s 26 Aggregate Income Equilibrium

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3/2/2011 Econ 11 -- Lecture #26 1

MAJOR ANNOUNCEMENT

The unexpected class holiday on Feb. 25 created amajor problem to our planned Test No. 3. Thereforethe exam is rescheduled as stated below.

SCHEDULE OF EXAMS:

o TEST #1 and TEST #2 -- DONE!

oTEST #3 March 9, 2011(Wednesday)

o Time will be held from 7:30 am to 9:00 am in rooms to beannounced.

o FINAL EXAM To be announced [FINALEXAM WEEK]

3/2/2011 Econ 11 -- Lecture #26 2

Lecture 26:

AGGREGATE INCOME AND

OUTPUT EQUILIBRIUM

Second view: AGGREGATE

EXPENDITURE (C+I+G+[X-M]) AND

AGGREGATE OUTPUT (C+S+T)

INCOME AND OUTPUTMULTIPLIER LEAKAGES AND

THEIR EFFECTS

3/2/2011 Econ 11 -- Lecture #26 3

INTERACTION OF

AGGREGATE DEMAND

AND

AGGREGATE SUPPLY


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3/2/2011 Econ 11 -- Lecture #26 4

RELATIONS OF MAJOR

NATIONAL INCOME CONCEPTS

We know from accounting identities,

GNE=GDP.

We know from thefirst view that

total expenditure (aggregate

demand) is equal to total output

(aggregate supply).

3/2/2011 Econ 11 -- Lecture #26 5

We use some of the national income

definitions in the analysis.

GNE, or Aggregate demand, is broken

down as:

GNE = C + I + G + (X-M)

Where:

C = Consumption expenditure

I = Investment expenditure

G = Government expenditure

(X-M) = Net Value of Exports over Imports

3/2/2011 Econ 11 -- Lecture #26 6

Use some of the national income

definitions in the analysis.

GDP, or Aggregate Supply, is

broken down as:

GDP = C + S + T

Where:

C = Consumption expenditure

S = Saving

T = Tax revenue


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3/2/2011 Econ 11 -- Lecture #26 7

At Income/ Output Equilibrium

Aggregate Demand = Aggregate

Supply

Or:

E = Y

Or:

C + I + G + (X-M) = C + S +T.

3/2/2011 Econ 11 -- Lecture #26 8

At Income/ Output Equilibrium

Deduct T from both sides.

Or:

C + I + (G-T) + (X-M) = C + S.

This result can be simplified still:I + (G-T) + (X-M) = S.

oIf G-T and X-M were both zero, then

I = S.

9

Summary of our results:Aggregate demand and aggregate supply are in

equilibrium when

C+I+(G-T)+(X-M)=C+S.

The term, (G-T), is government expenditure minustaxes. It is the fiscal balance or the governmentsbudget.

The term, (X-M), is the net demand of foreigners forthe countrys goods. It is often called thetrade balance.

Note: If (G-T) and (X-M) are both zero, theequilibrium condition is simply:

C+I=C+S.

Or simply, I=S.


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3/2/2011 Econ 11 -- Lecture #26 10

Example: Table 16-1. Note: Y=C+S & E=C+I

AGGREGATE

DEMAND

AGGREGATE

SUPPLYAD

= E

I C AS

= Y

C S

80 700 700 0

80 750 750 50

80 820 820 80

80 880 880 120

3/2/2011 Econ 11 -- Lecture #26 11


AGGREGATE

DEMAND

AGGREGATE

SUPPLY

AD

= E

I C AS

= Y

C S

780 80 700 700 700 0

830 80 750 800 750 50

900 80 820 900 820 80

960 80 880 1,000 880 120

3/2/2011 Econ 11 -- Lecture #26 12


AGGREGATE

DEMAND

AGGREGATE

SUPPLY

AD

= E

I C >or

700 700 0 ?

830 80 750 > 800 750 50 ?

900 80 820 = 900 820 80 ?

960 80 880 < 1,000 880 120 ?


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3/2/2011 Econ 11 -- Lecture #26 13


AGGREGATE

DEMAND

AGGREGATE

SUPPLYAD

= E

I C >or

700 700 0 ?

