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ECO102H1 Chapter Notes -Real Interest Rate, National Income And Product Accounts, Disposable And Discretionary Income

Course Code
Iris Au

of 10
Chapter 21
Desired aggregate expenditure the sum of desired spending on domestically produced output.
AE = C + I + G + (X-IM)
- It is no equal to actual spending.
“National income accounts measure actual expenditures in each of the four expenditure
categories. National income theory deals with desired expenditure in each of the four
** categories ( consumption, investment, government spending and net exports)
Autonomous vs induced
Autonomous expenditure components of aggregated expenditure that do not depend on the national
income. Spending that regardless of how much money there is supplied a given amount has to be spent.
Ex food and water essentials
Induced expenditure components of aggregated expenditure that do change systematically in
response to changes in national income.
Important simplifications
- consumptions is 55-60% of GDP, investment is about 20%
closed economy an economy that have no foreign trade in goods service or assets.
Desired consumption expenditure.
“ there are only two possible uses of disposable income- consumption and saving. When the -
households decides how much to put to one use, it has automatically decided how much to put
to the other use.
consumption function:
- the total desired consumption expenditure of all households to several factors that
determine it.
factors : wealth, disposable income, interest rates & expectations on the future.
Ex if a households disposable income increases form $3000-$3500 its monthly consumption will
increase but less than the amount of increase ($500) the remainder will be saved.
“ an increase in disposable income is assumed to lead to an increase in desired consumption
C=30 + 0.8YD c consumption
yD -- disposable income
30 = autonomous expenditure
0.8YD = induced expenditure
Average and marginal propensities to consume
- If the desired income is zero
consumption will be 30 billion
- For every $1 increase in
income consumption will
increase by 80 cents
Average propensity to consume (APC) desired consumption expenditure divided by disposable
income. APC falls as income rises.
Marginal propensity to consume (MC) the change in desired consumption to the change in
disposable income that brought about.
Slope positive slope the MPC is positive; increase in income leads to increase in consumption
45 degrees line a line where desired consumption is equal to disposable income, the
consumption cuts the 45 line it is called “break even” – when desired consumption exceeds
disposable income.
Shifts in consumption function:
Change in household wealth- when a household suddenly has an increase in income their buget
will have more room and be more flexible in terms of spending. If there’s a sudden decrease in
income the house hold will have to revaluate their spending to spend less in order to
compensate for the decrease.
“An increase in household wealth shifts the consumption function up; a decrease will shift the
function down”
Change in interest rates durable goods is more expensive many of them are purchased on
credit. Ex car, house. If the interest rates are low people will be more willing to spend on
durable goods therefore borrows money. If the interest rates are high people will be less willing
to borrow money.
“ 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.”
Change in expectations households expectations of the future if they are aware that there will
be a big change in money flow in the next few years then they will be saving up. Ex child going to
university, New born child. If a household one of the supporting members in the future will get
a raise = increase in income that will lead to an increase in consumption.
“Optimism leads to an upward shift in consumption function; pessimism leads to a downward
shift in consumption
The saving function
- Households decide how much to consume and how they when to save
Average propensity to save (APS) the proportion of disposable income that households want
to save.
Marginal propensity to save ( MPS) the change in desired saving to the change in disposable
income that brought it about.
APC + APS = 1
MPC + MPS = 1
Desired investment expenditure
Three categories of investment:
-residential investment
-new plant & equipment investment
-inventory investment
-most volatile components of GDP, changes in investment are strongly associated with
aggregated economic fluctuations.
Important determinates of aggregated investment expenditure:
- the real interest rate
- changes in the level of sales
- business confidence
Real interest rate:
Inventories- as an alternative to holding inventories firms lend out money at the going rate of
interest. The higher the real rate of interest, the higher the opportunity cost of holding an
inventory of a given size; the higher the opportunity cost the smaller inventories will be desired.
- firms, as interest rates increase, the amount to hold their inventories will cost more therefore
to prevent from paying a lot of interest firms are willing to hold smaller inventories.
Residential construction - money borrowed use to pay for houses ex mortgages
New plant & equipment high interest rates firms are less willing to invest in new plants and
equipment due to the credit that it involves therefore leads to a reduction in desired investment
whereas low real interest rates increase desired investment.
“The real interest rates reflect 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.”
Changes in sales- firms have target sales in which they meet in order to meet those sales so that
they have enough products to sell firms have inventories that they hold. If there is an increase in