In this chapter you will learn

In this chapter you will learn. . . 1. …the difference between desired expenditure and actual expenditure. 2. …the determinants of desired consumption and desired investment expenditures. 3. …the meaning of equilibrium national income. 4. …how a change in desired expenditure affects equilibrium income through the “simple multiplier. ”

Total desired expenditure is divided into the same categories: • desired consumption, C • desired investment, I • desired government purchases, G • desired net exports, NX

The sum is called desired aggregate expenditure:

IM C I G X C + I + G + (X - IM) = Desired Aggregate Expenditure

Two possible uses of disposable income: - consumption (C) or saving (S) In more advanced theories, individuals are forward looking, and so consumption depends more on “lifetime” income.

Properties of the 45º line C - bisects the quadrant - intercept of zero - slope of 1

The simple consumption function is written as: C C

Work this out

Work this out C $14000 $8000 $6000 $4000 $0 $5000 $8000 $20000 Yd

Work this out

What might cause a shift in the consumption function (the amount of consumption desired by all households at all levels of income)? - change in wealth - change in interest rates - change in expectations - change in population size or age distribution - change in taste - ?

The marginal propensity to consume (MPC) relates the change in desired consumption to the change in disposable income that brings it about. The MPC is the slope of the consumption function. In the previous diagram, the MPC is the same at any level of income.

In the previous diagram, the APC falls as the level of income rises.

Work this out

Since all of disposable income is either consumed or saved, we have:

If consumption function shifts upward, the saving function must shift downward.

Three important determinants of aggregate investment expenditure are:

The real interest rate is the opportunity cost for: - investment in new plants and equipment - investment in inventories - investment in residential construction Thus, all three components of desired investment expenditure are negatively related to the real interest rate, other things being equal.

When business confidence improves, firms want to invest now so as to reap future profits. Business confidence and consumer confidence may feed off of one another.

I I’’ Y

We will now start to tell our story (assemble our macroeconomic model). Our story has two key purposes: - to explain what determines the level of aggregate economic activity (the size of the GDP or Y) - to understand what might cause GDP (Y) to increase and what might cause GDP (Y) to decrease?

In the absence of government and international trade, desired aggregate expenditure is:

A closed economy with no government

The aggregate expenditure function relates the level of desired aggregate expenditure to the level of actual national income. But how? Through actual national income’s influence on C

Since implies that AE = C + I AE = a + I + b. Y What Canadian economic agents desire (intend or plan) to spend on final goods and services in this period depends on the level of actual national income (Y) this period.

Consider the following example.

C I The slope of the AE function is the marginal propensity to spend. In the simplest model with no taxes and no international trade, this is just the MPC.

Work this out

If desired aggregate expenditure exceeds actual output: - what is happening to inventories? falling - there is pressure for output to rise If desired aggregate expenditure is less than actual output: - what is happening to inventories? - there is pressure for output to fall rising

How the Economy Gets to Equilibrium - Inventory Adjustment Mechanism

How the Economy Gets to Equilibrium – Inventory Adjustment Mechanism

In words: Equilibrium national income is that level of national income where desired aggregate expenditure equals actual national income.

INVENTORIES!

In our simplest of macro models, the multiplier exceeds one.

AE Y

AE AE Y Y

AE Y Same outcome for a positive change in expectations, increase in wealth, increase in sales, etc

AE Y Same outcome for a negative change in expectations, decrease in wealth, decrease in sales, etc

Example: - imagine that firms feel optimistic about the future - this increases their desired investment, shifting up the AE curve - this increases Y, justifying the initial optimism

Now imagine the opposite scenario. It should be clear that if firms and households are pessimistic about the future in large numbers, the ensuing change in their behaviour will lead to a self-fulfilling prophecy of reduced national income.