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Dr. U.B. Raju
*Compiled from different published sources
*Strictly for academic purpose and for restricted private circulation
2. Income determination in Short run: Basic model
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Aggregate Expenditure and
Equilibrium Income
Definition of aggregate expenditure and
equilibrium income
How the economy adjusts to its equilibrium
position.
How changes in aggregate expenditure
affect equilibrium income.
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Aggregate Expenditure and
Equilibrium National Output
Aggregate expenditure (AE)
total amount that all economic agents want or
plan to spend on domestic goods and services.
the planned spending of
households,
firms, government, and
foreigners.
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Aggregate Expenditure AE = C + I + G + (X-M)
consumption (C),
investment (I),
government spending(G), and
exports less imports (X-M).
Note thatAE is not the same as GDP.
AErepresentsplannedspending
GDP represents actualspending or output.
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Aggregate Expenditure (AE) and
National Output (Y) AE and Y are not necessarily equal:
Firms formulate their production plans with an
estimate of the quantities that people want tobuy.
A mistake on their part will cause productionto exceed or fall below the amounts that peoplewant to buy.
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What ifAE and Y are not equal?
If AE < Y
people want to buy less than what has been
produced so firms will accumulate inventories. firms will reduce production
If AE >Y
What people want to buy is greater than actual
production so inventories will decline.
firms will increase production
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Equilibrium National Income AE = Y
Can be depicted by the intersection
between the AE schedule and the 45
degree line
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The 45
0
line The 45-degree line is a tool that assists us in
identifying the economy's equilibrium
position.
Property: every point along this line depicts
a situation wherein the value of the variable
on the horizontal axis (in this case actualoutput, (Y) is equal to its counterpart on the
vertical axis (AE).
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0100
100
450 line
450
200
200
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45
E0AE20
AE
0 20
Output, income (in Rs)
Aggregateexpen
diture(inRs)
Y
Y*
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Equilibrium Income (Y*) WhenAEis equal to Y
there is no reason for firms to adjust production.
this suggests that the economy is in equilibrium. Equilibrium requires the equality between
income and aggregate expenditure. That is,
Y = AE.
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Changes in AE and Income
Suppose that the economy's aggregate expenditureschedule shifts upwardAE0 toAE1,
Equilibrium point will move fromE0
toE1.
As a result, the economy experiences an increase inequilibrium income from YO* to Y1*
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45
AE0
E0
E1
AE1
20
30
AE
0 20 30
Y
Output, income (in pesos)
Aggregateexpen
diture(inpesos)
Y0 Y1
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Consumption and Income
Keynes (1936) suggested that consumption
spending(C) tends to increase with income.
In other words, households with higher incomes
tend to spend more.
There is a positive relationship between
consumption spending and income
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TABLE 9.1. Consumption and income
(1) (2) (3) (4) (5)
Income Consumption Change In
income
Change in
consumption
mpc
(Y) (C) (Y) (C) (C/Y)
0 200 _
200 350 200 150 0.75
400 500 200 150 0.75
600 650 200 150 0.75
800 800 200 150 0.75
1,000 950 200 150 0.75
1,200 1,100 200 150 0.75
1,400 1,250 200 150 0.75
1,600 1,400 200 150 0.75
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Consumption and income
Higher levels of income correspond to higherlevels of consumption spending
When income is equal to zero, consumptionspending is equal to 200.
Consumption spending and income are equal ateach other when income = 800.
When income is less than 800, consumption is higherthan income.
When income is greater than 800, consumption lessthan income
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0
450200
Consum
ptionSpending
Output, Income
400
600
800
1000
800 1200 1600
400
1200
1400
1600
C
Y
THE CONSUMPTION SCHEDULE
Y
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Consumption and Income
Observations from values above:
(a)autonomous consumptionspending-
component of consumption spending thatdoes not depend on income
- equal to 200 in example
(b) marginal propensity to consume (mpc) -shows the increase in consumption spendingfor a one rupee increase in income;
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Marginal Propensity to
Consume
MPC or the marginal propensity to consume represents the changein consumption spending that arises from a one rupee change inincome.
Value of MPCis between 0 and 1.
MPC=0.75 means that a one rupee increase in income leads to a 75
paise increase in consumption spending.
CmpcY
(!(
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M
arginal propensity to consume In example above,
C = 150 for Y = 200. Hence,
1500.75
200
CMPC
Y
(! ! !
