econ 7 - Dr. Mohammed Alwosabi ECON 141 Ch.7 Notes on...

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Dr. Mohammed Alwosabi ECON 141 – Ch.7 1 Notes on Chapter 7 EXPENDITURE MULTIPLIER FIXED PRICES AND EXPENDITURE PLANS ± From the AD-AS chapter, we studied that in the long run , LAS is vertical and price level and prices of factors of production are all variables. The RGDP is constant at the potential GDP. Hence, AD determines only the price in the LR. ± In the short run , price level varies along SAS but every thing else remain constant. So AD determines both P and the amount of RGDP. Firms increase prices if their sales increase more than they planned and reduce prices if the quantity sold is less than the planned sales. ± However, firms' prices are fixed in the very short run . It is costly to change prices every hour or every day (menu cost plus other costs). Supply curve in the very SR is horizontal at fixed price. ± So the quantities that firms sell depend on demand not supply (the shifts of AD). AD determines the aggregate amount that is sold but not the price level since the price level is fixed in the very short run. ± Thus, in the Keynesian model of aggregate expenditure, real GDP is determined by the level of aggregate demand because this model assumes that individual prices and the price level are fixed in the very short run. P Y LAS SAS VSAS RGDP P
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Dr. Mohammed Alwosabi ECON 141 – Ch.7 2 ± Because, in the very short run, prices are fixed it is easy for people to plan their expenditure. Aggregate planned expenditure (AE) is the sum of the planned amounts of consumption expenditure (C), investment (I), government purchase (G), net exports (NX) So, Planned AD = AE = C + I + G + (X – M) ± In the very SR, AE can be divided into two main components o Autonomous expenditures: They are fixed. They do not vary with RGDP. They exist even if RGDP = 0. They include I, G, and X. o Induced expenditures: They are not fixed. They depend on RGDP. They include C and M. But C and M have their autonomous parts as we will discuss later. ± Since RGDP influence C and M, and since C and M are components of AE, an increase in RGDP leads to an increase in AE, and an increase in AE leads to an increase in RGDP. Hence, there is a two- way link between AE and RGDP. ± Before discussing the equilibrium expenditure (or equilibrium RGDP) and before studying the multiplier let us have a look at each component of the planned aggregate expenditures (AE). Disposable income, Consumption Function, and Saving Function ± Consumption and saving are influenced by (1) Disposable income, (2) The real interest rate, (3) Wealth, (4) Expected future income. ± Disposable income (Y d ) equals to income (Y) minus tax plus transfer payments. If we define net tax (T) as tax minus transfer payments then Y d = Y – T. Y d = Y when T = 0 ± Disposable income (Y d ) is divided into consumption (C) and saving (S). Y d = C + S
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Dr. Mohammed Alwosabi ECON 141 – Ch.7 3 ± Consumption function shows the positive relationship between consumption expenditure (C) and disposable income (Y d ), other things remaining the same.
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econ 7 - Dr. Mohammed Alwosabi ECON 141 Ch.7 Notes on...

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