1. DETERMINING THE LEVEL OF CONSUMPTION

Learning Objectives1. Explain and graph the consumption function and the saving function,

explain what the slopes of these curves represent, and explain how the two are related to each other.

2. Compare the current income hypothesis with the permanent income hypothesis, and use each consumption.

3. Discuss two factors that can cause the consumption function to shift upward or downward.

1.1 Consumption and Disposable Personal Income

• A consumption function is the relationship between consumption and disposable personal income.

Plotting a Consumption Function

• The marginal propensity to consume is the ratio of the change in consumption (ΔC) to the change in disposable personal income (ΔYd).relationship between consumption and disposable personal income.

Point on curve A B C D E

Δyd(billions) $0 500 1,000 1,500 2,000

ΔC(billions) $300 700 1,100 1,500 1,900

ΔYd=$500ΔYd=$500

ΔC=$400ΔC=$400

EQUATION 1.1

MPC= ΔC/ Δyd

=400/500=0.8

EQUATION 1.1

MPC= ΔC/ Δyd

=400/500=0.8

EQUATION 1.2

C=$300 billion+0.8Yd

EQUATION 1.2

C=$300 billion+0.8Yd

Consumption and Personal Saving

• Personal saving is the disposable personal income not spent on consumption during a particular period.

EQUATION 1.3

• Saving function is the relationship between personal saving in any period and disposable personal income in that period.

• Marginal propensity to save is the ratio of the change in personal saving (ΔS) to the change in disposable personal income (ΔYd).

EQUATION 1.4

EQUATION 1.5

dY

SMPS

nconsumptio– income personal disposable saving Personal

1 MPS MPC

Consumption and Personal Saving

Point on curve A B C D E

Δyd(billions) $0 500 1,000 1,500 2,000

ΔC(billions) $300 700 1,100 1,500 1,900

ΔC(billions) -$300 -200 -100 0 100

ΔYd=$500ΔYd=$500ΔC=$400ΔC=$400

Saving functionSaving function

Consumption function

Consumption function

45Ο

ΔYd=$500ΔYd=$500ΔS=$100ΔS=$100

1.2 Current Versus Permanent Income

• The current income hypothesis states that consumption in any one period depends on income during that period.

• Permanent income is the average annual income people expect to receive for the rest of their lives.

• The permanent income hypothesis states that consumption in any period depends on permanent income.

1.3 Other Determinants of Consumption

• Changes in real wealth• Changes in expectations

C2

C1 C2

C1

2. THE AGGREGATE EXPENDITURES MODEL

Learning Objectives

1. Explain and illustrate the aggregate expenditures model and the concept of equilibrium real GDP.

2. Distinguish between autonomous and induced aggregate expenditures and explain why a change in autonomous expenditures leads to a multiplied change in equilibrium real GDP.

3. Discuss how adding taxes, government purchases, and net exports to a simplified aggregate expenditures model affects the multiplier and hence the impact on real GDP that arises from an initial change in autonomous expenditures.

2. THE AGGREGATE EXPENDITURES MODEL

• The aggregate expenditures model is a model that relates aggregate expenditures to the level of real GDP.

• Aggregate expenditures are the sum of planned levels of consumption, investment, government purchases, and net exports at a given price level.

2.1 The Aggregate Expenditures Model: A Simplified View

• Planned investment is the level of investment firms intend to make in a period.

• Unplanned investment is investment during a period that firms did not intend to make.

EQUATION 2.1

• Autonomous aggregate expenditures are expenditures that do not vary with the level of real GDP.

• Induced aggregate expenditures are expenditures that vary with real GDP.

Up III

Autonomous and Induced Aggregate Expenditures

Autonomous and Induced Consumption

ia CCC • RECALL THE FOLLOWING FROM

PREVIOUS SLIDES

EQUATION 2.2

EQUATION 2.3

billion 300$aC

YCi 8.0

Plotting the Aggregate Expenditure Curve

YAE 8.0400,1$

• The aggregate expenditure function is the relationship of aggregate expenditure to the value of real GDP.

EQUATION 2.4

EQUATION 2.5

EQUATION 2.6

billion 100,1$pI

pICAE

Plotting the Aggregate Expenditure Curve

Point on curve A B C D E F

ΔY (billions) $0 2,000 4,000 6,000 8,000 10,000

ΔAE(billions) $1,400 3,000 4,600 6,200 7,800 9,400

ΔAE=$1,600

ΔY=$2,000 Slope= ΔAE /ΔY=0.8

Aggregate expenditure Aggregate

expenditure

Determining Equilibrium in the Aggregate Expenditures Model

Adjusting to Equilibrium Real GDP

A Change in Autonomous Aggregate Expenditures Changes Equilibrium Real

GDP

The Multiplied Effect of an increase in Autonomous Aggregate Expenditures

Round of spending Increase in real GDP (billions of dollars)

1 $300

2 240

3 192

4 154

5 123

6 98

7 79

8 63

9 50

10 40

11 32

12 26

Subsequent rounds +103

Total increase in real GDP $1,500

Computation of The Multiplier

• The multiplier is the number by which we multiply an initial change in aggregate demand to get the full amount of the shift in the aggregate demand curve.

EQUATION 2.7ΔA

ΔYMultiplier eq

Computation of The Multiplier

• The marginal propensity to consume and the multiplier

EQUATION 2.8

Subtract the MPC ΔYeq term from both sides of the equations.

Factor out the ΔYeq term on the left:

Finally, solve for the multiplier

EQUATION 2.9

EQUATION 2.10

We can rearrange equation 2.9 to compute the impact of a change in autonomous aggregate expenditure.

EQUATION 2.11

eqeq ΔY MPC AΔΔY

AΔΔY MPCΔY eqeq

AΔ)MPC1(ΔYeq

)MPC1(

1

AΔ

ΔYeq

MPS

1Multiplier

MPC1

AΔΔYeq

2.2 The Aggregate Expenditures Model in a More Realistic Economy

• Taxes and the aggregate expenditure function• The addition of government purchases and net exports

3. AGGREGATE EXPENDITURES AND AGGREGATE DEMAND

Learning Objectives1. Explain and illustrate how a change in the price level affects the

aggregate expenditures curve.2. Explain and illustrate how to derive an aggregate demand curve

from the aggregate expenditures curve for different price levels.3. Explain and illustrate how an increase or decrease in autonomous

aggregate expenditures affects the aggregate demand curve.

3.1 Aggregate Expenditures Curves and Price Levels

• The wealth effect is the tendency for price level changes to change real wealth and consumption.

• The interest rate effect is the tendency for a higher price level to reduce the real quantity of money, raise interest rates, and reduce investment.

• The international trade effect is the impact of different price levels on the level of net exports.

From Aggregate Expenditures to Aggregate Demand

A’

C

B

A

B’

C’

AEp=1.0

AEp=1.5

AEp=0.5

Aggregate demand

3.2 The Multiplier and Changes in Aggregate Demand

A’

E

B

A

B’

AEp=1.0

AEp=1.5

Aggregate demand

AEp=1.0

AEp=1.5

D

D’

E’

$1,000$1,000

$2,000$2,000

$2,000$2,000

AD1

AD2

$1,000$1,000