aggregate expenditure model consumption, saving & investment
DESCRIPTION
Recall our first Lecture Developed the Circular Flow of Income Model. Illustrated the importance of assumptions and definitions. The Circular Flow of Income underpins estimation of GDP. Three methods of estimating GDP: Production (VA), Expenditure; & Income.TRANSCRIPT
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Macroeconomics in Macroeconomics in Asia-Pacific Asia-Pacific
Aggregate Expenditure ModelAggregate Expenditure Model
Part 1Part 1Consumption, Saving & InvestmentConsumption, Saving & Investment
GECO6400GECO6400
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Recall our first Lecture Developed the Circular Flow of Income Model.
Illustrated the importance of assumptions and definitions. The Circular Flow of Income underpins estimation of
GDP.
Three methods of estimating GDP: Production (VA), Expenditure; & Income.
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We examined both unemployment and inflation.
Unemployment Types Measurement
Inflation Measurement CPI
Recall our Second Lecture
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Building a model of the economy that attempts to explain the motivation of each of the sectors within the Circular Flow of Income.
3 factors important: Disposable Income Planned expenditure; and business expectations.
This is the Aggregate Expenditure model.
Today…
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The Keynesian Conception of Macroeconomic ActivityOutput can be analysed in various ways. Some analysis holds output constant and lets all other variable change around it.
Another way allows output to vary, output itself being an influential factor in determining how the economy runs.
John Maynard Keynes used this type of approach and allowed output (or income) to be a factor which influenced other macroeconomic variables.
AGGREGATE EXPENDITURE MODEL
Output and Aggregate Expenditure
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Keynes conceived macroeconomic activity as being highly dependent on his conception of Aggregate Expenditure, which in turn was dependent on output.
AE=C+I+G+(X-M)Where:C=ConsumptionI=InvestmentG=Government ExpenditureX=ExportsM=Imports
AGGREGATE EXPENDITURE MODEL
Output and Aggregate Expenditure
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DefinitionConsumption Consumption expenditure is the amount that households
plan to consume out of their disposable income. Consumption depends on disposable income Disposable income (Yd)=Income minus taxation (Y-T) There is no government sector in this model so all
income is disposable (Y=Yd)
AGGREGATE EXPENDITURE MODEL
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Consumption and SavingAE=C
Households can do two things with total income (Y):Consume (C) or Save (S).
Y=C+SC=Y-SS=Y-C
Both are dependent on (or a function of) income (Y). C=f(Y)S=f(Y)
AGGREGATE EXPENDITURE MODEL
Model Assumptions
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Consumption Function: C= a+ßYdWhere:a: autonomous consumption (the Y-axis intercept). This represents Consumption that does not depend on (or is independent of ) output or income.
ß: induced consumption (the slope of the line). This represents Consumption that does depend on (or is dependent on) output or income. This in calculated as the Marginal Propensity to Consume (MPC).
MPC=ΔC/ΔY
Yd= disposable income = (Y - T) but since T = 0, Yd =Y
The Average Propensity to Consume (APC) is that amount of income that is spent on consumption.
APC=C/Y
AGGREGATE EXPENDITURE MODEL
Consumption
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AGGREGATE EXPENDITURE
($)
INCOME ($)0
C= a+ßYd
AGGREGATE EXPENDITURE MODEL
45O
Consumption
a
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GDP & the 450 reference line Recall that the GDP could be estimated from actual data
by three methods. The two methods used here are the Income method and
the Expenditure method. Remember that these methods had to yield the same
value as they refer to the same actual output. This information is captured in the 450 reference line.
AGGREGATE EXPENDITURE MODEL
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AGGREGATE EXPENDITURE
($)
INCOME ($)0
C= a+ßYd
Consumption Function represents spending
plans
AGGREGATE EXPENDITURE MODEL
45O
45o line represents production
Consumption
a
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DefinitionSaving Saving is the amount that households plan to
save out of their disposable income. Since households can only consume or save
their income, S = Y – C.
