Jan 22 Flashcards
actual values of the various categories of expenditure
Ca
Ia
Ga
(Xa - IMa)
desired values of various categories of expenditure
same as actual values but without the a subscript
C: desired consumption
I: desired investment
G: desired gov purchases
X - IM: desired net exports
what does “desired” actually mean?
isn’t a list of what consumers and firms would buy if they had no constraints on their spending - it’s much more realistic
reflects what consumers and firms would like to purchase, given their REAL-WORLD CONSTRAINTS of income and market prices
what’s aggregate expenditure (AE)?
the sum of DESIRED or PLANNED SPENDING on DOMESTIC OUTPUT
by households, firms, governments and foreigners
AE equation
AE = C + I + G + (X - IM)
autonomous expenditures
elements of expenditure that don’t change systematically with national income
induced expenditures
any component of expenditure that’s systematically related to national income
assumptions of simplest short-run macro model
- no trade - closed economy
- no government - no taxes
- price level is constant
AE = C + I
what’s AE in the simplest macro model?
AE = C + I
in the simplest model, what mostly determines consumption?
disposable income (YD)
disposable income
YD
amount of income households receive AFTER DEDUCTING TAXES and ADDING TRANSFERS
2 possible uses of disposable income
- consumption (C)
- saving (S)
graph plotting per capita disposable income and per capita consumption
lines have steadily increased in tandem since the 1950s
the distance between real per capita disposable income and real per capita consumption is real per capita savings
in 2020 (pandemic) they started to diverge: disposable income increased and consumption decreased, meaning savings got larger
4 key factors influencing desired consumption
- disposable income
- wealth
- interest rates
- expectations about future income
equation for the simplest consumption function
C = a + b x YD
slope of the simple consumption function is less…
less than 1
it’s positive (because increase in YD leads to increase in C)
but less than 1 because most individuals want to save a fraction of each additional dollar they make
(if the slope equalled 1, people would be spending each dollar they made)
consumption function: what does the 45 degree line indicate?
at this level, all the disposable income possessed by households will be consumed
reference point we can use to determine if people are saving or not saving at each level of income
consumption function graph: where’s the break even level of income?
point where the consumption function intersects the 45 degree line
equation for the slope of the consumption function
b = change in C / change in YD
if you have the consumption function, you automatically have…
the savings function
because out of disposable income, everything that you don’t consume you end up saving
so if:
C = 30 + 0.8 YD
then
S = -30 + 0.2 YD
marginal propensity to consume (MPC)
MPC relates the change in desired consumption to the change in disposable income that brings it about
MPC = change in consumption / change in YD
MPC is the ______ of the ______ _______
slope of the consumption function
average propensity to consume (APC)
equal to total consumption divided by total disposable income
APC = C / YD
as the level of income rises, what happens to the APC?
it falls
because APC = C / YD
marginal propensity to save (MPS)
relates the change in desired saving to the change in disposable income
MPS = change in S / change in YD
average propensity to save (APS)
total desired saving divided by total disposable income
APS = S / YD
since all disposable income is either spent or saved…
APC + APS = 1
fractions of any increment to income consumed and saved must account for all of that increment…
MPC + MPS = 1
what happens to saving function if consumption function shifts down?
saving function shifts up
what causes a shift in the consumption function?
- change in wealth
- change in interest rate
- change in expectations
what causes a movement along the consumption function?
change in YD
income versus wealth
INCOME is a FLOW VARIABLE - it’s the money you get across time ie. per hour, per year
WEALTH is a STOCK - refers to the value of your ASSETS, SAVINGS, STOCKS
why would change in interest rate affect consumption?
interest rate is the cost of borrowing
increases in interest rate will increase cost of borrowing - discourages consumption in 2 ways:
- more expensive to borrow
- high interest rates means you’ll make more on your savings
reduction in interest rates does what to savings and consumption?
moves savings down
moves consumption up
what’s the most volatile component of GDP?
investment expenditure
changes in investment expenditures are strongly associated with SHORT-RUN FLUCTUATIONS
3 important determinants of aggregate investment expenditure
- real interest rate
- changes in level of sales
- business confidence/expectations about future
what does it mean to say that investment is autonomous?
it doesn’t depend on the current level of income
3 biggest components of private-sector investment
- plant and equipment
- residential construction
- inventories
all three fluctuate a lot in the short run
the real interest rate is the opportunity cost for:
- investment in new plants and equipment
- investment in inventories
- investment in residential construction
all three components of desired investment expenditure are related in what manner to the real interest rate?
related negatively
because if real interest rate is low, then high investment in all three areas
investment: change in sales/inventories
the higher the level of production and sales, the larger the desired stock of inventories
changes in the rate of sales cause TEMPORARY BOUTS OF INVESTMENT in inventories
higher sales = desire for higher inventories = higher investment
lower sales = desire for lower inventories = lower investment
investment: business confidence
when business confidence IMPROVES, firms want to invest now and reap future profits
business confidence and consumer confidence may FEED OFF ONE ANOTHER
^ people need to think the future will be good if they are to keep consuming and investing
we will assume that desired investment is ________, meaning it’s…
autonomous
unaffected by changes in national income
^ autonomous is different than constant
^ think of investment as concerning future benefit, and thus not concerned with the current level of GDP
AE function relates what to what?
relates DESIRED AGGREGATE EXPENDITURE to ACTUAL NATIONAL INCOME
what is AE in absence of government and international trade?
