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12.1© 2005 Prentice Hall, Inc.
Economics for Managersby Paul Farnham
Chapter 12:Spending by Individuals,
Firms, and Governments on Real Goods and Services
12.2© 2005 Prentice Hall, Inc.
Focus on the Short-Run
Potential GDP: maximum amount of output that can be produced
Depends on size of labor force, number of structures and amount of equipment in the economy, and state of technology
Policy goal is managing aggregate expenditure to keep economy close to potential output without starting inflation
Managers tend to focus on short-run
12.3© 2005 Prentice Hall, Inc.
Real Versus Nominal Terms
Real terms: measuring expenditures and income with price level held constant
Nominal terms: measuring expenditures and income with price level allowed to vary
12.4© 2005 Prentice Hall, Inc.
Components of Aggregate Expenditure
Aggregate expenditure: sum of personal consumption, investment, government, and net export expenditures on total amount of real output produced
Personal consumption expenditure: sum of durable goods, nondurable goods, and services
12.5© 2005 Prentice Hall, Inc.
Personal Consumption Expenditure and Income
Keynesian consumption function: assumes that as disposable income increases, consumption spending increases by smaller amount• Marginal propensity to consume
(MPC)• Marginal propensity to save (MPS)
Saving: amount of disposable income households do not spend on consumption
12.6© 2005 Prentice Hall, Inc.
Level of Personal Taxes
Level of taxes affects consumption spending• Economic Growth and Tax Relief
Act of 2001
• Tax cut of 2003 Taxes can be cut or increased
temporarily or permanently
12.7© 2005 Prentice Hall, Inc.
Real Interest Rate
Changes in interest rate affect spending, especially in durables• Real interest rate
• Nominal interest rate Lenders charge borrowers
nominal rate (i) based on the real rate (r) and the expected rate of inflation
12.8© 2005 Prentice Hall, Inc.
Consumer Confidence
University of Michigan’s Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI)
Some debate as to whether these confidence indices predict changes in consumer spending
12.9© 2005 Prentice Hall, Inc.
Consumer Credit andLevel of Debt
Federal Reserve Board monitors use of consumer credit
Increased consumer credit may have restraining influence on consumption
Consumption function:• C = f (Y, Tp, r, CC, W, CR, D)• C = C0 + c1 Y
12.10© 2005 Prentice Hall, Inc.
Consumption Function
Autonomous consumption expenditures: determined by factors other than level of real income in the economy
Induced consumption expenditures: result from changes in level of real income in the economy
12.11© 2005 Prentice Hall, Inc.
Components of Aggregate Expenditure
Figure 12.5a and 12.5b
Consumption
Y
C
C2
C1
0 Y1 Y2
C0
Y
C
Y
I
I2
I1
0 Y1 Y2
I0 Y
I
Investment
12.12© 2005 Prentice Hall, Inc.
Government
Y
G
0
G0
Components of Aggregate Expenditure
Exports
Y
X
0
X0
Figure 12.5c and 12.5d
12.13© 2005 Prentice Hall, Inc.
Components of Aggregate Expenditure
Figure 12.5e
Y
M
M2
M1
0 Y1 Y2
M0 Y M
Imports Consumption, investment, and import spending are assumed to be a function of the level of real income.
Government and export spending are determined by factors other than the level of real income.
Consumption, investment, and import spending are assumed to be a function of the level of real income.
Government and export spending are determined by factors other than the level of real income.
12.14© 2005 Prentice Hall, Inc.
Gross Private Domestic Investment
GPDI: total amount of spending on nonresidential structures, equipment, software, residential structures, and business inventories in a given time
Variety of factors influence GPDI
12.15© 2005 Prentice Hall, Inc.
Factors Influencing GPDI
Business investment spending and real income
Real interest rate Business taxes
• Relative prices: cost of capital versus cost of other inputs
Expected profits and business confidence
12.16© 2005 Prentice Hall, Inc.
Factors Influencing GPDI
Capacity utilization • Rates are prepared monthly by
Fed for manufacturing, mining, and electric/gas utilities industries
Residential investment spending Inventory investment
• Inventory investment function:
I = f (Y, r, TB, PR, CU)
12.17© 2005 Prentice Hall, Inc.
Government Expenditure
Includes total amount of spending by federal, state, and local governments on consumption outlays, depreciation, and investment capital outlays
Determined by legislative and executive institutions of all levels of government
12.18© 2005 Prentice Hall, Inc.
