Download The Income-Expenditure Model

Chapter 9
Econ 104 Parks
The Income-Expenditure Model
The Income-Expenditure Model
• The Income-Expenditure model, also known as
the Keynesian Cross model, was first
developed by the Depression-era economist
named John Keynes.
• The goal was to develop a model that could
explain how an economy could become
permanently “stuck” at a high-unemployment
level.
Model Assumptions
• The SIMPLEST model assumptions are:
– The price level is fixed.
– Suppliers will supply any level of output that is
demanded at the fixed price level.
– There are no government expenditures or net
exports.
– The interest rate in the economy is determined
outside the model.
– There are no taxes.
Aggregate Expenditures
• Aggregate PLANNED Expenditures (APE) is
the aggregate amount that consumers,
investors, government, and foreigners wish to
spend on the purchase of final goods and
services produced in the domestic borders,
given the price level.
APE = Cp + Ip + Gp + NXp
where p means planned
• Assuming G = NX = 0 for simplicity,
APE = Cp + Ip
Determining Consumption
• Consumption is the largest component of
Aggregate Expenditures, accounting for twothirds of GDP.
• It is influenced by
–
–
–
–
Disposable income
Wealth
Interest rates
Expectations of future income
The Consumption Function
• A consumption function shows the relationship
between total consumer expenditures and total
disposable income, holding all other
determinants of consumption constant.
• The equation for the consumption function is:
Cp = CA + MPC (DI)
where Cp is total planned consumption; CA is
autonomous consumption, MPC is the marginal
propensity to consume, and DI is disposable income.
Components of the Consumption
Function
• Autonomous consumption (CA) is the portion of
disposable income that is independent of
income.
• The Marginal Propensity to Consume (MPC)
tells us how much of an additional dollar of
disposable income will be spent.
– If the MPC = 0.80, then $0.80 of the next dollar
earned will be spent. The MPC for an economy
always lies between zero and one, 0 < MPC < 1.
The Consumption Function
• The consumption
function is upward
sloping, reflecting
the positive relation
between
consumption and
disposable income.
• The vertical intercept
is equal to CA, and
the slope of the line
is the MPC.
Determining Investment
• Investment is the most volatile component of
GDP, and accounting for approximately 17% of
GDP.
• Investment is determined by
– interest rates (higher rates lead to lower
investment)
– expectations of future revenue and costs
– business confidence
– taxes
– capacity utilization
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The Level of Investment
•For simplicity, the
income-expenditure
model assumes that
the level of
investment is given.
•The investment line,
then, is simply a
horizontal line at the
level of investment.
Aggregate Expenditures in the IncomeExpenditure Diagram
• Given that:
APE = Cp + Ip
Cp = CA + MPC (DI)
DI = Yactual (assuming no taxes), and
I = Ip, PLANNED
then at equilibrium
APE = CpA + MPC (Ya) + IP
The Aggregate Expenditures Function
• The Aggregate
PLANNED
Expenditure
Function plots
the level of
APE against
the level of
output (Y).
The 45 degree line
• On any chart, if the
horizontal and
vertical axes have the
same scale, then any
(x,y) point on the 45
degree line will have
the same value on
both axes.
• Notice that every
point on the 45
degree line has the
same x and y value.
Equilibrium in the Income-Expenditure
Model
• Equilibrium occurs at the point in which
Yactual = APE
or the level of income equals the level of
Aggregate Planned Expenditures.
• Equilibrium can be shown with a chart or with
algebra.
Equilibrium using a Graph
• Equilibrium
occurs at the
point in
which the
APE function
crosses the 45
degree line.
Algebraic Equilibrium
• Equilibrium can also be shown by the point
where
Yeq = APE
or
Yeq = CpA + MPC*(Yeq) + Ip
so
Yeq = (CpA + Ip) / (1 – MPC)
• Equilibrium Income =
AUTONOMOUS EXPENDITURES times the
MULTIPLIER
CA  IA P  G  (X - M)
Yeq 
1  mpc
 (CA  IA P  G  (X - M) ) * K
where K is the multiplier
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Changes in Equilibrium Income
• As a general rule, any
increase in
autonomous
consumption or
investment shifts the
AE schedule upwards
and leads to a rise in
equilibrium income.
This chart depicts an
increase in
autonomous
investment.
• An increase in CA, IAP, G, or (X-M) increases
equilibrium income by a multiple.
• A decrease in CA, IAP, G, or (X-M) decreases
equilibrium income by a multiple
• The multiplier also depends on the length of
time (1 year, 5 year, etc)
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