(
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Consumption Function
Consumption Function:
C = c + mpc.Y
C = 200 + 0.75Y
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Savings and Income Sum of consumption spending andsavings
(S) must equal income. In symbols,
Y = C + S. SubtractingC from both sides of this
equation leads to
S = Y -C
.
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(1) (2) (3) (4) (5) (6) MPS
Y C S Y C S S
Y
0 200 -200 - - - -
200 350 -150 200 150 50 0.25
400 500 -100 200 150 50 0.25
600 650 -50 200 150 50 0.25
800 800 0 200 150 50 0.25
1000 950 50 200 150 50 0.25
1200 1000 100 200 150 50 0.25
1400 1200 150 200 150 50 0.25
1600 1400 200 200 150 50 0.25
Relationship bet. Income and Savings
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Savings and income Savings - that component of income that
is not allocated to consumption.
S = Y C
How is savings linked to income?
oY p oS.
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Savings and Income Marginal propensity to save (MPS) is the
increase in savings for a one rupee increase in
income; In the example above, S = 50 for Y = 200.
Implies that
500.25
200
SMPS
Y
(! ! !
(
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Savings function
Note: MPC+MPS = 1
Savings schedule listing of values of
savings at each levels of income
Savings function in equation form
S = -200 + .25Y
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1
Y C S
Y C SY C S
Y Y Y
mpc mps
!
( ! ( (( ( (!
( ( (!
Relationship between mpc and mpc
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S
-200
-50
150
0
400 800 1,200 1,600
Income (in rupees)
Savings(inrupees)
Y
S
Propensity to Save
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The determination of equilibrium income in a
two-sector economy
Two sector economy - households and firms only
Implies that AE is given by:
AE = C + I Assume that I is autonomous and equal to 100
In equilibrium, Y = AE p equilibrium income (Y*) =
1200
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Table 9.3 Consumption, Investment and Equilibrium
Income.
Y C S I AE
400 500 -100 100 600
600 650 -50 100 750
800 800 0 100 900
1,000 950 50 100 1,050
1,200 1,100 100 100 1,200
1,400 1,250 150 100 1,350
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E0
S
I
-200
100
0800 1,200 1,600
Income
Y
Y*
(B)
S, I
(A)
E0
yy
C+I = AE
C
0 400 800 1,200 1,600
Y45
AE
300
200
y
Y*
y
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Investment andM
ultiplier Suppose that investment I increases from
100M rupees to 200M rupees
What happens to equilibrium income?
Equilibrium income Y* will increase
Not by 100M
But by a multiplied amount!!
WHY???
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Table 9.4 Effects of a 100 rupee increase
in investment.
Y C S I AE
400 500 -100 200 700
600 650 -50 200 850800 800 0 200 1000
1,000 950 50 200 1150
1,200 1,100 100 200 1300
1,400 1,250 150 200 1450
1600 1400 200 200 1600
1800 1550 250 200 1750
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Ag
gregateExpenditure(inpesos)
AE0
AE1
Y0
Y*0 Y*1
A
B
E1
E0
1200 1600
I=100
Theeffect ofan increase in investment
AE Y
45o
300
400
Y=400
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Calculation of equilibrium income
In numerical example,
* 1( ).
1Y C I
mpc
!
1 multiplier
1 mpcE! n
C 200, I 100,mpc 0.75! ! !
! !
1Y* (200 100) 1,200
1 0.75
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For I = 200, Y* = 1,600
Hence, if Io from 100 to 200 p Y*o from 1200
to 1600.
In other words,
( !
( !I 100
Y* 400
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The concept of the multiplier Increase in Y is greater than increase in I. Why?
Multiplier (E) - measures the change in
equilibrium income as a result of a one-rupeechange in the sum of the autonomous components
ofAE;
*
YI
(E !(
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Calculation of the multiplier:
1 1
1 mpc mpsE ! !
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Calculation of multiplier
With the mpc = 0.75,
The multiplier is used determine the amount by
which Y* changes in response to a change in
investment.
141 0.75
E ! !
Y* IE( ! (
( ! ( ! E (
1Y I I
1 mpc
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The Paradox of
Thrift
Many people believe that higher savingslead to higher income.
In the present model, we get a result thatis contrary to this belief.
In other words, equilibrium income fallswhen people want to save more.
