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The Textbook View
Developing the income-expenditure model with consumption
depending on expected income emphasizes that it is a variant
of a model of contingent behavior. In both models behavior
of people depends on their expectations of other people's
behavior. In addition, this development sets the stage for
discussing more complex forms of the consumption function.
However, there are at least two other ways to develop the
model, and each has advantages.
One alternative is to replace expected income with the
income of the last period. Consumption would then depend on
last period's income, and equilibrium would exist when this
period's income equaled last period's income. This
alternative is very close to our method, but it makes
explicit how expectations change: expected income is last
period's income.
The second alternative is to have people plan
expenditures based on actual income, which is determined by
actual production. If people plan to buy more than is
produced, someone's plans must be thwarted. Equilibrium
exists when planned expenditures equal income (which is
output). For example, suppose that when income is $20,000,
consumers plan to spend $20,000 and business plans to invest
$2,500. Since only $20,000 worth of goods has been produced,
and more than $20,000 is being purchased, inventories must
decline. But inventories are part of investment, so actual
investment must differ from planned investment. When planned
expenditures exceed production, inventories are depleted,
which businesses do not want to happen. They will respond by
increasing production, and in the process will hire more
resources, which will increase income. (They could also
increase prices, but the model does not give them this
option. In the model, all variables are in real terms.)
The advantage of this second alternative is that by
involving inventories in the adjustment process, spending is
linked to production. Adjustment takes place because the
plans of businesses are disrupted. In contrast, when
consumption depends on expected income, adjustment takes
place because the plans of consumers are disrupted. Since we
are mostly interested in what this model says about
equilibrium, we will not pursue this distinction.
Copyright
Robert Schenk
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