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Lecture9.docx
Outline for Lecture 9
Assumptions and Simplifications
The aggregate expenditures model was created by John Maynard Keynes in the 1930s in the hopes to explain both why the Great Depression had happened and how it might be ended.
_.
The model makes the assumption of fixed prices, or price rigidity. Why did Keynes make this assumption? because he had observed that prices had not declined sufficiently during the Great Depression to boost spending and maintain output and employment at their pre-Depression levels.
What was the impact of price rigidity observed during depression years on the U.S. output and unemployment? actual prices did not fall sufficiently during the Great Depression, and the economy sank far below its potential output. U.S. real GDP declined by 27 percent from 1929 to 1933, and the unemployment rate rose to 25 percent.
Consumption and Investment Schedules
The model is built on the commonsense notion that supply follows demand; firms produce what is demanded by households, business firms, government, and foreigners.
Because output produced depends on aggregate demand, or total expenditures, we start with the expenditures themselves, considering a private closed economy that has two parts.
Consumption
Referring to Chapter 27, how do we define consumption spending? Report the three categories of consumption and provide an example in each case. personal consumption expenditures are the expenditures of households for both durable and nondurable consumer goods. The first category is the durable goods which are the products that expected lives of 3 years or mor like jewelry, toys, and vehicles. Second, the nondurable goods which are the products with less than 3 years of expected life like drinks and fruits and vegetables. Last, services, like maintenance work.
We now introduce the consumption function that measures consumption spending C as a positive function of income Y (which also denotes output or GDP): C = a + b * Y.
In this expression, the parameter a represents autonomous expenditures, a positive amount spent on necessities such as food, clothing, and shelter even when income is zero.
The parameter b represents the marginal propensity to consume, the percentage of each dollar of income spent by the household.
Investment
Private investment takes four forms: business investment, construction, changes in inventories, and spending on research and development. Referring to Chapter 27, provide a definition and an example in each case.
Construction: architectural work, building homes and apartments. Construction spending is a metric that determines how much money is spent on new construction.
Business investment: buying assets like computers. An asset or object purchased for the purpose of producing income or appreciation is referred to as a business investment.
changes in inventories is additions to inventories vs. deductions from inventories
R&D like hiring scientists to develop new medicine. Direct costs associated with a company's efforts to create, design, and improve its products, services, technologies, or methods are referred to as research and development (R&D) expenses.
For convenience, we focus on business investment and assume that the demand for investment spending ID is a negative function of interest rate r (which measures the cost of borrowing for business firms): ID = c – d * r.
In this expression, the parameter c represents the replacement investment needed to maintain the capital stock regardless of interest rates.
The parameter d represents the interest elasticity of investment, which measures how responsive investment spending is to changes in interest rate.
Aggregate demand (Yad)
In a private closed economy, the aggregate demand is the sum of consumption and investment: Yad = C + ID = a + b * Y + c – d * r.
Outline for Lecture 10
Equilibrium GDP
The equilibrium in aggregate expenditures model occurs when output produced Y equals output demanded Yad (aggregate demand).
Provided that aggregate demand in a private closed economy equals consumption C (a + b * Y) plus investment ID (c – d * r), the equilibrium condition can be written as follows.
Y = Yad = C + ID = a + b * Y + c – d * r
Algebra
We can use the equilibrium condition to determine equilibrium output Ye algebraically.
In particular, if we have the values of a, b, c, d, and interest rate r, we can plug this information into the equilibrium condition and then solve for Y.
Example 1
Suppose that a = 97.5, b = 0.75, c = 60, d = 5, and interest rate is 8 percent. Using these values, we obtain equilibrium output Ye as follows.
Y = Yad = C + ID = a + b * Y + c – d * r
Y = 97.5 + 0.75 * Y + 60 – 5 * 8
Y – 0.75 * Y = 97.5 + 60 – 40
0.25 * Y = 117.5
Ye = 470
Example 2
Suppose that a = 97.5, b = 0.75, c = 60, and d = 5 as before. However, the central bank reduces interest rate from 8 percent to 7 percent in an effort to stimulate the economy.
What was investment demand at an interest rate of 8 percent?
Y = Yad = C + ID = a + b * Y + c – d * r
Y = 97.5 + 0.75 * Y + 60 – 5 * 8
Y – 0.75 * Y = 97.5 + 60 – 40
0.25 * Y = 117.5
Ye = 470 so = 97.5 + 0.75 * 470 + 60 – 5 * 8 = 470
What is investment demand at the new, lower interest rate of 7 percent?
Y = Yad = C + ID = a + b * Y + c – d * r
Y = 97.5 + 0.75 * Y + 60 – 5 * 7
Y – 0.75 * Y = 97.5 + 60 – 35
0.25 * Y = 122.5
Ye = 490 so = 97.5 + 0.75 * 490 + 60 – 5 * 7 = 490
How does the change in interest rate affect investment: positively or negatively?
positively
What is equilibrium output Ye at the new, lower interest rate of 7 percent?
490
How does the change in investment affect equilibrium output Ye: positively or negatively?
positively
Changes in Equilibrium GDP and the Multiplier
These examples indicate a multiplier effect: an initial change in aggregate demand (in this case, investment) leads to a larger change in equilibrium output.
