Download AGGREGATE EXPENDITURE MODEL

Macroeconomics in
Asia-Pacific
GECO6400
Aggregate Expenditure Model
Part 1
Consumption, Saving & Investment
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.

Recall our Second Lecture
We examined both unemployment and inflation.
Unemployment
 Types
 Measurement
Inflation
 Measurement
 CPI
Today…
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.
AGGREGATE EXPENDITURE
MODEL
Output and Aggregate Expenditure
The Keynesian Conception of Macroeconomic Activity
Output 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
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=Consumption
I=Investment
G=Government Expenditure
X=Exports
M=Imports
AGGREGATE EXPENDITURE
MODEL
Definition
Consumption
 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
Model Assumptions
Consumption and Saving
AE=C
Households can do two things with total income (Y):
Consume (C) or Save (S).
Y=C+S
C=Y-S
S=Y-C
Both are dependent on (or a function of) income (Y).
C=f(Y)
S=f(Y)
AGGREGATE EXPENDITURE
MODEL
Consumption
Consumption Function: C= a+ßYd
Where:
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
AGGREGATE
EXPENDITURE
($)
C= a+ßYd
a
45O
0
INCOME ($)
AGGREGATE EXPENDITURE
MODEL
0
GDP & the 45 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
Consumption
Consumption Function
represents spending
plans
AGGREGATE
EXPENDITURE
($)
C= a+ßYd
a
45O
0
45o line represents
production
INCOME ($)
AGGREGATE EXPENDITURE
MODEL
Definition
Saving
 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
Savings
Savings Function: S= -a+ßYd
Where:
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
SAVINGS
S= -a+ßYd
0
INCOME
-a
AGGREGATE EXPENDITURE
MODEL
Aggregate
Expenditure
C= a+ßY
EQUILIBRIUM INCOME
AE<Y
AE=Y
AE>Y
a
450
GDP
Aggregate
Savings
S= -a+ßY
S>0
S=0
-a
S<0
GDP
AGGREGATE EXPENDITURE
MODEL
The Simple Model
The components of Aggregate Expenditure are:
 Y = C + I + G + NX
 Consumption expenditure is the most stable;
investment is most volatile.
AGGREGATE EXPENDITURE
MODEL
The Simple Model
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
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
Defining Equilibrium GDP
Equilibrium 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
Defining Equilibrium GDP
We can demonstrate equilibrium GDP either by:



tabular analysis – expenditure-output, leakagesinjections, unplanned investment;
graphical analysis – expenditure-output, leakagesinjections, unplanned investment or
algebraic analysis.
AGGREGATE EXPENDITURE
MODEL
Illustrating Equilibrium GDP
Y
C
S
0
100
-100
250
300
-50
500
500
0
750
700
50
1000
900
100
AGGREGATE EXPENDITURE
MODEL
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
Propensities to Consume & Save
Y
C
S
APC
APS
MPC
MPS
0
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
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 + 800
C = 900
AGGREGATE EXPENDITURE
MODEL
Plotting the Consumption Function
Expenditure
1500
C = 100 + 0.8Y
1000
500
100
45O
0
500
1000
1500
2000
Income (Y)
AGGREGATE EXPENDITURE
MODEL
Modelling savings
General Form
Y=C+S
S=Y-C
Numerical Example
C=C+cY
C =100+0.8Y
S=Y-(C+cY)
S=Y-(100+0.8Y)
S=Y-C-cY
S=Y-100-0.8Y
S=-C+Y-cY
S=-100+Y-0.8Y
S=-C+(1-c)Y
S=-100+(1-0.8)Y
S=-C+sY
S=-100+0.2Y
AGGREGATE EXPENDITURE
MODEL
Consumption & Saving
Schedules2000
1500
C=100+0.8Y
1000
Ye=500
500
100
45O
500
1000
1500
2000
S=-100+0.2Y
-100
-500
AGGREGATE EXPENDITURE
MODEL
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.
AGGREGATE EXPENDITURE
MODEL
C=500+0.2Y
C=100+0.8Y
2000
1500
1000
Impact of an Increase in
Autonomous Consumption
(decrease in Autonomous
Saving)
500
100
45O
500
1000
1500
2000
S=-100+0.2Y
S=-500+0.2Y
-100
-500
AGGREGATE EXPENDITURE
MODEL
2000
C = 100 + 0.9Y
1500
Impact of an Increase in MPC
(decrease in MPS)
C = 100 + 0.8Y
1000
500
100
45O
500
1000
1500
2000
S = -100 + 0.2Y
S = -100 + 0.1Y
-100
-500
Alternate consumption theories
Be 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.
AGGREGATE EXPENDITURE
MODEL
Adding Investment
Investment
The 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
Definition
Investment
 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
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
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
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
Expected rate of net
profit (r)
and interest rate (i)
%
16
Investment Demand
Curve
14
12
10
8
6
4
2
0
5
10
15
20
25
30
35
40
Investment (billions of dollars)
AGGREGATE EXPENDITURE
MODEL
Shifts in Investment Demand
Other 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 shift the
investment demand curve
AGGREGATE EXPENDITURE
MODEL
Expected rate of net
profit (r)
and interest rate (i)
%
16
Investment Demand
Curve
14
12
10
8
6
4
2
0
5
10
15
20
25
30
35
40
Investment (billions of dollars)
AGGREGATE EXPENDITURE
MODEL
Investment and Income
We need to be able to add Investment
expenditure to Consumption expenditure.
 Autonomous investment

