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
What is inventory investment?
The value of change in total inventories held in the economy during a given period. Unlike other types of investment spending, inventory investment can be negative if inventories fall
What is unplanned investment spending?
An unintended swing in inventory that occurs when actual sales are higher or lower than expected sales
What is actual investment spending (definition)?
The sum of planned investment spending and unplanned inventory investment
What is actual investment spending (formula)
I = I(planned) + I(unplanned)
What is planned aggregate expenditure (definition)?
The total amount of planned spending in the economy; includes consumer spending and planned investment spending
What is planned aggregate expenditure (formula)?
AE(planned) = C + I(planned)
When is planned aggregate expenditure different from GDP?
When there is unplanned inventory investment
What is the relationship between inventories, planned aggregate expenditure, and GDP?
GDP = AE(planned) when no unplanned inventory investment is present. When they are not equal, the difference shows up in changes in inventories.
If there is a positive inventory investment, firms have overestimated sales and GDP will be above planned aggregate expenditure. If there is a negative inventory investment, firms will have underestimated sales and GDP will be below planned aggregate expenditure.
Example:
GDP = AE(planned) + I(unplanned)
GDP = 90 + (-30)
GDP = 60 (below AE(planned))
GDP = AE(planned) + I(unplanned)
GDP = 90 + 30
GDP = 120 (above AE(planned))
What is the income-expenditure equilibrium (definition)?
A situation in which aggregate output, measured by real GDP, is equal to planned aggregate expenditure and firms have no incentive to change output
What is income-expenditure equilibrium GDP (definition)?
The level of real GDP at which real GDP = planned aggregate expenditure (represented as Y*)
What is the Keynesian cross?
A diagram created by Paul Samuelson that identifies income-expenditure equilibrium as the point where the planned aggregate expenditure line crosses the 45-degree line
What is income-expenditure equilibrium GDP (formula)?
Y* = Multiplier x Autonomous change in AE(planned) (aka AE0)
OR
Y* = (AC+Ip)/1-MPC
Why is the multiplier effect weakened by trade?
When consumer spending rises or falls, part of that change is reflected in spending on imports, which don’t affect a nation’s own income. Some of the spending “leaks” abroad. The effect of this leakage reduces the size of the multiplier. The extent to which the multiplier falls depends on how much of an additional dollar of spending falls on imports rather than domestic goods.
What is the marginal propensity to import (MPI)?
How much of an additional dollar of spending falls on imports rather than domestic goods.
Imports, M, depend on changes in our income (when we have more money, we increase our import demand. During periods of recession, we will buy less. As a result, imports can be viewed as a means of disposable income)
What is planned aggregate expenditure in an open economy (formula)?
AE(planned) = C + I(planned) + (X-M)
What is the MPI Multiplier (formula)?
Multiplier = MPI*YD
What is the planned aggregate expenditure in an open economy, including MPI (formula)?
AE(planned) = (AC + Ip + X) + (MPC-MPI)*YD