AGGREGATE EXPENDITURE MODEL
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Savings Function: S= -a+ßYdWhere:a: autonomous Saving (the Y-axis intercept). This represents Saving that does not depend on (or is independent of ) output or income.
ß: induced Saving (the slope of the line). This represents Saving that does depend on (or is dependent on ) output or income. This in calculated as the Marginal Propensity to Save (MPS).
MPS=ΔS/ΔY
Yd= disposable income
The Average Propensity to Save (APS) is that amount of income that is saved. Algebraically, it can be represented as:
S/Y
AGGREGATE EXPENDITURE MODEL
Savings
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S= -a+ßYdSAVINGS
INCOME0
AGGREGATE EXPENDITURE MODEL
Savings
-a
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450
GDP
Aggregate Expenditure
C= a+ßY
AE<Y
AE>Y
EQUILIBRIUM INCOME
S= -a+ßY
GDP
Aggregate Savings
a
-a
S=0
AE=Y
S<0
S>0
AGGREGATE EXPENDITURE MODEL
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AGGREGATE EXPENDITURE MODEL
The components of Aggregate Expenditure are: Y = C + I + G + NX Consumption expenditure is the most stable;
investment is most volatile.
The Simple Model
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Assumptions Household sector interacts with Firm Sector a closed private economy - no government or
international sectors. Households consume and save out of their
disposable income – Y=C+S
AGGREGATE EXPENDITURE MODEL
The Simple Model
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Assumptions Firms invest Investment defines as capital goods plus
change in inventories. investment responds to real interest rates. prices and wages are fixed.
AGGREGATE EXPENDITURE MODEL
The Simple Model
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Defining Equilibrium GDPEquilibrium GDP refers to that level of total output
where planned Aggregate Expenditure is equal to actual output & there is no incentive to change output.
Equilibrium GDP is identified where: Planned AE = Actual Y Injections = Leakages Unplanned investment is zero.
AGGREGATE EXPENDITURE MODEL
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Defining Equilibrium GDPWe can demonstrate equilibrium GDP either by:
tabular analysis – expenditure-output, leakages-injections, unplanned investment;
graphical analysis – expenditure-output, leakages-injections, unplanned investment or
algebraic analysis.
AGGREGATE EXPENDITURE MODEL
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Y C S0 100 -100
250 300 -50
500 500 0
750 700 50
1000 900 100
AGGREGATE EXPENDITURE MODEL
Illustrating Equilibrium GDP
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Propensities to Consume & Save Average propensity to consume = C/Y Average propensity to save = S/Y APS gives us the Household saving ratio APC + APS = 1 Marginal propensity to consume = C/Y Marginal propensity to save = S/Y MPC + MPS = 1
AGGREGATE EXPENDITURE MODEL
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Y C S APC APS MPC MPS0 100 -100 - - - -
250 300 -50 1.20 -0.20 0.8 0.2
500 500 0 1.00 0.00 0.8 0.2
750 700 50 0.90 0.07 0.8 0.2
1000 900 100 0.93 0.10 0.8 0.2
AGGREGATE EXPENDITURE MODEL
Propensities to Consume & Save
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Consumption
In our model, this equation becomes:C = 100 + 0.8Y
That is, Households will spend a $100 on consumption irrespective of income (driven by factors other than income) and an extra 80 cents out of each additional dollar earned.
