Economic Models

 

• 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
• Theoretical
  • 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
• Empirical
  • 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
• Assumptions
  • 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

 

 

Consumption

 

• 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

Class Discussion

 

• The consumption function is C = 60 + 8Yd, the tax function is T = 10 + 0.3Y

1. What is autonomous consumption? What is the size of the autonomous consumption?
2. What is disposable income?
3. What is marginal propensity to consume? What is the size?
4. If the average income of households is $1,000, what is the amount of

disposable income?

1. At the $1,000 income level, what is the amount of planned consumption?
2. 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

at home.

• 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

 

 

Class Discussion

 

• Exports of the country are X = 20; the import function is M = 15 + 06Y

1. What is autonomous import? What is the size of the autonomous import?
2. What is marginal propensity to import? What is the size?
3. If the average income of households is $1,000, what is the amount of planned import?
4. At the $1,000 income level, what is the amount of planned net export?
5. 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?