2 - Aggregate Expenditure and Income Equilibrium

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Gustavo Indart

AGGREGATE EXPENDITURE AND INCOME EQUILIBRIUM Assumptions: Price level is fixed and there are only changes in real GDP. There is no depreciation and no indirect taxes. GDP = Net Domestic Income Aggregate expenditure: the sum of desired or planned spending on domestic output by households, firms, governments, and foreigners AE = C + I + G + (X - IM) National income accounts measure actual expenditures in each of the four expenditure categories while national income theory deals with desired expenditures. The AE function relates the level of desired AE to the level of real income. There is a level of income (Y*) at which AE is equal to the actual level of output (Y) → Y = AE. Actual expenditure (GDP) is equal to desired expenditure at Y*. Y* is the equilibrium level of income or output for the economy. If AE > Y, there is excess desired spending in the economy (excess demand) and the level of output will tend to rise. If AE < Y, there is insufficient desired spending in the economy (excess supply) and the level of output will tend to fall The implicit assumption is that desired aggregate expenditure determines the amount of goods and services produced in the economy. When AE differs from Y, equilibrium cannot be restored through a change in price level since P is assumed to be fixed. To restore equilibrium, output will have to increase/decrease to eliminate excess demand/supply. Simple Model: Consumption and Investment Consumption Function: total desired personal consumption expenditure by all households in the economy. Includes variables such as disposable income, wealth, interest rates, and expectations about the future. For simplicity, assume all these variables are constant except disposable income, and that the consumption function depends only on disposable income (YD). Note: changes in the other variables will cause the consumption curve to shift. Keynesian Consumption Function: C = + cYD = autonomous consumption cYD = induced consumption c = describes rate of change of consumption as disposable income changes (0 < c < 1) c = ∆C/∆YD → c is the marginal propensity to consume out of YD (MPC )YD Average propensity to consume (APC ) = /YD + c YD Saving Function: Since YD = C + S, S = YD - C = YD - ( +cYD) = - + (1 - c)YD = - +sYD, where s = ∆S/∆YD is the marginal propensity to save out of disposable income (MPS )
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