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The level of GDP, the overall price level, and the level of employmentthree chief concerns of macroeconomistsare influenced by events in three broadly defined markets: Goods-and-services market
PART V The Core of Macroeconomic Theory
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We build up the macroeconomy slowly. In Chapters 23 and 24, we examine the market for goods and services. In Chapters 25 and 26, we examine the money market. Then in Chapter 27, we bring the two markets together, in so doing explaining the links between aggregate output (Y) and the interest rate (r), and derive the aggregate demand curve. In Chapter 28, we introduce the aggregate supply curve and determine the price level (P). We then explain in Chapter 29 how the labor market fits into the macroeconomic picture.
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23
CHAPTER OUTLINE The Keynesian Theory of Consumption
Other Determinants of Consumption
The Multiplier
The Multiplier Equation The Size of the Multiplier in the Real World
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aggregate output The total quantity of goods and services produced (or supplied) in an economy in a given period.
aggregate income The total income received by all factors of production in a given period.
In any given period, there is an exact equality between aggregate output (production) and aggregate income. You should be reminded of this fact whenever you encounter the combined term aggregate output (income) (Y).
aggregate output (income) (Y) A combined term used to remind you of the exact equality between aggregate output and aggregate income.
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A consumption function for an individual household shows the level of consumption at each level of household income.
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The aggregate consumption function shows the level of aggregate consumption at each level of aggregate income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending.
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marginal propensity to consume (MPC) That fraction of a change in income that is consumed, or spent.
C Y
aggregate saving (S) The part of aggregate income that is not consumed. SYC
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The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consumption). The marginal propensity to save (MPS) is the fraction of an increase in income that is saved (or the fraction of a decrease in income that comes out of saving).
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In this simple consumption function, consumption is 100 at an income of zero. As income rises, so does consumption. For every 100 increase in income, consumption rises by 75. The slope of the line is .75.
Aggregate Income, Y
PART V The Core of Macroeconomic Theory
Aggregate Consumption, C 100 160 175 250 400 550 700 850
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Because S Y C, it is easy to derive the saving function from the consumption function. A 45 line drawn from the origin can be used as a convenient tool to compare consumption and income graphically. At Y = 200, consumption is 250. The 45 line shows us that consumption is larger than income by 50. Thus, S Y C = 50. At Y = 800, consumption is less than income by 100. Thus, S = 100 when Y = 800.
Y C = S AGGREGATE AGGREGATE AGGREGATE INCOME CONSUMPTION SAVING 0 100 -100
80
100 200 400 600 800 1,000
160
175 250 400 550 700 850
-80
-75 -50 0 50 100 150 11 of 29
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For the time being, we will assume that planned investment is fixed. It does not change when income changes, so its graph is a horizontal line.
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Y>C+I aggregate output > planned aggregate expenditure C+I>Y planned aggregate expenditure > aggregate output
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TABLE 23.1 Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium. The Figures in Column 2 Are Based on the Equation C = 100 + .75Y. (1) (2) (3) (4) (5) (6)
Planned Unplanned Aggregate Aggregate Inventory Output Aggregate Planned Expenditure (AE) Change Equilibrium? (Income) (Y) Consumption (C) Investment (I) C+I (Y = AE?) Y (C + I) 100
PART V The Core of Macroeconomic Theory
25 25 25 25 25 25 25
100 75 25 0 + 25 + 75 + 125
No No No Yes No No No
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Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned aggregate expenditure is the sum of consumption spending and planned investment spending.
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C+S=C+I
PART V The Core of Macroeconomic Theory
Because we can subtract C from both sides of this equation, we are left with: S=I
Thus, only when planned investment equals saving will there be equilibrium.
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Aggregate output is equal to planned aggregate expenditure only when saving equals planned investment (S = I). Saving and planned investment are equal at Y = 500.
PART V The Core of Macroeconomic Theory
2012 Pearson Education
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If planned spending is less than output, there will be unplanned increases in inventories. In this case, firms will respond by reducing output. As output falls, income falls, consumption falls, and so on, until equilibrium is restored, with Y lower than before.
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The Multiplier
multiplier The ratio of the change in the equilibrium level of output to a change in some exogenous variable.
exogenous variable A variable that is assumed not to depend on the state of the economythat is, it does not change when the economy changes.
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The Multiplier
FIGURE 23.8 The Multiplier as Seen in the Planned Aggregate Expenditure Diagram
At point A, the economy is in equilibrium at Y = 500. When I increases by 25, planned aggregate expenditure is initially greater than aggregate output. As output rises in response, additional consumption is generated, pushing equilibrium output up by a multiple of the initial increase in I. The new equilibrium is found at point B, where Y = 600. Equilibrium output has increased by 100 (600 - 500), or four times the amount of the increase in planned investment.
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The Multiplier
The Multiplier Equation Recall that the marginal propensity to save (MPS) is the fraction of a change in income that is saved. It is defined as the change in S (S) over the change in income (Y):
S MPS Y
Because S must be equal to I for equilibrium to be restored, we can substitute I for S and solve:
PART V The Core of Macroeconomic Theory
1 multiplier , MPS
or
1 multiplier 1 MPC
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The Multiplier
The Size of the Multiplier in the Real World In considering the size of the multiplier, it is important to realize that the multiplier we derived in this chapter is based on a very simplified picture of the economy. In reality, the size of the multiplier is about 2. That is, a sustained increase in exogenous spending of $10 billion into the U.S. economy can be expected to raise real GDP over time by about $20 billion.
PART V The Core of Macroeconomic Theory
2012 Pearson Education
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Looking Ahead
In this chapter, we took the first step toward understanding how the economy works. We assumed that consumption depends on income, that planned investment is fixed, and that there is equilibrium. We discussed how the economy might adjust back to equilibrium when it is out of equilibrium.
PART V The Core of Macroeconomic Theory
We also discussed the effects on equilibrium output from a change in planned investment and derived the multiplier. In the next chapter, we retain these assumptions and add the government to the economy.
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actual investment aggregate income aggregate output aggregate output (income) (Y)
multiplier
exogenous variable
identity
marginal propensity to consume (MPC) marginal propensity to save (MPS)
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