TUTORIAL 5 (7 – 11 APRIL) – ANSWER KEY

The AE Model
Textbook Reference: Chapter 5
Main Concepts
Components of Aggregate Expenditure
Exogenous and induced expenditure
Consumption Function
Short run equilibrium output
Income-Expenditure multiplier
Review Questions
Question 1
(i)
Define planned aggregate expenditure (AE) and list its components. Why does AE
change with income?
See p133,134. Planned aggregate expenditure (PAE) is total planned spending on domestically
produced final goods and services. It includes consumption spending, (planned) investment
spending, government purchases of goods and services, and net exports (exports less imports). We
can write it as:
where Ip is planned investment and excludes unplanned changes in inventories. In the national
accounts (actual) AE must add-up to the value of total output. So AE is given by:
where

.

Note that in the latest edition of BOF (3rd edition), PAE is written as follows:
If you compare this to the above definition you can see that
where Cd is defined as consumption spending on domestically produced goods and services.
Changes in output lead to changes in income received by households, which in turn affects
consumption spending (through the consumption function). As consumption is part of PAE, changes
in output lead to changes in PAE.
(ii)
Explain the concept of a consumption function. What are the main influences on
consumption? Explain the difference between the average propensity to consume and the
marginal propensity to consume.
P 134-136. The largest component of planned aggregate expenditure is consumption expenditure.
̅
(
)
The consumption function can be expressed as
Consumers’ willingness to spend affects sales and profitability in many industries and therefore
affects labour and capital income. Labour and capital income net of taxes is termed disposable
income (
) and any increase (decrease) in disposable income leads to an increase (decrease) in
consumption expenditure. The proportion of disposable income that is consumed is approximated by
the marginal propensity to consume , and therefore the component of consumption that is induced
) The remainding term in the consumption function is exogenous
by disposable income is (

This term reflects any change in consumption expenditure that occurs for any reason other than a change in disposable income. As production increases the economy will move towards (where ). expenditure is greater than output and firms will experience an unplanned decline in their inventories. ̅ . This is a signal to increase production in order to restore inventories to previous levels. . If . . This is a signal to decrease production in order to reduce inventories to previous levels. In the diagram. The marginal propensity to consume is the ratio of the change in consumption expenditure and the change in disposable income: ( ) The average propensity to consume is the ratio of consumption and disposable income: ( ) (iii) Draw a diagram of the AE model and explain the process by which the economy reaches equilibrium. expenditure is less than output and firms will experience an unplanned decline in their inventories.expenditure. which is defined as the effect of a change in asset prices on consumption expenditure. As production decreases the economy will move towards (where ). This term is primarily affected by the wealth effect.

9.600 (i) Graph the consumption function for the Simpsons and find their household’s marginal propensity to consume.350 22. where disposable income is on the horizontal axis and consumption on the vertical axis.000 Consumption Spending ($) 20.000 21.0=c We can also find the intercept of the consumption function. For example.000 3.000 28.9 x 1700.Question 2 Data on pre-tax income. it looks like the MPC is 0. if disposable income rises by yet another 1700 (26 000 – 24 300). Similarly. C. a rise of 1500. So the consumption function for the Simpsons is . we get .000 Tax Paid ($) 3. which is 0. consumption rises by 720 (22 070 – 21 350). So . which implies ̅ ( ).000 30. taxes and consumption spending (on domestic goods and services) for the Simpson family are given below.9.070 23. plug into the equation consumption function can be expressed as any of the numerical combinations of consumption and disposable income given above. consumption rises by 1530 = 0.000 27. To find C. Since 1350/1500 = 0.9. consumption rises by 1350. we know the ̅ ( ). Confirming this. ̅ ) if we set and ( .700 4. .500 3. Since the MPC is 0. Pre-tax Income ($) 25.9. The graph of the consumption function is a straight line through these points. If disposable income increases from 22 000 to 23 500. we see that if disposable income rises by another 800 (24 300 – 23 500).9 x 800.

000 and they paid taxes of $5. As a result the Simpson family increases its consumption by $1.(ii) Predict the Simpson’s level of consumption if their income was $32. ( ) (iii) Suppose that Homer Simpson wins the lottery. How does this change the Simpson’s consumption function? What happens to their marginal propensity to consume? What happens to their average propensity to consume? The new consumption function has shifted upwards (parallel) to: ( ) The marginal propensity to consume is unchanged: ( ) The average propensity to consume was: ( ) ( The average propensity to consume after the lottery is: ( ) ) .000.000 at each level of after-tax income (the lottery winnings are not treated as income).

[ ̅ [ )̅ ( ( )( ̅] ( )( ] ) [ ( ) )( ) ] (ii) Identify the exogenous expenditure and the induced expenditure components for this economy. Exogenous expenditure is expenditure that does not change with income.Question 3 Consider an economy described by the following equations. and ̅ is exogenous imports. planned aggregate expenditure is: ̅ ( ) ̅ Where ( ) is the marginal propensity to import. ( ) ̅ (i) Derive the equation for planned aggregate expenditure In general form. which is the sum: [ ̅ ( )̅ ̅] [ ( )( ) Induced expenditure is expenditure that changes with income: ( )( ) ( )( ) ] . ̅ Where ̅ is exogenous taxes. and is the marginal income tax rate.

Illustrate the equilibrium on a 45-degree diagram.(iii) Find the short-run equilibrium for this economy. In general form: [ ̅ )̅ ( In equilibrium [ ̅ [ In numeric form: In equilibrium )( ( [ )̅ ( ( ̅] [ ̅ ) )] )( ( ̅] )( [ ̅ )] [ ̅ )̅ ( )̅ ( ( )̅ ( ( )( )( ) ) ̅] ̅] ̅] .

. then Okun’s law is: ( ̇ ( ) ) ̇ The text gives a value of ̇ (v) Calculate the effect on short-run equilibrium of a decrease in planned investment spending from 900 to 800.500 = -250. In percentage terms: ̇ If the natural rate of unemployment is 4%. use Okun’s law to estimate the actual unemployment rate for the economy.250 – 8.5 (the magnitude of the multiplier) times the fall in investment expenditure. Note that this is equal to 2.(iv) What is the output gap for this economy? If the natural rate of unemployment is 4%. Initially: The constant term (exogenous expenditure) falls by 100: The change in GDP is 8. Illustrate your answer on a diagram. The output gap is the deviation of actual output from potential output: A contractionary gap.

and are price-inelastic in supply. . BOF p.131 (ii) Give an example of a good whose price changes very frequently and one whose price changes relatively infrequently.Discussion Questions Question 4 (i) What is the key assumption of the basic Keynesian model? Explain why this assumption is necessary if aggregate spending is a driving force behind short-term fluctuations in output. Examples of goods whose prices change infrequently are those that are priced using a cost-plus method and goods that are very price elastic. Examples of goods that change in price frequently are agricultural products and mining goods that are priced according to the level of demand.