Government Expenditure
Fiscal policy: use of expenditure and taxation policy to pursue macroeconomic goals of high employment and low inflation• G = f (Y, Policy) • G = G0
Both equations assume spending is determined only by policy and not by real income in economy
12.19© 2005 Prentice Hall, Inc.
Government Expenditure
Net export expenditure: difference between export spending on domestically produced goods and services by individuals in other countries and import spending on foreign produced goods and services by domestic residents
X = F (Y, Y*, R)
12.20© 2005 Prentice Hall, Inc.
Government Expenditure
Currency exchange rate: rate at which one nation’s currency can be exchanged for another (is determined in foreign exchange markets)
Import expenditures• M = f (Y, R)
• M = M0 + m1 Y
12.21© 2005 Prentice Hall, Inc.
Aggregate Expenditure and Equilibrium
Aggregate expenditure (E): planned spending on currently produced goods and services by all sectors of the economy• E = C + I + G + X – M
Aggregate expenditure function: relationship between aggregate expenditure and income, all other variables constantE = f (Y, TP, r, CC, W, CR, D, TB, PR, CU G, Y*, R)
12.22© 2005 Prentice Hall, Inc.
Aggregate Expenditure Function
Y
E
0
E0 Slope = (c1 + i1 – m1)
E0 represents autonomous aggregate expenditure determined by factors other than real income
E0 represents autonomous aggregate expenditure determined by factors other than real income
12.23© 2005 Prentice Hall, Inc.
Equilibrium Level ofIncome and Output
Level of income where desired spending equals value of aggregate output and income received from that production
Injections: supplement to consumer spending that increases domestic aggregate output and income
Leakages: uses of current income for purposes other than purchasing currently produced domestic goods and services
12.24© 2005 Prentice Hall, Inc.
Adjustment Toward Equilibrium
Y
E
EE
0 YE
E0
E1
45o
A
Slope = c1 (assuming i1 = m1 = 0)
Only at this level of income and output is desired expenditure just equal to value of output produced and income generated.
Only at this level of income and output is desired expenditure just equal to value of output produced and income generated.
12.25© 2005 Prentice Hall, Inc.
Adjustment Toward Equilibrium
At income level Ye1, individuals want to purchase more goods and services than are currently produced
Firms then have to draw down on their existing inventories of goods (called unplanned inventory decrease)
12.26© 2005 Prentice Hall, Inc.
Changes in Equilibrium
F
A
Figure 12.10
Y
EE2
0 YE1 YE2
EE1
E0
E1E1
E11
45o
B
C
E
Y
12.27© 2005 Prentice Hall, Inc.
The Multiplier
Multiplier: change in income and output resulting from a change in autonomous expenditure
Multiplier effect: results from fact that increase in autonomous expenditure represents an injection of new spending in circular flow of economic activity
End result is multiple increase in income determined by size of MPC and the term [ 1 / (1 – MPC)]
12.28© 2005 Prentice Hall, Inc.
Investment-Saving (IS) Curve
Shows alternative combinations of real interest rate and real income
Theoretical construct focusing on relationship between interest rate and level of real income and output
Summarizes the relationship between real interest rate and real spending
12.29© 2005 Prentice Hall, Inc.
Interest-Related Expenditure Function
Shows planned consumption and investment spending as a function of real interest rate
Points downward showing an inverse relationship between interest rate and planned consumption and investment expenditure
12.30© 2005 Prentice Hall, Inc.
IRE Function Summarized
Figure 12.11
IS
DA
Y
r
0 Y1 Y2
r2
r1
BC
12.31© 2005 Prentice Hall, Inc.
Shifting the IS Curve
Changes in any factor influencing autonomous aggregate expenditure causes IS curve to shift
IS: Y = f (r, TP, CC, W, CR, D, TB, PR, CU, G, Y*, R)
12.32© 2005 Prentice Hall, Inc.
Summary of Key Terms
Aggregate expenditure function Autonomous consumption expenditures Capacity utilization rates CCI and CSI Consumption function Currency exchange rate Equilibrium level of income and output Fiscal policy and government expenditure
12.33© 2005 Prentice Hall, Inc.
Summary of Key Terms
Gross private domestic investment Induced consumption expenditures Injections IRE function and IS curve Investment spending function Leakages Marginal propensity to consume and to
save (MPC) and (MPS) Multiplier
12.34© 2005 Prentice Hall, Inc.
Summary of Key Terms
Net export expenditure Nominal interest rate and real interest
rate Personal consumption expenditure Potential GDP Real terms and relative prices Saving Unplanned inventory increase and
unplanned inventory decrease
12.35© 2005 Prentice Hall, Inc.
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Do you have any questions?