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Chapter Twenty Four Aggregate Expenditure and Equilibrium Output

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Income, Consumption, and Saving (Y, C, and S) Saving = Income - Consumption S = Y - C

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The Role of Income 4 Disposable Income 4 Disposable Income: The current income you receive in your paycheck, after you pay taxes. 4 Expected Future Income 4 Expected Future Income: The income you expect to receive in the future

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The Role of Income Higher Income Higher Consumption

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Income = Consumption + Savings Y = C + S Income Consumption Savings

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Consumption Schedule Income 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Assuming Taxes=0

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Consumption Schedule Income 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Saving -500 -250 0 250 500 = +

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Graphing the Consumption Function Consumption 4000 3000 2000 1000 Household Income 4000200010003000 45 o line

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Graphing the Consumption Function Consumption Household Income Consumption

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Slope of the Consumption Function Consumption 45 o C Household Income DCDC DYDY Slope = C Y

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Slope of the Consumption Function Consumption 45 o C Household Income D C = 750 D Y = 1000 Slope = 0.75

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The Consumption Function C = 500 +.75*Income 4 People buy goods even when their income is zero 4 75% of each dollar of income is consumed 4 25% of each dollar is saved 4 0.75 is the Marginal Propensity to Consume (MPC)

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MPC and MPS marginal propensity to consume 4 The marginal propensity to consume (MPC) is that fraction of a change in income that is consumed or spent. marginal propensity to save 4 The marginal propensity to save (MPS) is that fraction of a change in income that is saved.

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Savings 4 Savings = Income - Consumption 4 MPS: marginal propensity to save 4 MPS = 1 - MPC

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Consumption & Saving Consumption 45 o Consumption Function Y C S Household Income

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Increase in MPC An increase in the MPC increases the slope of the consumption function...

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Increase in MPC Consumption 45 o Consumption Function Household Income

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Increase in the Constant An increase in the constant shifts the entire consumption function upward, parallel to the original.

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Increase in the Constant Consumption 45 o Consumption Function Household Income

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What Determines the Level of Planned Investment? 4 Real interest rates 4 Expected future profits

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What Determines the Level of Planned Investment? Lower Interest Rates Higher Expected Future Profits More Investment (I)

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Actual Investment 4 Actual Investment = Planned Investment + Inventories 4 Inventories = Production - Sales

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Inventory Adjustment ñ Consumers buy more than firms planned ñ Inventories fall ñ Actual Investment falls short of Planned Investment

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Output Adjustment ñ Inventories are lower than desired ñ Firms will increase production ñ Output will rise

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Output < C Planned Investment Inventory Adjustment

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Output = C Actual Investment Inventory Adjustment

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Actual Investment Planned Investment = Change in Inventories Inventories decline by the difference between planned investment and actual investment. Inventory Adjustment

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ñ Consumers buy less than firms planned ñ Inventories rise ñ Actual Investment exceeds Planned Investment

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Output Adjustment ñ Inventories are higher than desired ñ Firms will decrease production ñ Output will fall

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Output > C Planned Investment Inventory Adjustment

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C Output = Actual Investment Inventory Adjustment

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Actual Investment = Change in Inventories Inventories increase by the difference between planned investment and actual investment. Planned Investment Inventory Adjustment

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Aggregate Expenditures Schedule Income Y 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Planned Investment 50 Agg. Expend. C + I 550 1300 2050 2800 3550

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Planned Aggregate Expenditures AE = C + I Aggregate Income, Y 45 o C I Aggregate Expenditures = C + I

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Planned Aggregate Expenditures 500 550 AE = C + I Unplanned rise in inventories. Output falls. Aggregate Income, Y 45 o Output > Aggregate Expenditures

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Planned Aggregate Expenditures 500 550 AE = C + I Unplanned fall in inventories. Output rises. Aggregate Income, Y 45 o Output < Aggregate Expenditures

