chapter 21

Suppose AE = A + zY, then at equilibrium Y = AE = A + zY and so

(1 - z)Y = A

In this simplest model

AE = C + I

What Does "Desired" Really Mean?

"Desired" expenditure is not just a list of what consumers and firms would buy if they had no constraints on their spending — it is much more realistic than that. Desired expenditure is what consumers and firms would like to purchase, given their real-world constraints of income and market prices.

Two types of expenditures

- Autonomous Expenditures: -Induced expenditures

The real interest rate is the opportunity cost for

- investment in new plants and equipment - investment in inventories (unsold stock of goods) - investment in residential construction

average propensity to consume(APC)

- is equal to total consumption divided by total disposable income.

Business confidence and consumer confidence may

-FEED ONE ANOTEHR -Optimism about future economic prospects leads to higher investment.

If desired aggregate expenditure exceeds actual output (Y): What will happen to (unplanned) inventories?

-Inventories will decline (since actually spent > actual output). -This will lead to higher pressure on firms to produce more

What causes a shift?(factors that affect "a")

-delta wealth -delta interest rate - delta expectations about the future

In more advanced theories, individuals are ----

-forward looking -so consumption depends more on "lifetime" income, rather than only current income.

Assumptions of the simplest short-run macro model

-there is no trade with other countries -there is no government (No taxes and government expenditure) -the price level is constant

If desired aggregate expenditure is less than actual output:-what will happen to (unplanned) inventories?

-there is pressure for output to fall.

Suppose AE = A + zY, then

1.AE function will shift parallel to itself when A changes. 2.The slope of AE function changes when z (marginal propensity to spend with respect to Y) changes.

The sum is called desired aggregate expenditure:

AE = C + I + G + NX

Consider a consumption function: C = 30 + (0.8)Yand investment function: I = 75Then the AE function is then given by:

AE = C + I = 30 + (0.8)Y + 75 -> AE = 105 + (0.8)Y

The equilibrium national income occurs where

AE = Y

The simple consumption function is written as:

C = a + bYD, where a = autonomous C and bYD = induced C. Notice that bYD is induced because it depends on YD

The national accounts divide actual GDP into its components:

Ca, Ia , Ga, and NXa.

Autonomous Expenditures:

Components of aggregate expenditure that do not depend on the level of national income. So this is the expenditure even when (disposable) income is zero.

Changes in Sales

Firms hold inventories to meet unexpected changes in sales and production. The higher the level of production and sales, the larger the desired stock of inventories. The changes in rate of sales therefore cause temporary bouts of investment (or disinvestment) in inventories. Changes in sales have similar effects on investment in plant and equipment

35Economic Fluctuations as Self-Fulfilling Prophecies

Households and firms base their desired consumption and investment partly on their expectations of the future. Thus the changes in expectations can lead to real changes in the current state of the economy .If firms expect better future prospect, that will lead to higher desired investment and hence higher national income through multiplying effect. Firms may take pride in their predictive power; but the truth is their actions created the economic situation they predicted !!

Shifts in the Consumption Function

If consumption function shifts upward, the saving function must shift downward.

Convergence to Equilibrium

If desired AE > real GDP (the AE curve is above the 45° line; e.g., point B), an unplanned decrease in inventories induces firms to hire workers and increase production, so real GDP increases (moves from point B to D).

MPS = Marginal propensity to save.

If you spend $b out of your $1 extra disposable income, then your savings = 1 - b.Given C = 30 + 0.8 YD, Saving function is given by S = - 30 +0.2YD.

Desired Investment as Autonomous Expenditure:

In our simple model, we assume that desired Investment does not depend on national income Y and in that sense it is autonomous. However, it of course depends on real interest rate, business confidence and possibly many other factors

Shifts in the AE Function

It is caused by the changes in autonomous AE that does not depend on Y.

The AE function:

Shows the relationship between desired aggregate expenditure and actual national income. In the absence of government and international trade, desired aggregate expenditure is: AE = C + I

Induced expenditures:

The component that depends on or changes with the level of national income. They increase with income.

The Multiplier

The multiplier is a measure of the size of the change in equilibrium Y that results from a $1 change in autonomous expenditure, A.

Investment expenditure is the most volatile component of GDP and includes:

a) inventory accumulation, b) residential construction and c) new plant and equipment.

The Canadian consumption function has shifted upward over time due to

a)economic growth that has created greater household wealth. b)higher expected future income and c)A fall in interest rates that makes borrowing cheaper

In the simplest theory, consumption is determined primarily

by current disposable income (YD). Higher the disposable income higher is the consumption.

Investment increases

capacity to produce more

Two possible uses of disposable income (i.e., net income after paying taxes)

consumption (C) or saving (S). You either consumer your income or save for future consumption.

Equilibrium occurs at the point at which the AE curve

crosses the 45° line in part (a). That is where desiredAE = real GDP, Y

In other words, when real interest rate is higher (or the real cost of borrowing is higher)

firms and individuals invest less the investment expenditures fall.

When business confidence improves

firms want to invest nowand increase its capacity to produce to meet the future (increased) demand.

The slope of the AE function is the

marginal propensity to spend: In this simple model, it is equal to MPC (=b).

The marginal propensity to consume (MPC)

measures by how much your desired consumption changes in response to an increase in $1 disposable income.

Thus, all three components of desired investment expenditure are

negatively related to the real interest rate, other things being equal

output is said to be demand determined when

output is spurred by demand for consumption and/or investment)

Changes in investment expenditure are strongly associated with

short-run fluctuations in the economy

Equilibrium national income is

that level of national income where desired aggregate expenditure equals actual national income: AE = Y

The larger is z

the steeper is the AE curve and the larger is the simple multiplier (the effect of $1 increase in A on Y).When z = 0, the multiplier = 1.

By simplifying the model we are better able to

understand its structure and therefore how more complex versions of the model work.

Equilibrium occurs when there are no

unplanned changes in business inventories in part (b)

Total desired expenditure is also divided into the same categories:

• Desired consumption, C • Desired investment, I • Desired government purchases, G • Desired net exports (Exports - Imports), Net Exports, NX = X - IM

Three important determinants of aggregate investment expenditure are:

• the real interest rate •changes in the level of sales • business confidence