Income-Expenditure Model of GDP

Reference: e-book Chapter 4

Key Ideas

Fixed or Sticky Prices

Planned Aggregate Expenditure (PAE)
Consumption Function
(Short-run) Equilibrium
Income-Expenditure Multiplier
Background

We have defined aggregate output or GDP and now we

want a model of how it is determined.

Why was Australian GDP in 2014 equal to $1.6 trillion,

rather than $1.5 trillion or $1.7 trillion?

2
Background

Model is based on the ideas of John Maynard Keynes.

Classic book called The General Theory of Employment,

Interest and Money (1936)

Following model is one interpretation of Keynes ideas.

3
Keynesian Model

Key Assumption (or friction)

Prices of goods are fixed (common to say sticky) in the

short-run

Firms do not change prices in response to a change

in demand for their product

Instead they fix their price and then meet the

demand by varying their level of production

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In the short-run firms will:

accommodate a cut in demand by reducing output

and employment, not by reducing prices.

accommodate a rise in demand by increasing

output and employment, not by increasing prices.

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Deeper Assumptions (Microeconomic Foundations)

Firms have some ability to set prices (not perfectly

competitive world)

Firms face some cost to changing prices these are called

menu costs

In the long-run:

sustained or persistent changes in demand will eventually

lead firms to change their prices and cause production to
return to normal capacity.

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Frictionless View of the World

Fluctuations in demand will be accommodated by

flexible prices and wages without changes in output
and employment.

There will never be excess production because firms

will cut prices to sell it.

There will never be persistent unemployment

because workers will cut their wages to keep and get
jobs

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Expenditure Measure of GDP

4 components of aggregate expenditure:

Y = C + I + G + NX

C = Household expenditure
I = Investment expenditure
G = Government expenditure
NX = Net Exports (Exports Imports)

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Planned Aggregate Expenditure

(Keynesian) assumption is that firms meet demand by

changing production

Implies:

Aggregate output (or production) will be determined by

the total level of desired (or planned) spending.

We need a measure of desired spending.

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Planned Aggregate Expenditure

Definition:

Planned aggregate expenditure (PAE) is the total

planned spending on domestically produced final goods
and services.

Key word is planned or desired

10
Planned verses Actual Expenditure

Suppose aggregate production (GDP) = 100

We know from Week 1 that actual expenditure must

equal 100?

However planned expenditure can differ from 100.

Why is actual expenditure not always equal to planned

expenditure? Due to:

(Unplanned) changes in Inventories

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Reconciliation (in National Accounts)

Suppose Y = 100 but PAE = 90

Planned expenditure equals 90 but firms produced 100.

What happens to the extra 10 units?

Assumed (in national accounts) to be purchased by firms

and becomes an inventory of unsold goods.

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Unplanned Inventories

Y = 100 but PAE = 90

100 = 90 + 10 = 100

Y = PAE + (unplanned) Inventories

The firms did not plan to buy the 10 units of goods and so
it is called unplanned inventory investment.

Note there could be an unplanned fall in inventories if

PAE > Y

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2 Concepts

Aggregate Expenditure

=+++

Planned Aggregate Expenditure (PAE)

= + + +

I = actual investment (includes unplanned inventory

investment
= planned investment

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Equilibrium and Disequilibrium

Equilibrium Condition:
Y = PAE

Two equivalent conditions:

(unplanned) Inventories = 0

Equilibrium means there is no tendency for the level of real

GDP to change.

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Equilibrium and Disequilibrium

Disequilibrium

Y < PAE

Y > PAE

In both cases there will be some tendency for the level

of GDP to change.

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Disequilibrium (Example)

Y > PAE

Businesses experience:
unanticipated increase in inventories (goods
producers)
excess capacity to meet demand (service producers)

Signal to businesses to reduce their level of production.

GDP will fall.

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Disequilibrium (Example)

Y < PAE

Businesses experience:
unanticipated decrease in inventories (goods
producers)
insufficient capacity to meet demand (service
producers)

Signal to businesses to increase their level of production.

GDP will rise.

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To Summarise

Income-expenditure model assumes level of planned or

desired aggregate expenditure will determine the level
of aggregate output.

= + + +

But what determines the level of PAE?

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Two Sector Model (Households and Businesses)

Assumptions (simplifying):

no government sector (G = T = 0)

no foreign sector (i.e. a closed economy) (X = M = 0)

Planned aggregate expenditure

= +

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Two Sector Model

= +

Planned Investment

= 0

Assumed to be:

Autonomous or exogenous variable

Determined by factors other than GDP (Y).

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Two Sector Model

= +

Household Consumption
Non-durable goods
Durable goods
Services

Develop a simple model in which consumption expenditure

is a linear function of disposable income.

Keynesian consumption function

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Model of Consumption Expenditure

Hypothesize that a key influence on consumption spending

by households is current disposable income.

