Flashcards in GDP Simple Model Deck (12):

1

## List all the autonomous components?

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A) Autonomous Consumption (in the Consumption function that depends on Yd, not Y for this simple model)

B) Autonomous Investment (horizontal line)

C) combine autonomous consumption and investment to get Total Autonomous expenditure

*autonomous components are the y-intercepts

o At disposable income = 0, you still have autonomous expenditure

2

## List all the induced components?

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A) Induced consumption --> bYd where b = marginal propensity to consume

(recall that Yd = Y in this simple model)

B) induced expenditure --> zY where z = marginal propensity to spend

note z = b in this simple model

Induced expenditure - any component of expenditure that is systematically related to national income (Y) --> need to multiply by Y

3

## Assumptions of the simplest model (3)

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1) AE = C + I

(no government and no trade)

2) Yd = Y due to no government

3) Marginal Propensity to Spend (z) = Marginal Propensity to Consume (MPC or b)

*also constant price level

4

##
What is the difference between Desired Aggregate Expenditure and actual national income (Y)

What does Desired Aggregate Expenditure mean?

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Y = GDP = Ca + Ia + Ga + NXa --> Actual amounts

whereas

AE = C + I + G + (X - IM) --> desired amounts

Desired Aggregate Expenditure = what consumers and firms WANT to purchase, given their real-world constraints --> theoretical

5

##
Disposable income

C function

- variables that affect Consumption

- APC

- MPC

Savings function

- APS

- MPS

Relationship between consumption and savings?

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Disposable income is divided into consumption and savings

- increase in Yd increases both C and S!

C = Desired Consumption Function

- consists of autonomous consumption (a) and induced consumption (bYd)

- positively sloped

- x axis = Yd

- y axis = desired consumption (C)

C = a + bYd

*Yd = Y in this simplest model without government and trade

- Yd = disposable income, so all of national income is Yd

Variables that affect autonomous consumption (a) = parallel shifts:

1) disposable income --> causes a movement along the curve

2) wealth

- higher wealth = greater consumption = shift UP

- Household wealth consists of homes, cars, savings accounts, mutual funds, stocks or bonds

3) interest rates

- higher interest rates = lower consumption = shift DOWN

4) Expectations about the future

- optimism = greater consumption = shift UP

Average Propensity to Save = C/Yd

- APC falls as Yd increases

Marginal Propensity to Consume = change in C/ change in Yd

*MPC = b = slope of consumption function = % of Yd spent on consumption

- MPC IS CONSTANT!!

Savings Function:

- x axis = Yd

- y axis = desired savings (s)

- y intercept = - autonomous consumption

- slope = MPS = 1 - MPC

S = - a + (1 - b)Yd

- ALSO positively sloped (an increase in Yd increases savings)

- increased in consumption = decrease in savings by SAME amount

APS = desired savings/Yd

MPS = change in desired savings/ change in Yd

Relationship between Consumption and savings:

MPS + MPC = 1

APS + APC = 1

6

## 45 degree line on consumption function

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The 45-degree line represents all the points where C = Yd

(desired consumption = real disposable income)

At the breakeven level of Yd, desired consumptions equals real disposable income, so savings = 0

The vertical distance between C and the 45-degree line = savings

7

##
Desired Investment

Determinants of Investment?

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This is the MOST volatile part of GDP

Desired Investment (I) is considered autonomous (I0)

Desired Investment consists of:

1) Inventories

2) Plant & Equipment (capital goods)

3) Residential Housing/Construction

Determinants of Investment include:

1) interest rates* = opportunity cost of borrowing

- higher interest rate = decreased investment due to higher cost of borrowing

2) change in level of sales

- increased sales = increased investment

3) Business confidence*

- higher optimism = increased investment in order to satisfy large demands in the future

* means same as determinants of consumption

8

##
Desired Aggregate Expenditure function

Equilibrium Condition

If AE > Y...

If AE < Y...

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AE = C + I

= A + zY

At equilibrium: Y = AE (45 degree line)

- Actual National income = Desired Aggregate expenditure

Y = A/(1 - z)

Where z = marginal propensity to spend

= change in desired AE/change in national income

- can find desired consumption by rearranging AE = C + I

- can find desired savings, S = - a + (1 - b)Y

If AE > Y

- inventories fall due to increased demand

- firms increase output (Y)

If AE < Y

- inventories rise due to less demand

- firms decrease output (Y)

9

## Shifts in the aggregate expenditure function?

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Types types:

1) Parallel shift due to changes in autonomous expenditure (a and Io)

2) rotations due to changes in induced expenditure (slopes change)

10

##
Simple Multiplier

What happens when z is LARGE?

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when A changes, what happens to the magnitude of the change in Y?

Simple Multiplier = 1 / (1 - z)

Change Y = Change A * simple multiplier

- an increase in AUTONOMOUS aggregate expenditure (change in A = vertical distance between AE curves) increases equilibrium national income (horizontal distance) by a multiple of the initial increase (multiplier effect)

- multiplier > 1, meaning change in Y (horizontal change) is greater than change in A (vertical change)

- The LARGER the Marginal Propensity to Spend (z), the STEEPER the AE function and the LARGER the simple multiplier (greater change in Y)

- The smallest multiplier occurs when z = 0 where change in A = change in Y

11

##
Consider a simple macro model with a constant price level and demand-determined output.

In such a model, the level of national income will tend to RISE if...

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firms have unplanned DECUMULATION of investments

- produced too little, inventories are decreasing

- similar to situation where desired AE > actual Y

- firms experience decreasing inventories, will increase output

IF firms have unplanned accumulation of investments:

- firms produced too much, inventories are rising

- similar to situation where desired AE < actual Y

- firms experience increasing inventories, will decrease output

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