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TUTORIAL 5 (7 11 APRIL) ANSWER KEY

The AE Model
Textbook Reference: Chapter 5
Main Concepts
Components of Aggregate Expenditure
Exogenous and induced expenditure
Consumption Function
Short run equilibrium output
Income-Expenditure multiplier
Review Questions
Question 1
(i)
Define planned aggregate expenditure (AE) and list its components. Why does AE
change with income?
See p133,134. Planned aggregate expenditure (PAE) is total planned spending on domestically
produced final goods and services. It includes consumption spending, (planned) investment
spending, government purchases of goods and services, and net exports (exports less imports). We
can write it as:
where Ip is planned investment and excludes unplanned changes in inventories. In the national
accounts (actual) AE must add-up to the value of total output. So AE is given by:
where

Note that in the latest edition of BOF (3rd edition), PAE is written as follows:
If you compare this to the above definition you can see that
where Cd is defined as consumption spending on domestically produced goods and services.
Changes in output lead to changes in income received by households, which in turn affects
consumption spending (through the consumption function). As consumption is part of PAE, changes
in output lead to changes in PAE.
(ii)
Explain the concept of a consumption function. What are the main influences on
consumption? Explain the difference between the average propensity to consume and the
marginal propensity to consume.
P 134-136. The largest component of planned aggregate expenditure is consumption expenditure.

(
)
The consumption function can be expressed as
Consumers willingness to spend affects sales and profitability in many industries and therefore
affects labour and capital income. Labour and capital income net of taxes is termed disposable
income (
) and any increase (decrease) in disposable income leads to an increase (decrease) in
consumption expenditure. The proportion of disposable income that is consumed is approximated by
the marginal propensity to consume , and therefore the component of consumption that is induced
) The remainding term in the consumption function is exogenous
by disposable income is (

expenditure, . This term reflects any change in consumption expenditure that occurs for any reason
other than a change in disposable income. This term is primarily affected by the wealth effect, which
is defined as the effect of a change in asset prices on consumption expenditure.
The marginal propensity to consume is the ratio of the change in consumption expenditure and the
change in disposable income:

The average propensity to consume is the ratio of consumption and disposable income:

(iii)
Draw a diagram of the AE model and explain the process by which the economy reaches
equilibrium.

In the diagram,
, expenditure is less than output and firms will experience an unplanned
decline in their inventories. This is a signal to decrease production in order to reduce inventories to
previous levels. As production decreases the economy will move towards
(where
).
If
, expenditure is greater than output and firms will experience an unplanned decline in their
inventories. This is a signal to increase production in order to restore inventories to previous levels.
As production increases the economy will move towards
(where
).

Question 2
Data on pre-tax income, taxes and consumption spending (on domestic goods and services) for
the Simpson family are given below.
Pre-tax Income
($)
25,000
27,000
28,000
30,000

Tax Paid
($)
3,000
3,500
3,700
4,000

Consumption Spending
($)
20,000
21,350
22,070
23,600

(i)
Graph the consumption function for the Simpsons and find their households marginal
propensity to consume.

The graph of the consumption function is a straight line through these points, where disposable
income is on the horizontal axis and consumption on the vertical axis. If disposable income increases
from 22 000 to 23 500, a rise of 1500, consumption rises by 1350. Since 1350/1500 = 0.9, it looks like
the MPC is 0.9. Confirming this, we see that if disposable income rises by another 800 (24 300 23
500), consumption rises by 720 (22 070 21 350), which is 0.9 x 800. Similarly, if disposable income
rises by yet another 1700 (26 000 24 300), consumption rises by 1530 = 0.9 x 1700. So .9.0=c We can
also find the intercept of the consumption function, C. Since the MPC is 0.9, we know the

(
). To find C, plug into the equation
consumption function can be expressed as
any of the numerical combinations of consumption and disposable income given above. For example,

)
if we set
and (
, we get
, which implies

(
).
. So the consumption function for the Simpsons is

(ii)
Predict the Simpsons level of consumption if their income was $32,000 and they paid
taxes of $5,000.
(

(iii)
Suppose that Homer Simpson wins the lottery. As a result the Simpson family increases
its consumption by $1,000 at each level of after-tax income (the lottery winnings are not treated
as income). How does this change the Simpsons consumption function? What happens to their
marginal propensity to consume? What happens to their average propensity to consume?
The new consumption function has shifted upwards (parallel) to:
(
)
The marginal propensity to consume is unchanged:
(

The average propensity to consume was:


(
) (
The average propensity to consume after the lottery is:
(

Question 3
Consider an economy described by the following equations.
(
)

(i)

Derive the equation for planned aggregate expenditure

In general form, planned aggregate expenditure is:

Where

(
)
is the marginal propensity to import; and is exogenous imports.

Where is exogenous taxes; and is the marginal income tax rate.


[
[

)(

)(
]

)
)(

(ii)
Identify the exogenous expenditure and the induced expenditure components for this
economy.
Exogenous expenditure is expenditure that does not change with income, which is the sum:
[

)(

Induced expenditure is expenditure that changes with income:


(

)(

)(

(iii)
Find the short-run equilibrium for this economy. Illustrate the equilibrium on a 45-degree
diagram.
In general form:
[

In equilibrium
[

In numeric form:

In equilibrium

)(
(

]
[

)
)]

)(

)(

)]

)(

)(

)
]
]

(iv)
What is the output gap for this economy? If the natural rate of unemployment is 4%, use
Okuns law to estimate the actual unemployment rate for the economy.
The output gap is the deviation of actual output from potential output:
A contractionary gap.
In percentage terms:

If the natural rate of unemployment is 4%, then Okuns law is:


(

)
)

The text gives a value of

(v)
Calculate the effect on short-run equilibrium of a decrease in planned investment
spending from 900 to 800. Illustrate your answer on a diagram.
Initially:
The constant term (exogenous expenditure) falls by 100:

The change in GDP is 8,250 8,500 = -250. Note that this is equal to 2.5 (the magnitude of the
multiplier) times the fall in investment expenditure.

Discussion Questions
Question 4
(i)
What is the key assumption of the basic Keynesian model? Explain why this assumption is
necessary if aggregate spending is a driving force behind short-term fluctuations in output.
BOF p.131
(ii)
Give an example of a good whose price changes very frequently and one whose price
changes relatively infrequently.
Examples of goods whose prices change infrequently are those that are priced using a cost-plus
method and goods that are very price elastic.
Examples of goods that change in price frequently are agricultural products and mining goods that
are priced according to the level of demand, and are price-inelastic in supply.