Therefore if total income (Y) was $1000, then:
C = 100 + 0.8 (1000)C = 100 + 800C = 900
AGGREGATE EXPENDITURE MODEL
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Plotting the Consumption Function
Income (Y) 0 500 1000 1500 2000
Expenditure
500
1000
1500 C = 100 + 0.8Y
100
AGGREGATE EXPENDITURE MODEL
45O
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Y=C+SS=Y-C
S=-C+sYS=-C+sY S=-100+0.2Y=-100+0.2Y
C=C+cY
S=Y-(C+cY)S=Y-C-cY
S=-C+Y-cY
S=-C+(1-c)Y
General Form
C =100+0.8Y
S=Y-(100+0.8Y)
S=Y-100-0.8Y
S=-100+Y-0.8Y
S=-100+(1-0.8)Y
Numerical Example
AGGREGATE EXPENDITURE MODEL
Modelling savings
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100
500
1000
1500
2000
500 1000 1500 2000
-100
Consumption & Saving Schedules
-500
AGGREGATE EXPENDITURE MODEL
S=-100+0.2Y
C=100+0.8Y
Ye=500
45O
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Non-Income Determinants of Consumption & Saving
Wealth Price level Expectations Consumer indebtedness & availability of credit. Taxation. The effects of these variables are captured in the
autonomous components of consumption & saving
Changes in these variables cause a shift (up or down) in the curves.
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100
500
1000
1500
2000
500 1000 1500 2000
-100
-500
Impact of an Increase in Autonomous Consumption(decrease in Autonomous
Saving)
AGGREGATE EXPENDITURE MODEL
C=100+0.8Y
S=-100+0.2YS=-500+0.2Y
C=500+0.2Y
45O
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100
500
1000
1500
2000
500 1000 1500 2000
-100
-500
Impact of an Increase in MPC(decrease in MPS)
C = 100 + 0.9Y
S = -100 + 0.1Y
AGGREGATE EXPENDITURE MODEL
C = 100 + 0.8Y
S = -100 + 0.2Y
45O
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Alternate consumption theoriesBe aware that there are alternate consumption theories.
Absolute Income Hypothesis Consumption will increase but not as much as income.
AIH implied constant MPC but an APC that declines as income increases (the rich consume less of their income).
Life cycle Hypothesis Argues that consumption is a function of net present
value of lifetime income. Thus will be prepared to borrow in youth (against future expected higher income), save during prime working years to pay off debt & accumulate for old age, and run savings/wealth down in retirement.
Permanent Income Hypothesis Permanent income is that portion of your actual income
that you view as stable, expected or predicted. Transitory income is random or unexpected income received in the current period.
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InvestmentThe purchases of new buildings, new plant and new
equipment, together with additions to inventories or increases in stocks is gross investment. It serves to increase the PPF. (It does not include financial assets.)
In the National Accounts, gross investment is called private gross fixed capital formation.
It excludes public or government investment. Gross investment = replacement investment + net
investment
AGGREGATE EXPENDITURE MODEL
Adding Investment
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DefinitionInvestment Our interest is in Planned Investment – or the
intentions/plans of the business sector to invest. Businesses will plan both additions to capital goods
plus have some desired or planned level of inventories in readiness to meet sales’ requests.
So planned investment = planned purchase of capital goods +/- planned change in inventories.
AGGREGATE EXPENDITURE MODEL
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Defining Investment However if actual sales exceed (fall short of)
expectations, then actual investment will be less than (more than) planned investment due to the unplanned depletion (addition) in inventories.
Unplanned investment = unintended changes in inventory levels.
So actual investment = planned investment +/- unplanned investment.
AGGREGATE EXPENDITURE MODEL
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Determinants of Investment Expected rate of net profits that businesses hope to
realise from investment spending. Firms motivated by profit. Firms invest if they expect a net profit from this
investment. The real rate of interest
Inflation adjusted cost associated with borrowing money. Equals nominal interest rate minus the inflation rate.
Investment projects will only be undertaken if net expected profit rate exceeds real interest rate.
AGGREGATE EXPENDITURE MODEL
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Investment Demand Curve Shows graphically the investment–interest rate
relationship. Shows cumulative levels of investment at
possible levels of interest rates at some point in time.
