2. 1. DETERMINING THE LEVEL OF CONSUMPTION Learning Objectives 1.Explain and graph the consumption function and the saving function, explain what the slopes of these curves represent, and explain how the two are related to each other. 2.Compare the current income hypothesis with the permanent income hypothesis, and use each consumption. 3.Discuss two factors that can cause the consumption function to shift upward or downward.

3. 1.1 Consumption and Disposable Personal Income A consumption function is the relationship between consumption and disposable personal income.

4. Plotting a Consumption Function The marginal propensity to consume is the ratio of the change in consumption (ΔC) to the change in disposable personal income (ΔYd).relationship between consumption and disposable personal income. Point on curveABCDE Δy d (billions)$05001,0001,5002,000 ΔC(billions)$3007001,1001,5001,900 ΔY d =$500 ΔC=$400 EQUATION 1.1 MPC= ΔC/ Δy d =400/500=0.8 EQUATION 1.1 MPC= ΔC/ Δy d =400/500=0.8 EQUATION 1.2 C=$300 billion+0.8Y d EQUATION 1.2 C=$300 billion+0.8Y d

5. Consumption and Personal Saving Personal saving is the disposable personal income not spent on consumption during a particular period. EQUATION 1.3 Saving function is the relationship between personal saving in any period and disposable personal income in that period. Marginal propensity to save is the ratio of the change in personal saving (ΔS) to the change in disposable personal income (ΔYd). EQUATION 1.4 EQUATION 1.5

6. Consumption and Personal Saving Point on curveABCDE Δy d (billions)$05001,0001,5002,000 ΔC(billions)$3007001,1001,5001,900 ΔC(billions)-$300-200-1000100 ΔY d =$500 ΔC=$400 Saving function Consumption function 45 Ο ΔY d =$500 ΔS=$100

7. 1.2 Current Versus Permanent Income The current income hypothesis states that consumption in any one period depends on income during that period. Permanent income is the average annual income people expect to receive for the rest of their lives. The permanent income hypothesis states that consumption in any period depends on permanent income.

8. 1.3 Other Determinants of Consumption Changes in real wealth Changes in expectations C2C2 C1C1 C2C2 C1C1

9. 2. THE AGGREGATE EXPENDITURES MODEL Learning Objectives 1.Explain and illustrate the aggregate expenditures model and the concept of equilibrium real GDP. 2.Distinguish between autonomous and induced aggregate expenditures and explain why a change in autonomous expenditures leads to a multiplied change in equilibrium real GDP. 3.Discuss how adding taxes, government purchases, and net exports to a simplified aggregate expenditures model affects the multiplier and hence the impact on real GDP that arises from an initial change in autonomous expenditures.

10. 2. THE AGGREGATE EXPENDITURES MODEL The aggregate expenditures model is a model that relates aggregate expenditures to the level of real GDP. Aggregate expenditures are the sum of planned levels of consumption, investment, government purchases, and net exports at a given price level.

11. 2.1 The Aggregate Expenditures Model: A Simplified View Planned investment is the level of investment firms intend to make in a period. Unplanned investment is investment during a period that firms did not intend to make. EQUATION 2.1 Autonomous aggregate expenditures are expenditures that do not vary with the level of real GDP. Induced aggregate expenditures are expenditures that vary with real GDP.

12. Autonomous and Induced Aggregate Expenditures

13. Autonomous and Induced Consumption RECALL THE FOLLOWING FROM PREVIOUS SLIDES EQUATION 2.2 EQUATION 2.3

14. Plotting the Aggregate Expenditure Curve The aggregate expenditure function is the relationship of aggregate expenditure to the value of real GDP. EQUATION 2.4 EQUATION 2.5 EQUATION 2.6

15. Plotting the Aggregate Expenditure Curve Point on curveABCDEF ΔY (billions)$02,0004,0006,0008,00010,000 ΔAE(billions)$1,4003,0004,6006,2007,8009,400 ΔAE=$1,600 ΔY=$2,000 Slope= ΔAE /ΔY=0.8 Aggregate expenditure

16. Determining Equilibrium in the Aggregate Expenditures Model

17. Adjusting to Equilibrium Real GDP

18. A Change in Autonomous Aggregate Expenditures Changes Equilibrium Real GDP

19. The Multiplied Effect of an increase in Autonomous Aggregate Expenditures Round of spendingIncrease in real GDP (billions of dollars) 1$300 2240 3192 4154 5123 698 779 863 950 1040 1132 1226 Subsequent rounds+103 Total increase in real GDP$1,500

20. Computation of The Multiplier The multiplier is the number by which we multiply an initial change in aggregate demand to get the full amount of the shift in the aggregate demand curve. EQUATION 2.7

21. Computation of The Multiplier The marginal propensity to consume and the multiplier EQUATION 2.8 Subtract the MPC ΔY eq term from both sides of the equations. Factor out the ΔY eq term on the left: Finally, solve for the multiplier EQUATION 2.9 EQUATION 2.10 We can rearrange equation 2.9 to compute the impact of a change in autonomous aggregate expenditure. EQUATION 2.11

22. 2.2 The Aggregate Expenditures Model in a More Realistic Economy Taxes and the aggregate expenditure function The addition of government purchases and net exports

23. 3. AGGREGATE EXPENDITURES AND AGGREGATE DEMAND Learning Objectives 1.Explain and illustrate how a change in the price level affects the aggregate expenditures curve. 2.Explain and illustrate how to derive an aggregate demand curve from the aggregate expenditures curve for different price levels. 3.Explain and illustrate how an increase or decrease in autonomous aggregate expenditures affects the aggregate demand curve.

24. 3.1 Aggregate Expenditures Curves and Price Levels The wealth effect is the tendency for price level changes to change real wealth and consumption. The interest rate effect is the tendency for a higher price level to reduce the real quantity of money, raise interest rates, and reduce investment. The international trade effect is the impact of different price levels on the level of net exports.

25. From Aggregate Expenditures to Aggregate Demand A’ C B A B’ C’ AE p =1.0 AE p =1.5 AE p =0.5 Aggregate demand

26. 3.2 The Multiplier and Changes in Aggregate Demand A’ E B A B’ AE p =1.0 AE p =1.5 Aggregate demand AE p =1.0 AE p =1.5 D D’ E’ $1,000 $2,000 AD 1 AD 2 $1,000