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Secon d Part Lecture 8 Aggregate Expenditure Model

Secon d Part Lecture 8 Aggregate Expenditure Model. Consumption Function. Consumption Function: It shows the relationship between disposable income and consumption. What is disposable income? If we subtract tax from total income then we get disposable income. Suppose M= Total income

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Secon d Part Lecture 8 Aggregate Expenditure Model

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  1. Second PartLecture 8Aggregate Expenditure Model

  2. Consumption Function • Consumption Function: It shows the relationship between disposable income and consumption. • What is disposable income? • If we subtract tax from total income then we get disposable income. Suppose M= Total income T= Tax M-T= Disposable income =Y • So consumption function is C= f(Y) which implies that consumption is a function of disposable income. So consumption function shows how consumption changes when disposable income changes.

  3. Here the equation for consumption function is C= a + b Y where a= intercept = autonomous consumption ( the consumption we will have when we do not have any income) b= slope = MPC = ΔC/ ΔY So the slope of the consumption function (b) is called the marginal propensity to consume (MPC), which shows the change in consumption due to the change in disposable income. MPC is always between 0 and 1. So 0< MPC <1. Why? The reason is that if our income increases then we will consume some amount and save the rest. So ΔC< ΔY. This implies that MPC cannot be greater than 1.

  4. Example: • Suppose initially income is Y1=100. Now income increases to Y2=200. So the change in income is ΔY= 200-100= 100. • This increase in income causes an increase in consumption. Initially consumption was C1=80 and then with income increase it increases to C2= 160. So the change in consumption is ΔC= 160-80=80 • So MPC= ΔC/ ΔY = 80/100= 4/5

  5. Savings Function • It shows the relationship between savings and disposable income. That is it shows how savings changes as disposable income changes. • S=f(Y)

  6. Marginal Propensity to Save (MPS) • Here the equation for savings function is S= -a + d Y where -a= intercept = dissavings ( when we do not have income we still have to consume goods and services and we do this by borrowing ) d= slope = MPS = ΔS/ ΔY So the slope of the savings function (d) is called the marginal propensity to save (MPS), which shows the change in savings due to the change in disposable income. MPS is always between 0 and 1. So 0< MPS <1. Why? The reason is that if our income increases then we will consume some amount and save the rest. So change in savings will be less than change in income that is ΔS< ΔY. This implies that MPS cannot be greater than 1.

  7. Relation between MPC and MPS • We know that Y= C+ S • So we will have MPC+ MPS=1. • So we can write MPC = 1- MPS

  8. 45° Relationship between Consumption and Saving C Saving Consumption Schedule Consumption Dissaving Disposable Income Saving Dissaving Saving Schedule S Saving Disposable Income

  9. Total consumption Total savings APC = APS = Total income Total income • Average Propensity to Consume (APC): The ratio of consumption and income is known as average propensity to consume. If we divide the total consumption by total income then we get APC. • Average Propensity to Save (APS) : The ratio of savings and income is known as average propensity to save. If we divide the total savings by total income then we get APS.

  10. (2) Consump- tion (C) (1) Disposable Income (Y) (4) Average Propensity to Consume (APC) (2)/(1) (5) Average Propensity to Save (APS) (3)/(1) (6) Marginal Propensity to Consume (MPC) Δ(2)/Δ(1) (7) Marginal Propensity to Save (MPS) Δ(3)/Δ(1) (3) Saving (S) (1-2) APC, APS, MPC and MPS • $370 • 390 • 410 • 430 • 450 • 470 • 490 • 510 • 530 • 550 $375 390 405 420 435 450 465 480 495 510 $-5 0 5 10 15 20 25 30 35 40 1.01 1.00 .99 .98 .97 .96 .95 .94 .93 .93 -.01 .00 .01 .02 .03 .04 .05 .06 .07 .07 .75 .75 .75 .75 .75 .75 .75 .75 .75 .25 .25 .25 .25 .25 .25 .25 .25 .25

  11. Change in Real GDP Change in Real GDP Change in investment spending Change in Spending The Multiplier Equation The multiplier of investment describes the impact of an initial increase in investment on real GDP. It shows how much real GDP changes when there is a change in investment. Multiplier = Derive the formula: The marginal propensity to save may be expressed as: MPS = ΔS/ΔY Because DS must be equal to DI for equilibrium to be restored, we can substitute DI for DS and solve: • MPS=ΔI/ΔY ΔY=ΔI/MPS ΔY/ΔI= 1/MPS So = ΔY/ΔI = Multiplier= 1/MPS ,or

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