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.
· 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.
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
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
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.)
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.
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.
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.
· 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