Idea: the attempt to achieve highersavings may reduce equilibrium income
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S0
Income
Savings
Y
S,I S1
I
Y0Y10
The Paradox of Thrift
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Unemployment and Inflationthe Phillips Curve
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NAIRU(non-accelerating inflation rate of unemployment)
arose to explain how Stagflation could occur.
The latter theory, also known as the natural rate of
unemployment", distinguished between the "short-term"Phillips curve and the "long-term" one.
The short-term Phillips Curve looked like a normal
Phillips Curve, but shifted in the long run as
expectations changed.
In the long run, only a single rate of unemployment (the
NAIRU or "natural" rate) was consistent with a stable
inflation rate.
The long-run Phillips Curve was thus vertical, so therewas no trade-off between inflation and unemployment.
Edmund Phelps won the Nobel Prize in Economics in 2006
for this.
G
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GDP and Unemployment
The negative relationship between unemployment and output is
called Okuns law:
Typically, as per US statistics, for every percentage point the
unemployment rate rises, real GDP growth typically falls by 2
percent
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Inflation (respectively, deflation) is a sustainedincrease (respectively, decrease) in the general price level
over a period of time.
Disinflation is a slowing of the rate of inflation.
Demand pull inflation is inflation caused by sustained
or continual increases in aggregate demand.
Cost push inflation is inflation caused by sustained orcontinual decreases in SR aggregate supply.
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Concept of business/trade cycle
According to J.M.Keynes
A trade cycle is composed of periods of good trade characterised
by rising prices & low unemployment percentages with periods of bad
trade characterised by falling prices & high unemployment rate.
Business cycles are recurrent but irregular fluctuations ineconomic activity & occurs one after another
The time span of the period & phases may vary
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The Business cycle is therise and fall ofeconomic activity
Business cycle is therise and fall ofeconomic
activityrelativeto thelong-term growthtrend ofthe
economy
The Business Cycle
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Features of Business Cycles
Business cycles are irregular in nature
Fluctuations occur in a number of other variables simultaneously
apart from production
Investment & Consumption of durable goods are more affectedInvestment & Consumption of non durable goods are much less
affected
Immediate effect on the level of inventory stock
Profits fluctuate more than any other incomes
Phases of Business Cycles
Expansion (Boom, Upswing or Prosperity)
Peak (Upper Turning Point, when economic activity begins to slow
down)Contraction (Downswing, Recession or Depression)
Trough (Lower Turning Point, when economic activity begins to
rise)
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Causes ofBusiness Cycles
There are many theories suggesting explanations for business cycles.
Climatic changes
Under consumption
Over Investment
Keynes theory of effective demand, particularly investment
Booms/recessions can be generated by rise/fall in governmentexpenditure, fiscal policy.
Similarly, a wave of optimism/pessimism can cause consumers to spend
more/less than usual.
Similarly, firms may invest more (build up new capacities)/disinvest.
Another possible cause of recessions and booms is monetary policy.
A firm faced with high interest rates may decide to postpone building a
new factory.
Households may be lured by cheap housing loans, and construction
activities may boom.
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Movements of Certain Macro economic Variables during Business
Cycles
Procyclical- Variables have positive correlation...
Countercyclical- Variables have negative correlation.
Unemployment is countercyclical.
Acyclical- Variables have zero correlation,.
Variables can be classified as leading, coincident or lagging
variable.
Leading Indicator: which occurs ahead of the occurrence of
business cycle variable.
Coincident Indicator:which move up and down along with thebusiness cycle variable.
Lagging Indicator: which follow the business cycle variable after
some time lag.
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Leading Indicators
Housing starts
New orders for plant and equipment
stock prices
demand for consumer durablesconsumer expectations
New employment
Deliveries by Companies
Index of consumer confidence
Money growth rate (M2)
Coincident Indicators
Nonagricultural employment
Index of industrial production
Personal income
Manufacturing and trade sales
Lagging IndicatorsWage rates
Rate of inflation
Consumer credits
Lending rates
Outstanding loans
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Cross Classification of Indicators
Items Direction of change Time of occurrence
Industrial output procyclical coincident
Capacity utilization procyclical coincident
Employment procyclical coincident
Unemployment countercyclical coincident
Inflation rate procyclical lagging
Corporate profits procyclical coincident
Short-term interest procyclical lagging
Share price procyclical Leading
Capital stock acyclical lagging
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