AE = C + I
in the simple macro model, write AE in terms of YD or Y?
Y
because there are no taxes
so Y = YD
slope of the AE function
MARGINAL PROPENSITY TO SPEND
z = change in AE / change in Y
in the simple model, it’s just MPC
marginal propensity to spend (z)
the amount of EXTRA TOTAL EXPENDITURE induced when NATIONAL INCOME RISES by $1
(slope of AE function)
z = change in AE / change in YD
MPC versus z
z (marginal propensity to spend) is the amount of extra TOTAL expenditure induced when NATIONAL INCOME rises by $1
MPC is the amount of extra CONSUMPTION expenditure induced when HOUSEHOLDS’ DISPOSABLE INCOME rises by $1
in the simple macro model, what determines equilibrium level of national income?
assumption that firms can produce any amount of output demanded without changing prices
so equilibrium level of national income occurs where desired aggregate expenditure equals national income
Y = AE
if AE > Y, pressure for
output to rise
whereas if AE < Y, pressure output to fall
if desired AE exceeds actual output what’s happening to inventories?
inventories are DEPLETED
pressure for inventories to rise
pressure to increase production
if desired AE is less than actual output, what’s happening to inventories?
inventories are FULL
pressure for inventories to fall
so less output
in the simple macro model, output is said to be…
demand determined
equilibrium condition is Y = AE (Y)
IN WORDS: equilibrium national income is that level of national income where desired aggregate expenditure equals actual national income
the difference between desired saving and desired investment is always equal to…
to the difference between actual national income and desired aggregate expenditure
S - I = W
W = the difference between savings and investment
S - I = W can also be expressed as…
Y - C - I = W
(because S is Y - C)
Y - AE = W
the economy is in equilibrium when what relationship exists between investment and desired saving?
when they’re equal
when desired investment equals desired saving
at every level of national income, the difference between actual national income and desired aggregate expenditure is exactly equal to the difference between…
desired saving and desired investment
2 types of shifts can occur with the AE function…
- AE function can shift parallel to itself
^ affect the CONSTANT
- slope of AE function can change
^ affect the SLOPE
AE function can shift parallel to itself due to effects of…
- change in wealth
- change in interest rate
- change in expectations
- change in sales
slope of AE function can change due to…
- change in the marginal propensity to spend (z)
^ in this simple model, z = MPC
relationship between S and I and and why the diff between them reflects the gaap between actual income and desired expenditure
diff between savings and investment represents the imbalance between what’s being saved and invested
this imbalance directly affects income level
when Y > AE, SAVING EXCEEDS INVESTMENT, so people are saving more than businesses are investing
when Y < AE, SAVING IS LESS THAN INVESTMENT, so there’s more spending than saving
the imbalance in saving and investment causes economy to ADJUST TOWARDS EQUILIBRIUM, where saving equals investment and national income equals AE
THUS the difference between desired saving and desired investment reflects the GAP between actual income and desired expenditure
in summary, the diff between desired saving (S) and desired investment (I) is awlays equal to the diff between…
actual national income and desired aggregate expenditure because this difference DRIVES THE ADJUSTMENTS that bring the economy toward equilibrium
(equilibrium is where desired saving equals desired investment, and where actual output equals desired expenditure)
simple multiplier is a measure of what?
measure of the SIZE of CHANGE IN EQUILIBRIUM Y that results from a change in AUTONOMOUS expenditure
ie. the change in investment alone is smaller than the resulting change in income
multiplier effect
initial change in spending leads to LARGER CHANGE IN OVERALL ECONOMIC ACTIVITY
increase in spending (by gov, businesses, or consumers) will cause a RIPPLE EFFECT in the economy, leading to an even greater increase in economic output that the og spending itself
simple multiplier equation
change in Y / change in A = 1 / (1 - z)
where z is the marginal propensity to spend out of national income
when change in A is the change in AUTONOMOUS EXPENDITURE
in our simplest of macro models, the simple multiplier exceeds…
one
this means that the change in autonomous expenditure increases equilibrium national income by a MULTIPLE of the initial change in autonomous expenditure
equation of simple multiplier written in words
the simple multiplier is the change in equilibrium national income divided by the change in autonomous expenditure that brought it about
what determines the size of the multiplier effect?
the slope of the AE function aka z
the larger z is, the steeper the AE curve, and the LARGER the simple multiplier
higher slope (z) means what for the multiplier effect?
higher z/slope means higher multiplier effect
algebra behind the simple multiplier
- begin with: AE = A + zY
^ A: autonomous expenditure
^ zY: induced expenditure
- use equilibrium condition: Y = AE
- sub and rearrange
^ Y = A + zY
^ Y = 1 / (1 - z) x A
- simple multiplier is:
change in A/change in Y = 1 / (1 - z)
economic fluctuations as self-fulfilling prophecies
- households and firms base their desired investment and consumption partly on their expectations for the future
- changes in expectations can lead to real changes in current state of the economy
EXAMPLE: imagine firms feel optimistic about the future. this increases their desired investment, shifting up the AE curve. this increases Y, justifying the initial optimism.
