Components of Aggregate Expenditure: Consumption, Investment, Government Purchases, and Net Exports

I.  Consumption

A key decision in the circular flow model we studied is how much households spend on consumption.  Consumption and income tend to be highly correlated.

# A.  Income and Consumption

Disposable Income - Income actually available for spending is personal income less net taxes.  The difference between disposable income and consumption is savings.

·       Consumer spending and disposable income move together over time.

·       Consumer spending and disposable income increased nearly every year.

·        The relationship between consumer spending and disposable income has remained relatively stable

*In the 90s, we have spent about 92 percent of our disposable income, and saved about 8 percent.  More recently consumers have in some months increased consumption faster than income resulting in a negative savings rate (higher debt accumulations).

The Consumption Function - The relationship between the level of income in an economy and the amount households plan to spend on consumption, other things constant.

Households look at their level of disposable income and decide how much to spend. So spending depends on disposable income.

·       The relationship between consumption spending and disposable income is captured by the slope of the consumption function.

·       The influences of other factors that are independent of income are captured by the intercept.

## B.  Marginal Propensity to Consume and Save

Economists use marginal analysis to the relationship between changes in disposable income and changes in consumption.

Marginal analysis seeks to answer questions like, "If U.S. households receive another billion dollars in disposable income, what will happen to consumption spending, what about savings?"

·       MPC = change in consumption divided by the change in disposable income

·       MPS = change in consumption divided by the change in disposable income

·       Since disposable income is either saved or consumer: MPC + MPS = 1

## C.  MPC, MPS, and the Slope of the Consumption and Saving Functions

The slope of the consumption function is the MPC.  Because the slope of a line constant everywhere along the line, the MPC for any linear consumption function will be constant at all levels of income.

The slope of the saving function equals the MPS.  It is also a positive fraction that represents a leakage rate from increases in household income in the circular flow of income.   Because the slope of a line is the same everywhere on that line, the MPS for any linear savings function is constant for all levels of income.

The savings function can be derived from the consumption function:

·       C = a + b Y

·       S = -a + (1-b) Y

## D.  Non-income (Autonomous) Determinants of Consumption

Along the consumption function, consumption spending depends on the level of disposable income, other things constant.  What factors are held constant, and how do they affect Consumption?

·       Net Wealth and Consumption

Net Wealth - The value of a household's assets minus its liabilities (debts owed).

(Assets - home, cars, furniture, savings accounts, checking accounts; Liabilities - student loans, car loans, mortgage, credit card balances)

Household wealth is assumed constant along a consumption function.

o      An increase in net wealth makes a household more likely to spend and less likely to save at each level of disposable income.

o      A decrease in net wealth makes a household less likely to spend and more likely to save at each level of disposable income.

**Example, a fall in stock prices. What happens to net wealth if the value of stock declines?  It falls. Households that own stock have a decrease in net wealth and are likely to spend less and save more. The consumption function shifts down.

·       The Price Level

Some household wealth is held in dollar-denominated assets (bank accounts, cash).

When the price level changes, so does the real value of dollar-denominated assets.  A falling price level increases the real value of dollar-denominated assets, thereby encouraging greater consumption for goods and services.  A higher price level discourages consumption demand as it lowers the real value of the dollar.

·       The Interest Rate

Consumers make inter temporal decisions to consumer (or save) over their lifetime.  Interest is the reward to savers for current saving.  When graphing the consumption function, we assume a given interest rate.

If the current interest rate increases, savers will save more, borrow less, and spend less because it increases the opportunity cost of consumption. This, in turn causes the consumption function to shift downward.  Lower current interest rates increase consumption and lower savings.

·       Expectations

Example: If people grow more concerned about job security and future expected income, they will reduce their consumption spending at all levels of disposable income.  An expected tax cut that is viewed as permanent could increase current consumption.

Expectations about future prices can also affect current consumption.  Higher expected prices for real assets can increase current consumption.  Higher expected prices of financial assets can lower consumption.  (Remember that “investing” in financial assets is savings.)

