Basic Macroeconomic Models: Aggregate Expenditure

Explain, measure, and illustrate the relationship between disposable income, consumption, and saving with the assumptions of the Keynesian model in the aggregate expenditure model.
Determine the consumption and savings functions, the marginal and average propensity to consume and save, and autonomous consumption and saving given algebraic, tabular, or graphical formats.
Classify and illustrate the determinants of consumption and saving.
Classify and illustrate the function and determinants of planned investment and add planned investment to the aggregate expenditure model.
Apply government spending, (lump sum) taxes, and net exports to the aggregate expenditure model to determine and illustrate actual (short run) equilibrium real GDP.
Explain, measure, and illustrate the multiplier and multiplier effect in the aggregate expenditure model.
Identify the relationship between the aggregate expenditure model and the aggregate demand curve.

Keynes revisited:
- Aggregate demand determines output (horizontal SRAS).
- Prices are fixed.
- Examine the elements of aggregate demand (AD = C + I + G + NX).

Disposable Income (Yd):
- Income after taxes.
Consumption (C):
- Spending on new goods and services out of a household’s current available income.
Saving (S):
- Not consumption nor investment (physical capital).
Disposable income = Consumption + Saving. (Yd = C + S)
Primary determinant of spending (or saving) is Disposable Income (Yd = Y – T)
- At Macro level, GDP after Taxes
Consumption Function:
- The relationship between (planned) consumption expenditures and their current level of real income.

3 ways to look at C + I + G + NX:
- Algebraic form
  - C = MPC * Yd + Autonomous Consumption
  - C = 0.8Yd + 100
- Table form
- Graph form
Marginal Propensity to Consume (MPC):
- The ratio of the change in consumption to the change in disposable income.
- This is the slope of the consumption function.
- MPC = \frac{change \ in \ consumption}{change \ in \ real \ disposable \ income}
Autonomous Consumption:
- The part of consumption that is independent of the level of disposable income.
- This is the constant of the consumption function.
  - C = 0.8Yd + 100
  - Consumption = MPC * Yd + Autonomous Cons.
  - Consumption = MPC * (Y-T) + Autonomous Cons.
Dissaving
- Negative saving; spending exceeds income.
Marginal Propensity to Save (MPS)
- The ratio of the change in saving to the change in disposable income.
- MPS = 1 – MPC
- MPS = \frac{change \ in \ saving}{change \ in \ real \ disposable \ income}
Average Propensity to Consume (APC)
- Consumption divided by disposable income.
- The proportion of total disposable income that is consumed.
- APC = \frac{consumption}{real \ disposable \ income}
Average Propensity to Save (APS)
- Saving divided by disposable income
- The proportion of total disposable income that is saved
- APS = \frac{saving}{real \ disposable \ income}

Planned Investment
- Actual investment = Planned investment + Unplanned investment
- Unplanned investment = change in inventories
Historically, Investment has been more volatile than consumption
AD = C + I + G + NX

What causes the planned investment function to shift?
- Expectations of future profitability
- Business taxes
- Cash flow
Investment is not a function of GDP, only interest rates
Added into the model autonomously, like the autonomous portion of C
In equilibrium, there are no change in inventories
- Production and unemployment are stable

Government (G)—C + I + G
- Federal, state, and local
  - Does not include transfer payments.
  - Is autonomous.
Lump-Sum Tax (T)
- A tax that does not depend on income or the circumstances of the taxpayer
  - autonomous

The Foreign Sector—C + I + G + NX
- Net exports (NX) = exports - imports
  - Autonomous
  - Depends on the economic conditions in each country

Observations
- If C + I + G + NX = GDP
  - Equilibrium
- If C + I + G + NX > GDP
  - Unplanned drop in inventories
  - Businesses increase output
  - GDP increases & returns to equilibrium
- If C + I + G + NX < GDP
  - Unplanned rise in inventories
  - Businesses decrease output
  - GDP decreases & returns to equilibrium
Equilibrium
- Aggregate expenditure equals aggregate production
- Assume the economy is not growing

Assume an economy has a consumption function of C = 0.64 (Yd) + $201. Additionally, this economy has investment spending = $544, government purchases = $298, taxes = $143, exports = $207, and imports = $294. What is the equilibrium level of GDP based on this information?

Multiplier
- The ratio of the change in the equilibrium level of real national income to the change in autonomous expenditures

Assume an economy has a consumption function of C = 0.64 (Yd) + $201. Additionally, this economy has investment spending = $694, government purchases = $298, taxes = $143, exports = $207, and imports = $294. What is the equilibrium level of GDP based on this information?

How can $1.6 trillion of I generate $8.0 trillion of Y?
- The autonomous spending multiplier

The multiplier formula
- Multiplier = \frac{1}{1 - MPC} = \frac{1}{MPS}
Measuring the Change in Equilibrium Income from a Change in Autonomous Spending
- Change in equilibrium income (real GDP) = multiplier x change in level of real autonomous spending

Assume an economy has a consumption function of C = 0.64 (Yd) + $201 and equilibrium GDP is $2,401. Suppose investment increases by $150 to $694. How much will GDP rise?

The multiplier effect on equilibrium real national income will not be as great if part of the increase in nominal national income occurs because of increases in the price level.