Determination of National Income - Topic 2
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Transcript of Determination of National Income - Topic 2
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7/28/2019 Determination of National Income - Topic 2
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21.0
1. Aggregate Output in the Short
Run
Potential output
the output the economy would produce
if all factors of production were fullyemployed
Actual output
what is actually produced in a period
which may diverge from the potential
level
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21.1
2. Initial Model
Prices and wages are fixed
At these prices, there are workers without a jobwho would like to work and firms with sparecapacity they could profitably use
The actual quantity of total output is demand-determined
this will be a Keynesian model
Government intervention to keep output closeto the potential output
For now, also assume: no government
no foreign trade
Later topics relax these assumptions
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21.2
3. Aggregate Demand
Given no government and no
international trade, aggregate
demand has two components:
Investment
firms desired or planned additions to
physical capital & inventories
for now, assume this is autonomous Consumption
households demand for goods and services
so, AD = C + I
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21.4
5. The Consumption Function
Income
C = 8 + 0.7 Y
The consumption function shows desired aggregate
consumption at each level of aggregate income
0
With zero income,
desired consumptionis 8 (autonomous
consumption).
{
8
The marginal propensi ty
to consume(the slope ofthe function) is 0.7 i.e.
for each additional 1 of
income, 70p is consumed.
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21.5
5. Saving Function
Saving is income not consumed.
When income is zero, saving is -A
Since a fraction c of each extra
pound is consumed , a fraction of 1
c of income is saved
MPC + MPS = 1
S = -A + (1-C)Y
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21.6
5. Saving Function
S = -8 + 0.3 Y
Income0
The saving function shows
desired saving at each
income level.
Since all income is either
saved or spent on
consumption, the saving
function can be derivedfrom the consumption
function orvice versa.
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21.7
6. Aggregate Demand
In the simple model, aggregate
demand is simply consumption
demand plus investment demand AD: add I to the previous
consumption function
The slope of AD is the MPC
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21.8
7. The Aggregate Demand
Schedule
Income
C
Aggregate demand is
what households plan
to spend on consumption
and what firms plan to
spend on investment.
AD = C + I
IThe AD function is
the vertical addition
of C and I.
(For now I is assumedautonomous.)
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21.9
8. Equilibrium Output: output
expenditure app roach
Wages and prices are fixed in the
model
AD < Potential Output, then firmcannot sell as much as they would
like
Involuntary excess capacity and
involuntary unemployment
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21.10
8. Equilibrium Output
Output, Income
45o line The 45o line shows the
points at which desired
spending equals output
or income.
AD
Given the AD schedule,
This the point at whichplanned spending equals
actual output and income.
equilibrium is thus at E.
E
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21.12
9. An Alternative Approach
Output, Income
An equivalent view of
equilibrium is seen by
equating
Iplanned investment (I)
S
to planned saving (S)
The two approaches are equivalent.
again giving us
equilibrium at E
E
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21.13
10. Effects of a Fall in Aggregate Demand
autonomous con sumpt ion or investment
Output, Income
45o lineAD0
Y0
Suppose the economy
starts in equilibrium
at Y0.
a fall in aggregatedemand to AD1
AD1
Leads the economy
to a new equilibrium
at Y1.Y1
Notice that the change in equilibrium output is
larger than the original change in AD.
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21.14
10. Effects of a Fall in Aggregate
Demanda change in MPC
Output, Income
45o lineAD0
Y0
Suppose the economy
starts in equilibrium
at Y0.
There is a change inMPC
AD1
Leads the economy
to a new equilibrium
at Y1.Y1
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21.15
11. The Multiplier
The multiplier is the ratio of the change in
equilibrium output to the change in autonomous
spending that causes the change in output.
It tells us how much output change after a shift indemand; K = Y/ AD
K = 1/ (1- MPC) = 1/MPS
The larger the marginal propensity to consume,
the larger is the multiplier. The higher is the marginal propensity to save, the more
of each extra unit of income leaks out of the circular
flow.
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Keynesian Consumption
$1
Disposable
Income
80% to Consumption
20% to Savings
% of extra $ ofIncome used forConsumption is
MarginalPropensity toConsume
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Why is the MPC important?
Government
spends $100
on road
repair
Cumulative Increase in GDP (MPC = 0.8)
Cumulative Increase in Savings (MPS = 0.2)
$100
Road
contractors
spend $80
and save
$20
$180
$20
Retailers
spend
$80*0.8=$64
and save $16
$244
$36
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Total impact of $100
After allrounds are
complete
Change in GDP = $500
Change in Savings = $100
Total Impact =
$100/(1-MPC) =
$100/0.2 =$500
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Reality Check
US multiplier is about 1.8 2.2
depending on kind of spending
Simplistic, but gives benchmark Expansions (why do we monitor
consumer spending?) think about
CNN report
Recessions (why is consumer spending
an indicator of recession?)
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21.20
11. The Paradox of Thrift
Earlier, we analyse a shift in AD caused by
changed in autonomous investment
Now consider a parallel shift in the AD schedule
caused by a change in autonomous part ofplanned consumption and savings
An autonomous consumption increase of 10 will
cause an upward shift in AD
This is equivalent to a fall in autonomous saving,thus a parallel downward shift in saving function
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21.22
11. The Paradox of Thrift
A change in the amount households wish to save
of each levels of income leads to a change in
equilibrium income, but no change in equilibrium
saving, which must equal planned investment.This is the paradox of thrift
If all households decide to increase saving, this
will lead to a fall in AD, employment, income but
no rise in saving