Topic 3: Aggregate Expenditure (Short Run Model) - Knowledge Summary and Exam Analysis

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Economics for Management Studies
Iris Au

Knowledge Summary: Topic 3: Part A – Aggregate Expenditure – The Simplest Short-Run Model Model of the Macro Economy (In general form) AE = AE +oC Y Y Where AE = aggregate expenditure = aggregate demand AEo = constant = autonomous expenditure CY = dAE/dY = constant = marginal propensity to spend out of GDP Y = GDP = output = income (Here we refer to as output) Macro Model in the simplest form: AE = C + I + G + X – IM Note: • Exogenous variables – constant (Meaning that you do not have to solve for them, but may change due to external factors) • Endogenous variables – the values are determined within the model (Meaning you have to solve for them) o In particular, C and IM change as Y (income) changes; C and IM positively related to Y How to solve for Equilibrium? • The equilibrium level of Y, Y*, is the level of Y that generates enough AE to buy itself Set Y = AE Y = AE o C YY Y(1 - CY) = AEo Therefore, Y* = AE o(1 - CY) Consumption Function C = C(DI) where DI = disposable income = (Y – T + TR) C = C oC D1 Where C o= constant = autonomous consumption C 1 marginal propensity to consume out of DI Note: • Consumption is positively related to DI, and consumers spend a fraction of their DI on final goods and services • If T = 0 & TR = 0, then DI = Y Investment Function I = I(r) where r = real interest rate I = o – dr Where Io = constant = autonomous investment d = dI/dr = constant Note: • Investment is inversely related to the interest rate because firms borrow to finance investments and the interest rate is the cost of borrowing • When the real interest rate increases, the cost of borrowing increases, therefore, undertaking investment becomes less profitable, so investment drops Topic 3: Part B – Adjustment Mechanism – How Does the Economy End Up in Its Equilibrium When the initial level of Y is not in equilibrium, the economy will adjust itself so that Y wil
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