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ShortRunModel1 - Aggregate Expenditure and Equilibrium...

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A E di Aggregate Expenditure and Equilibrium Income Slide 1
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Assumptions We will assume that: ¾ There is no depreciation There is no ¾ There are no indirect taxes ¾ f i f f d i i Net payment to foreign factors of production is nil Therefore, GDP , Net Domestic Income , and Gross National Product are all equal In other words, output and income are assumed to be equal and we will use the notation Y to refer to b h Slide 2 both
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Graphical Representation of GDP N i l I (Y) GDP = National Income (Y) GDP GDP = Y Slope = 1 Y 45º Slide 3
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Assumptions (continued) We will also assume that the price level ( P ) is fixed ¾ Therefore this model applies to a situation Therefore, this model applies to a situation where the economy is in a deep recession characterized by excess capacity and high characterized by excess capacity and high unemployment ¾ Th i ill id h ll d h That is, we will consider the so-called short- run Keynesian model Slide 4
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Aggregate Expenditure Aggregate Expenditure ( AE ) is the total desired or planned expenditure on goods and services in the expenditure on goods and services in the economy, that is: AE = C + I + G + NX Using the expenditure approach, we have seen that GDP was equal to: Y = C + I + G + NX GDP i l h t l di d d is equal to the actual expenditure on goods and services in the economy ¾ That is, actual expenditure is equal to income ( Y ) Slide 5 That is, actual expenditure is equal to ) since GDP is equal to income
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Aggregate Expenditure (cont’d) The Aggregate Expenditure function indicates the desired level of expenditure at each level of income ( Y ) ¾ The Aggregate Expenditure function is an increasing function of Y Therefore, there must be a level of income at which desired aggregate expenditure ( AE ) is equal to actual desired ) is equal to actual aggregate expenditure ( GDP = Y ) Thi l l f i hi h Y AE i h This level of income at which Y = AE is the equilibrium level of output or income ( Y* ) ¾ At Y* the goods market is in equilibrium Slide 6 At the goods market is in
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Aggregate Expenditure (cont’d) If Y AE , then the economy is not in equilibrium ¾ If Y > AE Æ excess supply in the goods market ¾ If Y < AE Æ excess demand in the goods market S d f d h h l Since P is assumed fixed, then the implicit assumption is that aggregate expenditure determines the amount of goods produced in the economy That is, Y must change in order to restore equilibrium i th in the economy ¾ Y must increase to eliminate an excess demand ¾ Y d li i l Slide 7 must decrease to eliminate an excess supply
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A Simple Model Consider a simple model of an economy without government sector ( G = 0 ) and without external sector ( X = Q = 0 ) Therefore, AE = C + I How is equilibrium income ( Y* ) determined in this economy? Slide 8
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The Planned Consumption F i Function The planned consumption function is a description of the total planned personal consumption expenditure by all households in the economy Planned consumption expenditure depends on variables such as ¾ disposable income ¾ wealth ¾ interest rates ¾ expectations about the future Slide 9
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