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Aggregate Demand - Aggregate Supply Equilibrium

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The Fixed-Price Keynesian Model: An Economy Below Full – Employment Focus on the Demand Side

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Factors that Affect AD Consumption ≈ 68% of gdp –INCOME –Wealth Price –Interest Rates Price –Expectations Future Income Future Prices –Demographics –Taxes Investment ≈ 17% of gdp –Interest Rates Price –Technology –Cost of Capital Goods –Capacity Utilization –Expectations!!! AD = C + I + G + NX Government Spending ≈ 18% of gdp Net Exports ≈ - 3% of gdp – Foreign Income – Domestic INCOME – Foreign Prices – Domestic Prices – Exchange Rates – Foreign Interest Rates – Domestic Interest Rates – Government Policy – Tariffs, Quotas, etc. – Gov’t Procurement

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Consumption and Disposable Income 1947-2002

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Simple Consumption Function Ignore depreciation, taxes, etc. for the time being Then DI = Y = Aggregate Income = Real GDP & C = a + bY is a straight line with slope b. autonomous consumption & a is autonomous consumption. marginal propensity to consumeMPC & The slope, b, is the marginal propensity to consume (MPC). 0 < MPC < 1. MPC is C/ Y, the amount by which consumption changes for each dollar change in Y C Aggregate Income Y a CC YY MPC = C/ Y = b

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Saving Function and Autonomous Shifts in Consumption and in Saving

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Investment Spending (I) Capital goods have a long life. Capital goods take time to build. Capital goods involve large expenditure. The present value of a capital good depends on the income it generates over a long time horizon. –Businesses must form expectations about future conditions and profitability. –Investment is inherently risky. erraticInvestment expenditure tends to be erratic.

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Investment as a Function of Current Income Investment depends more on expectations of the future than on what’s happening now.

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G + NX The Aggregate Expenditures Function AE = C + I + G + NX

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Real GDP (Output) Aggregate planned expenditure 400 500 600 700 0300400500600700 45 o line: AE = Y Total Expenditure Reduce Output, Reduce Employment Increase Output, increase Employment Movement to Equilibrium

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Equilibrium Real GDP: mpc =.75 (1) Real GDP (Y) (2) Consumption (C) (3) Planned Investment (I) (4) Gov’t Spending (G) (5) Net Exports (NX) (6) Aggregate Expenditures (AE) (7) Unplanned Change in Inventories (8) Change in Real GDP 01002500125-125Up 1001752500200-100Up

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Equilibrium Real GDP: mpc =.75 (1) Real GDP (Y) (2) Consumption (C) (3) Planned Investment (I) (4) Gov’t Spending (G) (5) Net Exports (NX) (6) Aggregate Expenditures (AE) (7) Unplanned Change in Inventories (8) Change in Real GDP 01002500125-125Up 1001752500200-100Up 2002502500275-75Up 3003252500350-50Up

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Equilibrium Real GDP: mpc =.75 (1) Real GDP (Y) (2) Consumption (C) (3) Planned Investment (I) (4) Gov’t Spending (G) (5) Net Exports (NX) (6) Aggregate Expenditures (AE) (7) Unplanned Change in Inventories (8) Change in Real GDP 01002500125-125Up 1001752500200-100Up 2002502500275-75Up 3003252500350-50Up 400 2500425-25Up 50047525005000No chg

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Equilibrium Real GDP: mpc =.75 (1) Real GDP (Y) (2) Consumption (C) (3) Planned Investment (I) (4) Gov’t Spending (G) (5) Net Exports (NX) (6) Aggregate Expenditures (AE) (7) Unplanned Change in Inventories (8) Change in Real GDP 01002500125-125Up 1001752500200-100Up 2002502500275-75Up 3003252500350-50Up 400 2500425-25Up 50047525005000No chg 700625250065050Down

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Equilibrium Real GDP: mpc =.75 (1) Real GDP (Y) (2) Consumption (C) (3) Planned Investment (I) (4) Gov’t Spending (G) (5) Net Exports (NX) (6) Aggregate Expenditures (AE) (7) Unplanned Change in Inventories (8) Change in Real GDP 01002500125-125Up 1001752500200-100Up 2002502500275-75Up 3003252500350-50Up 400 2500425-25Up 50047525005000No chg 600550250057525Down 700625250065050Down

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Equilibrium Real GDP: mpc =.75 (1) Real GDP (Y) (2) Consumption (C) (3) Planned Investment (I) (4) Gov’t Spending (G) (5) Net Exports (NX) (6) Aggregate Expenditures (AE) (7) Unplanned Change in Inventories (8) Change in Real GDP 01002500125-125Up 1001752500200-100Up 2002502500275-75Up 3003252500350-50Up 400 2500425-25Up 50047525005000No chg 600550250057525Down 700625250065050Down