AGGREGATE EXPENDITURE MODEL
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Investment Demand Curve
Investment (billions of dollars)
Expected rate of net profit (r)
and interest rate (i) %
16
14
12
10
8
6
4
2
05 10 15 20 25 30 35 40
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Shifts in Investment DemandOther determinants of investment: Acquisition, operation and maintenance costs Business taxes Technological change Business expectations (animal spirits) Stock of capital goods on hand
Changes in these factors Changes in these factors shiftshift the the investment demand curveinvestment demand curve
AGGREGATE EXPENDITURE MODEL
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Investment Demand Curve
Investment (billions of dollars)
16
14
12
10
8
6
4
2
05 10 15 20 25 30 35 40
Expected rate of net profit (r)
and interest rate (i) %
AGGREGATE EXPENDITURE MODEL
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Investment and IncomeWe need to be able to add Investment
expenditure to Consumption expenditure. Autonomous investment
desired level of investment based upon long-term profit expectations
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Instability of Investment Consumption (especially non-durables) is
relatively stable BUT Investment is unstable: Why?
Durable and therefore postponable purchases Irregularity of innovation Profit variability Variable expectations
AGGREGATE EXPENDITURE MODEL
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I = IAGeneral Form
I = 200Numerical Example
In our simple income determination model we assume that all investment is independent of changes in Real GDP (that is investment expenditure is autonomous).
AGGREGATE EXPENDITURE MODEL
Modelling Planned Investment
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GDP
AGGREGATE EXPENDITURE MODEL
Investment
I=A
Investment is Autonomous
0
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45o
GDP
Aggregate Expenditure
AD<Y
AD>Y
EQUILIBRIUM INCOME
S
I
Aggregate Saving and Investment
S<I
S>I
AE=C
AGGREGATE EXPENDITURE MODEL
AE=C+I
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Y C I AE0 100 200 300
500 600 200 800
1000 900 200 1100
1500 1300 200 1500
2000 1700 200 1900
Determining Aggregate Expenditure:
Planned AE = planned C + planned I
AGGREGATE EXPENDITURE MODEL
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100
500
1000
1500
500 1000 1500 2000
-100
Consumption & Saving Schedules
200
300
AGGREGATE EXPENDITURE MODEL
AE=C+I
SI
AE=C
45O
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EQUILIBRIUM BY TABULAR ANALYSIS
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Equilibrium GDP by tabular analysis – Expenditure-output
Actual
Y C IS AEUnplanned
I*Y
change
0
500
1000
1500
2000
100 -100
500 0 700 -200
900
1300
1700
100
200
300
-100
1900
1500
1100
0
100
200 300 -300
200
200
200
200
Equilibrium
*Unplanned Investment refers to a build-up or run-down of inventories
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Equilibrium GDP by tabular analysis – Leakages - Injections
Y C IS AEUnplanned
I*Y
change
0
500
1000
1500
2000
100 -100
500 0 700 -200
900
1300
1700
100
200
300
-100
1900
1500
1100
0
100
200 300 -300
200
200
200
200
Equilibrium
*Unplanned Investment refers to a build-up or run-down of inventories
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Equilibrium GDP by tabular analysis – Unplanned Investment
Y C IS C + IUnplanned
I*Y
change
0
500
1000
1500
2000
100 -100
500 0 700 -200
900
1300
1700
100
200
300
-100
1900
1500
1100
0
100
200 300 -300
200
200
200
200
Equilibrium
*Unplanned Investment refers to a build-up or run-down of inventories
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EQUILIBRIUM BY ALGEBRAIC ANALYSIS
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C=100+0.8Y I=200 AE=C+I AE=100+0.8Y+200 AE=300+0.8Y
EQUILIBRIUM IDENTITYY=AE
Y=300+0.8YY-0.8Y=3000.2Y=300Y=300/0.2
Y=1500
AGGREGATE EXPENDITURE MODEL
Determining Equilibrium Income
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Next Week We will add government & the external sector into
the Aggregate Expenditures Model.
Review Mc Taggart ch 24, especially understanding about multipliers pp. 500 -507
Read Mc Taggart Ch 25 Fiscal Policy