Chapter
9: 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.
Disposable
Income - Income actually
available for spending is personal income less net taxes. The difference between disposable income and
consumption is savings.
*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.
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?"
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:
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 - 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.
**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.
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.
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.
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.)
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
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.
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.
Unlike
consumption, Investment depends more on interest rates and on business
expectations than on level of income.
Investment
Function – 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
investment is independent of level of income.
E.
The
Autonomous Investment Function (Non
income Determinants of Investment)
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
The
Net Export Function –
The relationship between net exports and the level of income in the economy,
other things constant.
B.
Non income Determinants of Net Exports
Factors
held constant along the net export function include the following:
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
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