desired level of investment based upon long-term
profit expectations
AGGREGATE EXPENDITURE
MODEL
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
Modelling Planned Investment
General Form
I = IA
Numerical Example
I = 200
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
Investment
Investment is Autonomous
I=A
0
GDP
AGGREGATE EXPENDITURE
MODEL
Aggregate
Expenditure
AE=C+I
EQUILIBRIUM INCOME
AD<Y
AE=C
AD>Y
45o
GDP
S
Aggregate Saving
and Investment
S>I
I
S<I
AGGREGATE EXPENDITURE
MODEL
Determining Aggregate Expenditure:
Planned AE = planned C + planned I
Y
C
I
AE
0
100
200
300
500
600
200
800
1000
900
200
1100
1500
1300
200
1500
2000
1700
200
1900
AGGREGATE EXPENDITURE
MODEL
Consumption & Saving Schedules
AE=C+I
1500
AE=C
1000
500
300
100
45O
500
200
-100
1000
1500
2000 S
I
EQUILIBRIUM BY TABULAR
ANALYSIS
Equilibrium GDP by tabular analysis – Expenditure-output
Actual
Y
C
S
I
AE
Unplanned
Y
I*
change
0
100
-100
200
300
-300
500
500
0
200
700
-200
1000
900
100
200
1100
-100
1500
1300
200
200
1500
2000
1700
300
200
1900
0 Equilibrium
100
*Unplanned Investment refers to a build-up or run-down of inventories
Equilibrium GDP by tabular analysis – Leakages - Injections
Y
C
S
0
100
500
1000
Unplanned
Y
I*
change
I
AE
-100
200
300
-300
500
0
200
700
-200
900
100
200
1100
-100
1500 1300
200
200
1500
0
2000 1700
300
200
1900
100
Equilibrium
*Unplanned Investment refers to a build-up or run-down of inventories
Equilibrium GDP by tabular analysis – Unplanned Investment
Y
C
S
I
C+I
Y
Unplanned
change
I*
0
100
-100
200
300
-300
500
500
0
200
700
-200
1000
900
100
200
1100
-100
1500
1300
200
200
1500
0
1700
300
200
1900
100
2000
Equilibrium
*Unplanned Investment refers to a build-up or run-down of inventories
EQUILIBRIUM BY
ALGEBRAIC ANALYSIS
AGGREGATE EXPENDITURE
MODEL
Determining Equilibrium Income





C=100+0.8Y
I=200
AE=C+I
AE=100+0.8Y+200
AE=300+0.8Y
EQUILIBRIUM IDENTITY
Y=AE
Y=300+0.8Y
Y-0.8Y=300
0.2Y=300
Y=300/0.2
Y=1500
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