MAJOR ANNOUNCEMENT

The unexpected class holiday on Feb. 25 created a major problem to our planned Test No. 3. Therefore the exam is rescheduled as stated below. SCHEDULE OF EXAMS:
o TEST #1 and TEST #2 -- DONE!

o TEST #3 March 9, 2011 (Wednesday)

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

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o FINAL EXAM To be announced [FINAL EXAM WEEK] Econ 11 -- Lecture #26

Lecture 26:

AGGREGATE INCOME AND OUTPUT EQUILIBRIUM

Second view: AGGREGATE EXPENDITURE (C+I+G+[X-M]) AND AGGREGATE OUTPUT (C+S+T) INCOME AND OUTPUT MULTIPLIER LEAKAGES AND THEIR EFFECTS
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INTERACTION OF AGGREGATE DEMAND AND AGGREGATE SUPPLY

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Econ 11 -- Lecture #26

RELATIONS OF MAJOR NATIONAL INCOME CONCEPTS We know from accounting identities, GNE=GDP. We know from the first view that total expenditure (aggregate demand) is equal to total output (aggregate supply).
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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 Exports over Imports 3/2/2011 Econ 11 --of Lecture #26 5

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
Econ 11 -- Lecture #26

3/2/2011

At Income/ Output Equilibrium Aggregate Demand = Aggregate Supply Or:

E=Y Or:
C + I + G + (X-M) = C + S +T.
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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. o If G-T and X-M were both zero, then I = S.
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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 minus taxes. It is the fiscal balance or the governments budget. The term, (X-M), is the net demand of foreigners for the countrys goods. It is often called the trade balance. Note: If (G-T) and (X-M) are both zero, the equilibrium condition is simply:

C+I=C+S. Or simply, I=S.

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

AD =E I C AS =Y

AGGREGATE SUPPLY
C S

80 700 80 750 80 820 80 880

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

700 750 820

0 50 80

880 120
10

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

AD =E 780 830 900 960
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AGGREGATE SUPPLY
AS =Y C S

80 700 80 750 80 820 80 880

700 700 800 750 900 820

0 50 80

1,000 880 120

Econ 11 -- Lecture #26 11

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

AD =E 780 830 900 960
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AGGREGATE SUPPLY
AS =Y C S Output Net tendency 0 ? ? ? ?
12

> or <

80 700 80 750 80 820 80 880

> > = <

700 700 800 750 900 820

50 80

1,000 880 120

Econ 11 -- Lecture #26

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

AD =E 780 830 900 960
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AGGREGATE SUPPLY
AS =Y C S Output Net tendency 0 ? ? ? ?
13

> or <

80 700 80 750 80 820 80 880

> > = <

700 700 800 750 900 820

50 80

1,000 880 120

Econ 11 -- Lecture #26

What happens when E>Y? (Note: The same as: C+I>C+S).

With excess aggregate demand, sellers make new orders from producers to meet demand. Sellers look at their inventory of goods. They sell faster than their normal replenishment of new supply. So, they make additional orders for goods. Output rises.
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What happens when E<Y? (Note: The same as: C+I<C+S).

With the given demand, sellers discover that they are not selling all their inventory of goods fast enough. As a result, sellers reduce their orders for goods. Producers cut down their production. Output falls.
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Example: Table 16-1. Note: Y=C+S & E=C+I AGGREGATE DEMAND

AD= E 780 830 900 960
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AGGREGATE SUPPLY
AS =Y 700 800 900 1,000
Econ 11 -- Lecture #26

> or <

Output Net tendency 0

80 80 80 80

700 750 820 880

> > = <

700 750 820

increase increase

50

80 equilibrium

880 120

decrease
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E=Y line Saving E E0 =900

Illustration of Equilibrium Output (Y0) with E0=Y0 at 900

450 line

0
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900 1,000 Output=Y (billion pesos) Y0#26 Econ 11 -- Lecture 17

800 Y

NOW THAT WE KNOW HOW NATIONAL OUTPUT EQUILIBRIUM IS DETERMINED, 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 3/2/2011 Econ 11 -- Lecture #26 18 INVESTMENT)

Exactly by how much will output increase if we knew the marginal propensity to consume (mpc) to be and the exact increase in expenditure ( E = 10 billion pesos)?

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Econ 11 -- Lecture #26

19

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 = = = 4. Multiplier = 1- mpc 1 0.75 0.25 Therefore, E=10 Multiplier = 10 4 = 40.
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Let us assume the Expenditure item is Consumption. C The 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 consumption 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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First level of spending Second level of spending Third level of spending Fourth level of spending
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Leakage

Leakage

Leakage
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Spending level

Initial spending 1st level mpc=c = 0.75 2nd level C=c Y 3rd level C=0.75 Y 4th level 5th level 6th level 7th level 8th level 9th level 10th level

Amount of Base spending new spending at level after leakage 10.00 7.50 10.00 5.25 7.50 4.21 5.25 3.16 4.21 2.37 3.16 1.78 2.37 1.33 1.78 1.00 1.33 0.75 1.00 0.56 0.75
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Sum of spending up to 10th level = 38.3 billion

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 of spending = 10 (1+c + c 2 + c3 + ... + c ) Change in output = Change in spending We can call the factor 1 . 1-c

1 as the MULTIPLIER. 1-c

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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 1 Multiplier = = = = 4. 1- mpc 1 0.75 0.25 Therefore, E=10 Multiplier = 10 4 = 40.
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E=Y line Saving E E0 =900

Illustration of Equilibrium Output (Y0) with E0=Y0 at 900

450 line

800 Y

900 Y0

1,000 Output=Y (billion pesos)

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E=Y line

E'=E+E
E E E0

450 line

An increase in E and effect on equilibrium output

Y0 Y Output=Y (billion pesos)27

THE INCOME MULTIPLIER WORKS IN BOTH DIRECTIONS:

AN EXPANSION OF EXPENDITURE
INCREASES OUTPUT BY THE AMOUNT OF THE MULTIPLIER.

A FALL OF EXPENDITURE
DECREASES OUTPUT BY THE AMOUNT OF THE MULTIPLIER.
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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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E0 =900

E=Y line Saving E=C+I+ . C (Consumption) I (Investment)

450 line

We label the components of expenditure: E=C +I+..

800 Y 900 Y0 1,000 Output=Y (billion pesos)
30

10

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)
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First level of spending Second level of spending Third level of spending Fourth level of spending Saving Leakage= Saving
THERE ARE OTHER FORMS OF LEAKAGES TO THE SPENDING CHAIN!
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Saving

First level of spending Second level of spending Third level of spending Fourth level of spending Leakage
Saving Tax Import Tax
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Leakage
Saving Import Tax

Leakage
Saving

Import

11

THERE ARE THREE TYPES OF LEAKAGES: SAVING: What is not spent on consumption 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.
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Saving Saving mps

0

Output

Tax Tax mpt

0

Imports

Output Import mpm

35

Output

The modified multiplier formula includes the three leakages in the form of the three marginal propensities: to save, m; to tax t; and to import m.

Multiplier
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Econ 11 -- Lecture #26

1 s+t+m

36

12

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]=

Y = E k = 10 2 = 20. New output level = Old output + Change in output = 800 + 20 = 820 billion pesos.
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2.

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]=

Y = E k = 10 2 = 20. New output level = Old output + Change in output = 800 + 20 = 820 billion pesos.
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2.

End of todays lecture. Good day! Lecture 26

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