption Function and MPC
• Consumption function - the relationship between consumption and disposable income.
• C = f(Dicurrent, Difuture, wealth, inflation, interest rate). But we can hold various things constant to reduce it
to C = f(DI).
• A very simple form of this is a linear equation: C = A + (MPC * YD) where marginal propensity to
consume (MPC) is the slope of the consumption function.
• MPC = change in consumption/change in disposable income. This is the slope of the line. Eg: If MPC =
0.9, that means 90 cents out of every new dollar of YD is spent.
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