EC111LectNG12

EC111LectNG12 - EC111 MACROECONOMICS Spring Term 2012...

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1 EC111 MACROECONOMICS Spring Term 2012 Lecturer: Jonathan Halket Week 17 Topic 2: National Income Determination So far we have seen how the different components of National Expenditure add up to equal national income or GNP. Different categories of expenditure are distinguished because they are determined by different behavioural relationships. We start with the simplest Keynesian model (after J. M. Keynes, a British economist who wrote in the 1930s). Note at the outset two important assumptions: Prices are assumed fixed; so we can think of changes in expenditures as changes in quantities. There is spare productive capacity in the economy so that increases in output are possible. We focus on the short run changes: quarter-to-quarter or year-to- year. When these assumptions hold, what is actual output relative to potential output? Which margin, supply or demand, determines output under these assumptions?
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2 A “Short-run” model of Consumption and Income with only Investment As we have seen, households can allocate their disposable income to two things: consumption of goods and services or saving. We assume that, in aggregate, consumption, C, will be related to disposable income, Y, as in the diagram: In the short run, if income increases, consumers spend some proportion (less than one) of the additional income. This is the Marginal Propensity to Consume (MPC) We can express this as (assuming MPC is constant): Where A is the ―autonomous‖ component of consumption (the intercept), and c is the marginal propensity to consume. Thus, using Δ for ‗change in‘: ΔC = c ΔY. The average propensity to consume, APC, is: If c is constant and A is positive, APC falls as income rises. Saving is that part of disposable income that is not spent on consumption, so: C Y A Slope = c = MPC
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3 So the marginal propensity to save (MPS) is one minus the MPC. Note that this is a very simple consumption function. It abstracts from: Consumption depends not only on current income by on what households expect their future (sometimes called permanent) income to be. Thus if income were to drop temporarily households reduce their consumption by less than if they thought the fall was permanent. Over the long run, A is smaller and c is larger. There is a return to saving—the interest rate. The opportunity cost of current consumption is 1 + r (where r is the real interest rate). A higher interest rate might cause households to consume less now (shifting the consumption function down) and more in the future (an inter-temporal substitution effect). Consumption may depend on wealth (which is a stock) as well as current income (which is a flow). E.g. owner occupiers seem to spend more when the value of their house goes up.
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This note was uploaded on 03/15/2012 for the course EC 111 taught by Professor Timhatton during the Spring '12 term at Uni. Essex.

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EC111LectNG12 - EC111 MACROECONOMICS Spring Term 2012...

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