Econ 1V – Discussion 7

Real GDP Recall: Y = C + I + G +X Where Y is our real GDP C is consumption G is government spending X is net exports

Consumption Consumption is related to income through the marginal propensity to consume (MPC). Typically the MPC in the US is considered to be about 0.6 So consumption may be related to income by a function such as: C= Y One other thing we often consider is consumption as a function of disposable income (Y-T), as this is actually what households have to spend, for example: C= (Y-T) Note that in the case that T=200 these are identical.

Expenditure Line Graph We can combine the consumption function with the other components of GDP (I,G,X) to get our expenditure function. Using the identity that Income = Spending in our economy as a whole, we can derive a model.

What is happening in this model? Suppose we increase I in our model. This shifts our expenditure line up. What does this mean within our equations?

Expenditure in Action Suppose C=800+.6(Y-T) I = 600 G = 800 X=100 T = 300

Expenditure in Action – Increase in I Suppose C=800+.6(Y-T) I = 700 G = 800 X=100 T = 300

Expenditure Line and the Real Interest Rate Remember from our discussion on SAM, that C, I, and NX all depend negatively on the real interest rate. In other words an increase in r, will decrease C, I, and NX. So we can think of the expenditure line as also depending on r. An increase in r will shift the expenditure line down.

Monetary Policy Rule Central banks tends to keep to a target inflation rate which might or might not be announced publicly. Central banks will react to rising inflation, by increasing the interest rate. This will tend to cool down the economy and create disinflation in the long run. Recall the inverse relationship between interest rates and bond prices. This holds here through a different mechanism.

Deriving AD We can use our expenditure model and the monetary policy rule to derive the AD curve.

Inflation Adjustment (IA) Line In the SR, we tend to think of prices as sticky because of wage contracts, long term order contracts, etc. In the SR, we will assume the IA line is flat.

Potential GDP In the LR, we expect our economy to return to potential GDP, though as we have seen previously there are fluctuations around it. Let’s look at this adjustment mechanism when we start below potential GDP.

SR and LR effects of changes in the economy Consider a sudden increase in investment in an economy that is starting at potential GDP. Note that this means for any given real interest rate, investment is higher. We will also assume as a secondary effect, Imports depends positively on consumption (though the primary effect is still the negative relation with r)