ECO 120
Macroeconomics
Week 2
Aggregate Expenditures
Model
Lecturer
Dr. Rod Duncan
News
• Tutorials begin this week. The tutorial lists
are on the class webpage and on the wall
outside Rod’s office C2-232.
• There is a second tutorial (T9) on Tuesday
5-6pm for Jim Browning in C2-206.
Topics
• Measurement of GDP (what does it
represent and how do we measure it?)
• Two sector AE model
• Consumption functions
• Savings functions
Why measure GDP?
• What are the goals of economics?
– Answer: Achieve the greatest happiness (welfare or
utility) for individuals in society.
– Problem: We can’t measure happiness.
• Second best: We measure the resources and
opportunities available to members of society.
– We assume that happiness is related to the range of
choices individuals have within society. The more
choices people have, the more likely they are to find a
choice they are happy with.
Measures of economic output
• Gross domestic product- The total market
value of all final goods and services produced in
a period (usually the year) within a country.
• Gross national product- The total market value
of all final goods and services produced in a
period (usually the year) by Australians.
– So an Australian lawyer working overseas for 6
months would include his overseas earnings as
Aussie GNP but not Aussie GDP.
• Important: GDP/GNP figures use “market
prices” to value things and do not count
intermediate goods.
Why measure GDP?
• We can’t measure the range of choices, so we
measure the value of what we produce and
assume that a greater value of production meant
that we had more opportunities.
• Paradox of happiness: Richer people report
themselves as happier than poorer people. But
average happiness in rich societies is not
greater than average happiness in poor
societies.
– So how can we say we are measuring happiness
when more GDP does not make people happier?
Does GDP = happiness?
• Citizens of richer countries generally:
– Lead longer, healthier lives;
– Are better educated and spend more years in
education;
– Have more leisure time and opportunities;
– Have greater levels of political participation;
– Lead less risky lives from natural or man-made
disasters;
– Breathe cleaner air and drink cleaner water;
–…
• So perhaps asking people about their
“happiness” is not the right question.
Does GDP = happiness?
• Principle of revealed preference
– Definition: If I see someone choosing option A over
Option B, I assume that person is at least as happy
with option A as option B.
• Fact: I observe millions of people risking their
lives, their health and their wealth to leave low
GDP countries to move to high GDP countries. I
observe very, very few people moving in the
opposite direction to better their lives.
• So does revealed preference tell us life is better
in high GDP than in low GDP countries?
Problems with using GDP
measures
• We assume that higher GDP is better.
• But is GDP the right way to measure economic
output?
• GDP only counts things which are valued in
markets- so have market prices.
– If we dirty our water, pollution is generally unpriced,
so this would not come into GDP calculations.
– A parent taking care of his or her own children is not
paid in the market, so is not counted as part of GDP.
– Black market/illegal activities are not measured or
counted as part of GDP.
Measurement of GDP
• Example: In the 1980s, Italy engaged in major
reforms of its regulatory practices- slashing a lot
of red tape. Italian GDP growth rates were
among the highest in Europe. So can we say
that Italian reforms greatly increased the welfare
of Italians?
– Problem: Much of the expansion in GDP was simply
new reporting from firms that had been operating in
the black market due to the difficulty of regulations
becoming “legit” after the reforms. This was not new
output.
Measuring GDP
• Alternates methods of calculating GDP
– Income approach: add up the incomes of all
members of the economy (value of all goods
and services sold)
– Value-added approach: add up the value
added to goods at each stage of production
– Expenditure approach: add up the total
spent by all members of the economy (value
of all goods and services bought)
Expenditure approach
• GDP is calculated as the sum of:
– Consumption expenditure by households (C)
– Investment expenditures by businesses (I)
– Government purchases of goods and services
(G)
– Net spending on exports (Exports – Imports)
(NX)
Aggregate Expenditure: AE = C + I + G + NX
The big picture
P, Wealth, H/h Expectations,
H/h Taxes
C
P, i, Business Expectations,
Business Taxes
I
AE
Government policy, and?
P, and?
G
NX
AD
Goods market
• Just as in microeconomics, we will model a
market for “goods” (this is really shorthand for all
goods and services sold in the economy).
• Demand: Goods demand is the purchase of all
goods- AE = C + I + G + NX
• Supply: Goods supply is the value of all goods
produced- Y
• Equilibrium: We have equilibrium in the goods
market when demand is equal to supply:
Y = AE = C + I + G + NX
Two sector model
• The simplest model of the goods market is the
two sector model, where goods demand is C
and I- private consumption and investment
demand.
• In this simplest model, we do not have a
government sector (so no G and no taxes), and
we do not have trade with the outside world (so
no NX).
• We have equilibrium Y* when goods supply, Y, is
equal to goods demand, C + I, so what
determines C and I?
Two sector model
• C is assumed to be a function of Y- economists
usually write this as C = C(Y).
– C(Y) tells us the value of C for every value of Y.
