capter 16 output and aggregate demand 1 chapter 16: begg, vernasca, fischer, dornbusch (2012).mcgraw...
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Capter 16Output and Aggregate Demand
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Chapter 16: Begg, Vernasca, Fischer, Dornbusch (2012).McGraw Hill
Learning ObjectivesPotential output vs. current outputDistinguish between autonomous expenditure
and induced expenditure and explain how real GDP influences expenditure plans
Explain how real GDP adjusts to achieve equilibrium expenditure
Explain the expenditure multiplier
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Aggregate Output
Full employment output (or potential output) is the level of output produced when the labor market is in equlibrium and the economy is producing at full employment
Potential output is not the maximum level of output an economy can produce
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Aggregate Output
Potential output reflects the level of labour that workers wish to supply
Current output what is currently produced, and might be diverge from potential output
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The Aggregate Expenditure Model
Prices and wages are fixedOutput is determined by the demand sideFor the time being, we assume that there is
noGovernmentForeign Trade
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The Aggregate Expenditure ModelA model that explains what determines the
quantity of real GDP demanded and changes in that quantity at a given price level
Aggregate Expenditure: Consumption, and Investment
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The Aggregate Expenditure Model
The key assumption is that we divide expenditure plans into:
Autonomous expenditure does not respond to changes in real GDP
Induced expenditure does respond to changes in real GDP
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The Consumption Function
All income is either spent on consumption or saved in an economy in which there are no taxes
Saving = Aggregate Income-Consumption
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The Consumption Function
Some of the determinants of aggregate consumption:Household IncomeHousehold WealthInterest ratesHousehold’s expectations about the future
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The Consumption Function
In the General theory, Keynes argued that consumption depends directly on income
Consumption function:
C =A+ cY
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The Consumption Function
The slope of the consumption function (c) is called the marginal propensity to consume (MPC), or the fraction of a change in income that is consumed, or spent, 0<c<1
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The Consumption FunctionThe fraction of a change in income that is
saved is called the marginal propensity to save (MPS).
Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore,
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1MPC + MPS
S Y C
The Consumption Function
C Y 1 0 0 7 5.
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At a national income of zero, consumption is $100 billion (a).
For every $100 billion increase in income (Y), consumption rises by $75 billion (C).
The Consumption Function
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)( TY =Disposable Income (DI) (Income - Net Taxes)
C = A + c (Y – T) A = autonomous consumption expenditure
c = marginal propensity to consume
The Determinants of Consumption
Expectations: a more optimistic outlook on the economy will raise consumer’s expenditures
The interest rate cause consumers to postpone consumption
Others: price level, and wealth
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Changes in the Consumption Function
Consumption expenditure increases and the consumption function shifts upward if
• The real interest rate falls
• Wealth increases
• Expected future income increases
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Real interest rates falls, wealth increases, expected future income increases
Changes in Consumption Function
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Real interest rates increases, wealth decreases, expected future income decreases
The Saving Function
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C Y 1 0 0 7 5.S Y C
Y - C = S
AGGREGATEINCOME
(Billions of Dollars)
AGGREGATE CONSUMPTION
(Billions of Dollars)
AGGREGATE SAVING
(Billions of Dollars)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
Investment
Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stock.
One component of the inventory is determined by how much households decide to buy, which is not under complete control of firms
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Actual versus Planned Investment
Desired or Planned investment refers to the additions to capital stock and inventory that are planned by firms.
Actual Investment is the actual amount of investment that takes place; it includes items such as unplanned changes in inventories
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The Planned Investment Function
For now, we assume that planned investment is fixed
That is, it does not change when income changes
The planned investment is an autonomous variable
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Investment FunctionAt this point investment is planned
investment expenditures (I)Investment is closely linked to the
interest rate, since interest represents the opportunity cost of investing in capital
The investment function will shift with changes in expectations for business profits
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Autonomous Investment
Although investment is related to the interest rate and business expectations, investment does not depend in any significant way on disposable income As such, investment is “autonomous”
However, changes in the interest rate or expectations for profits will still shift autonomous investment
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Determinants of InvestmentFactors that can cause a shift in the investment function are:The interest rateExpectationsTechnology
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Planned Aggregate Expenditure = Aggregate Demand
Planned aggregate expenditure is the total amount the economy plans to spend in a given period. It is equal to Aggregate Demand. It is equal to consumption (C) plus planned investment (I).
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IC AD
Equilibrium
In the macroeconomics good market, equilibrium occurs when desired spending equals to aggregate output, income
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EquilibriumOutput = Desired Spending
Y =AD = C + IDisequilibria
Output > Desired SpendingOutput < Desired Spending
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C Y 1 0 0 7 5. I 2 5Deriving the Desired Spending Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 are Based on the Equation C = 100 + .75Y.
(1) (2) (3) (4) (5) (6)
AGGREGATEOUTPUT
(INCOME) (Y)
AGGREGATECONSUMPTION (C)
PLANNEDINVESTMENT (I)
DESIRED (AD)C + I
UNPLANNEDINVENTORY
CHANGEY (C + I)
EQUILIBRIUM?(Y = AD)
100 175 25 200 100 No
200 250 25 275 75 No
400 400 25 425 25 No
500 475 25 500 0 Yes
600 550 25 575 + 25 No
800 700 25 725 + 75 No
1,000 850 25 875 + 125 No
Y Y 1 0 0 7 5 2 5.
Y C I (1)
C Y 1 0 0 7 5.(2)
I 2 5(3)
By substituting (2) and (3) into (1) we get:
There is only one value of Y for which this statement is true. We can find it by rearranging terms:
Y Y 1 0 0 7 5 2 5.
Y Y .7 5 1 0 0 2 5Y Y .7 5 1 2 5
.2 5 1 2 5Y
Y 1 2 5
2 55 0 0
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The Saving and Investment approach to equilibriumAggregate output (Y) will be equal
to Aggregate Demand only when saving equals planned investment (S = I).
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The MultiplierThe multiplier is the ratio of the change
in the equilibrium level of output to a change in some autonomous variable.An autonomous variable is a variable that is assumed not to depend on the state of the economy—that is, it does not change when the economy changes.
In this chapter, for example, we consider planned investment to be autonomous
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The MultiplierThe multiplier of autonomous
investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income.
The size of the multiplier depends on the slope of the planned aggregate expenditure line.
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The MultiplierThe marginal propensity to save may
be expressed as:
Because S must be equal to I for equilibrium to be restored, we can substitute I for S and solve:
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M P SS
Y
M P SI
Y
Y IM P S
1
m ultip lierM P C
1
1
The Multiplier
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After an increase in planned investment, equilibrium output is four times the amount of the increase in planned investment.