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.

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Copyright Robert Schenk