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Chapter 13 – Private Sector Components of
Aggregate Demand
Read pages 267-286
I Determining the Level of Consumption
A) Consumption and Disposable Personal
Income.
1) Disposable Personal Income is the
income that people have available to
spend on goods and services.
2) The relationship between consumption
and disposable personal income is called
the consumption function.
3) The marginal propensity to consume
(MPC) is the change in consumption one
expects for a one unit change in disposable
income.
a) Example: MPC = $400/$500 = .8
b) It is the slope of the consumption
function.
4) Personal savings is disposable personal
income not spent on consumption during a
particular period.
a) Personal savings =disposable income –
consumption.
5) The savings function relates personal
saving in any period to disposable personal
income in that period.
6) The ratio of the change in personal savings
to the change in disposable personal income
is the marginal propensity to save.
a) Example: MPS = $100/$500 =.2
b) The marginal propensity to save is the
slope of the savings function.
C) Current versus Permanent Income
1) The current income hypothesis holds that
consumption in any one period depends on
income during that period (alone).
2) Permanent income is the average annual
income people expect to receive for the rest
of their lives.
3) The permanent income hypothesis assumes
that consumption in any period depends on
permanent income.
D) Other Determinants of Consumption
1) Changes in real Wealth – an increase or
decrease in stock and bond prices makes
holders of these assets wealthier or poorer
and they would be likely change their
consumption in response.
2) Changes in expectations – consumers are
more willing to consume when they are
optimistic about the future.
II The Aggregate Expenditure Model
A) The aggregate expenditure model relates
aggregate expenditures, which equal the
sum of planned levels of consumption,
investment and government purchases and
net exports at a given price level to the
level of real GDP.
B) The Aggregate Expenditure Model: A
simplified View
1) We will only included investment and
consumption.
2) The level of investment firms intend to
make in a period is called planned
investment.
3) Unplanned investment is investment
during a period that firms did not intend to
make. Typically consists of changes in
inventories.
C) Autonomous and Induced Aggregate
Expenditures.
1) Expenditures that do not vary with the
level of real GDP are called autonomous
aggregate expenditures.
2) Expenditures that vary with real GDP are
called induced aggregate expenditures.
D) Autonomous and Induced Consumption
Consider the consumption function
C = $300 Billion + .8Y
1) Autonomous consumption is $300 Billion.
2) Induced consumption is .8Y
E) Plotting the Aggregate Expenditure Curve.
Assume planned investment is entirely
autonomous: Ip = $1,100Billion.
AE = C + Ip
= $300 B +.8Y +$1,100 B
= $1,400B + .8Y
1) If Y=$6000 B, then AE = $6,200 B
F) The Slope of the Aggregate Expenditure
Curve equals the marginal propensity to
consume.
F) Equilibrium in the Aggregate Expenditure
Model
1) Equilibrium occurs when aggregate
expenditures equals aggregate supply,
AE=AS.
2) The possible equilibrium can be graphed
as a 45 degree line.
3) The observed equilibrium occurs where
the observed AE curve crosses the 45
degree line.
G) Changes in Aggregate Expenditures: The
Multiplier.
1) Consider the previous model, but assume that
planned investment expenditures increases to
1,400 B. The new
AE = $300 B +.8 Y + $1,400 B
= $1,700 B +.8Y
The new equilibrium occurs when AE=Y, or at
$8,500 for an increase of $8,500-$7,000= $1,500.
Thus a $300 increase in spending resulted in a
$1,500 increase in GDP for a multiplier of
1,500/300=5.
2) The domino effect of a spending change
can be illustrated by Exhibit 13-11.
3) The multiplier is related to the marginal
propensity to consume by
Multiplier = 1/(1-MPC)
Example: In the example MPC=.8, so
Multiplier = 1/.2 = 5
H) Application of the Aggregate Expenditure
Model to a More Realistic View of the
Economy.
1) In a model in which taxes take some of
the additional income, disposable income
does not increase by as much in each
successive round and thus the multiplier is
smaller.
2) Government spending and net exports
become part of autonomous spending.
3) This differences make the AE curve
somewhat flatter and have a higher
intercept.
4) The flatter curve implies a smaller
multiplier and can be illustrated in the
following diagram.
III Aggregate Expenditures and Aggregate Demand.
A) Aggregate expenditure curves and price levels.
1) Consider an initial price level of p=1.0 as our
reference point. This induces a demand for goods in
our diagram of $6,000.
2) Next consider a higher price level of p=1.5. Due
to a negative wealth effect, expenditures will be
lower inducing a demand of $2,000.
3) Next consider a price level of p=.5. Due to a
positive wealth effect, expenditures will be higher
inducing a demand of $10,000.
4) These produce a downward sloping demand curve.
B) The multiplier and changes in Aggregate
Demand.
Any change in autonomous aggregate
expenditures shifts the aggregate demand
curve. The amount that it shifts equals the
change in autonomous aggregate
expenditures times the multiplier.