4.1 - Relevant Syllabus.
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The relationship between the consumption function, the marginal propensity to consume and the marginal propensity to save.
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The concept of macroeconomic equilibrium.
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Demonstrate the impact of changes in aggregate expenditure on the equilibrium level of income/output using the AE model.
4.2 - Summary.
4.3 - Content.
4.3.1 - The consumption function of the aggregate expenditure model.
The consumption function describes the relationship between the level of disposable income received by households and the level of consumption and saving.
Figure 9.5 assumes:
- There is no government or overseas sector.
- Consumers can only either spend or save their income (Y = C + S).
4.3.1.1 - Components of Figure 9.5 (incomplete aggregate expenditure model).
The y-axis shows the level of household spending and the x-axis shows the level of disposable income (aka. real GDP).
The 45 degree line shows where planned expenditure equals total income which represents an economy’s equilibrium state where the level of income, output, and spending is equal and balanced.
The breakeven point occurs at the intersection of consumer spending and the levels of disposable income (in this case, 150 billion).
- Levels of income above the breakeven point see consumption being less than income and savings is positive (>0 on the y-axis).
- Levels of income below the breakeven point see consumption exceeds income and savings is negative (dissaving, <0 on the y-axis).
4.3.1.2 - The consumption function line.
In Figure 9.5, AE = C.
The consumption function (C) can be expressed as a linear line:
- C = a + bY
Autonomous spending (a) refers to the level of spending on essentials that must occur regardless of the levels of income. The level of a occurs at the vertical intercept. - Autonomous spending occurs even when households have no income (0), where households would draw on previous savings, receive transfer payments, or borrow. - a = dissaving.
Marginal propensity to consume (MPC) (b) is the proportion of the change in income that is spent on consumption. Another view is the proportion of income spent minus autonomous spending. - MPC = Change in C / Change in Y = Rise of C / Run of C Can be found using equilibrium point and autonomous spending.
Marginal propensity to save (MPS) is the proportion of the change in income that is saved. MPS = Change in S / Change in Y = Rise of S / Run of S Can be found using the breakeven point and the inital dissaving point or 1 - MPC.
MPC + MPS = 1 is a must given that Figure 9.5 assumes all income can only be either spent or saved.
MPC and MPS are dependent on the attitude of consumers with an increase in MPC will see the consumption function line steepening as per a given level of income, more is spent.
Average propensity to consume (APC) and average propensity to save (APS) is the overall proportion of income spent or saved.
As income rises:
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MPC and MPS do not change because they are constant, reflecting the proportion of the change in income that is spent or saved.
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APC and APS changes, reflecting the proportion of the whole income that is spent or saved.
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MPC remains constant (e.g., 0.6 of 100) means that as income increases by a constant, APC decreases because the spending is getting smaller relative to the increasing income.
4.3.2 - The financial sector of the aggregate expenditure model.
The financial sector acts as an intermediary to channel the savings of households to firms who draw on these funds to finance investment.
Figure 9.6 assumes:
- Investment spending (Ip) is a fixed amount ($60B) independent of income.
Figure 9.6 relaxes the assumption that income can only either be spent or saved.
In Figure 9.6, AE = C + I.
The level of investment is shown by the horizontal line (I) at a fixed amount of $60B.
Total planned spending (C+I) = The amount of investment (I) + the amount of consumption at each level of income (C).
Equilibrium occurs where total planned spending equals the level of income / output or where planned saving equals planned investment by firms. Occurs at the intersection of C+I and the 45 degree line or at S and I. - At equilibrium, economic forces are balanced and there is no tendency for change. - Inventories (unplanned investment) drives the economy towards equilibrium. The level of savings is greater than the level of planned investment -> Inventories rises -> Firms reduce production -> Reduce employment and income -> Reduce consumption. - The level of savings is less than investment -> Inventories falls -> Firms increase production -> Increase employment and income -> Increase consumption.
4.3.3 - The full aggregate expenditure model.
Figure 9.7 relaxes the assumption that there are no government or overseas sector.
The y-axis is now aggregate expenditure and the x-axis is now real GDP.
AE = C + Ip + G + (X - M)
The aggregate expenditure model assumes that:
- I, G, and X are autonomous, independent of real income or real GDP, and constant.
- M is a function of income.
- C is a function of income.
The marginal propensity to import (MPM) is the proportion of income that is spent on import.
4.3.3.1 - The concept of equilibrium in aggregate expenditure.
Macroeconomic equilibrium occurs when total planned spending equals production / income. When the AE function intersects the 45 degree line.
If real GDP is below the equilibrium:
- Total spending exceeds output -> Decrease inventories -> Firms respond by hiring additional resources (Increase income) -> Increases output until equilibrium is reached.
If real GDP is above the equilibrium:
- Total spending is below output -> Increases inventories -> Firms reduces production (Decrease income) -> Decreases output until equilibrium is reached.
At equilibirum, there are no unplanned changes to inventories which means there are no tendency for output or income to change.