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# slide_4 - Basic Classical Model Part II Demand Side...

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Basic Classical Model: Part II Demand Side & Equilibrium February 1, 2012

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Outline of model closed economy, °exible-prices Supply side: factor markets (supply, demand, price) determination of output/income distribution of output/income Demand side: determinants of C; I , and G Equilibrium: goods (and service) market, ±nancial market
Demand for goods & services ° Components of aggregate demand: ° C = consumer demand for goods & services ° I = demand for investment goods ° G = government demand for goods & services ° (closed economy: no NX )

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Consumption, C ° Households receive income from their labor and ownership of capital W P L + R P K = Y ° Def: Disposable income is total income minus total taxes: Y ± T . ° Households divide Y ± T between consumption and saving. ° Consumption function : C = C ( Y ± T ) Shows that " ( Y ± T ) then " C
° Def: Marginal propensity to consume (MPC) is the amount by which C increases when disposable income increases by one unit: MPC = dC d ( Y ± T )

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° MPC < 1 ° Eg: MPC = 0 : 7 , Households spend 70 cents of each additional dollar of disposable income ° Assume the MPC is 0.7 and the total output is ±xed. If the government made a tax cut so that its total tax revenues decrease by 100, then what would happen to consumption? (a) consumption increases by 100. (b) consumption decreases by 100. (c) consumption increases by 70. (d) consumption decreases by 70.
Investment, I ° Buy investment goods to add to their stock of capital and replace existing capital as it wears out. ° The quantity of investment goods demanded depends on the interest rate. ° Investment function : I = I ( r ) ° r : the real interest rate, the nominal interest rate corrected for in°ation. ° the cost of borrowing

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° the opportunity cost of using one²s own funds to ±nance investment spending. ° So, " r = ) # I
Government Purchases, G ° Government purchases are the third component of the demand for Y ° G = govt spending on goods and services. ° Here we take government purchases and taxes as exogenous variables: G = ° G , T = ° T

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Budget surplus and de±cit ° If T > G , budget surplus , ( T ± G ) = "public saving" ° If T < G , budget de°cit , public saving is negative.
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slide_4 - Basic Classical Model Part II Demand Side...

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