Transcript Chap24
Chapter 24 Aggregate Expenditure Components © 2006 Thomson/South-Western 1 Exhibit 1: Disposable Income, Consumption, and Saving The relationship between disposable income and consumption has been relatively constant and stable over time Saving is the difference between disposable income and consumption 2 Exhibit 2: U.S. Consumption Depends on Disposable Income 3 The Consumption Function The relationship between consumption and income, other things constant Consumption is the dependent variable Disposable income is the independent variable. Because consumption depends on income, it is a function of income 4 Exhibit 3: The Consumption Function Both disposable income and consumption are measured in real terms, or in inflation-adjusted dollars Consumption increases with disposable income, assuming other determinants of consumption remain constant 5 Exhibit 4a: Marginal Propensity to Consume Slope of the consumption function equals the marginal propensity to consume In 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 6 Exhibit 4b: Marginal Propensity to Save Income that is not spent is saved Here, saving increases by $0.1 trillion as a result of a $0.5 trillion increase in income The marginal propensity to save, MPS, equals 0.1 / 0.5, or 1/5 Generally, MPC + MPS = 1 7 Nonincome Determinants What are these factors that could cause the entire consumption function to shift? Net wealth and consumption Price level Interest rate Expectations 8 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 9 Exhibit 5: Shifts in the Consumption Function C" •Increase in net wealth shifts consumption function from C to C'' •Decrease in net wealth shifts it from C to C' C C' 0 Real disposable income 10 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 11 Price Level When price level changes, real value of dollar-denominated financial assets (bank accounts, cash) also 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 consume more and save less 12 Interest Rate Interest The reward savers earn for deferring consumption 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) and the consumption function shifts downward Conversely, a lower interest rate shifts the consumption function upward 13 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 14 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 return is in the future, investors must estimate how much a particular investment will yield in all years of its productive life 15 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 16 Exhibit 6: Rate of Return on Golf Carts and the Opportunity Cost of Funds 17 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. 18 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 19 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 are The market interest rate Business expectations 20 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 21 Real planned investment (trillions of dollars) Exhibit 8: Planned Investment Function 1.1 I" 1.0 I 0.9 I' 0 2.0 4.0 6.0 8.0 The horizontal investment functions imply that planned investment does not vary with real disposable income, it is autonomous 10.0 12.0 14.0 Real disposable income (trillions of dollars) 22 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 23 Business Expectations Factors that could affect business expectations – and investment – include: Wars Technological change Changes in the tax structure Other destabilizing events that make long-term planning more uncertain 24 Exhibit 9: Annual Percentage Change in U.S. Real GDP, Consumption, Investment 25 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 26 Transfer Payments Transfer payments are another government outlay 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 27 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 28 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 29 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 income Net 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 30 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 31 Exhibit 10: Net Export Function 32 Exhibit 11: U.S. Spending Components as Percentages of GDP Since 1959 33