ECON6049 ECONOMIC ANALYSIS, S1 2021
Week 9: Unit14 – Unemployment
and Fiscal Policy (Part A)
OUTLINE
A. The Aggregate Demand function
B. The multiplier model
C. Household wealth
D. Investment
E. The role of government (W10)
F. Linking Aggregate Demand and unemployment (W10)
A. The Aggregate Demand function
Consumption function
Aggregate consumption has 2 parts:
• Autonomous consumption(c0) = the fixed amount one will spend,
independent of current income.
• Consumption dependent on income (c1Y); in which c1 is the marginal
propensity to consume (MPC). c1 expresses the change in consumption from
a one unit change in income. The value of the MPC is autonomous in this
model.
C = c0 + c1Y
c1= MPC = ΔC/ΔY
• It is assumed that 0<MPC<1
• Slope of consumption function = marginal propensity to consume (MPC)
Consumption function
Consumption function
Marginal propensity to consume varies across people:
• poor households with credit constraints react a lot to variation in
current income, so their MPC is large
• for wealthy households, current income matters little for current
consumption, so their MPC is small
Autonomous consumption captures the impact on
consumption of (i) consumer confidence, such as, expectations
about future income and employment; (ii) household wealth;
(iii) interest rates; and (iv) the price level etc.
MPC by
distribution of
net wealth
Source: OECD (2014)
Investment
• Investment (I) is spending by firms on
new equipment and new commercial
buildings; and spending on residential
structures (the construction of new
housing).
• In our simple model, we assume
investment is independent of output, so
I is constant.
• Later we will relax this assumption.
Goods market equilibrium
AD =C + I = 0 + 1 +
The slope of AD line is MPC
The 45° line is where Y = AD
Goods market equilibrium:
Y = AD
B. The multiplier model
Equilibrium income and the multiplier
• In equilibrium: Y = AD If there is a ΔI → ΔY = ΔI x (1/(1 –c1)
If there is a Δc0→ ΔY = Δc0 x [1/(1 –c1)]
k is the multiplier
The multiplier process
• Initial equilibrium is A.
• Fall in investment:
→ fall in aggregate demand
→ lower output and income
→ further fall in demand and
income
→ lower output and income
→…
→ new equilibrium is Z
The multiplier process
Assume MPC = c1= 0.6
• Step 1: ΔAD = ΔI = -€1.5b (Distance AB)
• Step 2: ΔY= -€1.5b (BC)
• Step 3: ΔAD = c1 ΔY = 0.6 x (-€1.5b) = -€0.9b (CD)
• Step 4: ΔY= -€0.9b (DE)
• Process continues until point Z is reached.
• Total ΔY = ΔIx (1/(1 –c1) = -€1.5b x [1/(1 –0.6)]
= -€1.5b x 2.5 = -€3.75b
The multiplier effect
The total change in output can be greater than the initial change in
aggregate demand.
This is because of the circular flow of expenditure, income, and output.
The multiplier represents the relative magnitude of this change.
• multiplier = 1: the increase in GDP = the initial increase in spending
• multiplier > (<) 1: the total increase in GDP > (<) the initial increase in
spending
Changes in consumption function
• Consumption decisions can also shift the AD curve.
• E.g. a fall in house prices will be bad news for a household with a
mortgage. They may choose to save more (precautionary saving) and
hence their autonomous consumption would fall.
• Credit constraints and consumption smoothing is reflected in the slope of
the AD curve and the size of the multiplier.
The Great Depression
• A: goods market equilibrium (1929)
• B : fall in investment = downward
shift of AD
• C: fall in autonomous consumption =
further downward shift of AD
• uncertainty due to stock market
crash, pessimism, banking crisis and
collapse of credit
C. Household wealth
Composition of Household wealth
• Household wealth impacts autonomous consumption.
Broad wealth = broad assets – debt
Precautionary saving
• Target wealth = the level of wealth that
a household aims to hold, based on its
economic goals (or preferences) and
expectations.
• Precautionary saving = An increase in
saving to restore wealth to its target
level.
• A fall in expected earnings will lead to
cut in consumption (precautionary
savings) to restore target wealth.
Consumption and the housing market
• Changes in house prices affect consumption through two channels:
i. Via change in household wealth (home equity)
ii. Via change in credit constraints: lower house value makes it
more difficult to borrow (greater credit constraint)
D. Investment
Investment spending
Firms’ decision about what to do with its profits depends on
• Owner’s discount rate (ρ)
• Interest rate on assets (r): A lower interest rate makes investment more
likely.
• Net profit rate on investment (Π)
i. Consume the extra income (dividends) if ρ > r ≥ Π
ii. Save the extra income/repay debts if r > ρ ≥ Π
iii. Invest (at home or abroad) if Π > ρ ≥ r
Investment spending: supply side effects
• Higher expected rate of profit increases investment, holding r constant.
• Improvement in business environment (such as fall in the risk of
expropriation by the government) also increases investment.
• Change in interest rate is a demand-side factor.
Aggregate investment function
• Aggregate investment function = An
equation that shows how investment
spending in the economy as a whole
depends on other variables (interest rate
and profit expectations).
• In practice, investment is not very
sensitive to interest rate. Instead, the
shift factors are much more important.
