CHAPTER 3DETERMINATION OF EQUILIBRIUM INCOME

AGGREGATE OUTPUT & AGGREGATE INCOME•Each period, firm produces some aggregate quantity of G&S which is referred to as aggregate output (Y).•From the previous chapter we know that GDP can be calculated in terms of either income or expenditures.•Because every dollar of expenditure is received by someone as income, GDP can be computed either by adding up the total spent on all final goods during a period or by adding up all the income (wages, rents, interest, profits) received by all the factors of production.•Therefore, the variable Yis used to refer to both aggregate output & aggregate income.

•Aggregate output can also be looked on as the aggregate quantity supplied (AS) because it is the amount that firms are supplying during the period.•Therefore:Aggregate Output = Aggregate Income = Aggregate Supply (AS) = Real GDP = Y

Two-Sector Economy•Two-sector economy consists of household & firms.•We begin our analysis in a simple world with no government and a closed economy (no X & M).•Each period (weeks, months, years) households receive some aggregate amount of income (Y).•In such a world, a household can do only two things with its income (Y): 1. buy G&S (consumption [C])2. save (S)Y = C + SS = Y – C C = Y – S

Determinants of C & S1. Household income (+ve)2. Household wealth (+ve)3. Interest rate (i.e. cost of borrowing) (-ve)4. Household expectation about the future - It can be +ve (positive expectation about the future) or –ve (uncertainty about the future).

Relationship Between Aggregate Income (Y) and Aggregate Consumption (C)•Since Y & C are positively related, according to Keynes (1936) the aggregate consumption function can be written as follows:C = a + bYwhere C = aggregate consumptionY = aggregate incomea = intercept (autonomous consumption)b = ΔC/ΔY = slope of the function

C = a + bYΔCΔYCYSlope = ΔC/ΔY = MPCConsumption FunctionAutonomous Consumptiona

Autonomous Consumption•AC – represents consumption when income is zero.•In the consumptipn function, autonomous consumption is represented by the value of intercept (a).

Marginal Propensity to Consume (MPC)•MPC – the fraction of a change in income that is consumed.•In the consumption function, MPC represented by b•Therefore, MPC = b = the slope consumption function.

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Relationship Between Aggregate Income (Y) and Aggregate Saving (S)•We know that: Y = C + S and S = Y – C•Since C = a + bY, the aggregate saving function can be written as follows: S = Y – (a + bY)= Y – a – bY = – a + (Y– bY]S = – a + (1– b)Ywhere S = aggregate savingY = aggregate income–a = intercept (autonomous saving)(1 – b) = ΔS/ΔY = slope of the function

Marginal Propensity to Save (MPS)•MPS – the fraction of a change in income that is saved.•In the consumption function, MPS is represented by [1 – b].•Therefore, MPS = 1 – b.

S = -a + (1-b)YΔSΔYSYSlope = ΔS/ΔY = MPS-a0Saving FunctionAutonomous Saving

Relationship Among Y, C & SY = C + S [1]Eq. [1]/Y: Y/Y = C/Y + S/Y1 = APC + APS [the fraction of incomespent (APC) and saved (APS)]ΔY = ΔC + ΔS [2]Eq. [2]/ΔY: ΔY/ΔY = ΔC/ΔY + ΔS/Δ1 = MPC + MPS [the fraction of a change in incomespent (MPC) and saved (MPS)]

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