Lecture 7

Workhorse model of AD AS

Sections D & E , PGP Fin_03

RAC Chair RAC Area Member RAC Cross-Area Member

Prof. Sumit Mitra Prof. Anubha S. Sinha Prof. Debabrata Chatterjee
Learning objective
• What does Aggregate expenditure mean and its components?
• What are the determinants of each components?

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Motivation
Earlier, we understood that ALL GDP produced ( production side) has to be bought by
the consumers( Spending) using National income to ensure markets to have no glut.
 Now we concentrate on the spending side of the system, which Keynes believes is
the fulcrum of GDP growth.
Some factors could be influencing the various spending components to spend more
or less during the quarter or financial year.
Creates an imbalance as to what we produced and what we are spending on.
 An equilibrium between spending and production is required and we need a
mechanism to reach this equilibrium
 We study how aggregate expenditure model address this issue

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The composition of Agg. Expenditure
 Consumption (C) = purchase of goods and services by consumers.
 Investment (I) = purchase of capital goods.
 business investment on physical capital
 residential construction, inventories
 Government Spending (G) = purchase of goods and services by
government.
 Net exports (X  M) is the fourth component of Agg. Demand
 Imports (M) = our purchases of foreign goods and services.
 Exports (X) = purchases of our goods and services by foreigners.

• What does Agg. Expenditure depend on?

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Consumption
First of all what does households spend on?

Durables Non-durables Services

They are highly-cyclical Non-cyclical Not very cyclical

Example: Automobiles, AC Example: Food, Clothing Example; Hair cut,
Transportation

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Pandemic and Post Pandemic Consumer sentiment
Articles in VC

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Consumption Determinant
•Disposable income, (YD), is the income that remains once consumers
have paid taxes (T).
C  C (YD )
()

The function C(YD) is called the consumption function.

Disposable income is defined as:

YD  Y  T
CMIE Data Analysis
Current and Future expectation Index

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0
0 1 2 3 3 4 5 6 6 7 7 8 8 9 9 0 0 1 1 2
c -1 p-1 n-1 r-1 c-1 p-1 n-1 r-1 v-1 y-1 v-1 y-1 v-1 y-1 v-1 y-2 v-2 y-2 v-2 y-2
De S e J u a De S e J u a o a o a o a o a o a o a
M M N M N M N M N M N M N M

Current situation index Future expectations index

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Consumption
• A more specific form of the consumption function is this
linear relation:
C  c 0  c1Y D

 c1 is the Marginal Propensity to Consume (MPC) = the

effect of an additional rupee of disposable income on
consumption.

 Consumption increases with disposable income, but less

than one for one: 0 < c1 < 1
Consumption function

C  C (YD )
YD  Y  T
C  c 0  c1 (Y  T )
 Savings
• YD = C + S
• An additional rupee of disposable Income (DI) is either spent or saved
• So MPC + MPS = 1 C
MPC 
DI
• Alternatively,
• YD = C + S
• Differentiating both sides w.r.t. YD
S
• 1 = MPC + MPS MPS 
DI
• Consider the following situations where there is an increase in income
that leads to an increase in consumption expenditures.
• Calculate the marginal propensity to consume (MPC).

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• Consider the following situations where there is an increase in income
that leads to an increase in consumption expenditures.
• Calculate the marginal propensity to consume (MPC).

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Non-income determinant of consumption

Expected future income: Suppose there is an increase in future income, household increase
consumption with some dip in current saving.

Uncertainty: Higher uncertainty of future income, increase the savings due to precautionary motive
and therefore lower future consumption also.
Wealth: Higher wealth leads to higher current consumption and lower saving from current disposable
income .
They can dip into the accumulated savings rather than depending on income.
Interest rate : Higher current interest rate leads to lower current consumption and higher current
savings.
Price level – affects the real value of cash and bank savings
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Second component : Investment spending
Sub components of Investment

Private Inventory Government

fixed investment Investment
investment

Includes spending by business and households and governments on fixed assets.

 More volatile than consumption during a business cycle
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Determinants of Investment spending
o Interest rate – Investment expenditure falls with an increase in market
interest rate (cost of borrowing or the opportunity cost of investing in
capital)
o Expected profitability – Investment is influenced by business
expectations (“animal spirits”) which are linked to the prospects of the
economy
o Business taxes – Higher taxes reduce PAT and therefore the incentive to
invest
o Stock prices – “q theory”
o Access to financing- ( in the case of LMDCs)
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Government Expenditure

Government expenditure, G
(along with taxes, T) is
determined by fiscal policy
the choice of spending and
taxes by the government is
made by ministers and
bureaucrats depending on
national priorities.
Net Exports

Income-When income rises, spending on all

goods rises including imported ones
Therefore, Imports depend on domestic income
Exports depend on foreigner's income
Exchange rates:- A depreciation in currency aids
exports
Taste for foreign goods: Imports increases
Trade policies: Trade wars can influence NX
Agg. Expenditure
The agg. expenditure (AE) function for goods is written as:
C(YD) + I + G + NX(YD)

We treat I and G as autonomous expenditure i.e. not affected by the

current income (Y). We treat NX as fixed for the time being.

We need to understand how AE changes with policies, price level and
how it affects the economy.