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Planned Aggregate Expenditures 500 550 AE = C + I Planned Investment = Actual Investment Output does not change. Aggregate Income, Y Equilibrium 45 o Output = Aggregate Expenditures

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Income Identities s C + S + T = Y (household budget) s C + I = AE (planned expenditure) s AE = Y (equilibrium)

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In equilibrium... C + S = Y C + I = AE AE = Y S = I

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Adjustment to Equilibrium Expenditures C C + I 2000 2200 2400 I = 100 C = 2300 Y = 2400 S = 100 Aggregate Income, Y 45 o

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Adjustment to Equilibrium Expenditures C C + I 2000 2200 2400 I = 50 C=2150 Y= 2200 S = 50 Aggregate Income, Y 45 o

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Adjustment to Equilibrium - C & S - Consumption=600+.75Y Aggregate Planned Expenditures Savings = -600 +.25Y 600 Aggregate Income, Y 45 o

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Adjustment to Equilibrium AE I Consumption=600+.75Y Investment=$50 Expenditures Savings 600 650 AE = C + I Aggregate Income, Y 45 o

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Adjustment to Equilibrium AE < Y Expenditures 600 650 AE = C + I Actual Inventoriesexceed Planned Inventories $3000 Aggregate Income, Y 45 o

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When AE < Y, Output is too High... 4 Firms produce more than consumers and firms want to buy 4 Inventories accumulate 4 Actual inventories exceed planned inventories 4 Firms will cut back on production

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Adjustment to Equilibrium AE > Y Expenditures 600 650 AE = C + I Actual Inventories less than Planned Inventories $800 Aggregate Income, Y

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When AE > Y, Output is too Low... 4 Firms produce less than consumers and firms want to buy 4 Inventories decline 4 Actual inventories are less than planned inventories 4 Firms will increase on production

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Adjustment to Equilibrium AE = Y Expenditures 600 650 AE = C + I Actual Inventories equal Planned Inventories $2600 Aggregate Income, Y

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When AE = Y, Equilibrium... 4 Equilibrium income: the level at which C+I = Y 4 Planned Inventories = Actual Inventories

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The Simple Model and the Multiplier > C = 500 + 0.75*Y > I = 50 Equilibrium: C + I = Y 2200 = Y

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Suppose that I rises to 60... è C = 500 + 0.75*Y è I = 60 Equilibrium: C + I = Y 2240 = Y

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Where do the numbers come from?? >C + I = 500 + 0.75Y + 60 = 560 + 0.75Y >Set C + I equal to Y: >560 + 0.75 Y = Y >Solve for Y: >560 + 0.75Y - 0.75Y = Y - 0.75 Y >560 = 0.25 Y >560/0.25 = Y implies Y = 2240

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Aggregate Planned Expenditure 2240 2200 I=50 I=60 Aggregate Income, Y The change in I causes a shift in AE

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Investment spending increases by 10, but income increases by 40... Investment spending increases by 10, but income increases by 40...

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The Multiplier!! 4 Multiplier effect 4 Multiplier effect: Equilibrium GDP increases by more than the change in I or autonomous C 4 Changes in autonomous expenditures multiply through the economy. 1/(1-MPC) 4 Multiplier = 1/(1-MPC) = 1/MPS

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Suppose $10 is injected into the economy, with an MPC =.75: $10 $7.50 $2.50 $5.63 1.87 $4.22 $1.41 SSS Y= C C C $3.17 $1.05 C S $10,$17.50,$23.13,$27.35,$30.52,...

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Add up the increments in Y: >$10 + $7.50 + $5.63 + $4.22 +... = $40 >$40 = $10 * multiplier = $10 * 4

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Review Terms & Concepts 4 Actual investment 4 Aggregate income 4 Aggregate output 4 Autonomous variable 4 Change in inventory 4 Consumption function 4 Planned investment 4 Equilibrium 4 Identity 4 Investment 4 Marginal propensity to consume (MPC) 4 Marginal propensity to save (MPS) 4 Multiplier 4 Paradox of thrift 4 Saving

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