INCOME EXPENDITURE
MODEL: GOODS
MARKET EQUILIBRIUMDongpeng Liu
Department of Economics
Nanjing University
ROADMAP
MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2
INCOME
EXPENDITURE
LIQUIDITY
PREFERENCE
IS
CURVE
LM
CURVE
AGGREGATE
DEMAND
SHORT-RUN
LABOR
MARKET
AGGREGATE
SUPPLY
AS-AD
MODEL
IS-LM
MODEL
PHILLIPS
CURVE
INTERMEDIATE-RUN
SOLOW
MODEL
LONG-RUN w/
CAPITAL
ACCUMULATION
LONG-RUN
AS-AD
MODEL
LONG-RUN w/o
CAPITAL
ACCUMULATION
TOTAL EXPENDITURE
Total expenditure: 𝑍 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 Expenditures are made by consumers, firms, governments and foreigners
For the majority of the course, we focus on closed economy
macroeconomics
𝑁𝑋 = 0
𝑍 = 𝐶 + 𝐼 + 𝐺
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CONSUMPTION
Disposable income is the income after all taxes and transfer
payments
𝑌𝐷 = 𝑌 − 𝑇
Y is total income, T is the difference between taxes and transfer payment.
For simplicity, throughout this course, T will be called “taxes”
The tax discussed here is a lump-sum tax: a tax that is a fixed amount, no
matter the change in circumstance of the taxed entity
Note: Y, Z, C, I, G, NX, and T are real values, rather than nominal values
Consumption function: 𝐶 = 𝑐0 + 𝑐1𝑌𝐷 𝑐0: Autonomous consumption expenditure
𝑐1: Marginal propensity to consume
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CONSUMPTION
𝑐0: Amount of consumptions when disposable income is 0 When 𝑌𝐷 = 0, 𝐶 = 𝑐0
Normally, 𝑐0 > 0 (Why?)
Marginal propensity to consume: The additional consumption
expenditure when disposable income increases by 1 unit
0 < 𝒄1 < 1
Consumption increases as disposable income increases
Only a part of the increase of disposable income is consumed
Whose marginal propensity to consume is higher, the rich or the poor?
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CONSUMPTION
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INVESTMENT
For simplicity, in this lecture, we assume that investment is
exogenously given
𝐼 = 𝐼
Variables whose values are determined or explained by the model are
endogenous variables
Variables whose values are not determined nor explained by the model are
exogenous variables
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FISCAL POLICY
Fiscal policies are governments’ choices of government purchase
(G) and Taxes (T)
Throughout this course, G and T are treated as exogenous
variables
One major task of macroeconomists is to propose fiscal policies. Hence, we
want economic models to tell us what would be the consequences of a policy
of interest. That is why G and T shall be treated as exogenous variables,
rather than explained with the model.
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GOODS MARKET EQUILIBRIUM
Goods market equilibrium means total output (Y) equals to total
expenditures (Z)
𝑌 = 𝑍
𝑌 = 𝑐0 + 𝑐1 𝑌 − 𝑇 + 𝐼 + 𝐺 = 𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺 + 𝑐1𝑌
𝑌 =1
1−𝑐1(𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺)
𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺 is the part of total expenditure not depending on
total output, which is called autonomous spending
Autonomous spending can only be negative when there is huge (government)
budget surplus. For the purpose of this course, we ignore this possibility.
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GOODS MARKET EQUILIBRIUM
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The intersect of the total
expenditure line and the 45
degree line shows the
equilibrium level of total
output (or total
income/expenditures)
WHAT IF GOVERNMENT PURCHASE INCREASES BY $1
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G
increase
s by $1
Output and
income
increases
by $1
Consumption
and total
expenditure
increases by
𝑐1
Output
and
income
increase
s by 𝑐1
Consumption
and total
expenditure
increases
by 𝑐12
Output
and
income
increases
by 𝑐12
THE MULTIPLIER EFFECT
This is an infinite decreasing geometric series
The change of GDP caused by an $1 increase in G is
∆𝑌 = 1 + 𝑐1 + 𝑐12 + 𝑐1
3 +⋯ =1
1 − 𝑐1> 1
1/(1 − 𝑐1) is the multiplier. for each $1 increase of 𝑐0 − 𝑐1𝑇 + 𝐼 + 𝐺(autonomous spending), GDP will increase by 1/(1 − 𝑐1)
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AN EXAMPLE OF CALCULATING GDP
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EFFECTIVENESS OF EXPANSIONARY FISCAL POLICIES
In the short-run, expansionary fiscal policies can raise total
output
In response to a recession, the government can hire some workers to dig a
big hole, and then fill the it with dirt
However, expansionary fiscal policy is not a panacea
Income expenditure model relies on very restrictive assumptions
Expansionary fiscal policies will raise interest rate and crowd out a part
of investment (IS-LM model)
Expansionary fiscal policies will cause inflation and change the expected
price level of firms, making the expansion unsustainable (AS-AD model)
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SAVINGS AND INVESTMENT
Private savings (S) are the savings of
𝑆 = 𝑌𝐷 − 𝐶 = 𝑌 − 𝑇 − 𝐶
Public savings: 𝑇 − 𝐺
IS relation
𝑆 = 𝐶 + 𝐼 + 𝐺 − 𝑇 − 𝐶 = 𝐼 − 𝑇 − 𝐺𝐼 = 𝑆 + 𝑇 − 𝐺
Investment = Private savings + Public savings
Savings are the source of investment. IS relation and the
income expenditure model are the two sides of the same coin.
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SUMMARY
Income expenditure model
Consumption function
Goods market equilibrium
Fiscal policies
The multiplier effect
IS relation
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