Chapter 6 Notes

## 6.1 Desired Aggregate Expenditure - Actual expenditure categories are denoted as $C_a$, $I_a$, $G_a$, and $(X_a − IM_a)$. - Desired expenditure categories use the same letters without the "a" subscript: - Desired consumption: $C$ - Desired investment: $I$ - Desired government purchases: $G$ - Desired net exports: $(X – IM)$ - "Desired" expenditure reflects what consumers and firms would purchase given real-world constraints of income and market prices. - Desired aggregate expenditure (AE) is the sum of desired spending by households, firms, governments, and foreigners on domestic output.
$AE = C + I + G + (X − IM)$ - Autonomous expenditures do not change systematically with national income. - Induced expenditures change systematically in response to changes in national income. - Assumptions of the simplest short-run macro model: - Closed economy (no trade with other countries) - No government (and hence no taxes) - Constant price level ## Desired Consumption Expenditure - Disposable income is calculated as household income minus taxes. - Saving is disposable income not spent on consumption. - The consumption function illustrates the relationship between desired consumption expenditure and its determinants. - Desired consumption is determined by disposable income, wealth, interest rates, and expectations about the future. ### Average Propensity to Consume (APC) - $APC = C / YD$ - APC falls as disposable income rises. ### Marginal Propensity to Consume (MPC) - $MPC = \Delta C / \Delta YD$ - MPC is the slope of the consumption function. - The constant slope of the consumption function indicates that the MPC is the same at any level of disposable income. ## The Saving Function - Households decide how much to consume and how much to save. ### Average Propensity to Save (APS) - $APS = S / YD$ ### Marginal Propensity to Save (MPS) - $MPS = \Delta S / \Delta YD$ - Since all disposable income is either spent or saved:
$APC + APS = 1$ - The fractions of any increment to income consumed and saved must account for all of that increment:
$MPC + MPS = 1$ - The consumption function shifts upward with an increase in wealth, a decrease in interest rates, or an increase in optimism about the future. - The saving function shifts downward with an increase in wealth, a decrease in interest rates, or an increase in optimism about the future. ## Desired Investment Expenditure - Three categories of investment: inventory accumulation, residential construction, and new plant and equipment. - Investment expenditure: - Most volatile component of GDP. - Strongly associated with aggregate economic fluctuations. - Determinants of desired investment expenditure: - Real interest rate. - Changes in the level of sales. - Business confidence. - The current level of real GDP is not an important determinant of current desired investment. - Simplifying Assumption: Investment as autonomous expenditure ## The Aggregate Expenditure Function - The aggregate expenditure (AE) function relates the level of desired aggregate expenditure to the level of actual national income. - In the absence of government and international trade:
$AE = C + I$ - Example: - Consumption function: $C = 30 + (0.8)Y$ - Investment function: $I = 75$ - AE function: $AE = C + I = 30 + (0.8)Y + 75 = 105 + (0.8)Y$ - The slope of the AE function is the marginal propensity to spend, which in this simple model, is just the marginal propensity to consume. ## 6.2 Equilibrium National Income - If desired aggregate expenditure exceeds actual income, inventories are falling, and there is pressure for actual national income to rise. - If desired aggregate expenditure is less than actual income, inventories are rising, and there is pressure for actual national income to fall. - The equilibrium level of national income occurs when desired aggregate expenditure equals actual national income. - National income is in equilibrium when desired aggregate expenditure equals actual national income. - The equilibrium condition occurs when $AE = Y$ - If actual $Y < Y0$, desired AE will exceed national income, and output will rise. - If actual $Y > Y0$, desired AE will be less than national income, and production will fall. - Only when $Y = Y0$ will the economy be in equilibrium ($E0$). ## 6.3 Changes in Equilibrium National Income - One shift in equilibrium occurs when the AE function shifts parallel to itself. - Another possible shift is when there is a change in the slope of the AE function. ## The Multiplier - The simple multiplier is the ratio of the change in equilibrium national income to the change in autonomous expenditure that brought it about, calculated for a constant price level. - In the simple macro model, the multiplier is greater than 1. - z is the marginal propensity to spend out of national income - $\Delta A$ is the change in autonomous expenditure - The larger the marginal propensity to spend, the steeper the AE function and the larger is the simple multiplier. ## Economic Fluctuations as Self-Fulfilling Prophecies - Households’ and firms’ expectations about the future state of the economy influence desired consumption and desired investment. - Changes in desired aggregate expenditure will, through the multiplier process, lead to changes in national income. - This link between expectations and national income suggests that expectations about a healthy economy can actually produce a healthy economy—what economists call a self-fulfilling prophecy. - If firms begin to feel optimistic about future economic prospects, this optimism may lead them to increase their desired investment, which shifts up the economy’s AE function. - The upward shift in the AE function increases national income. - If enough firms are optimistic and take actions based on that optimism, their actions will create the economic situation that they expected.