830 80 750 > 800 750 50 ?

900 80 820 = 900 820 80 ?

960 80 880 < 1,000 880 120 ?

3/2/2011 Econ 11 -- Lecture #26 14

What happens when E>Y?

(Note: The same as: C+I>C+S).

With excess aggregate demand, sellersmake new orders from producers tomeet demand.

Sellers look at their inventory of goods.

They sell faster than their normalreplenishment of new supply. So, theymakeadditional orders for goods.

Output rises.

3/2/2011 Econ 11 -- Lecture #26 15

What happens when E


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3/2/2011 Econ 11 -- Lecture #26 16


AGGREGATE

DEMAND

AGGREGATE

SUPPLY

AD=

E

I C > or

700 700 0 increase

830 80 750 > 800 750 50 increase

900 80 820 = 900 820 80 equilibrium

960 80 880 < 1,000 880 120 decrease

3/2/2011 Econ 11 -- Lecture #26 17

Illustration of

Equilibrium

Output (Y0) with

E0=Y0 at 900

Saving

Output=Y

(billion pesos)

450 line

E=Y line

0900

E0 =900

1,000800

Y0Y

E

3/2/2011 Econ 11 -- Lecture #26 18

NOW THAT WE KNOW HOW

NATIONAL OUTPUT EQUILIBRIUM ISDETERMINED, WE ASK A NEW

QUESTION.

WHAT HAPPENS TO AGGREGATE

OUTPUT IF THE LEVEL OF

AGGREGATE EXPENDITURE

RISES?(FOR THE MOMENT, IGNORE WHETHER THE INCREASE IN

EXPENDITURE COMES FROM CONSUMPTION OR

INVESTMENT)


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3/2/2011 Econ 11 -- Lecture #26 19

Exactly by how much will

output increase if we knew themarginal propensity to

consume (mpc) to be and the

exact increase in expenditure

( = 10 billion pesos)?E

20

Quick answer to be fully

explained later:

For instance, change in expenditure, E, is

equal to 10 and mpc=0.75.

Multiply E by the multiplier.

1 1 1

Multiplier = 4.1- mpc 1 0.75 0.25

Therefore,

E=10 Multiplier = 10 4= 40.

= = =

3/2/2011 Econ 11 -- Lecture #26 21

Let us assume the Expenditure item is Consumption.

CThe marginal propensity to consume = c = .

Y

For every change in output equal to Y, the amount of new consumption

is:

C = c Y.

But every new cons

umption expenditure represents income to some other

economic agent, so it becomes a basis for new expenditure. Assuming that

the mpc is the same for all agents, we can say that at each evel of

consumption spending, the amount going to consumption is

C = c Y.

What is not consumed is a "leakage" from the output-spending chain.

The next table is an example where mpc or c = 0.75.


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3/2/2011 Econ 11 -- Lecture #26 22

First level

of spending

Second levelof spending

Third level

of spending

Fourth level

of spending

Leakage

Leakage

Leakage

23

Spending level Amount of

new spending

after leakage

Base spending

at level

Initial spending 10.00

1st level 7.50 10.00

2nd level 5.25 7.50

3rd level 4.21 5.25

4th level 3.16 4.21

5th level 2.37 3.16

6th level 1.78 2.37

7th level 1.33 1.78

8th level 1.00 1.33

9th level 0.75 1.00

10th level 0.56 0.75

mpc=c = 0.75

C=c Y

C=0.75 Y

Sum of spending up to 10th level = 38.3 billion

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There is a simple way to calculate the total amount of

new spending ad infinitum. This is the formula from

elementary algebra for a chain of spending.

Given the value of the mpe or c, the total

sum of2 3

spending = 10 (1+c c c ... c )

1Change in output Change in spending .

1 - c

1We can call the factor as the MULTIPLIER.

1 - c

+ + + +

=


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3/2/2011 Econ 11 -- Lecture #26 25

The INCOME (OR

EXPENDITURE) MULTIPLIER :

For instance, change in expenditure, E, is

equal to 10 and mpc=0.75.

Multiply E by the multiplier.

