▪ Simplifying Assumptions:
• Using the decomposition of GDP we can write Z as Z = C + I + G +X – IM
• All firms produce the same good, used by consumers for consumption,
firms for investments or government.
• All firms are willing to supply any amount of the good at a given price
level (P)’
• The economy is closed ( X= IM = 0)
• Z=C+I+G
CONSUMPTION (C)
o In this context, consumption depend on income, more precisely disposable
income (Yd).
o C = C0 + C1Yd
▪ Linear relation between consumption and disposable income
characterized by C0 and C1
▪ The parameter C1 is called the marginal propensity to consume (it gives the
effect of an additional Rand of disposable income has on consumption:
If C1 is equal to 0.6, then additional Rand of disposable income
increases consumption by R1 x 0.6 = 60 cents.
▪ The parameter C0 is autonomous consumption
Siyanda Zwane | UNIVERSITY OF CAPE TOWN
, ▪
▪ Disposable income is equal to Yd = Y – T, where Y is income and T is taxes
paid minus government transfers received by consumers.
▪ Therefore. C = c0 + c1 (Y-T) :
This equation depicts C as a function of income Y and taxes T.
Higher income ↑ consumption, higher taxes ↓consumption.
INVESTMENTS (I)
o Models have two types of variables:
▪ Endogenous (variables that depend on other variables in the model)
▪ Exogenous (not explained in the model and taken as given)
o In this section, we will take investments as given and write I = 𝐈̅
o Putting a bar on investment reminds us to take investment as given.
GOVERNMENT SPENDING (G)
o Together with taxes T, G describes fiscal policy B- the choice of taxes and spending
by the government.
o We also take G and T as exogenous but in this case we assume that they are
exogenous based on two distinct arguments:
▪ Government do not behave with the same regularity as consumers or firms.
Siyanda Zwane | UNIVERSITY OF CAPE TOWN
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