Chapter Nine: Module Summary -- The Income-Expenditure Model

  • There are several assumptions that we make in constructing the income-expenditure model. These include a fixed price level, suppliers will supply any level of output that is demanded at the fixed price level, there are no government expenditures or net exports, the interest rate in the economy is determined outside the model, and there are no taxes.

  • Aggregate Expenditures is the aggregate amount that consumers, investors, government, and foreigners wish to spend on the purchase of final goods and services produced in the domestic borders, given the price level. AE = C + I + G + NX.

  • Consumption is the largest component of Aggregate Expenditures, accounting for two-thirds of GDP. Factors that influence Consumption are Disposable Income (DI), wealth, interest rates, and expectation of consumer incomes.

  • A Consumption Function shows the relationship between total consumer expenditures and total disposable income, holding all other determinants of consumption constant. The equation for the consumption function is C = Ca + MPC (DI).

  • The Marginal Propensity to Consume (MPC) tells us how much of an additional dollar of disposable income will be spent.

  • Investment is the most volatile component of GDP. Investment is determined by interest rates, business confidence, taxes, and capacity utilization.

  • The level of Aggregate Expenditures depends upon the level of income. As Y rises, so does AE. Therefore the Aggregate Expenditure schedule slopes upwards.

  • Equilibrium is the point where the quantity produced (Y) is equal to the quantity demanded (AE), or Y = AE. On any chart, if the horizontal and vertical axes have the same scale, then any (x,y) point on the 45 degree line will have the same value on both axes. Every point on the 45 degree line is a point that satisfies the condition Y = AE. Therefore, we must look for equilibrium where the AE line crosses the 45 degree line.

  • The equilibrium level of income is determined by this equation: Y = (Ca + Ia)/(1 - MPC).

  • Any increase in autonomous consumption or investment shifts the AE schedule upwards and leads to a rise in equilibrium income. The opposite occurs when autonomous consumption or autonomous investment declines.

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