ECN 102 Principles of Macroeconomics Dr.
Ahmed Fekri
Fall 2010
LECTURE NOTES FOUR
The following five topics were covered in class:
1. Aggregate Planned Expenditures (AE):
• Aggregate planned expenditure equals planned consumption expenditure (C),
plus planned investment (I), plus planned government purchases (G), plus
planned exports minus planned imports (X-M).
• In the very short run, when prices are assumed to be fixed, in
order to understand real GDP fluctuations, we must understand
aggregate demand fluctuations.
• In this Keynesian model in the short run, investment, government purchases and
exports are assumed to be autonomous; i.e., don't vary with GDP. Planned
consumption expenditure and planned imports are induced; i.e., vary with GDP.
Note that, consumption and imports still can have an autonomous component.
• A two-way link exists between aggregate expenditure and real
GDP:
o An increase in real GDP increases aggregate expenditure.
o An increase in aggregate expenditure increases real GDP.
2. Consumption and Saving Functions:
• The consumption function is the relationship between consumption expenditure
and disposable income, other things remaining the same. The saving function is
the relationship between saving and disposable income, other things remaining
the same.
• As Yd increases (ceteris paribus) C and S
• As wealth increases (ceteris paribus) C and S
• As expected future income increases (ceteris paribus) C and S
• As real interest rate increases (ceteris paribus) C and S
• C = 200 + 0.75 Yd
• The above expression is called the
"consumption function".
• (200) is called autonomous consumption;
it's the consumption when Yd = zero.
• (0.75) is called the marginal propensity to
consume, MPC.
• (0.75 Yd) is called induced consumption.
• Note that: MPC = ΔC / ΔYd
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ECN 102 Principles of Macroeconomics Dr. Ahmed Fekri
Fall 2010
• So, MPC is the slope of consumption function.
• S = −200 + 0.25 Yd
• The above expression is called the "saving function".
• (−200) is called dissaving; there is dissaving in the economy as long as C
is greater than Yd.
• (0.25) is called the marginal propensity to save, MPS.
• Note that: MPS= ΔS / ΔYd
• So, MPS is the slope of the saving function.
• Since Yd = C + S, then, Δ Yd = Δ C + Δ S, and therefore, MPC + MPS = 1
3. Equilibrium Level of AE:
• The equilibrium condition is: aggregate planned expenditures = real GDP
Consumption Government Aggregate planned
Import
Real GDP expenditure Investment purchases Exports expenditure
s
(Y ) (C ) (I ) (G ) (X ) AE=C+I+G+X−M
(M )
8 4.2 2 2 1 0.8 8.4
9 5.1 2 2 1 0.9 9.2
10 6 2 2 1 1 10
11 6.9 2 2 1 1.1 10.8
• The equilibrium level of aggregate expenditures (or real GDP) = 10.
• At real GDP levels below the equilibrium level, AE is greater than real GDP, so
producers will face this excess "demand" by withdrawing from inventories. Since
producers want to keep the inventory at a certain target level they will have to
increase production to compensate for the decline in inventory level. They will
keep increasing production until real GDP is equal to AE.
• At real GDP levels above the equilibrium level, real GDP is greater than AE,
which means that inventories will start to pile up, so producers will respond by
cutting back production so that real GDP is equal AE again.
• That's how the economy always converges towards equilibrium. In short:
o If AE > real GDP, an unplanned decrease in inventories induces firms to
hire workers and increase production, so real GDP increases.
o If AE < real GDP, an unplanned increase in inventories induces firms to
fire workers and decrease production, so real GDP decreases.
• Note that: the change in Inventory = AE – real GDP
4. Multiplier:
• The multiplier is the amount by which a change in autonomous expenditure (say:
investment or government purchases) is magnified or multiplied to determine the
change in equilibrium expenditure and real GDP.
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ECN 102 Principles of Macroeconomics Dr. Ahmed Fekri
Fall 2010
• The basic idea of the multiplier is that an increase in investment (or any other
component of autonomous expenditure) increases aggregate expenditure and
hence real GDP. That increase in real GDP leads to an increase in induced
expenditure. The increase in induced expenditure leads to further increases in
aggregate expenditure and real GDP. So real GDP ends up increasing by more
than the initial increase in autonomous expenditure.
• If there are no imports or income taxes, the multiplier equals:
1 1
or equivalently .
1− MPC MPS
• When imports and income taxes are included, the value of the multiplier
decreases (why?), so it would be equal:
1 1
1−slope of the AE curve or
MPS + MPM + t
• Note that:
The slope of the AE function is the marginal propensity to spend.
(MPM) is the marginal propensity to import.
(t) is the marginal tax rate.
5. Relationship between (AE) and Aggregate Demand (AD) :
• The AE curve is the relationship between aggregate planned expenditures and real
GDP, holding the aggregate price level fixed.
• The AD curve is the relationship between the aggregate quantity of real GDP
demanded and the price level.
• When the price level changes, the AE curve shifts and there is a movement along
the AD curve (check the two graphs below).
• As the aggregate price level rises from 120 to 140, the AE curve shifts downward
from AE0 to AE1, causing the equilibrium level of real GDP to decrease from $11
trillion to $9 trillion. Consequently, the aggregate quantity of real GDP demanded
decreases.
• Such decrease in the quaintly of real GDP demanded is represented by a
movement along AD curve.