Exercises:

Answer “Try it Yourself” on page 273 in the textbook.

Read “Getting Started:  Japan’s Plea to Consumers” on page 267 and answer question 3 on page 287.)

### II.        Investment

Gross Private Domestic Investment is spending in three categories:

1.    New factories and new equipment, such as buildings or computers

2.    New housing

3.    Net increases in inventories

#### A.  The Demand for Investment

Firms buy capital goods now in the expectation of a future return.

Expected Rate of Return: the annual dollar earnings expected from the investment divided by the purchase price.

Example:

Hacker Haven Golf Club is considering buying solar-powered golf carts to rent to golfers. The carts sell for \$2000, and they require no maintenance or operating expenses.

They expect the first cart purchased to earn \$400/year in rental income.

What is the future expected rate of return on the first cart?

They expect the second cart purchased to earn \$300/year in rental income.

Why does it earn less?  What is the future expected rate of return on the second cart?

A third cart is expected to earn \$200/year in rental income.  What is the expected rate of return on the third cart?

A fourth cart is expected to earn \$100/year in rental income.  What is the expected rate of return on the third cart?

Suppose a fifth cart would not be used at all.  Its rate of return would be zero.

Question:  Should the owners of Hacker Haven purchase any carts?  If so, how many?

1.     What is the marginal revenue from the golf carts?  The marginal efficiency of investment is the discount rate that equates the present value of future expected returns with the purchase price of the carts.

2.     If the owners are borrowing to invest, the market interest rate represents the marginal cost of borrowing the money.  (If the owners have the money on hand to invest, the market interest rate reflects what the owners could earn by saving the money.  So the market interest rate is the opportunity cost of investing.)

3.     Investment will occur if the marginal efficiency of investment (marginal revenue) is greater or equal to the marginal cost of funds.

##### B.   From Micro to Macro

We gave an example of the investment decisions of a single golf course, but there are 13,000 golf courses in the U.S.  And what about all the other industries?

The investment demand curve for the economy is obtained by summing the amount of investment undertaken by each firm at each interest rate.

Most industries have downward sloping investment demand curves, because more is invested as the opportunity cost of investing decreases.

C.  Investment Demand for the Economy

The economy’s investment demand curve shows the inverse relationship between the quantity of investment demanded and the market rate of interest, other things equal.

Business expectations are held constant along this curve. If businesses become more optimistic, the demand for investment increases, and the entire curve shifts to the right.

The price of capital goods is also held constant.  If capacity constraints increase the cost of equipment, then less investment will occur at every interest rates because the marginal efficiency of investment decreases.

Falling prices of capital goods (computers) increases the volume of investment.

##### D.  The Investment Function:

The investment function is the relationship between the amount businesses plan to invest and the level of income in the economy, other things constant.

The simplest investment function assumes that planned investment is autonomous,

i.e. independent of level of income.

The determinants of investment include the following:

·       The Current Level of Income.  Higher current income increases production demands and boosts the demand for capital.  This shifts the investment demand to the right but makes the AE curve steeper.  This, in turn, increases the income multiplier from other autonomous facts that shift the AE schedule.

·       The Market Interest Rate: a movement along the investment demand curve will shift the AE curve.  Lower interest rates increase investment and shift the AE curve upward.

·        Business Expectations:  a shift in the investment demand curve will shift the AE curve.  Positive expectations increase AE, negative expectations reduce AE.

·       The Stock of Capital:  A higher existing stock results in more investment to replace depreciated capital, but a higher stock may result in less investment since less may be needed.  (Two opposing influences, but investment based upon depreciation is quantitatively more important.)

·       Capacity Utilization:  The higher the current rate of capacity utilization the more likely that investment plans will be realized.

·       The Cost of Capital Goods:  Higher prices of capital goods lowers the marginal efficiency of capital and lower investment demand at every interest rate.

