Unit 14
Context:
● Fluctuations in aggregate demand affect GDP growth through a multiplier process,
because households face limits to their ability to save, borrow & share risks.
● Governments can impose tax changes & alter their spending to stabilize the economy.
● If 1 household saves, their wealth increases; if all households save, aggregate income
may eventually fall (without the help of the government)
● There are good & bad shocks
● Aggregate demand can fluctuate due to consumption & investment decisions.
Definitions:
➔ Aggregate demand: the total of the components of spending in the economy, added to
get GDP (so the total demand for goods & services produced in an economy)
★ Y=C+I+G+X-M
➔ Multiplier process: a mechanism through which the direct & indirect effect of a change in
autonomous spending affects aggregate demand.
➔ Consumption function: an equation that shows how consumption spending in the
economy as a whole depends on other variables
➔ Consumption (C): expenditure on consumer goods including both short-lived goods and
services and long-lived goods (durables)
➔ Investment (I): expenditure on newly produced capital goods (machinery and equipment)
and buildings, including new housing.
➔ Autonomous spending: consumption that is independent of current income
➔ Marginal propensity to consume (MPC): the change in consumption when disposable
income changes by one unit.
➔ Goods market equilibrium: the point at which output = the aggregate demand for goods
produced in the home economy. The economy will continue producing at this output level
unless something changes spending behaviour.
➔ Capacity utilization rate: a measure of the extent to which a firm, industry, or entire
economy is producing as much as the stock of its capital goods and current knowledge
would allow.
➔ Target wealth: the level of wealth that a household aims to hold, based on its economic
goals and expectations (we assume households try to maintain this level of wealth in the
face of changes in their economic situation, as long as its possible to do so.)
➔ Precautionary savings: an increase in savings to restore wealth to its target level.
➔ Financial accelerator: the mechanism through which firms and households ability to
borrow increases when the value of collateral they have pledged tp the lender goes up.
➔ Monetary policy: central bank (or government) actions aimed at influencing economic
activity through changing interest rates or the prices of financial assets
➔ Expropriation risk: the probability that an asset will be taken from its owner by the
government or some other action
, ➔ Exogenous: coming from outside the model rather than being produced by the workings
of the model itself
➔ Marginal propensity to import: the change in total imports qssociated w/ a change in total
income
➔ Exchange rate: the number of units of home currency that can be exchanges for one unit
of foreign currency.
Keynesian Theory
● Keynes (an economist) formed a theory about the great depression: he suggested it was
caused by an unusually low level of aggregate spending.
→ he based his argument on this
graph:
→ there was a dramatic decrease in the
severity of the business cycle
fluctuations after the end of the 2nd
world war
→ at the same time, there was an
increased role on government in the
economy
→ so, it seems as though fluctuations in
output growth decreased dramatically while the size of the government expanded → BUT this
DOES NOT mean gov spending stabilized the economy → statistical correlation is not
necessarily causation.
→ therefore Keynes suggested that the cure for a low aggregate demand = gov spending → this
will lead to extra spending & further increases in output and income.
14.1 The transmission of shocks: The multiplier process
● In a capitalist economy, private spending = driven by expectations about future post-tax
profits.
● Spending on investments usually occur in clusters:
➢ Firms adopt new tech @ same time
➢ Firms have similar beliefs about expected future demand.
● Changes in current income influence spending, affecting the income of others →
therefore indirect effects through the economy amplify the direct effect of a shock to the
aggregate demand
,The multiplier:
→ represents the relative magnitude of total change in output as a result of the initial change in
spending.
∆GDP
∆AD
1. Multiplier = 1 : total increase in GDP = initial increase in spending
2. 1 > Multiplier > 1 : total increase in GDP = greater/less than initial increase in spending.
Multiplier process explains why GDP may rise by more than the initial increase in investment
spending:
➢ Uses an aggregate consumption function to explain.
➢ Combines the behaviour of consumption-smoothing & non-smoothing households to
represent consumption spending by the economy as a whole.
➢ Consumption depends on current income, among other stuff.
➢ Consumption-smoothing households will not increase their consumption one-for-one (or
at all) due to a temp increase in income.
➢ Credit-constrained households will.
➢ If multiplier > 1 → additional consumption spending resulting from a temp increase in
income = greater than zero; less than 1 (eg 60 cents)
The multiplier model
- In a simple model, two types of expenditure:
1. Consumption
2. Investment
- Assumption:
Aggregate consumption spending is twofold:
1. Autonomous consumption → fixed amount: how much people will spend
independent of income.
, 2. A variable amount, depending on income.
Aggregate consumption =
autonomous consumption (C0) + consumption depending on income (c1 x Yd)
→ marginal propensity to consume (MPC) = C1 = the change in consumption with 1 additional
unit of disposable income. This is the slope of the consumption line. This is assumed to be
positive, but less than 1 → which means only a part of the extra income = consumed,
rest = saved.
➢ Steeper: larger consumption response to a change in income.
➢ Flatter line: households are smoothing their consumption so it doesn’t really vary
with income (probs richer)
→ Yd = income
So therefore (c1 x yd) = the variable amount; the consumption that is based on income.
Yd = C + S → part of income is consumed (MPC), rest is saved (MPS1).
→ C0 = autonomous consumption. Expectations about future income = reflected here.
→ for poorer households, MPC =
approx 0.8 → they spend about 80%
of the additional income they receive
→ higher MPC = poorer household
→ wealthier households, MPC =
closer to zero.
1
Marginal propensity to save: the change in savings when income increases by 1 unit.