Disposable Income = Y T

Y = national income or GDP

T = taxes (TA) transfers (TR) interest on government

debt (INT)

Assume retained earnings (RE=0)

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Consumption Function

= 0 + ( )

Linear relationship

Household consumption depends on:

a constant 0 , and

disposable income ( )

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Consumption Function

= 0 + ( )

0 is exogenous (or autonomous) consumption

Factors (other than disposable income) that could affect

consumption, e.g. wealth, real interest rates

The value of an exogenous variable is determined outside

of the model under consideration

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Consumption Function

= 0 + ( )

c(Y T ) captures the effect of disposable income on

consumption (sometimes called induced consumption)

c = marginal propensity to consume (parameter).

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Marginal Propensity to Consume (MPC)

MPC is the change in consumption when disposable income

changes by a dollar.

= 0 + ( )

= =
( )
Assume: 0 < c < 1

A dollar increase in disposable income raises consumption by

less than one dollar

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Consumption Function

45o

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Consumption Function

C
= 0 + ( )

Slope = c
C0
45o
0
Y-T

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MPC and APC

Impact of an additional dollar

Marginal Propensity to consume: =
()

Proportion of income that is used for consumption

Average Propensity to consume: =

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Relationship between MPC and APC (in linear model)

= 0 + ( )

Divide both sides by (Y-T)

0 + ( ) 0
= = = +

APC > MPC but approaches MPC (c) as Y-T increases

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(Back to) Two Sector Model

= +

Consumption Function

= 0 +

Investment

= 0

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Model to be Solved for Y (GDP)

= +

= 0 +

= 0

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Graphical Representation

= +

= 0 +

Measure Y on horizontal axis

Everything else on vertical axis

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A Diagram Showing Consumption and Investment

C, I P
= 0 +

C0

I0 IP

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A Diagram Showing PAE

C, I P PAE = C + IP
= 0 +

C0

I0 IP

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A Diagram Showing all Cases where Y = PAE

PAE

45o

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Equilibrium GDP in the 2-Sector Model

45-degree line
PAE
PAE=C+IP

Ye Y

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Recap

We can graphically determine equilibrium level of GDP

Questions

What if for some reason Y was different to Ye?

(Disequilibrium)

What happens to Ye when PAE changes?

(Multiplier)

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Disequilibrium

45-degree line
PAE
PAE

Ye Y

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Disequilibrium

45-degree line
PAE
PAE

Y0 Ye Y

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Disequilibrium PAE > Y

45-degree line
PAE
PAE

PAE0

Y0 Ye Y

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Adjustment to Equilibrium

Firms will experience an unplanned decline in their

inventories

To re-build their inventories firms will increase their level of

production

This will cause GDP to increase and it will move towards its
equilibrium value, where PAE cuts the 45-degree line

GDP will increase until PAE=Y.

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Disequilibrium PAE > Y

45-degree line
PAE
PAE

PAE0

Y0 Ye Y

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The Multiplier

Suppose that the level of PAE increases. So does the level of

GDP.

PAE PAE1

PAE0

0 1 Y

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The Multiplier

In the following diagram compare the relative sizes of the

change in Y caused by the change in PAE.

PAE PAE1

PAE 0

PAE
Y

Y0e Y1e Y

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The Multiplier

An additional dollar of exogenous PAE generates more than a

dollars worth of GDP

>1

How much more? (It depends!)

Need to do the algebra.

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Equilibrium GDP in the 2-Sector Model: The Algebra

Definition of PAE = +

Consumption Function = 0 +

Investment = 0

Equilibrium Condition =

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Substitution

= +

= 0 +

= 0

= 0 + 0 +

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Collect Terms in Y

= 0 + 0 +

= 0 + 0

(1 ) = 0 + 0

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Equilibrium GDP

(1 ) = 0 + 0

1
= [0 + 0 ]
1

Above equation is the solution to the 2-sector model.

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The Multiplier in the 2-Sector Model

Equilibrium GDP

1
= [0 + 0 ]
1

What is the effect on equilibrium GDP of a change in:

Autonomous consumption, C0

Autonomous investment, I0

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The Multiplier in the 2-Sector Model

Equilibrium GDP

1
= [0 + 0 ]
1

Multipliers:

Write model in terms of changes in induced (endogenous)

and autonomous (exogenous) variables.

1
= [0 + 0 ]
1

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The Multiplier in the 2-Sector Model

1
= [0 + 0 ]
1

Autonomous consumption: (So set 0 = 0)

1
= [0 ]
1

1
=
0 1

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The Multiplier in the 2-Sector Model

1
= [0 + 0 ]
1

Autonomous investment: (So set 0 = 0)

1
= [0 ]
1

1
=
0 1

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The Multiplier in the 2-Sector Model

Multipliers:

Autonomous consumption
1
= >1
0 1

Autonomous planned investment

1
= >1
0 1

Must be greater than one, since MPC: 0<<1

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Size of the Multiplier

Two-sector model

Suppose MPC = 0.75

1 1 1
Multiplier = = = =4
1 10.75 0.25

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