– C increases as Y increases.
– The equilibrium value of C* will depend on the
equilibrium value of Y, Y*. C is an “endogenous”
variable- determined within the model.
– One simple form would be that C is a linear function
of Y, so
C(Y) = a + b Y
– Since C is increasing in Y, b > 0.
Properties of a consumption
function
• What assumptions are we going to make about
aggregate consumption of goods and services in
an economy?
– An aggregate consumption function is simply adding
up all consumption functions of all individuals in
society.
– If personal income is 0, people consume a positive
amount, through using up savings, borrowing from
others, etc, so C(0) should be greater than 0.
– As personal income rises, people spend more, so the
slope of C(Y) should be positive.
A consumption function
Can we graph this?
C(Y)
A consumption
function could
look like this.
C(Y*)
C(0)
Y*
Y
A linear consumption function
• C(Y) = a + b Y, a > 0 and b > 0
C(Y)
C(0) = a, so
even if
Y=0, C > 0.
a
Slope is b > 0,
so C is
increasing in Y.
Y
Graphing a function in Excel
• This subject use a lot of “quantitative data”
(which means lists of numbers measuring
things).
• Students will need to develop their quantitative
skills– Graphing data
– Using data to support an argument
– Modelling in Excel
• We will be using Excel during this subject. You
must become familiar with Excel.
Investment
• In the two sector model, we assume that I
is a fixed value, such as $40 billion.
– Investment does not depend on Y.
– The equilibrium value of I is determined
outside the model, so I is called an
“exogenous” variable.
– Later in the subject, we will allow I to vary and
discuss the factors that influence I.
Savings
• Y is the total value of production, but Y is also
the total value of income in the economy. All
sales have to end up as someone’s income.
– Sales from a company end up paying worker wages
or as income to the owners of the company.
• If Y is income and C of income is spent, then Y –
C is saved, so we must also have a savings
function, S(Y), which relates the aggregate level
of savings to aggregate income.
• What are the properties of this S(Y)?
Savings function
• Just as with consumption, aggregate savings in
an economy should be the sum of every
individual’s savings function.
• At very low levels of income, people will borrow
(negative savings) rather than starve, so S(0) <
0.
• As income rises, people consume some and
save some of their incomes, so S(Y) should be
increasing in Y.
• Can we use this knowledge to graph an
aggregate savings function?
Graphing the savings function
• The 45° line from the origin graphs the
function Y = Y. S(Y) = Y – C(Y).
Y
C(Y)
Y*
S(Y*) = Y* - C(Y*)
C(Y*)
At Y=0, S(0)
is less than
0.
Y*
C(Y*)
Y*
Y
A linear savings function
• If C(Y) is linear, then S(Y) = Y - a - bY, or S(Y) =
-a + (1-b) Y, which is also a linear function.
• We assume that if income rises, people
consume a part of the increase and save a part
of the increase. This means that:
0 < b < 1 and 0 < (1-b) < 1.
• The savings function will then have a negative
vertical intercept (at –a) and a positive slope (1b).
• So what does a linear savings function look like?
Linear savings function
Y*
S(Y*)
C(Y)
Y*
C(Y*)
S(Y)
Y’
Negative S
Y*
Positive S
Y
Y
Y’
Negative S
Positive S
Average propensity
• Average Propensity to Consume (APC)
is consumption as a fraction of Y:
APC = C / Y
• Average Propensity to Save (APS) is
savings as a fraction of Y:
APS = S / Y
• Since all income is either consumed or
saved, we have:
APC + APS = 1
Marginal propensity
• Marginal Propensity to Consume (MPC)
is the change in consumption as Y
changes:
MPC = (Change in C) / (Change in Y)
• Marginal Propensity to Save (APS) is
the change in savings as Y changes:
MPS = (Change in S) / (Change in Y)
Marginal propensity
• For our linear consumption and savings
functions, MPC = b and MPS = (1-b). If Y
changes, then consumption and savings
must change to use up all the change in Y,
so
MPC + MPS = 1.
What else determines C?
• Household consumption will also depend
on:
– Household wealth
– Average price level of goods and services
– Expectations about the future
• Changes in these factors will produce a
shift of the whole C and S functions.
Practice exam question: Alice and
Sam
• Question: Alice and Sam are a typical
two-income couple who live for ballroom
dancing. Their combined salaries come to
$1,400 per week after tax. They spend:
•
•
•
•
$300 per week on rent,
$300 per week on car payments,
$200 per week on ballroom dancing functions and
$200 per week on everything else.
• (a) Calculate their APC, APS, MPC and
MPS.
Alice and Sam
• Sam injures his back and is forced to take a
lighter work-load, so their combined incomes
drop to $1,000 per week. Due to the back injury,
Alice and Sam are forced to stop their ballroom
dancing, however their spending in the
‘everything else’ category rises to $300.
• (b) Calculate their APC, APS, MPC and MPS.
Create graphs to show this information.