Chapter 11: Income and Expenditure Flashcards
What are the four assumptions backing the multiplier and income-expenditure model?
- Producers are willing to supply additional output at a fixed price. If consumers spend an additional $1, firms will produce $1 output without changing price levels.
- Interest rate is given and fixed
- No government spending or taxes
- Exports and imports are 0
What is the marginal propensity to consume (MPC)?
The increase in consumer spending when disposable income rises by $1. Because consumers normally spend part but not all of an additional dollar of disposable income, MPC is between 0 and 1
How do you calculate MPC?
Change in consumer spending/Change in disposable income
What is the marginal propensity to save (MPS)?
The fraction of an additional dollar of disposable income that is saved
How do you calculate MPS?
1-MPC
How do you calculate total increase in real GDP?
(Change in YD + MPC + MPC^2 + MPC^3 +…MPC^n) * Investment spending (AE0)
OR: Multiplier (1/1-MPC) * Investment spending (AE0)
What is an autonomous change in aggregate expenditure?
An initial rise or fall in aggregate expenditure at a given level of real GDP
What is the multiplier?
The ratio of total change in real GDP caused by an autonomous change in aggregate expenditure to the size of that autonomous change
What is the relationship between the size of the multiplier and the size of the MPC?
They are positively related - the higher the MPC, the higher the multiplier
What is the individual consumption function (definition)?
An equation showing how an individual household’s consumer spending varies with the household’s disposable income
What is the individual consumption function (formula)?
c = ac + MPC*yd
What is the aggregate consumption function (definition)?
The relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending
What is the aggregate consumption function (formula)?
C = AC + MPC*YD
What are the two principle causes that shift the aggregate consumption function?
Changes in expected future disposable income and changes in aggregate wealth
Who came up with the permanent income hypothesis?
Milton Friedman in his 1957 book A Theory of Consumption Function
What is the permanent income hypothesis?
When the economy grows, current and future incomes rise together. Higher current income leads to higher savings today, but higher future income leads to less savings today. As a result, there’s a weaker relationship between current income and the savings rate.
Consumer spending ultimately depends mainly on the income people expect to have over the long term rather than their current income
What is the life cycle hypothesis?
Consumers plan their spending over a lifetime, not just in response to their current disposable income. As a result, people try to smooth their consumption over their lifetimes - they save some of their current disposable income during their years of peak earnings (typically occurring during a worker’s 40s and 50s) and during their retirement live off the wealth they accumulated while working
What are econometrics?
The use of statistical techniques to fit economic models to empirical data
What is planned investment spending?
The investment spending that firms plan to undertake during a given period. Planned investment spending may differ from actual investment spending due to unplanned inventory investment
What are the three factors that planned investment spending depends on?
- The interest rate
- The expected future level of real GDP
- The current level of production capacity
What is the relationship between the interest rate and investment spending?
An inverse relationship. Firms with investment spending projects will only go ahead with a project if they expect the rate of return to be higher than the cost of the funds they would have to borrow to finance the project
What is the relationship between investment spending and the current level of production capacity?
The current level of production capacity has a negative (inverse) effect on investment spending. The higher the current level of production capacity, the lower the investment spending
What is the accelerator principle?
The proposition that a higher growth rate in real GDP results in higher levels of planned investment spending, and a lower growth rate in real GDP leads to lower planned investment spending
What are inventories?
Stocks of goods and raw materials to facilitate business operations
