ae = c + i + g + nx c = consumption expenditures durable goods: t.v.’s, and cars. does not...

AE = C + I + G + NX

C = Consumption expenditures Durable goods: T.V.’s, and cars. Does not include houses Non-durable goods: clothing, food, and fuel Services: health care, education

I = Investment expenditures Business fixed investment on structures (factories, warehouses) and equipment

(vehicles, furniture, computers) Residential investment on the construction of new homes

G = Government expenditures on goods and services New aircraft carriers, Air Force I, Presidential limo, FBI vehicles, etc. Does the government buy US products only?

NX = net exports = eXports – iMports X is the amount spent by foreigners on goods built in the USA M is the amount spent by Americans on goods from outside of the USA

Aggregate Expenditure

Consumption expenditure

The Consumption function is the relationship between consumption and disposable income

Disposable income (DI) is aggregate income (GDP) minus net taxes (T).

DI = Y – T

where T = taxes paid to the government minus transfer payments received from the government.

The diagram to the right shows how C and DI evolve over time.

Download the data, use Excel to derive the C function

http://research.stlouisfed.org/fred2/graph/?g=o4I

Simulated consumption





A = W + Ye – PL – r

C = A + mpc ∙ DI

C = [ W + Ye – PL – r ] + mpc ∙ DI

Example: Suppose consumer wealth is $8 trillion, expected future income is $12 trillion, the price level is $14.5 thousand, the real rate of interest is 3.5 percent, net tax revenue is $3 trillion, government expenditure is $3 trillion, and the marginal propensity to consume is 0.75. Derive the consumption function.

C = [ W + Ye – PL – r ] + mpc ∙ DI



A = W + Ye – PL – r

C = A + mpc ∙ DI

C = [ W + Ye – PL – r ] + mpc ∙ DI


C = [ 8 + Ye – PL – r ] + mpc ∙ DI



A = W + Ye – PL – r

C = A + mpc ∙ DI

C = [ W + Ye – PL – r ] + mpc ∙ DI


C = [ 8 + 12 – PL – r ] + mpc ∙ DI



A = W + Ye – PL – r

C = A + mpc ∙ DI

C = [ W + Ye – PL – r ] + mpc ∙ DI


C = [ 8 + 12 – 14.5 – r ] + mpc ∙ DI



A = W + Ye – PL – r

C = A + mpc ∙ DI

C = [ W + Ye – PL – r ] + mpc ∙ DI


C = [ 8 + 12 – 14.5 – 3.5 ] + mpc ∙ DI



A = W + Ye – PL – r

C = A + mpc ∙ DI

C = [ W + Ye – PL – r ] + mpc ∙ DI


C = [ 8 + 12 – 14.5 – 3.5 ] + 0.75 ∙ DI



A = W + Ye – PL – r

C = A + mpc ∙ DI

C = [ W + Ye – PL – r ] + mpc ∙ DI


C = 2 + 0.75 ∙ DI


Example (continued):

C = 2 + 0.75 DI

When DI = 0

C = 2 + 0.75(0)

C = 2

When DI = 8

C = 2 + 0.75(8)

C = 2 + 6

C = 8

0

2

DI

C

8

8



0

2

DI

C

8

8


C = 2 + 0.75 DI

When consumption lies on the 45° line, all disposable income is consumed and saving is zero.

Saving = DI – C

= 8 – 8 = 0

45 o




C = 2 + 0.75 DI

When consumption lies below the 45° line, saving occurs.

When DI = 9.5

C = 2 + 0.75(9.5) = 2 + 7.125 = 9.125

S = DI – C = 9.5 – 9.125

= 0.3750

9.50

2

DI

C

45 o

9.125




C = 2 + 0.75 DI

When consumption lies above the 45° line, dissaving occurs.

When DI = 6

C = 2 + 0.75(6) = 2 + 4.5 = 6.5

S = DI – C = 6 – 6.5

= –0.5

60

2

DI

C

45 o

6.5



Example (continued): With real GDP held constant at 15 trillion dollars, show what happens to the consumption model when

• consumer wealth rises to 8.5 trillion dollars

• expected future income decreases to 11.5 trillion dollars

• price level increases to 14.5 thousand dollars

• mpc increases to 0.8

• real rate of interest increases by 0.5 pct. points

• tax revenue is cut by 0.5 trillion dollars

• government expenditure is raised by 0.5 trillion dollars

What is monetary policy, and who conducts it?

What is fiscal policy, and who conducts it?

Compute the budget balance. Is there a budget deficit or surplus?


http://www.halsnarr.com/excel/consumption.xlsx


Because AE, AD, SRAS, and LRAS are graphed with Y on the horizontal axis, C should be too:

C = [ W + Ye – PL – r ] + mpc ∙ DI

DI = Y – T

C = [ W + Ye – PL – r ] + mpc ∙ (DI)

C = [ W + Ye – PL – r ] + mpc ∙ (Y – T )

C = [ W + Ye – PL – r ] + mpc ∙ Y – mpc ∙ T

C = [ W + Ye – PL – r – mpc ∙ T ] + mpc ∙ Y

Simulated consumer expenditure


Simulated consumer expenditure







• tax revenue is cut by 0.5 trillion dollars

• government expenditure is raised by 0.5 trillion dollars



Compute the budget balance. Is there a budget deficit or surplus?

http://www.halsnarr.com/excel/s_consumption.xlsx

Import function Money is spent on domestic products (C ) & imported products (M ). M is the amount spent by

Americans on goods from outside of the USA. In the short run, the factor influencing imports is U.S. real GDP

If Y = 0, products cannot be imported (M = 0)

As Y rises, expenditures on imports increase. Download the following data to generate an empirical iMport function

http://research.stlouisfed.org/fred2/graph/?g=o4M

Marginal Propensity to iMport is the fraction of a rise in Y spent on imports.