1 1 1Multiplier = 4.

1- mpc 1 0.75 0.25

Therefore,

E=10 Multiplier = 10 4= 40.

= = =

26

Illustration of

Equilibrium

Output (Y0) with

E0=Y0 at 900

Saving

Output=Y

(billion pesos)

450 line

E=Y line

0900

E0 =900

1,000800

Y0Y

E

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An increase in E

and effect on

equilibrium

output

Output=Y

(billion pesos)

450 line

E=Y line

0

E0

Y0

E

E'=E+ E

Y

E

E


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3/2/2011 Econ 11 -- Lecture #26 28

THE INCOME

MULTIPLIER WORKS IN BOTH

DIRECTIONS:

AN EXPANSION OF EXPENDITURE

INCREASES OUTPUT BY THEAMOUNT OF THE MULTIPLIER.

A FALL OF EXPENDITURE

DECREASES OUTPUT BY THEAMOUNT OF THE MULTIPLIER.

3/2/2011 Econ 11 -- Lecture #26 29

THE INCOME

MULTIPLIER MODIFIED

BREAKING DOWN THE

COMPONENTS OF AGGREGATE

EXPENDITURE

o CONSUMPTION

o INVESTMENT

o GOVERNMENT BALANCE

o NET FOREIGN BALANCE

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We label the

components of

expenditure:

E=C +I+..

Saving

Output=Y

(billion pesos)

450 line

E=Y line

0900

E0 =900

1,000800

Y0Y

E=C+I+

.

I (Investment)

C (Consumption)


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3/2/2011 Econ 11 -- Lecture #26 31

REVIEW: COMPONENTS OF

EXPENDITURE & OF OUTPUT

E = C + I + (G-T) + (X-M)

C Consumption spending

I Investment spending

G Government spending minus

Taxation (GOVERNMENT BUDGET )

X Foreign demand minus Import

Demand (NET FOREIGN DEMAND)

32

First level

of spending

Second level

of spending

Third level

of spending

Fourth level

of spending

Saving

Saving

Leakage=

Saving

THERE ARE

OTHER

FORMS OF

LEAKAGESTO THE

SPENDING

CHAIN!

33

First level

of spending

Second level

of spending

Third level

of spending

Fourth level

of spending

Leakage

Leakage

Leakage

Saving

Import

Tax

Saving

Import

Tax

Saving

Import

Tax


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3/2/2011 Econ 11 -- Lecture #26 34

THERE ARE THREE TYPES OF

LEAKAGES:

SAVING: What is not spent onconsumption goes to saving.

TAX: What the government collects as

tax is a leakage from aggregate

expenditure.

IMPORTS: What people buy from

abroad is a leakage on domestic

aggregate expenditure.

35

Saving

0Output

Saving

mps

Tax

0

Output

Tax

mpt

Imports

0 Output

Import

mpm

3/2/2011 Econ 11 -- Lecture #26 36

The modified multiplier formula

includes the

three leakages in the form of the

three marginal propensities:

to save,m;

to taxt;

and to importm.

mts

1Multiplier

++=


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Example: Given s=0.25, t=0.10, and m=0.15, what is

the effect of an increase in total expenditure of 10

billion pesos if initially, the GDP is 800 billion pesos.

First calculate the modified multiplier (we call it k).

k = 2

Because 1/[s+t+m] = 1/[0.25+0.10+0.15]=1/[0.5]=

2.

Y = E k = 10 2 = 20.

New output level = Old output + Change in output

= 800 + 20

= 820 billion pesos.

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Example: Given s=0.25, t=0.10, and m=0.15, what is

the effect of an increase in total expenditure of 10

billion pesos if initially, the GDP is 800 billion pesos.

First calculate the modified multiplier (we call it k).

k = 2

Because 1/[s+t+m] = 1/[0.25+0.10+0.15]=1/[0.5]=

2.

Y = E k = 10 2 = 20.

New output level = Old output + Change in output

= 800 + 20

= 820 billion pesos.

3/2/2011 Econ 11 -- Lecture #26 39

End of todays lecture.

Good day!

Lecture 26

s 26 Aggregate Income Equilibrium

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