Context:
● Fluctuations in aggregate demand affect GDP growth through a multiplier process,
because households face limits to their ability to save, borrow & share risks.
● Governments can impose tax changes & alter their spending to stabilize the economy.
● If 1 household saves, their wealth increases; if all households save, aggregate income
may eventually fall (without the help of the government)
● There are good & bad shocks
● Aggregate demand can fluctuate due to consumption & investment decisions.
Definitions:
➔ Aggregate demand: the total of the components of spending in the economy, added to
get GDP (so the total demand for goods & services produced in an economy)
★ Y=C+I+G+X-M
➔ Multiplier process: a mechanism through which the direct & indirect effect of a change in
autonomous spending affects aggregate demand.
➔ Consumption function: an equation that shows how consumption spending in the
economy as a whole depends on other variables
➔ Consumption (C): expenditure on consumer goods including both short-lived goods and
services and long-lived goods (durables)
➔ Investment (I): expenditure on newly produced capital goods (machinery and equipment)
and buildings, including new housing.
➔ Autonomous spending: consumption that is independent of current income
➔ Marginal propensity to consume (MPC): the change in consumption when disposable
income changes by one unit.
➔ Goods market equilibrium: the point at which output = the aggregate demand for goods
produced in the home economy. The economy will continue producing at this output level
unless something changes spending behaviour.
➔ Capacity utilization rate: a measure of the extent to which a firm, industry, or entire
economy is producing as much as the stock of its capital goods and current knowledge
would allow.
➔ Target wealth: the level of wealth that a household aims to hold, based on its economic
goals and expectations (we assume households try to maintain this level of wealth in the
face of changes in their economic situation, as long as its possible to do so.)
➔ Precautionary savings: an increase in savings to restore wealth to its target level.
➔ Financial accelerator: the mechanism through which firms and households ability to
borrow increases when the value of collateral they have pledged tp the lender goes up.
➔ Monetary policy: central bank (or government) actions aimed at influencing economic
activity through changing interest rates or the prices of financial assets
➔ Expropriation risk: the probability that an asset will be taken from its owner by the
government or some other action
, ➔ Exogenous: coming from outside the model rather than being produced by the workings
of the model itself
➔ Marginal propensity to import: the change in total imports qssociated w/ a change in total
income
➔ Exchange rate: the number of units of home currency that can be exchanges for one unit
of foreign currency.
Keynesian Theory
● Keynes (an economist) formed a theory about the great depression: he suggested it was
caused by an unusually low level of aggregate spending.
→ he based his argument on this
graph:
→ there was a dramatic decrease in the
severity of the business cycle
fluctuations after the end of the 2nd
world war
→ at the same time, there was an
increased role on government in the
economy
→ so, it seems as though fluctuations in
output growth decreased dramatically while the size of the government expanded → BUT this
DOES NOT mean gov spending stabilized the economy → statistical correlation is not
necessarily causation.
→ therefore Keynes suggested that the cure for a low aggregate demand = gov spending → this
will lead to extra spending & further increases in output and income.
14.1 The transmission of shocks: The multiplier process
● In a capitalist economy, private spending = driven by expectations about future post-tax
profits.
● Spending on investments usually occur in clusters:
➢ Firms adopt new tech @ same time
➢ Firms have similar beliefs about expected future demand.
● Changes in current income influence spending, affecting the income of others →
therefore indirect effects through the economy amplify the direct effect of a shock to the
aggregate demand
,The multiplier:
→ represents the relative magnitude of total change in output as a result of the initial change in
spending.
∆GDP
∆AD
1. Multiplier = 1 : total increase in GDP = initial increase in spending
2. 1 > Multiplier > 1 : total increase in GDP = greater/less than initial increase in spending.
Multiplier process explains why GDP may rise by more than the initial increase in investment
spending:
➢ Uses an aggregate consumption function to explain.
➢ Combines the behaviour of consumption-smoothing & non-smoothing households to
represent consumption spending by the economy as a whole.
➢ Consumption depends on current income, among other stuff.
➢ Consumption-smoothing households will not increase their consumption one-for-one (or
at all) due to a temp increase in income.
➢ Credit-constrained households will.
➢ If multiplier > 1 → additional consumption spending resulting from a temp increase in
income = greater than zero; less than 1 (eg 60 cents)
The multiplier model
- In a simple model, two types of expenditure:
1. Consumption
2. Investment
- Assumption:
Aggregate consumption spending is twofold:
1. Autonomous consumption → fixed amount: how much people will spend
independent of income.
, 2. A variable amount, depending on income.
Aggregate consumption =
autonomous consumption (C0) + consumption depending on income (c1 x Yd)
→ marginal propensity to consume (MPC) = C1 = the change in consumption with 1 additional
unit of disposable income. This is the slope of the consumption line. This is assumed to be
positive, but less than 1 → which means only a part of the extra income = consumed,
rest = saved.
➢ Steeper: larger consumption response to a change in income.
➢ Flatter line: households are smoothing their consumption so it doesn’t really vary
with income (probs richer)
→ Yd = income
So therefore (c1 x yd) = the variable amount; the consumption that is based on income.
Yd = C + S → part of income is consumed (MPC), rest is saved (MPS1).
→ C0 = autonomous consumption. Expectations about future income = reflected here.
→ for poorer households, MPC =
approx 0.8 → they spend about 80%
of the additional income they receive
→ higher MPC = poorer household
→ wealthier households, MPC =
closer to zero.
1
Marginal propensity to save: the change in savings when income increases by 1 unit.
