MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © 2010 Chapter 6 Output, Aggregate Expenditure, and Aggregate Demand.

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MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © 2010 Chapter 6 Output, Aggregate Expenditure, and Aggregate Demand

Learning Outcomes ©2010 McGraw-Hill Ryerson Ltd. Chapter 6 2 This chapter explains AD & output (Y) in the short run Consumption, saving, & investment functions Export & import functions Aggregate expenditure & Y e in the short run The multiplier Leakages, injections, & Y e Equilibrium output & AD

AD & Output in the short Run ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.1 3 Assume:  All prices & wages are fixed  Interest rates & exchange rates are fixed  Business produces output demanded  Business employs labour need for production

AE, AD, & Output with Constant Prices ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.1 4 AD 0 AS 0 Y0Y0 Real GDP and Income GDP Deflator P0P0 Y P E AE(P 0 ) Y = AE Y0Y0 Real GDP and Income Aggregate Expenditure A0A0 Y AE E 45 o AE 0 Equilibrium Y 0 @ Y = AE  POSITION of AD

Aggregate Expenditure (AE) Components of AE: AE is planned aggregate expenditure From National Accounts (without govt): AE ≡ C + I + X - Z With P constant: (Y = AE)  equilibrium real GDP

Consumption, Saving, and Investment ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.2 6 C ≡ planned consumption expenditure by households Consumption Function:  Relationship between C & disposable income (YD)  Assuming no govt  YD = Y C Function argues that: Changes in Y cause Changes in C, e.g. ↑ Y  ↑ C & ↓ Y  ↓ C, and 0 <∆C/∆Y < 1

The Consumption Function Example of the C function: Let C 0 = constant > 0 Let 0 < c < 1 (a positive fraction) Then argue:C = C 0 + cY, C 0 ≡ autonomous consumption (consumption not related to current Y) c = marginal propensity to consume c = ∆C/∆Y ≡ MPC ( cY = consumption determined by Y) Chapter 6.2 ©2010 McGraw-Hill Ryerson Ltd.

The Consumption Function A numerical example: C = C 0 + cY, or C = 20 + 0.8 Y Y C∆C/∆YS = Y – C ∆S/∆Y 0 20 -- – 20 -- 50 60 0.8 – 10 0.2 100 100 0.8 0 0.2 150 140 0.8 10 0.2 200 180 0.8 20 0.2 Autonomous C = 20 MPC = ∆C/∆Y = 0.8 Chapter 6.2 ©2010 McGraw-Hill Ryerson Ltd.

The Consumption Function A diagram to illustrate C = 20 + 0.8Y C 100 60 C = 20 + 0.8Y C 0 = 20 50 100 Y ∆Y = 50 ∆C = 40 ∆C/∆Y = 40/50 = 0.8 9 Chapter 6.2 ©2010 McGraw-Hill Ryerson Ltd.

The Consumption Function ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.2 10 The black regression line shows the relationship between C and Y ∆YD ∆C

The Saving Function ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.2 11 C = 20 + 0.8Y S = Y – C S = Y – (20 + 0.8Y) S = -20 + 0.2Y Saving (S) S = -20 + 0.2Y -20 -10 0 50 100 Y + – MPS = ∆S/∆Y = 10/50 =0.2

Investment Expenditure ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.2 12 Investment (I) planned business spending on plant, equipment & inventories I = I 0 – bi 0 (assuming i constant) Investment is autonomous, Based on business expectations of demand for output & profit ∆i &/or ∆Expectations  shift I function Real GDP and Income I = I 0 – bi 0 I0I0 Investment Y

The Export and Import Functions ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.3 13 Exports (X): Spending by residents of foreign countries on domestic output X is autonomous: X = X 0 X depends on foreign Y, domestic & foreign P & exchange rates

The Export and Import Functions Imports (Z): Domestic spending on foreign output Z is embedded in C, I & X Z = Z 0 + zY Z 0 = autonomous imports z = ∆Z/∆Y, marginal propensity to import Z depends on Y, foreign Y, P & foreign P, & exchange rates

Exports and Imports ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.3 15 Suppose: X = 100 Z = 40 + 0.2Y X, Z 100 40 300 Y X 0 =100 Z = 40 + 0.2Y 150 450 X > Z X < Z

Volatility of AE Components Consumption is the largest & most stable part of AE Investment & exports are volatile parts of AE ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.3 16

The AE Function ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.4 17 AE = C + I + X – Z Suppose: C = 20 + 0.8Y I = 20 X = 50 Z = 10 + 0.2Y AE = 80 + 0.6Y YCIXZAE∆AE/∆Y 02020501080 - 100100205030140 0.6 150140205040170 0.6 200180205050200 0.6

Aggregate Expenditure Functions ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.4 18 C = C 0 + C YAE = C 0 + I 0 +Z 0 + cY – zY I = I 0 AE = A 0 + (c –z)Y X = X 0 Z 0 +zY AE A0A0 Y0Y0 Y1Y1 Y ∆Y ∆AE AE 0 AE 1 AE = A 0 + (c – z)Y ∆AE/∆Y = (c – z)

Aggregate Expenditure Functions C = 20 + 0.8YAE = 20 + 20 + 50 – 10 + 0.8Y – 0.2Y I = 20AE = 80 + 0.6Y X = 50 Z = 10 + 0.2Y AE Y AE = 80 + 0.6Y 80 250 230 150 170 ∆Y =100 ∆AE = 60 Chapter 6.4 ©2010 McGraw-Hill Ryerson Ltd. 19 ∆AE/∆Y = 60/100 = 0.6

