The Income-Expenditure Model

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Presentation transcript:

The Income-Expenditure Model Chapter 9 The Income-Expenditure Model © OnlineTexts.com p. 1

The Income-Expenditure Model The Income-Expenditure model, also known as the Keynesian Cross model, was first developed by the Depression-era economist named John Keynes. The goal was to develop a model that could explain how an economy could become permanently “stuck” at a high-unemployment level. © OnlineTexts.com p. 2

Model Assumptions The model assumptions are: The price level is fixed. Suppliers will supply any level of output that is demanded at the fixed price level. There are no government expenditures or net exports. The interest rate in the economy is determined outside the model. There are no taxes. © OnlineTexts.com p. 3

Aggregate Expenditures Aggregate Expenditures (AE) is the aggregate amount that consumers, investors, government, and foreigners wish to spend on the purchase of final goods and services produced in the domestic borders, given the price level. AE = C + I + G + NX Assuming G = NX = 0, AE = C + I © OnlineTexts.com p. 4

Determining Consumption Consumption is the largest component of Aggregate Expenditures, accounting for two-thirds of GDP. It is influenced by Disposable income Wealth Interest rates Expectations of future income © OnlineTexts.com p. 5

The Consumption Function A consumption function shows the relationship between total consumer expenditures and total disposable income, holding all other determinants of consumption constant. The equation for the consumption function is: C = CA + MPC (DI) where C is total consumption; CA is autonomous consumption, MPC is the marginal propensity to consume, and DI is disposable income. © OnlineTexts.com p. 6

Components of the Consumption Function Autonomous consumption (CA) is the portion of disposable income that is independent of income. The Marginal Propensity to Consume (MPC) tells us how much of an additional dollar of disposable income will be spent. If the MPC = 0.80, then $0.80 of the next dollar earned will be spent. The MPC for an economy always lies between zero and one, 0 < MPC < 1. © OnlineTexts.com p. 7

The Consumption Function The consumption function is upward sloping, reflecting the positive correlation between consumption and disposable income. The vertical intercept is equal to CA, and the slope of the line is the MPC. © OnlineTexts.com p. 8

Determining Investment Investment is the most volatile component of GDP, accounting for approximately 17% of GDP. Investment is determined by interest rates (higher rates lead to lower investment) business confidence taxes capacity utilization © OnlineTexts.com p. 9

The Level of Investment For simplicity, the income-expenditure model assumes that the level of investment is given. The investment line, then, is simply a horizontal line at the level of investment. © OnlineTexts.com p. 10

Aggregate Expenditures in the Income-Expenditure Diagram Given that: AE = C + I C = CA + MPC (DI) DI = Y (assuming no taxes), and I = IA, then AE = CA + MPC (Y) + IA © OnlineTexts.com p. 11

The Aggregate Expenditures Function The Aggregate Expenditure Function plots the level of AE against the level of output (Y). © OnlineTexts.com p. 12

The 45 degree line On any chart, if the horizontal and vertical axes have the same scale, then any (x,y) point on the 45 degree line will have the same value on both axes. Notice that every point on the 45 degree line has the same x and y value. © OnlineTexts.com p. 13

Equilibrium in the Income-Expenditure Model Equilibrium occurs at the point in which Y = AE or the level of income equals the level of Aggregate Expenditures. Equilibrium can be shown with a chart or with algebra. © OnlineTexts.com p. 14

Equilibrium using a Graph Equilibrium occurs at the point in which the AE function crosses the 45 degree line. © OnlineTexts.com p. 15

Algebraic Equilibrium Equilibrium can also be shown by the point where Y = AE or Y = CA + MPC(Y) + IA so Y = (CA + IA) / (1 – MPC) © OnlineTexts.com p. 16

Changes in Equilibrium Income As a general rule, any increase in autonomous consumption or investment shifts the AE schedule upwards and leads to a rise in equilibrium income. This chart depicts an increase in autonomous investment. © OnlineTexts.com p. 17