- An economic model is a simplified description of reality
- designed to yield hypotheses about economic behaviour that can be tested
- two broad classes of economic models—theoretical and empirical
- seek to derive verifiable implications about economic behaviour under the assumption that agents maximise specific objectives subject to constraints that are well defined in the model
- aim to verify the qualitative predictions of theoretical models and convert these predictions to precise, numerical outcomes.
Aggregate Expenditure (AE) Model
- It is based on the model developed by John Maynard Keynes, back in the 1930s
- The basic explanation is quite simple: the level of production in the economy depends on the level of aggregate
- In the Keynesian model, it is normally referred to as aggregate expenditure
- there is a specific rate of output associated with full employment
- wages and prices are completely inflexible until full employment is reached
- Once full employment is achieved, additional demand will lead only to higher prices
- The components of planned aggregate expenditures are consumption (C), investment (I), government purchases (G), and net exports (NX).
- Lets look at each of the components of the circular flow
- Keynes believed that people’s current income primarily
determines their consumption spending
- disposable income—one’s income after taxes—is by far the most
important determinant of current consumption.
- If disposable income increases, consumers will increase their planned expenditures
- there is a positive relationship between consumption and
- When income is low, households dissave—they either borrow money or draw from their past savings to purchase consumption goods.
- As income increases, consumption will also increase, but not as rapidly as income
- the marginal propensity to consume is less than one
C = co +bYd
- The consumption function is C = 60 + 8Yd, the tax function is T = 10 + 0.3Y
- What is autonomous consumption? What is the size of the autonomous consumption?
- What is disposable income?
- What is marginal propensity to consume? What is the size?
- If the average income of households is $1,000, what is the amount of
- At the $1,000 income level, what is the amount of planned consumption?
- At the $1,000 income level, what is the amount of tax collected?
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- Investment encompasses expenditures on:
- fixed assets, such as buildings and machines
- changes in the inventories of raw materials and final products not yet sold
- Keynes argued that, in the short run, investment is best viewed as an autonomous expenditure
- business investment decisions, at least in the short run, don’t hinge on people’s current
income and spending
- investment is primarily a function of current sales relative to plant capacity, expected future sales, and the interest rate
- Government expenditures are a policy variable determined by the political process
- In the basic Keynesian model Government expenditures are assumed to be independent of income (autonomous)
- These expenditures need not change with the level of income
- Exports (X)
- Exports are sold to people abroad, and thus depend largely on their incomes, not on incomes
- These decisions are unaffected by changes in a nation’s domestic output level and spending
- Imports (M)
- In contrast, increases in domestic income will induce consumers to purchase more foreign as well as domestic goods. So the level of imports increases as income rises
M = M0 + mY
- When aggregate income rises, net exports fall; when aggregate income falls, net exports
- Exports of the country are X = 20; the import function is M = 15 + 06Y
- What is autonomous import? What is the size of the autonomous import?
- What is marginal propensity to import? What is the size?
- If the average income of households is $1,000, what is the amount of planned import?
- At the $1,000 income level, what is the amount of planned net export?
- If income level increases to $1,100, what is the change in exports? What is the amount of planned net exports at this income level?
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