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Chapter 21

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ECON 102
Ying Kong

TEXTBOOK NOTES 2/1/2013 12:54:00 AM DESIRED AGGREGATE EXPENDITURE - desired expenditure is what people want to spend with the resources they have - we consider four groups of expenditure decision makers   domestic households  firms  governments  foreign purchasers of our products - desired aggregate expenditure is the sum of the desired expenditure of these groups AE = C + I + G + (X-IM) - national income accounts measure actual expenditure in each of the four expenditure categories. National income theory deals with desired expenditure in each of these 4 categories - autonomous expenditure does not change in response to national income - induced expenditure does change in response to national income - changes in induced expenditure plays a key role in determining equilibrium - consumption is the largest component of aggregate expenditure (55-60% of GDP) - investment includes accumulation of inventories & expenditure on new machines which adds to physical capital  (20% of GDP) Desired Consumption Expenditure - by definition there are two possible uses of disposable income  consumption  saving - when the household decides how much to put to one use, it automatically decides how much to put to the other - the consumption function and saving functions summarizes how much disposable income a household will choose to spend or save The Consumption Function - factors determining desired consumption  disposable income  wealth  interest rates  expectations about the future - holding constant other determinants of desired consumption, an increase in disposable income is assumed to lead to an increase in consumption a = autonomous expenditure bY D induced expenditure b = slope  for every 1 dollar increase in disposable income, consumtion will rise by b -Properties of the consumption function:  average propensity to consume  marginal propensity to consume  slope  45° line - APC is desired consumption divided by disposable income - MPC relates the change in desired consumption to the change in disposable income that brought it about - slope = MPC - MPC is positively sloped (increase income = increase desired expenditure) - MPC is constant  MPC is the same at any level of disposable income - the 45° line has a slope of 1  every point on the line is a possible equilibrium - a point where the consumption line and 45° line meet, savings = 0 The Savings Function - APS is desired savings divided by disposable income - MPS relates the change in desired savings to the change in disposable income that brought it about APC + APS = 1 MPC + MPS = 1 - when desired consumption > income  negative savings - when desired consumption < income  positive savings Shifts in the Consumption Function - household wealth is the value of the accumulation of all assets minus debts - if household wealth increases, the consumption function will shift up, savings function will shift down - if household wealth decreases, the consumption function will shift down, savings function will shift up - since most household durable goods require credit (borrowing money) to purchase, interest rate is relevant - decrease of interest rate, shifts consumption function up, savings function shifts down  because cost of borrowing has decreased - increase of interest rate, shifts consumption function down, savings function shifts up - positive future expectations, shifts consumption function up, savings shifts down - negative future expectations, shifts consumption function down, savings shifts up A SHIFT is shows autonomous changes in consumption A MOVEMENT shows induced changes in consumption Desired Investment Expenditure - Investment expenditure is the most volatile component of GDP, and changes in investment are strongly associated with aggregate economic fluctutations - three determinants of aggregate expenditure fluctuations:  real interest rate o inventories o residential construction o new plant and equipment  changes in the level of sales  business confidence Desired Investment and Real Interest Rate - a rise in interest rate decreases desired investment - a firm ties up its money in holding inventories - when interest rate is high, the opportunity cost of holding these inventories is higher  could be doing more productive things with that money - THEREFORE when interest rates are high, less inventories will be held - most residential houses are bought with borrowed money (mortgages) - about half of a persons mortgage is interest  when the interest rate is high, there is a lower demand for housing - when i-rates are high, it is expensive
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