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Week 3 chapter notes

Economics for Management Studies
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Iris Au

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Chapter 21 The Simplest Short-Run Macro Model Notes
21.1 Desired Aggregate Expenditure
x desired aggregate expenditure (AE)—the sum of desired or planned spending on domestic output by households, firms,
governments, and foreigners
x AE = C + I + G + (X – IM)
x 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
x autonomous expenditure—elements of expenditure that do not change systematically with national income
x induced expenditure—any component of expenditure that is systematically related to national income
x closed economy—an economy that has no foreign trade in goods, services, or assets
Desired Consumption Expenditure
x saving—all disposable income that is not spent on consumption
x by definition, there are only 2 possible uses of disposable income—consumption and savings; when the household decides how
much to put to one use, it has automatically decided how much to put to the other use
x consumption function—the relationship between desired consumption expenditure and all the variables that determine it; in the
simplest case, the relationship between desired consumption expenditure and disposable income
x factors influencing desired consumption are assumed to be: disposable income, wealth, interest rates, expectations about future
x holding constant other determinants of desired income, an increase in disposable income is assumed to lead to an increase in
desired consumption
x average propensity to consume (APC)—desired consumption divided by the level of disposable income
x APC = C / YD = consumption / disposable income
x marginal propensity to consume (MPC)—the change in desired consumption divided by the change in disposable income that
brought it about
x MPC = ûC / ûYD = change in consumption / change in disposable income
x average propensity to save (APS)—desired saving divided by disposable income
x APS = S / YD = savings / disposable income
x marginal propensity to save (MPS)—change in desired saving divided by the change in disposable income that brought it about
x MPS = ûS / ûYD = change in saving / change in disposable income
x an increase in wealth shifts the consumption function up; a decrease in wealth shifts the consumption function downs
x a fall in interest rates 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
x expectations about the future state of the economy influence desired consumption; optimism leads to an upward shift in the
consumption function, pessimism leads to a downward shift in the consumption function
x main points are:
1) Desired consumption is assumed to be positively related to disposable income. In a graph, this relationship is shown by the
positive slope of the consumption function, which is equal to the marginal propensity to consume (MPC).
2) There are both autonomous and induced components of desired consumption. A movement along the consumption function
shows changes in consumption induced by changes in disposable income. A shift of the consumption function shows
autonomous changes in consumption.
3) An increase in household wealth, a fall in interest rates, or greater optimism about the future are all assumed to lead to an
increase in desired consumption and an upward shift of the consumption function.
4) By definition, all disposable income is either consumed or saved. Therefore, there is a saving function associated with the
consumption function. Any event that causes the consumption function to shift must also cause the saving function to shift
by an equal amount in the opposite direction.
Desired Investment Expenditure
x investment is most volatile component of GDP, and changes in investment are strongly associated with economic fluctuations
x 3 important determinants of aggregate investment expenditure are real interest rate, changes in level of sales, business confidence
x real interest rate represents real opportunity cost of using money (either borrowed money or retained earnings) for investment
purposes—a rise reduces amount of desired investment expenditure
x real interest rate reflects the opportunity cost associated with investment, whether it is investment in inventories, residential
construction, or plant and equipment; the higher the real interest rate, the higher the opportunity cost of investment, and thus the
lower the amount of desired investment
x the higher the level of sales, the larger the desired stock of inventories; changes in the rate of sales therefore cause temporary
bouts of investment (or disinvestment) in inventories
x investment depends on firms’ expectations about the future state of the economy; optimism leads to more desired investment,
pessimism leads to less desired investment
The Aggregate Expenditure Function
x aggregate expenditure (AE) function—the function that relates desired aggregate expenditure to actual national income
x AE = C + I
x marginal propensity to spend—the change in desired aggregate expenditure on domestic output divided by the change in national
income that brought it about
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