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1
Aggregate Expenditure Components
Chapter 24
© 2006 Thomson/South-Western
2
Exhibit 1: Disposable Income, Consumption, and Saving
The relationship between disposable income and consumption has been relatively constant and stable over timeSaving is the difference between disposable income and consumption
3
Exhibit 2: U.S. Consumption Depends on Disposable Income
4
The Consumption Function
The relationship between consumption and income, other things constantConsumption is the dependent variable Disposable income is the independent variable.
Because consumption depends on income, it is a function of income
5
Exhibit 3: The Consumption Function
Both disposable income and consumption are measured in real terms, or in inflation-adjusted dollarsConsumption increases with disposable income, assuming other determinants of consumption remain constant
6
Exhibit 4a: Marginal Propensity to Consume
Slope of the consumption function equals the marginal propensity to consumeIn this case, the change in consumption is $0.4 trillion and the change in income is $0.5 trillion: the marginal propensity to consume = 0.4 / 0.5 or 4/5
7
Exhibit 4b: Marginal Propensity to Save
Income that is not spent is savedHere, saving increases by $0.1 trillion as a result of a $0.5 trillion increase in incomeThe marginal propensity to save, MPS, equals 0.1 / 0.5, or 1/5Generally, MPC + MPS = 1
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Nonincome Determinants
What are these factors that could cause the entire consumption function to shift?Net wealth and consumptionPrice levelInterest rateExpectations
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Net Wealth
Net wealth is the value of all assets that households own minus any liabilities, or debts owed
A decrease in net wealth would make consumers less inclined to spend, more inclined to save
Increase in net wealth increases consumption
10
Exhibit 5: Shifts in the Consumption Function
0
C
Real disposable income
C"
C'
•Increase in net wealth shifts consumption function from C to C''•Decrease in net wealth shifts it from C to C'
Rea
l Co
nsu
mp
tio
n
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Shifts and Movements Along
Difference between a movement along the consumption function and a shift of the consumption function
Movement along the consumption function results from a change in income
Shift of the consumption function results from a change in one of the nonincome determinants of consumption
12
Price Level
When price level changes, real value of dollar-denominated financial assets (bank accounts, cash) also changesIncrease in the price level reduces the
purchasing power of wealth held in fixed dollar assets – households consume less and save more
Decreases in the price level increase the purchasing power of wealth held in fixed assets – households consume more and save less
13
Interest Rate
InterestThe reward savers earn for deferring consumption The cost paid by borrowers for current spending
power
The higher the interest ratehigher the interest rate, the less is spent on items purchased on credit (households save more and borrow less) and the consumption function shifts downward
Conversely, a lower interest rate shifts the consumption function upward
14
Expectations
Changing expectations about price levels, interest rates, job security and other such factors influence consumer behavior
If expectations become more pessimistic, then consumption function shifts downward
If expectations become more optimistic, then consumption function shifts upward
15
Investment
Investment consists of spending onNew factories and new equipmentNew housingNet change in inventories
Firms invest in capital goods now in the expectation of a future return
Since return is in the future, investors must estimate how much a particular investment will yield in all years of its productive life
16
Demand for Investment
Firms buy new capital goods only if they expect this investment to yield a greater return than other possible uses of their funds
The expected rate of return equals the annual dollar earnings expected from the investment divided by the purchase price
Market interest rate is the opportunity cost of investing in capital
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Exhibit 6: Rate of Return on Golf Carts and the Opportunity Cost of Funds
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Exhibit 7: Investment Demand Curve for the Economy
•Shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant. •Sums the investment demanded by each firm at each interest rate. •At lower interest rates, more investment projects become profitable for individual firms, so total investment in the economy increases.
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Planned Investment and Income
Investment depends more on interest rates and on business expectations than on the prevailing level of income
Thus, the investment decision is said to be “forward looking,” based more on expected profit than on current levels of income and output
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Investment Function
The investment function isolates the relationship between the level of income in the economy and planned investment – the amount firms would like to invest, other things constant
Two determinants of investment assumed to be constant areThe market interest rateBusiness expectations
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Market Interest Rate
A decline in the rate of interest, other things remaining constant, will reduce the cost of borrowing and increase planned investment: investment function shifts upward
Conversely, when the interest rate increases, the planned investment function shifts downward
22
Exhibit 8: Planned Investment Function
1.0
0 2.0 4.0 6.0 8.0 10.0 12.0 14.0
Real disposable income (trillions of dollars)
I
1.1 I"
0.9 I'
The horizontal investment functions imply that planned investment does not vary with real disposable income, it is autonomous
Rea
l p
lan
ned
in
vest
men
t(t
rilli
on
s o
f d
olla
rs)
23
Business Expectations
The primary determinant of investment is business expectations
If firms become pessimistic about profit prospects, planned investment will decrease at every level of income
On the other hand, if profit expectations become rosier, the investment function will shift upward
24
Business Expectations
Factors that could affect business expectations – and investment – include:WarsTechnological changeChanges in the tax structure Other destabilizing events that make
long-term planning more uncertain
25
Exhibit 9: Annual Percentage Change in U.S. Real GDP, Consumption, Investment
26
Government Purchase Function
Government purchase function relates government purchases to the level of income in the economy, other things constant
Decisions about government purchases do not depend directly on the level of income in the economy
27
Transfer Payments
Transfer payments are another government outlay Outright gifts from governments to households and
are thus not considered part of aggregate expenditure
Social SecurityWelfare benefits and Unemployment benefitsMake up about a third of government outlays
Transfer payments vary inversely with income – as income increases, transfer payments decline
28
Net Taxes
Governments impose taxes to fund expenditures
Net taxes equal taxes minus transfers and are independent of income
Taxes tend to increase with income while transfers decrease with income
Net taxes affect aggregate spending indirectly by changing disposable income, in turn changing consumption
29
Net Exports and Income
How do imports and exports relate to the level of income in the economy?When their incomes rise, Americans spend
more on everything including exports and when incomes decline, Americans spend less on imports
The exports purchased by the rest of the world depends on the income of foreigners, not on the U.S. level of income
30
Net Export Function
Shows the relationship between net exports and the level of income in the economy, other things constant
Exports are relatively insensitive to level of U.S. income, but imports tend to increase with incomeNet exports (exports minus imports) tend to decline
as U.S. income increases
For simplicity, assume that net exports are autonomous and independent of the level of income
31
Nonincome Determinants of Net Exports
Factors assumed constant along the net export function include: The U.S. price levelPrice levels in other countriesInterest rates here and abroadForeign income levelsExchange rates between the dollar and
foreign currencies
32
Exhibit 10: Net Export Function
33
Exhibit 11: U.S. Spending Components as Percentages of GDP Since 1959