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Lecture 12

Lecture 12. Aggregate Expenditure. Aggregate expenditure is the total amount the economy plans to spend in a given period. There are four components in aggregate expenditure which consumption expenditure, investment expenditure, government expenditure and net export. AE= C+ I + G + NX.

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Lecture 12

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  1. Lecture 12

  2. Aggregate Expenditure • Aggregate expenditure is the total amount the economy plans to spend in a given period. There are four components in aggregate expenditure which consumption expenditure, investment expenditure, government expenditure and net export. • AE= C+ I + G + NX

  3. Equilibrium Aggregate Output (Income) • Equilibrium occurs when there is no tendency for change. Equilibrium occurs when planned aggregate expenditure is equal to aggregate output/GDP. • In the figure below the point E shows the equilibrium where AE cuts the 45 degree line. At the equilibrium aggregate expenditure is equal to aggregate output/GDP. That is Y=AE

  4. Investment Function • We already know what is a consumption function. Now lets talk about investment function. • We know that investment depends on the interest rate. For investment firms have to borrow from the bank and interest rate is the cost of borrowing. If the interest rate is high (that implies high cost of borrowing) then firms will take less loan and invest less. So there is a negative relation between investment and interest rate. Thus investment function can shown as a downward sloping l • So investment depends on interest rate. It does not depend on GDP or aggregate output.

  5. Net Export Now lets see how net export and GDP are related. • We know net export= Export- Import Export depends on Foreigner’s income, relative price and exchange rate. • If Foreigner’s income increase then they buy more goods and services that means we can export more. • If relative price of our product decreases then our product becomes cheaper so we can export more. • When a country's currency depreciates its goods simply become less expensive compared with those of other countries. So export will increase. Import depends on domestic people’s income, relative price and exchange rate. • If our income increase then we buy more goods and services that means we can import more. • If relative price of our product increases then our product becomes expensive so we import more. • When a country's currency depreciates its goods simply become less expensive compared with those of other countries. So import will decrease. So net export depends on Foreigner’s income, domestic people’s income, relative price and exchange rate. Net export does not depend on GDP / Aggregate Output.

  6. Breaking Down Aggregate Expenditure • We start the discussion by the simplest aggregate expenditure model which is the two sector closed economy. • Two sector or private ( no govt) closed economy: In this model we just include consumption expenditure and investment expenditure. • AE= C + I • Equilibrium is at E where AE=Y ( aggregate expenditure= total income )

  7. Three sector model/ closed economy (no trade) : Here we bring government in the aggregate expenditure model. So we will consider tax ( T) and government expenditure ( G). As we have tax in the economy so we need to use disposable income instead of income. So we have the following equation: • AE= C(Y-T) + I + G where C( Y-T) shows that consumption is a function of disposable income. • Equilibrium is at E where AE=Y ( aggregate expenditure= total income )

  8. Four sector model/Open Economy: This is the complete model where we consider international trade ( export and import) and that is why this model is called open economy. So this model has four components: Consumption ( C), Investment ( I), Govt. Expenditure ( G) and Net export ( NX). So we can write • AE= C(Y –T)+ I + G + NX • Equilibrium is at E where AE=Y ( aggregate expenditure= total income )

  9. (1) Level of Output and Income (GDP=DI) (5) Net Exports (Xn) (7) Aggregate Expenditures (C+Ig+Xn+G) (2)+(4)+(5)+(6) (2) Consump- tion (C) (4) Investment (Ig) (6) Government (G) Exports (X) Imports (M) (3) Saving (S) Aggregate Expenditure Model …in Billions of Dollars 20 20 20 20 20 20 20 20 20 20 $415 430 445 460 475 490 505 520 535 550 • $370 • 390 • 410 • 430 • 450 • 470 • 490 • 510 • 530 • 550 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 $375 390 405 420 435 450 465 480 495 510 $-5 0 5 10 15 20 25 30 35 40 $20 20 20 20 20 20 20 20 20 20

  10. Aggregate Demand and Aggregate Supply • The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. • The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

  11. P P2 1. A decrease Aggregate in the price demand level . . . Y Y2 2. . . . increases the quantity of goods and services demanded. The Aggregate-Demand Curve... Price Level Quantity of 0 Output

  12. Short-run aggregate supply P P2 2. . . . reduces the quantity 1. A decrease of goods and services in the price supplied in the short run. level . . . Y2 Y The Short-Run Aggregate-Supply Curve is upward sloping Price Level Quantity of 0 Output

  13. Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Equilibrium occurs at the intersection of Aggregate Demand and Aggregate Supply curves Price Level Quantity of 0 Output

  14. Difference between long run and short run • Short Run: Short run is defined as a situation where some factors are fixed. Example: in short run production function land can be fixed. That means we cannot change the amount of land in our production process. • Long Run: Long run is defined as a situation where all factors are variable. Example: in long run production function we can change the amount of land. That means we can increase or decrease the amount of land that we are using in production process.

  15. THE AGGREGATE-SUPPLY CURVE • In the long-run, aggregate-supply curve is vertical. • The change in price level does not affect the aggregate quantity supplied in the long run and that is why it is vertical. Reason of vertical long run aggregate supply: The long-run, aggregate-supplycurve is vertical at the point of natural level of output/GDP. The natural level of GDP is defined as the level of GDP that arises when the economy is fully employing all of its available input resources. That means we are fully utilizing our input resources, so an increase in price level will not increase the aggregate output.

  16. Long-run aggregate supply P P2 2. . . . does not affect 1. A change the quantity of goods in the price and services supplied level . . . in the long run. The Long-Run Aggregate-Supply Curve Price Level Quantity of 0 Natural level Output of output

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