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Chapter 21

Chapter 21 - The simplest short-run macro model

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McGill University
Economics (Arts)
ECON 295
Kenneth Ragan

Chapter 21: The Simplest Short-Run Macro Model Expenditure: the action of spending funds Desired aggregate expenditure (AE): The sum of desired or planned spending on domestic output by households, firms, governments, and foreigners The national accounts divide actual GDP into its components: Ca, Ia, Ga and NXa Total desired expenditure is divided into the same categories:  Desired consumption, C  Desired investment, I  Desired government purchases, G  Desired net exports, NX The sum is called desired aggregate expenditure: AE = C + I + G + NX National income accounts measure actual expenditures in each of the four expenditure categories. National income theory deals with desired expenditures in each of these four categories. Two types of expenditures:  Autonomous expenditures do not depend on the level of national income  Induced expenditures do depend on the level of national income Desired Consumption Expenditure: (In this chapter we are assuming that there are no taxes, no government, no trades with rest of the world) Two possible uses of disposable income:  Consumption ( C )  Saving (S) In the simplest theory, consumption is determined primarily by current disposable income (Yd) In more advanced theories, individuals are forward looking, and so consumption depends more on “lifetime” income. (we know that today our income is very low because we are students, but we are going to school because we know that the investment in human capital will grow, and that we will be able to produce a higher income in the future) On average, income is higher than consumption, and both have been getting higher, so saving has fallen. Closed economy: An economy that has no foreign trade in goods, services, or assets. Saving: All disposable income that is not spent on consumption. (consumption – income) By definition, there are only two possible uses of disposable income – consumption and saving. When the household decides how much to put to one use; it has automatically decided how much to put to the other use. The amount of a household’s disposable income that they decide to consume, and the amount they decide to save is explained by two factors: consumption function and the saving function. The Consumption Function: relates the total desired consumption expenditures of all households to the several factors that determine it. (relationship between desired consumption expenditure and disposable income). C = a + bYd (slope = b, assumption is that b is less than 1) Holding constant other determinants of desired consumption, an increase in disposable income is assumed to lead to an increase in disposable consumption. Two technical expressions for the consumption function:  Average propensity to consume: APC = C/Yd (desired consumption divided by level of disposable income)  Marginal propensity to consume (MPC) MPC = ∆C/∆Yd (change in desired consumption divided by the change in disposable income that brought it about) Consumption function has a slope of ∆C/∆Yd -> marginal propensity to consume. Positive slope shows that MPC is positive; increase in income lead to increase in desired consumption expenditure. Constant slope shows that MPC is the same at any level of disposable income Usually assume that less than 1 Shifts in the Consumption Function: If consumption function shifts upward, the saving function must shift downward. What causes a shift? -∆ wealth (change in stock exchanges/market) -∆ interest rates (increase in interest rate, can shift consumption function down, and vice versa.) -∆ expectations about the future (will change your behavior today) income is a flow variable, wealth is a stock variable (stock of assets you have at a point in time) 45 degree line: “break-even” level of income. When the consumption function is about the 45 degree line, desired consumption exceeds disposable income. Desired saving must be negative; households are financing their consumption either by spending out of their accumulated saving or by borrowing funds. When consumption function is below the 45 degree line, desired consumption is less than disposable income, so desired saving is positive; households are paying back debt or accumulating assets. At the break-even level of disposable income, desired consumption exactly equals disposable income and so desired saving is 0. Two saving concepts:  Average Propensity to Save (APS): S/Yd (desired saving divided by disposable income)  Marginal propensity to save (MPS): ∆S/∆Yd (change in desired saving divided by the change in disposable income that brought it about) APC and APS = 1 MPC and MPS = 1 Household wealth is the value of all accumulated assets minus accumulated debts. An increase in household wealth shifts the consumption function up; a decrease in wealth shifts the consumption function down. Household consumption can be divided into consumption of durable and non-durable goods. Durable goods are goods that deliver benefits for several years. Non-durable goods are consumption goods that deliver benefits to household for only short periods of time. A fall in interest rates usually leads to an increase in desired consumption at any level of disposable income; the consumption function shifts up. A rise in interest rates shifts the consumption function down. Expectations about the future state of the economy influence desired c
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