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Macro Model Objectives : Understand the Difference Between Desired

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Macro Model Objectives : Understand the Difference Between Desired Macro Model Objectives : Understand the difference between desired expenditure and actual expenditure. Explain the determinants of desired consumption and desired investment expeditures. Understand the meaning of equilibrium national income. Recognize the difference between movements along and shifts of the aggregate expenditure functions. Desired expenditure Everyone makes expenditure decisions. Fortunately, it is unnecessary for our purposes to look at each of the millions of such individual decisions. Instead, it is sufficient to consider four main groups of decision makers. The sum of their desired expenditures on domestically produced output is called desired aggregate expenditure, or more simply aggregate expenditure (AE). AE = C + I +G +(X-M) Autonomus versus induced expenditure. Components of aggregate expenditure that do not depend on national income are called autonomous expenditures. Components of aggregate expenditure that do change in response to changes in national income are called induced expenditures. Global Economics : macro model 2 Important simplifications Our goal is to develop the simplest possible model of national-income determination. To do so we focus on only two of the four components of desired aggregate expenditure. Consumption and investment Desired consumption expenditure By definition, there are only two possible uses of disposable income–consumption and saving. W hen 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 relates to total desired consumption expenditures of all households. The consumption behaviour of households depends on the income that they actually have to spend, which is called disposable income. Under the assumptions, here, there are no governments, therefore no taxes. Hence, disposable income, which we denote Yd is equal national income, Y. The consumption function describes the relationship between consumption and the variables that influence Global Economics : macro model 3 it; in the simplest theory, consumption is determined primarily by current disposable income. W hen a household‘s income is zero, it will still consume some minimal amount. This level of consumption expenditure is autonomous because it persists even when there is no income. The higher a households income, the more it will want to consume. Let us take an example where autonomous consumption expenditure is $30 billion, where induced consumption expenditure is 80 percent of disposable income(for every $1 increase in disposable income, there is an 80 cent increase in consumption). The equation for this simple consumption function is C = a + b Yd where is is eual to $30 billion and b is equal to 0.8. Global Economics : macro model 4 Global Economics : macro model 5 Average and marginal propensities to consume. The average propensity to consume(APC) is total consumption expenditure divided by total disposable income: APC = C Yd The marginal propensity to consume(MPC) relates to change in desired consumption ot the change is disposable income. MPC = C Y W here the Greek letter means a change in. The slope of the consumption function The consumption function has a slope of C Y W hich is, by definition, the marginal propensity to consume. The positive slope of the consumption function shows that MPC is positive; increases in income lead to increases in consumption expenditure. Global Economics : macro model 6 The 45o line. This line is constructed by connecting all points where desired consumption (measured on the vertical axis) equals disposable income (measured on the horizontal axis). Because both axis are given the same units, this line has a positive slope equal to one; that is, it forms an angle of 45o with the axes. The 45o is a useful reference line. The consumption function cuts the 45o line at the break-even level of income. The 45o line is also useful because its slope, which is equal to one, is greater than the slope of the consumption function, which is equal to the marginal propensity to consume. This is simply a graphic reminder that the MPC is less than one, and that the higher is the MPC, the steeper is the consumption function. Global Economics : macro model 7 The saving function There are two saving concepts that are exactly parallel to the consumption concepts of APC and MPC. The average propensity to save APS = S/Yd The marginal propensity to save MPS = S/ Yd There is a simple relationship between the saving and the consumption propensities APC and APS must sum to one, so must MPC and MPS“ APC + APS = 1 MPC + MPS = 1 Global Economics : macro model 8 Global Economics : macro model 9 Global Economics : macro model 10 The aggregate expenditure function The aggregate expenditure AE function relates the level of desired expenditure to the level of actual income. In this simplified model, in which there is no government and no international trade, desired aggregate expenditure is just equal to desired consumption plus desired investment, C + I. AE = C + I Global Economics : macro model 11 Equilibrium national income Suppose that firms are producing a final output of $300 billion, and thus national income is $300. At this level of income aggregate desired expenditure is $345 billion. In our example the plans to purchase $345 billion worth of commodities is the face of current output of $300 billion will reduce inventories by $45 billion. Eventually inventories will run out and firms will increase their outputs(more production, more work, more income) and national income will increase. Global Economics : macro model 12 Desired saving and desired investment. Y = C + I Y = C + S and S = Y - C C + I = C + S I = S Global Economics : macro model 13 Changes in equilibrium National Income Global Economics : macro model 14 Global Economics : macro model 15 The multiplier W e have learned how to predict the direction of the changes in national income that occur in response to various shifts in the AE function. W e would also like to predict the magnitude of these changes. The multiplier is the change in equilibrium national income divided by the change in autonomous expenditure that brought it about. The mutiplier is greater than one. Global Economics : macro model 16 Global Economics : macro model 17 The multiplier The larger the marginal propensity to spend, the steeper the AE function and thus the larger the simple multiplier. Global Economics : macro model 18 Global Economics : macro model 19 Exercises Global Economics : macro model 20 2) Consider the following diagram of the AE function and the 45o line. Global Economics : macro model 21 Global Economics : macro model 22 4) W hat happens to the level of national income if every household in the economy tries to increase its level of desired savings? W ill it increase? Fall? W ill saving end up being more, less, the same as initially? Global Economics : macro model 23.
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