Transcript The Art and Science of Economics

Aggregate Expenditure
Components
CHAPTER
24
© 2003 South-Western/Thomson Learning
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Consumption
Consumption both reflects income and
depends on income
There is a stable and positive
relationship between consumption and
income both for the household and for
the economy
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Consumption Function
Because consumption depends on income,
we say that consumption is a function of
income
Consumption is the dependent variable
Disposable income is the independent variable
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Marginal Propensities to Consume and Save
What happens to consumption and
saving when income changes?
Marginal Propensity to Consume, MPC
equals the change in consumption divided
by the change in income
Marginal Propensity to Save, MPS equals the
change in saving divided by the change in
income
MPC + MPS = 1
This equality exists because all disposable
income must either be spent on
consumption or saved
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Nonincome Determinants
Along a given consumption function,
consumer spending depends on the
level of disposable income in the
economy, other things constant
What are these factors that could cause
the entire consumption function to
shift?
Net Wealth
Price Level
Interest Rate
Expectations
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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  the consumption
function would shift from C down to C’
in Exhibit 6
Increase in net wealth  increases
consumption  consumption function
would shift from C to C”
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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
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Price Level
Some household wealth is held in
dollar-denominated assets such as bank
accounts and cash
Whenever the price level changes, the
real value of these dollar-denominated
financial assets changes
Increase 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 consumer more and
save less
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Interest Rate
Interest
The reward savers earn for deferring
consumption and,
the cost paid by borrowers for current
spending power
The higher the interest rate, the less is
spent on items purchased on credit 
households save more and borrow less
 consumption function shifts
downward
Conversely, a lower interest rate shifts
the consumption function upward
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Expectations
Expectations influence economic behavior
in a variety of ways
Changing expectations about price levels,
interest rates, job security and other such
factors influence consumer behavior
If expectations become more pessimistic
 consumption function shifts downward
If expectations become more optimistic 
consumption function shifts upward
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Investment
Investment consists of spending on
New factories and new equipment
New housing
Net change in inventories
Firms invest in capital goods now in the
expectation of a future return
Since the return is in the future,
investors must estimate how much a
particular investment will yield in all
years of its productive life
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Investment
Firms buy new capital goods only if they
expect this investment to yield a
greater return than other possible uses
of their funds
Recall the distinction between
Gross investment
Net investment
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Demand for Investment
The expected rate of return equals the
annual dollar earnings expected from
the investment divided by the purchase
price
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Investment
Should the firm invest in golf carts, and
if so, how many?
Suppose they plan to borrow the money
to buy the carts  the number of carts
they purchase will depend on the
interest rate they must pay to borrow
the money
If we now suppose that the market
interest rate is 8% per year, the first
three carts, all with expected rates of
return exceeding 8%, would more than
pay for themselves
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Investment
The step like relationship indicates the
amount to be invested in golf carts at
each interest rate
When the interest rate is 8%, profit will
be maximized when $6,000 is invested
in the carts
The market interest rate is the
opportunity cost of investing in capital
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From Micro to Macro
Other things constant, more is invested
when the opportunity cost of borrowing
is lower
With some modifications, the downward
sloping demand curve for the entire
economy can be derived from a
horizontal summation of all industries’
downward sloping investment demand
curves
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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
One reason for this is that some investments
take years to complete
Additionally, investment, once in place, is
expected to last for years
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 simplest investment function
assumes that planned investment is
unrelated to the current level of
disposable income
That is, investment is assumed to be
autonomous with respect to income 
planned investment does not vary even
though real disposable income does
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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 of the determinants of investment
that are assumed to be constant are
The market interest rate
Business expectations
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Market Interest Rate
In Exhibit 8, when the interest rate was
8%, planned investment is $0.8 trillion
 shown as I
A decline in the rate of interest from,
say 8% to 6%, other things remaining
constant, will reduce the cost of
borrowing and increase planned
investment from $0.8 to $0.9 trillion 
investment function shifts upward from
I to I"
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Business Expectations
The primary determinant of investment
is business expectations
If firms become more pessimistic about
profit prospects, planned investment
will decrease at every level of income as
shown by the shift in the investment
function from I to I’ in Exhibit 9
On the other hand, if profit expectations
become rosier, the investment function
will shift upward from I to I”
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Business Expectations
Factors that could affect business
expectations hence investment would
include
Wars
Technological change
Changes in the tax structure
Other destabilizing events that make longterm planning more uncertain
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Government Purchase Function
Government purchases in 2001
accounted for about 18% of GDP
One-third of the total was by the federal
government
Two-thirds by state and local governments
The government purchase function
relates government purchases to the
level of income in the economy, other
things constant
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Government Purchase Function
Because decisions about government
purchases are largely under the control
of public officials, they do not depend
directly on the level of income in the
economy
Therefore, we assume that government
purchases, G, are autonomous, or
independent of the level of income
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Transfer Payments
Government purchases represent only
one of the components of government
outlays
The other is transfer payments
Outright gifts from governments to
households and are thus not considered part
of aggregate expenditure
Social Security
Welfare benefits and Unemployment
benefits
Make up about a third of government
outlays
Transfer payments vary inversely with
income  as income increases, transfer
payments decline
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Net Taxes
To fund government outlays, governments
impose taxes
Taxes vary directly with income  as
income increase, so do taxes
Net taxes equal taxes minus transfers
Since taxes tend to increase with income
while transfers decrease with income, we
will assume that net taxes, NT, are
autonomous, or independent of income
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Net Taxes
Net taxes affect aggregate spending
indirectly by changing disposable
income, which in turn changes
consumption
In our discussion of the circular flow
that by subtracting net taxes, we
transform real GDP into disposable
income
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Net Exports
The rest of the world affects aggregate
expenditure through imports and
exports
The United States, with only onetwentieth of the world’s population –
accounts for about one-sixth of the
world’s imports and one-eighth of the
world’s exports
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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
How does the value of U.S. exports
relate to the economy’s level of income?
The exports purchased by the rest of the
world depends on the income of foreigners,
not on the U.S. level of income
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Net Export Function
The net export function shows the
relationship between net exports and
the level of income in the economy,
other things constant
Since exports are relatively insensitive
to the level of U.S. income but our
imports tend to increase with income,
net exports – Exports minus imports –
tend to decline as U.S. income increase
However, for simplicity, we will assume
that net exports are autonomous and
independent of the level of income
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Nonincome Determinants of Net Exports
Factors assumed constant along the net
export function include
The U.S. price level
Price levels in other countries
Interest rates here and abroad
Foreign income levels
Exchange rates between the dollar and
foreign currencies
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