Textbook Notes (363,103)
Canada (158,195)
Economics (319)
ECON 110 (192)
Chapter 21

Chapter 21.docx

5 Pages
Unlock Document

Queen's University
ECON 110
Ian James Cromb

Chapter 21: The Simplest Short Run Macro Model Desired Aggregate Expenditure  Desired Aggregate Expenditure is the sum of desired or planned spending on domestic output by households, firms, gov’ts, and foreigners with the resources they actually have  AE = C + I + G + (X – IM), desired expenditure need not equal actual expenditure  National income accounts measure actual expenditures in each of the categories  National income theory deals with desired expenditures in each of the categories Autonomous vs. Induced Expenditure  Autonomous Expenditures are elements of expenditure that do not change systematically with national income  Induced Expenditures are any component expenditures that are systematically related to national income – plays a key role in determining the equilibrium national income Important Simplifications  In this chapter, only dealing with consumption and investment  Consumption is the largest component of GDP and of aggregate expenditure (AE) o Provides the most important link between desired AE and real national income  Investment is a smaller component and is also more volatile  Also are considering a closed economy – one that has no foreign trade – and no gov’t and that the price level is constant Desired Consumption Expenditure  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 automatically decides how much to put to the other use The Consumption Function  This relates the total desired consumption expenditures of all households to the several factors that determine it – the key factors are o Disposable income, wealth, interest rates, expectations about the future  Holding other determinants constant, an increase in disposable income is assumed to lead to an increase in desired consumption  Consumption = Autonomous Spending (a) + induced spending (zY ) D o Z = the marginal propensity to spend Average and Marginal Propensity to Consume  Average propensity to consume =  Marginal propensity to consume = The Slope of the Consumption Function  The slope of the production function is the marginal propensity to consume (MPC)  Since it is positive, increases in income lead to increases in desired consumption expenditure  The constant slope shows that the MPC is the same at any level of income The 45 Line  A line that connects points where desired consumption = disposable income, slope = 1  Where consumption function cuts the 45 line is called “the break-even” level of income o Consumption above the line, desired consumption exceeds disposable income o Consumption below the line, desired consumption is less than disposable income The Saving Function  Average propensity to save =  Marginal propensity to save =  APS + APC = 1, MPS + MPC = 1  Desired saving is always equal to the vertical distance between the consumption function and the 45 line – +/- savings depending on if consumption exceeds income or not Shifts in the Consumption Function  In this model, changes in disposable income leads to movements along the consumption function; changes in the other factors will lead to shifts of the consumption function A Change in Household Wealth  Household wealth is the value of all accumulated assets minus accumulated debts  If an increase in wealth occurs and is constant, households will need to save less current income for future consumption – households will spend more of their current income  An increase in household wealth will shift the consumption curve up; a decrease in wealth will shift the consumption curve down A Change in Interest Rates  Non-Durable goods are consumption goods that deliver benefits for a short period of time  Durable goods are goods that deliver benefits for several years o Most durable goods are expensive and are bought on credit – must pay interest  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 A Change in Expectations  If large numbers of households become pessimistic about the current state of the economy and their employment, they will increase current savings o This will lead to a downward shift of the consumption function  Optimism in the economy leads to an upward shift in the consumption function  The saving function will shift in the opposite direction of the consumption function Desired Investment Expenditure  Three categories of investment: inventory, residential, new plant and equip – ch. 20  Investment expenditure is very volatile and changes in investment are strongly associated with aggregate economic fluctuations  The things that explain these fluctuations are: the real interest rate, the changes in the level of sales, and business confidence Desired Investment and the Real Interest Rate  Real interest rate represents the real opp cost of using money for investment purposes o Rise in real interest rate reduces the amount of desired investment  Easily seen if we separate investment into three components Inventories  Since inventory investment is one of the more volatile elements of total investment, it has an important influence on fluctuations in investment expenditure  If a firm as a lot of
More Less

Related notes for ECON 110

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.