EC1001 - Short run GDP determination

Assumptions for Macroeconomixc theory

Closed economy

Single industrial sector producing a homogenous output

Fixed price

No government

Excess capacity

Unique eequlibirum and potential output level

What determines aggregate spending

Aggregate spending is the sum of the desired spending in:

-Private Consumption(C)

-Investment(I)

-Government purchases(G)

-Net Exports(X-M)

AE is the sum of all of these

Desired vs Actual Spending

Desired - What people choose to spend given the income or wealth available to them.

Actual - what people actually spend given the income or wealth available to them.

Desired spending does not need to equal actual spending

Autonomous spending

Components of aggregate spending that do not depend on current domestic incomes

Endogenous spending

Components of aggregate spending that do change in response to changes in income

Desired Private Consumtion Spending

Thre are two possible used of dispoable income:

-Savings

-Consumption

Consumption function describes relationship betewen consumption spending and variables that influence it.

Private Consumption function

C = a + bY

C - desired consumption spending

a - autonomous spending

b - induced spending

Y - Disposable income: income after taxes and transfers

average propensity to consume

APC = C/Yd

If APC = 1 this is the break even level of income

APC > 1 => income below break even, consumption exceeds disposable income

APC < 1 => income is above break even level, therefore disposable income exceeds consumption

Marginal propensity to consume

MPC = deltaC/deltaYd

0

Saving function - Average propensity to save

APS = S/Yd

MPS = deltaS/deltaYd

APC + APS = 1

MPC + MPS = 1

MPC vs APC

MPC - measures response to extra income, focuses on change at the marigin and determines slope of C function

APC - measures share of total income, focuses on overall average

3 major investment forms

Investment in inventories - changes in stocks of finished goods, work in progress and raw materials help by rms.

Investment in residential housing construction: expenditure on new and existing houses but not change in owner ship.

Investment in business fixed capital: factories, offices, machines and all other durable things that firms use for their operations.

Aggregate spending function

AE = C + I = a + bY + I, this equations relates desired real spending to level of real GDP.

a + I is autonomous spending, b is the slope which is the marginal propensity - the fraction of any increment to GDP taht will be spent on purchasing domestic output

Equilbirum GDP

AE > Y means Y will rise - firms cannot meet demand of existing production, inventories fall and in response firms will increase output.

AE < Y means Y will decrease - firms are unable to sell all goods they produce, inventories increase and firms respon by cutting output - GDP fall.

AE = Y then Y will not change, firms sell exatly all the produce so no incentive to change production

Equation at equlibrium GDP

Y = C + I

S = Y - C

S = C + I - C = I

S = I, in equlibrium savings equal investment

The multiplier

What is the equilibrium condition in the simple Keynesian model?

Y = AE

Write AE in terms of autonomous spending.

AE = A + bY

What is autonomous spending (A)?

Spending independent of income (e.g. a + I)

What is b?

MPC (Marginal Propensity to Consume)

Derive equilibrium income from Y = A + bY.

Y = A / (1 - b)

What is the multiplier formula?

1 / (1 - b)

What does the multiplier measure?

ΔY / ΔA

If MPC increases, what happens to the multiplier?

It increases

Why does the multiplier increase with MPC?

Because (1 - b) gets smaller

When is the multiplier large?

When MPC is close to 1

Why does the multiplier process converge?

Because 0 < b < 1

What is the total change in income?

ΔY = ΔA + bΔA + b²ΔA + ...

What does this sum equal?

ΔY = ΔA / (1 - b)

If MPC = 0.8, what is the multiplier?

5

If investment rises by 50 and multiplier = 4, what happens to GDP?

GDP increases by 200