202-T&C-7(1) copy - Econ 202 Terms and Concepts 7 THE...

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Econ 202: Terms and Concepts 7: THE INCOMES-EXPENDITURES MODEL The Incomes-Expenditure Model: We have removed relative prices from the picture, so we need a model that shows how changes in Income alone can equilibrate Aggregate Supply and Aggregate Demand. The Incomes-Expenditure Model does this. In the graph on the following page, we have Aggregate Demand (the sum of expenditures on consumption and investment) on the y-axis, and national incomes created by these expenditures on the x-axis. The national incomes created have to be equal to the expenditures made. The Aggregate Supply curve is therefore the set of all points that allow incomes to equal expenditures. Instead of being a behavioral function that describes the response of the supplier to changes in price, it is an identity, a set of predetermined equilibrium points where the economy must settle. Incomes (Y) Expenditures (C, I) Aggregate Demand Aggregate Supply 45-degrees 0 Graphically, the set of all points that allow incomes to equal expenditures is represented by a line with a slope of positive one. It bisects the origin and creates a 45-degree angle with the x-axis and the y-axis. Our behavioral functions are the consumption function and the investment function. We are going to add them to this picture and see how changes in the behavior of consumers and investors will alter the national equilibrium.
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The slope of the Aggregate Supply curve is positive one, and we know that the slope of the consumption function is less than positive one (0 < MPC < 1), so the consumption function will cut the Aggregate Supply line at an angle. Incomes (Y) Expenditures (C, I) Aggregate Demand Aggregate Supply 45-degrees 0 Consumption Y e The equilibrium point must be a point on the Aggregate Supply curve. It is the point where expenditures by consumers (Aggregate Demand) are absorbing all the output that suppliers are producing. It must be the intersection of the consumption function and the Aggregate Supply curve. That intersection determines what national income will be. In the graph it is Y e . A couple things to note about the definition of terms in an identity and the nature of the equilibrium point: • Because there is only one kind of expenditure in our picture so far – Consumption - we have the following equality at equilibrium: Expenditures = Consumption = Aggregate Demand = Aggregate Supply = national Incomes • There are no Savings in this picture because there are no expenditures on capital goods to absorb the savings of consumers. In fact, if incomes fell below this equilibrium point, represented by Y e , households would be forced to dissave , to use up some of their previously stored surpluses in order to meet necessary consumption levels. It is only above this level of income that savings are possible.
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Incomes (Y) Expenditures (C, I) Aggregate Demand Aggregate Supply 45-degrees 0 Consumption Y e Dissavings Savings But we know that every economy engages in some investment activity – creation of shelter, production of tools, setting aside seeds for the next plantings, etc.
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