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Date Submitted: 11/17/2012 09:17 PM

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BASIC KEYNESIAN MODEL - short-run, demand-driven model - assumes fixed price level ⇒ firms operating in their "normal" production range (where don't need to raise price as Q expands) To model demand at macro level: Aggregate Expenditure (AE) - is the "demand curve" in this model - has same categories as Expenditure GDP: AE = C + Ig + G + Xn - initially assume G = 0 and Xn =0 (no gov't and closed economy, so Xn = 0): AE = C + Ig ⇒ we model both C and Ig (outline their determinants), then put these together, get AE

Consumption Function Model of Personal Consumption Expenditure: • Durable Goods • Non-Durable Goods • Services Major factors determining these: - income - prices - interest rates - wealth (owned assets) – WEALTH EFFECT - consumer confidence To model this, separate income (Y) from others: C = factors other than income + part tied to income (autonomous cons) + (induced cons) Since part of consumption directly related to income, when the state of the economy changes, C automatically changes in same direction - use a linear function to model this:

C = a + bY a = intercept (value of C when Y = 0) b = slope = ∆C/∆Y = rate of change in C when ↑Y = $1 a = autonomous consumption - positive: when Y = 0, C >0 (people use savings) b = marginal propensity to consume (MPC) - positive: as Y↑, C↑ - fraction: if ↑Y = $1, ↑C < $1 ex: if MPC = 0.8, if ↑Y = $1, ↑C = $.80, or, for every $1 ↑Y, C rises by $.80 Q: How does the consumption function shift? A: Anything that changes autonomous consumption (intercept) shifts the curve Ex: Interest rates fall ⇒ durable goods spending (part of C) rises ⇒ autonomous C rises => larger intercept ⇒ parallel upward shift of C


C C’ C a’ Y

Technically: when Y = 0, autonomous C is greater A better way to understand this: C can change even if Y does not (∆ autonomous C) Interpret this as: for a given Y (=Y1), is greater C Saving Function - with income identity: Y = C + S saving function derivable from consumption function using...