Equilibrium Output ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.3 20 Short-run equilibrium: Y = AE Current output = current planned expenditure Business revenues cover costs & expected profit No unplanned ∆ inventories

Equilibrium Output: the 45 o Diagram ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.4 21 Equilibrium: Y = AE AE = A 0 + (c – z)Y 45 0 line plots all Y = AE At intersection AE & 45 0 line Y = AE AE = A 0 + (c – z)Y AE Y YeYe Y1Y1 45 0 A0A0 AE 1 Y 1 AE e AE 1 > Y 1  Unplanned ↓ inventories ↑ Y  Y e Equilibrium

Equilibrium Output ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.4 22

Adjusting to Short-Run Equilibrium ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.4 23 Suppose Y ≠ AE  Unplanned ∆ inventories Y > AE  unplanned inventory ↑  ↓ Y Y < AE  unplanned inventory ↓  ↑ Y ∆Y  Y = AE

Equilibrium Output and Employment In equilibrium Y e = AE However if: (Y e < Y P ) ≡ Recessionary gap & high unemployment (Y e > Y P ) ≡ Inflationary gap & low unemployment (Y e = Y P ) ≡ ‘full employment’ ©2010 McGraw-Hill Ryerson Ltd.Chapter 6.4 24

The Multiplier ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.5 25

The Multiplier: ∆Y e /∆A ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.5 26 45 o Real GDP Y=AE AE A0A0 Ye’Ye’YeYe ΔYeΔYe A1A1 ΔAΔA A 0 + (c – z)Y A 1 + (c – z)Y ∆Y e = ∆A/(1 – c + z) = ∆A x multiplier Example ∆ A 0 = ∆(C 0 + I 0 + X 0 - Z 0 )

Multiplier ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.5 27

The Size of the Multiplier A Numerical example: Initial caseIncreased A: ∆X = 10 Consumption: C = 20 +0.8Y C = 20 +0.8Y Investment: I = 20 I = 20 Exports: X = 50 X = 60 Imports: Z = 10 + 0.2Y Z = 10 + 0.2Y Equilibrium:Y = 80 + 0.6Y Y = 90 + 0.6Y Y e = 200 Y e = 225 ∆Y/∆A = 25/10 = 2.5 = 1/(1 – 0.6) ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.5 28

Leakages & Injections ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.6 29 An alternative view of equilibrium Y: From Y = AE Y = C + I + X – Z, which gives Y – C = I + X – Z, but Y – C = S Thus S + Z = I + X gives Y e S & Z are leakages from AE I & X are injections into AE Injections = Leakages  equilibrium Y

Leakages & Injections Equilibrium Y: S + Z = I + X S + Z, I + X S 1 + Z 1 I 0 + X 0 0 S 0 + Z 0 S + Z I + X YeYe Y1Y1 Y At Y e : S + Z = I + X At Y 1 : S 1 + Z 1 < I + X Leakages < planned I + X Unwanted ↓ Inventories  ↑ Y 30 Chapter 6.6 ©2010 McGraw-Hill Ryerson Ltd.

AE & AD Model Key model concepts: Autonomous expenditure:  Independent of current income  A 0 = C 0 + I 0 + X 0 + Z 0 Induced expenditure  Determined by current income  MPC & MPZ  (c – z)∆Y = ∆AE ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.7 31

AE & AD Model Key model concepts: Equilibrium Y = A 0 x multiplier Induced expenditure  multiplier ∆A x multiplier  ∆Y > ∆A Volatility in A  Business cycles in Y Chapter 6.7 32 ©2010 McGraw-Hill Ryerson Ltd.

Equilibrium Y & AD ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.7 33 The AD function: Y e from Y = AE positions the AD curve ΔA  horizontal shift in AD = ΔA x multiplier Fluctuations in AD from fluctuations in A  business cycles in Y A diagram to illustrate

Equilibrium Y & AD ©2010 McGraw-Hill Ryerson Ltd. Chapter 6.7 34 Y=AE A 0 Y e ΔYΔY ΔAΔA YeYe Ye’Ye’ P0P0 ΔYΔY AS AD 0 AD’ AE 45 0 Ye’Ye’Y A1A1 AE 0 AE 1 Y ∆A  ∆Y = ∆A x multiplier  shift AD = ∆A x multiplier P

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 6 35 Aggregate demand determines Y at constant P Equilibrium Y = AE positions AD AE AE ≡ planned (C + I + X – Z) AE = autonomous expenditure + induced expenditure C linked to YD by MPC = ∆C/∆YD, 0 < MPC < 1 S = Y – C, MPS = ∆S/∆Y, MPS = 1 – MPC

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 6 36 Imports (Z) linked to Y: MPZ = ∆Z/∆Y. 0 < ∆Z/∆Y <1 Equilibrium Y = AE  equivalently, S + Z = I + X. AE > Y  unplanned fall in inventories  ↑ Y AE < Y  unplanned rise in inventories  ↓ Y The multiplier ≡ ∆Y e /∆A = 1/(1 – slope AE) ∆A  ∆Y  shift AD  ∆Y e in AD/AS ∆A  ∆AD  business cycles in Y

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