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Chapter 21

Chapter 21- The Simplest Short Run Macro Model.docx

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Department
Economics
Course
ECO100Y5
Professor
Kalina Staub
Semester
Fall

Description
Chapter 21- The Simplest Short Run Macro Model 21.1 Desired Aggregate Expenditure  • Desired Aggregate Expenditure (AE)- The sum of desired or planned spending on domestic output by households, firms, governments, and foreigners : AE = C + I + G + (X – IM) • Desired expenditure does not need to equal actual expenditure, either in total or in any individual category • National income accounts measure actual expenditures in each of the four expenditure categories; our model of the macro economy also deals with desired expenditures in each of these four categories • Autonomous VS. Induced Expenditure  Autonomous Expenditure- Elements of expenditure that do not change systematically with national income  Induced Expenditure- Any component of expenditure that is systematically related to national income • Important Simplifications  Three assumptions: 1. There is no trade with other countries; economy is closed economy; Closed Economy- An economy that has no foreign trade in goods, services, or assets 2. There is no government and hence no taxes 3. The price level is constant  Simplifying the model helps us better understand its structure and how more complex versions of the model work Desired Consumption Expenditure  • Saving- All disposable income that is not spend on consumption • 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 Consumption Function  Consumption Function- The relationship between desired consumption expenditure and all the variables that determine it; in simplest case, the relationship between desired consumption expenditure and disposable income  Factors influences consumption function: o Disposable income o Wealth o Interest rates o Expectations about the future  Holding constant other determinants of desired consumption, an increase in disposable income is assumed to lead to an increase in desired consumption  Average and Marginal Propensities to Consume o Average Propensity to Consume- Desired consumption divided by the level of disposable income  APC = C/ Yd o Marginal Propensity to consume- The change in desired consumption divided by the change in disposable income that brought it about  MPC = ∆C/∆Yd  The Slope of the Consumption Function o Slope = MPC and positive slope means increases in disposable income lead to increases in desired consumption expenditure while the constant slope means that MPC is same at any level of disposable income  The 45 degree Line: a reference line o Connects all points where desired consumption = disposable income o When disposable income < break even level of income, desired consumption > disposable income; desired saving must be negative and households are financing their consumption by borrowing or spending out of their savings o When disposable income > break even level of income, desired consumption < disposable income and desired saving is positive; households are paying back debt • The Saving Function  Two saving concepts exactly parallel to consumption concepts of APC and MPC: o Average Propensity to Save- Proportion of disposable income that households want to save; desired saving/disposable income (S/YD) o Marginal Propensity to Save- Change in desired saving/change in disposable income that brought it about (∆S/∆YD) o APC + APS = 1 and MPC + MPS = 1 (fractions of income consumed and saved must account for all income and any increment to income consumed and saved must account for all of that increment) • Shifts of the Consumption Function  Changes in disposable income lead to movements along the consumption function and changes in the other three factors (wealth, interest rates, and expectations) lead to shifts of consumption function  Change in Household Wealth o Household wealth is the value of all accumulated assets (savings accounts, mutual funds, etc) minus accumulated debts (home mortgages, car loans, outstanding lines of credit from banks) o An increase in household wealth shifts the consumption function up at any level of disposable income; a decrease in wealth shifts consumption function down  Change in Interest Rates o Consumption can be divided into consumption of durable (goods that deliver benefits for several years like cars and household appliances) and nondurable goods (goods that deliver benefits to households for only short periods of time like groceries, clothing, etc) o A fall in interest rates usually leads to an increase in desired consumption at any level of disposable income; the consumption function shifts up and a rise in interest rates shifts the consumption function down  Change in Expectations o Expectations about the future state of the economy often influence desired consumption; optimism leads to an upward shift in the consumption function and pessimism leads to a downward shift in the consumption function Desired Investment Expenditure Important determinant of aggregate investment expenditure: • Desired Investment and the Real Interest Rate  The real interest rate reflects the opportunity cost associated with investment, whether it is investment in inventories, residential constru
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