M = mpm∙ Y

Simulated net foreigner expenditure eXports are exogenous NX = X – M

NX = X – mpm∙Y

Example: In addition to W = 8, Ye = 12, PL = 14.5, r = 3.5, mpc = 0.75, and T = 3, assume, investment expenditures total $2.75 trillion, government expenditures total $3 trillion, exports total $2 trillion, and mpm = 0.25. Derive the AE equation.

NX = 0.5 – 0.25∙Y

Net foreigner expenditure




AE = [C ]+ I + G + NX }

Simulated AE

AE = [C ]+ I + G + {NX}

NX = X – mpm∙ Y

C = W + Ye – PL – r – mpc ∙ T + mpc ∙ Y

AE = [W + Ye – PL – r – mpc ∙ T + mpc ∙ Y ] + I + G + {X – mpm∙ Y }

AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + mpc ∙ Y – mpm∙ Y

AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y


Simulated AE

AE = [C ]+ I + G + {NX}

M = mpm∙ Y

C = W + Ye – PL – r – mpc ∙ T + mpc ∙ Y

AE = [W + Ye – PL – r – mpc ∙ T + mpc ∙ Y ]+ I + G + X – {mpm∙ Y }

AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + mpc ∙ Y – mpm∙ Y



Simulated AE


Simulated AE




Simulated AE


AE = [8 + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y


AE = [8 + 12 – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y

Simulated AE



Simulated AE


AE = [8 + 12 – 14.5 – r – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y


Simulated AE


AE = [8 + 12 – 14.5 – 3.5 – mpc ∙ T + I + G + X ] + { mpc – mpm }∙ Y


Simulated AE


AE = [8 + 12 – 14.5 – 3.5 – 0.75 ∙ T + I + G + X ] + { 0.75 – mpm }∙ Y


Simulated AE


AE = [8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + I + G + X ] + { 0.75 – mpm }∙ Y


Simulated AE


AE = [8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + G + X ] + { 0.75 – mpm }∙ Y


Simulated AE


AE = [8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + X ] + { 0.75 – mpm }∙ Y


Simulated AE


AE = [8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + 2 ] + { 0.75 – mpm }∙ Y


Simulated AE


AE = [8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + 2 ] + { 0.75 – 0.25 }∙ Y


Simulated AE


AE = [ 7.5 ] + { 0.5 }∙ Y


When Y = 0

AE = 7.5 + 0.5 (0) = 7.5

When Y = 15

AE = 7.5 + 0.5 (15) = 15

Simulated AE


AE = 7.5 + 0.5 ∙ Y

Example:

Point 1

Y = 0

AE = 7.5

Point 2

Y = 15

AE = 15

Since aggregate planned expenditure equals GDP, the change in firms’ inventories equals the planned change.

The AE model has reached an equilibrium

0

7.5

Y

AE

15

15

45 o


Simulated AE

Example: Suppose real GDP is $19 trillion.

AE = 7.5 + 0.5(19) = 7.5 + 9.5 = 17

AE < Y

When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs.

0 Y

AE

45 o


19

17

Simulated AE

0 Y

AE

45 o


19

AE = Y

Simulated AE

17

15

15

firms cut production. Real GDP decreases until it reaches equilibrium.


AE = 7.5 + 0.5(19) = 7.5 + 9.5 = 17

AE < Y

When aggregate planned expenditure is less than real GDP, an unplanned increase in inventories occurs.

13


AE = 7.5 + 0.5(11) = 7.5 + 5.5 = 13

AE > Y

When aggregate planned expenditure exceeds real GDP , an unplanned decrease in inventories occurs.

0 Y

AE

45 o


11

Simulated AE

13

firms raise production. Real GDP increases until it reaches equilibrium.

0 Y

AE

45 o


11 15

15


AE = 7.5 + 0.5(11) = 7.5 + 5.5 = 13

AE > Y

When aggregate planned expenditure exceeds real GDP , an unplanned decrease in inventories occurs.

AE = Y

Simulated AE


Simulated AE







• tax revenue is cut by 0.5 trillion dollars. Compute the tax cut multiplier. Compute the budget balance.

• government expenditure is raised by 0.5 trillion dollars. Compute the government expenditure multiplier. Compute the budget balance.



http://www.halsnarr.com/excel/AE.xlsx

AE = [8 + 12 – 14.5 – 3.5 – 0.75 ∙ 3 + 2.75 + 3 + 2 ] + { 0.75 – 0.25 }∙ Y

Y

AE

What happens if the price level rises by 1 thousand dollars?

15.5

AE > Y

13

AE = 5.25 + 0.5 Y

Y = 5.25 + 0.5 Y

0.5 Y= 5.25

Y= 10.5

15

45 o

Y

PL

15

AD

13


Simulated AD


6.5

7.5

(PL = 15.5)

(PL = 14.5)

14.5

15.5Unplanned increase

in inventories

Real GDP will fall

ae = c + i + g + nx c = consumption expenditures durable goods: t.v.’s, and cars. does not...

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