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Equilibrium Output (Y) & Spending (AE) and Autonomous Spending Multiplier Polish your algebra Y = C + I = {100 +.75 Y} + 25 Y = 125 +. 75 Y Y -.75 Y = (1 -.75)Y = (1 – mpc) Y = 125.25 Y = 125 = Autonomous Spending Y = (1/.25) 125 = 4 x 125 = 500 In general, Y = Autonomous Spending/(1 – mpc) = Autonomous Spending/mps =AutonomousSpend/{marginal propensity to leak}

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Spending Multiplier The spending multiplier measures the change in equilibrium income (real GDP) produced by change in autonomous expenditures: ΔY/ΔI By how many dollars does real GDP change for every dollar change in autonomous expenditures?

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Multiplier at Work

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Introduce Government Spending: mpc =.75 (1) Real GDP (Y) (2) Tax (T) (3) Disposable Income (Y d ) (4) Consumption C=100+.75 Y d (C) (5) Planned Investment (I) (6) Gov’t Spending (G) (7) Aggregate Expenditure (AE) (8) Change in Real GDP 0001002550175Up 1000 1752550250Up 2000 2502550325Up 3000 3252550400Up 4000 2550475Up 5000 4752550550UP

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Introduce Government Spending: mpc =.75 (1) Real GDP (Y) (2) Tax (T) (3) Disposable Income (Y d ) (4) Consumption C=100+.75 Y d (C) (5) Planned Investment (I) (6) Gov’t Spending (G) (7) Aggregate Expenditure (AE) (8) Change in Real GDP 0001002550175Up 1000 1752550250Up 2000 2502550325Up 3000 3252550400Up 4000 2550475Up 5000 4752550550UP 6000 5502550625UP

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Introduce Government Spending: mpc =.75 (1) Real GDP (Y) (2) Tax (T) (3) Disposable Income (Y d ) (4) Consumption C=100+.75 Y d (C) (5) Planned Investment (I) (6) Gov’t Spending (G) (7) Aggregate Expenditure (AE) (8) Change in Real GDP 0001002550175Up 1000 1752550250Up 2000 2502550325Up 3000 3252550400Up 4000 2550475Up 5000 4752550550UP 6000 5502550625UP 7000 6252550700No Change

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Now add a tax (leakage): mpc =.75 (1) Real GDP (Y) (2) Tax (T) (3) Disposable Income (Y d ) (4) Consumption C=100+.75 Y d (C) (5) Planned Investment (I) (6) Gov’t Spending (G) (7) Aggregate Expenditure (AE) (8) Change in Real GDP 20050150212.502550287.50Up 30050250287.502550362.5Up 40050350362.502550437.50Up 50050450437.502550512.50UP 70050650587.502550662.50DOWN

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Now add a tax (leakage): mpc =.75 (1) Real GDP (Y) (2) Tax (T) (3) Disposable Income (Y d ) (4) Consumption C=100+.75 Y d (C) (5) Planned Investment (I) (6) Gov’t Spending (G) (7) Aggregate Expenditure (AE) (8) Change in Real GDP 20050150212.502550287.50Up 30050250287.502550362.5Up 40050350362.502550437.50Up 50050450437.502550512.50UP 60050550512.502550587.50DOWN 70050650587.502550662.50DOWN

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Now add a tax (leakage): mpc =.75 (1) Real GDP (Y) (2) Tax (T) (3) Disposable Income (Y d ) (4) Consumption C=100+.75 Y d (C) (5) Planned Investment (I) (6) Gov’t Spending (G) (7) Aggregate Expenditure (AE) (8) Change in Real GDP 20050150212.502550287.50Up 30050250287.502550362.5Up 40050350362.502550437.50Up 50050450437.502550512.50UP 55050500475.002550550.00NO Change 60050550512.502550587.50DOWN 70050650587.502550662.50DOWN

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Government Spending Multiplier: ΔY/ΔG = 1/(1 – mpc) = 1/mps = 1/(1 -.75) = 1/.25 = 4 in our example Tax Multiplier: Y = C + I + G = a + mpc (Y – T) + I + G (1 – mpc) Y = a + I + G – mpc T Y = {1/(1-mpc)}{a + I + G – mpc T} When tax is increased ΔY = {1/(1-mpc)}{ - mpc ΔT} ΔY/ ΔT = {- mpc/mps} ΔT = -.75/.25 = -.75 x 4 = - 3 in our example

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