·       Other Factor Costs:  If capital and labor are substitutes, a higher wage rate will induce greater capital investment.  This has the effect of increasing labor productivity and lowering labor costs.

·       Technological Change:  New technologies often require greater capital investment (computers, fiber optics, etc.)

·       Public Policy:  Accelerated depreciation, investment tax credits, lower taxes on corporate profits, a lower capital gains tax increase the demand for capital goods.  Subsidies for transportation, education, etc. encourage greater capital investment by local governments.  Environmental laws may result in more or less investment, depending on their competitive influence.

###### III.Government Purchases

Federal, state, and local governments purchase thousands of goods and services.

In 1998, government purchases accounted for 17% of GDP.

The Government Purchase Function: The relationship between government purchases and the level of income in the economy, other things constant.  Government purchases are considered autonomous that do not depend directly on the level of income in the economy, because spending decisions are made by government officials.

IV.         Net Exports

Net Exports = Exports – Imports

##### A.   Net Exports and Income

The Net Export Function – The relationship between net exports and the level of income in the economy, other things constant.

·       When incomes rise, Americans spend more, and some of the increased spending goes to imported goods.

·       The amount of U.S. exports depends on the incomes of foreigners, not U.S. income.  Hence, it is considered to be autonomous.

·       So, net exports tend to decline as income increases.

B.    Non income Determinants of Net Exports

Factors held constant along the net export function include the following:

·       The U.S. price level

·       Price levels in other countries

·       Interest rates here and abroad

·       Foreign income levels

·       The Exchange rate between the dollar and foreign currencies

Example: A change in one of these factors can shift the net export function.  Suppose the value of the dollar decreases relative to foreign currency (fall in the dollar’s exchange value).  With the dollar worth less on world markets, foreign products become more expensive for Americans, and U.S. products become cheaper for foreigners. What happens to net exports?

Imports decrease and e

exports increase. à Net exports = Exports – Imports increase.

What is the effect of an increase in the dollar’s exchange value?

V.     Composition of Aggregate Expenditure

·       Consumption’s share of aggregate spending has increased

·       Share of spending on government purchases decreased (Declines in defense.)

·       Investment spending has fluctuated

·       Net Exports have been negative.

Negative net exports mean that C + I + G  (spending) exceeds GDP. U.S. spending exceeds amount produced by U.S. economy.   Americans spend more than they make by borrowing from abroad.

VI.         Aggregate Expenditures and the Income Multiplier

A.      The Simplified Model:  Private Domestic Economy

1.     Assumptions of model:

·       Aggregate spending is either for consumption or investment

·       Consumption depends on income and autonomous forces

·       Investment is either planned (Ip) or unplanned

·       Planned investment is autonomous

2.     Plotting the aggregate expenditures curve

·       Aggregate output equal to income on 45 degree line

·       AE = C + Ip  is the sum of planned aggregate expenditures

·       The intersection of AE with the 45 degree line is an equilibrium level of income

3.     An increase in planned spending due to autonomous forces shifts the AE line resulting in a new level of equilibrium income.

4.     Income increases by a multiplier of the increase in autonomous spending due to induced consumption.

5.     The multiplier is the reciprocal of the leakage rate.

B.         The general model:  the role of autonomous taxes, income taxes, and imports

1.     Autonomous taxes shift the AE schedule.

2.     Income taxes and imports flatten the slope of the AE schedule.

3.     The flatter the AE schedule the lower the income multiplier.

4.     Savings, income taxes, and imports are leakages that determine the value of the income multiplier.

VII.    Aggregate Expenditures and Aggregate Demand

A.    The effect of a price change on the AE schedule.

1.     A higher price level lowers consumption, investment, and net exports resulting in lower aggregate expenditures.

2.          Lower aggregate expenditures results in lower equilibrium output at a higher price level.  This is, in fact, the aggregate demand schedule of the economy.

3.          Factors other than a price change that affect aggregate expenditures result in a shift in the aggregate demand schedule.

Exercises:  Work problem 6 on page 287