In particular, the decrease in interest rate from 8 percent to 7 percent raises investment demand from __470__ to __490__.
This increase in investment, therefore aggregate demand, raises equilibrium output from 470____ to ___490_.
What is the size of multiplier in this example? Explain why there is a multiplier.
An upward shift of the aggregate expenditures schedule from (C + Ig)0 to (C + Ig)1 will increase the equilibrium GDP. Conversely, a downward shift from (C + Ig)0 to (C + Ig)2 will lower the equilibrium GDP. The extent of the changes in equilibrium GDP will depend on the size of the multiplier, which in this case is 4 (= 20/5). The multiplier is equal to 1/MPS (here, 4 = 1/.25).
Outline for Lecture 11
Adding International Trade
Net Exports and Aggregate Expenditures
Referring to Chapter 27, how do define exports X? Provide examples. Should the U.S. exports be added to or subtracted from the U.S. aggregate demand? Explain.
Export is sending goods from the USA to another country such as exporting soybeans to china.
Add net exports which is export minus imports.
Referring to Chapter 27, how do define imports M? Provide examples. Should the U.S. imports be added to or subtracted from the U.S. aggregate demand? Explain.
Imports is bringing goods from abroad to the US. Such as the US imports diamonds from India
subtracted from the U.S. since we will add the net exports to the aggregate demand we will subtracted imports from exports to obtain the net export.
Referring to Chapter 27, how do define net exports Xn? According to the Global Perspective Box 31.1, are net exports constant across countries or do they vary? Provide examples.
Net exports equal exports minus imports.
The net export vary across countries for example china has positive net export but the USA has negative net exports in 2017.
Net Exports and Equilibrium GDP
With the addition of trade to a private closed economy, the aggregate demand in a private open economy is: Yad = C + ID + Xn = a + b * Y + c – d * r + X – M.
Example 1
Suppose as before that a = 97.5, b = 0.75, c = 60, d = 5, and interest rate is 8 percent. Suppose further that exports exceed imports by 5. We obtain equilibrium output Ye as follows.
Y = Yad = C + ID + Xn = a + b * Y + c – d * r + X – M
Y = 97.5 + 0.75 * Y + 60 – 5 * 8 + 5
Y – 0.75 * Y = 97.5 + 60 – 40 + 5
0.25 * Y = 122.5
Ye = 490
Note that the multiplier is 4; an initial increase of 5 in aggregate demand (due to net exports) leads to a larger increase of 20 in equilibrium output (from 470 to 490). Evidently, positive net exports are an expansionary influence on the economy.
Example 2
All else constant, suppose that net exports fall from 5 to -5.
Determine equilibrium output Ye. Are negative net exports expansionary or contractionary: do they raise or reduce equilibrium output? reduce equilibrium output
What is the size of multiplier?
Adding the Public Sector
In the aggregate expenditures model, there are two variables pertaining to the public sector: government spending and taxes.
Referring to Chapter 27, how do we define government spending G? Provide examples.
government purchases are Expenditures by government for goods and services that government consumes in providing public services as well as expenditures for publicly owned capital that has a long lifetime; the expenditures of all governments in the economy for those final goods and final services. Such as buying goods for the military, repairing public places, and providing security.
As for taxes, they affect consumption: an increase in taxes T reduces disposable income Y – T, income left after taxes are paid, which in turn lowers consumption.
With the addition of public sector to a private open economy, the aggregate demand in a mixed open economy is: Yad = C + ID + Xn + G = a + b * (Y – T) + c – d * r + X – M + G.
Example 1
Suppose as before that a = 97.5, b = 0.75, c = 60, d = 5, interest rate is 8 percent, and net exports are 5. Suppose further that the government runs a balanced budget: it collects 20 in taxes to pay for spending of 20 (G = T = 20). We obtain equilibrium output Ye as follows.
Y = Yad = C + ID + Xn + G = a + b * (Y – T) + c – d * r + X – M + G
Y = 97.5 + 0.75 * (Y – 20) + 60 – 5 * 8 + 5 + 20
Y = 97.5 + 0.75 * Y – 15 + 60 – 40 + 5 + 20
Y – 0.75 * Y = 97.5 – 15 + 20 + 5 + 20
0.25 * Y = 127.5
Ye = 510
Evidently, the addition of a government with a balanced budget is an expansionary influence on the economy; equilibrium output rises from 490 to 510.
Example 2
All else constant, suppose that the government expands in size such that G = T = 40.
Determine equilibrium output Ye. Is a larger government expansionary or contractionary: does it raise or reduce equilibrium output? Rise equilibrium output
Materials for Lecture 11
Start with the textbook to get familiar with the content and progression of the lecture. Then, go to videos and supplemental articles, if provided, for further clarification and additional examples.
Textbook
Read carefully pages 606 through 612 from the textbook.
Video
Equilibrium in aggregate expenditures model
Multiplier in aggregate expenditures model
Article
Stimulus bill
http://www.igmchicago.org/surveys/economic-stimulus-revisited
Infrastructure investment
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