The Income-Expenditure Model Chapter 9 Econ 104 Parks The Income-Expenditure Model Econweb.com

The Income-Expenditure Model The Income-Expenditure model, also known as the Keynesian Cross model, was first developed by the Depression-era economist named John Keynes. The goal was to develop a model that could explain how an economy could become permanently “stuck” at a high-unemployment level. Econweb.com

Model Assumptions The SIMPLEST model assumptions are: The price level is fixed. Suppliers will supply any level of output that is demanded at the fixed price level. There are no government expenditures or net exports. The interest rate in the economy is determined outside the model. There are no taxes. Econweb.com

Aggregate Expenditures Aggregate PLANNED Expenditures (APE) is the aggregate amount that consumers, investors, government, and foreigners wish to spend on the purchase of final goods and services produced in the domestic borders, given the price level. APE = Cp + Ip + Gp + NXp where p means planned Assuming G = NX = 0 for simplicity, APE = Cp + Ip Econweb.com

Determining Consumption Consumption is the largest component of Aggregate Expenditures, accounting for two-thirds of GDP. It is influenced by Disposable income Wealth Interest rates Expectations of future income Econweb.com

The Consumption Function A consumption function shows the relationship between total consumer expenditures and total disposable income, holding all other determinants of consumption constant. The equation for the consumption function is: Cp = CA + MPC (DI) where Cp is total planned consumption; CA is autonomous consumption, MPC is the marginal propensity to consume, and DI is disposable income. Econweb.com

Components of the Consumption Function Autonomous consumption (CA) is the portion of disposable income that is independent of income. The Marginal Propensity to Consume (MPC) tells us how much of an additional dollar of disposable income will be spent. If the MPC = 0.80, then $0.80 of the next dollar earned will be spent. The MPC for an economy always lies between zero and one, 0 < MPC < 1. Econweb.com

The Consumption Function The consumption function is upward sloping, reflecting the positive relation between consumption and disposable income. The vertical intercept is equal to CA, and the slope of the line is the MPC. Econweb.com

Determining Investment Investment is the most volatile component of GDP, and accounting for approximately 17% of GDP. Investment is determined by interest rates (higher rates lead to lower investment) expectations of future revenue and costs business confidence taxes capacity utilization Econweb.com

GDI is more volatile © OnlineTexts.com p. 10 Econweb.com

The Level of Investment For simplicity, the income-expenditure model assumes that the level of investment is given. The investment line, then, is simply a horizontal line at the level of investment. Econweb.com

Aggregate Expenditures in the Income-Expenditure Diagram Given that: APE = Cp + Ip Cp = CA + MPC (DI) DI = Yactual (assuming no taxes), and I = Ip, PLANNED then at equilibrium APE = CpA + MPC (Ya) + IP Econweb.com

The Aggregate Expenditures Function The Aggregate PLANNED Expenditure Function plots the level of APE against the level of output (Y). Econweb.com

The 45 degree line On any chart, if the horizontal and vertical axes have the same scale, then any (x,y) point on the 45 degree line will have the same value on both axes. Notice that every point on the 45 degree line has the same x and y value. Econweb.com

Equilibrium in the Income-Expenditure Model Equilibrium occurs at the point in which Yactual = APE or the level of income equals the level of Aggregate Planned Expenditures. Equilibrium can be shown with a chart or with algebra. Econweb.com

Equilibrium using a Graph Equilibrium occurs at the point in which the APE function crosses the 45 degree line. Econweb.com

Algebraic Equilibrium Equilibrium can also be shown by the point where Yeq = APE or Yeq = CpA + MPC*(Yeq) + Ip so Yeq = (CpA + Ip) / (1 – MPC) Econweb.com

Equilibrium Income = AUTONOMOUS EXPENDITURES times the MULTIPLIER © OnlineTexts.com p. 18 Econweb.com

Changes in Equilibrium Income As a general rule, any increase in autonomous consumption or investment shifts the AE schedule upwards and leads to a rise in equilibrium income. This chart depicts an increase in autonomous investment. Econweb.com

An increase in CA, IAP, G, or (X-M) increases equilibrium income by a multiple. A decrease in CA, IAP, G, or (X-M) decreases equilibrium income by a multiple The multiplier also depends on the length of time (1 year, 5 year, etc) © OnlineTexts.com p. 20 Econweb.com