Transcript Chapter 9 Building the Aggregate Expenditures Model

Chapter 9
Building the Aggregate
Expenditures Model
2 important questions
• 1. what determines the level of GDP,
given a nation’s production capacity?
• 2. what causes real GDP to rise in one
period and fall in another?
• To answer we construct the AGGREGATE
EXPENDITURES model
Chapter 9 pretends we are a
“private closed economy” and only
consists of
• Personal Consumption and Investment
• (we will add G and Xn in chapter 10)
Simplifying assumptions
• Savings consist only of personal savings
• Deprecation and net foreign factor income
are zero
• GDP , NI (national income), PI (personal
income) and DI (disposable income) are
all equal
Tools of the Aggregate Expenditure
Model
• Amount of goods and services produced depend directly
on the level of aggregate expenditures (total spending)
• Businesses will only produce a level of output they think
they can profitably sell
• Businesses will idle their workers and machinery when
there are no markets for their goods and services
• We assume the economy has excess production
capacity and unemployed labor- an increase in AE will
increase real output and employment, but we will
assume unless stated otherwise that PRICE LEVEL
remains constant!
What do you think is the most
significant determinant of
consumer spending?
•
•
•
•
A.
B.
C.
D.
Wealth
Consumer expectations
Disposable income
Taxes
Consumption
• Most significant determinant of consumer
spending is INCOME (in particular, DI)
• Households consume most of their income
and both consumption and saving are
directly related to income level
Consumption and Savings
• S = DI – C
Average Propensity to Consume
and Save
• The fraction, or percentage, of total
income that is
consumed = APC = c/I
saved = APS = s/ I
APC + APS = 1
Example
• Income = 100,000
• C= 80,000
•
•
•
•
•
Find APC
A. 20%
B. 40%
C 80%
D. 100%
Global Perspective
Average Propensities to Consume
Select Nations GDPs
Average Propensities to Consume
.80
.85
.90
.95
1.00
United States
.963
Canada
.958
United Kingdom
.953
Japan
.942
Germany
.896
Netherlands
.893
Italy
France
.840
.833
Source: Statistical Abstract of the United States, 2006
Marginal Propensity to Consume
and Save
• The fact that households consume a certain proportion
of a particular income does not guarantee the same
proportion of any change in income they might receive
• The proportion, or fraction, of any change in income
consumed = mpc = change in c/ change in income
savings = mps = change in s/ change in income
MPC + MPS = 1
Example
DI
C
S
430
420
10
450
435
15
MPC and MPS as slopes
• The MPC is the numerical value of the
slope of the consumption schedule and
• The MPS is the numerical value of the
slope of the saving schedule
If Margy's MPC is .9, this means
that she will:
• A. spend 90 cents out of every additional
dollar of disposable income
• B. spend 90% of her total disposable
income
• C. spend all her disposable income when
her disposable income is $9000
• D. save 10% of her total disposable
income
A. spend 90 cents out of every
additional dollar of disposable
income
• The marginal propensity to consume (MPC) is
the change in spending divided by the change in
disposable income. In this example, this implies
that for every additional dollar of disposable
income, 90 cents will be spent.
[Income change, movement from point to point]
SAVING
Consumption
Consumption
C2
Breakeven
C1
DISSAVING
DI2 Disposable Income
S
SAVING
o
DISSAVING
o
o DI3 DI1
Saving
[Negative saving]
45
So, the key to a
change in QC(QS)
is a change in ?
S
Disposable Income
Remember, # 1 factor that
determines C or S
• Income!!!!!!!!!
• Change in income will be a movement
along a C or S line
Non-income determinants of
Consumption and Saving (will shift
entire curve)
•
•
•
•
Wealth
Expectations
Taxation
Household Debt
Non-income Determinants of C and
S
• These will cause the C and S lines to
SHIFT!!!! (up or down)
• Cheat sheet….Y means income!!!
• By wealth we mean real assets (house,
car, other durables) and financial assets
(cash, savings accounts, stocks, bonds)
Expect. PL incr.
Expect. of positive Y
Expect. of shortages
Decrease in debt (pay
Off debt, have more to C)
*Decrease in taxes
Increase in debt
Consumption
[shift/whole
curve/non-income]
May be caused
by:
C2
Increase in wealth
Decrease in PL
C1
o
I’ll buy more and
save even more.
Saving
*Decrease in taxes
increases both C & S
Increases in
consumption
means…
45
o
Disposable Income
S1 Decrease
S2 in saving
o
Disposable
Income
[shift/whole curve/non-income]
May be caused by:
o
o
Decreases in
consumption
means…
45
Disposable Income
Increase
S2
S in saving
0
Saving
*Increase in taxes
decreases both C & S
Consumption
Decrease in wealth
Increase in PL
Expect. PL decrease
Expect. neg. future Y
Increase in debt
*Increase in taxes
C1
C2
o
Disposable Income
Stability
• Although changes in non-income
determinants can shift the c and s
schedules, usually these schedules are
relatively stable
• This may be because c-s decisions are
strongly influenced by long-term
considerations like s for emergencies or
retirement
Investment
• Expenditures on new plants, capital
equipment, machinery, inventories, etc
• Businesses will invest in all projects for
which the expected rate of return exceeds
the interest rate
2 basic determinants of investment
spending
• 1. Expected Rate of Return: the increase in
profit a firm anticipates it will obtain by
purchasing capital; expressed as a percentage
of the total cost of the investment activity
• 2. Real Interest Rate: interest rate adjusted for
inflation
• * if the expected rate of return exceeds the real
interest rate, firms will undertake investment
• Firms should invest in projects where r = I (rate
of return = investment)
Single Firm
Positive profit expectations and the real interest
rate are the most important determinants of investment.
Drill Press - $1,000
A. Expected gross profits = $1,100 or a 10% return.
[$100/$1,000 x 100 = 10%]
[At 8%, invest in the drill; at 12%, don’t invest]
B. Real interest rate [nominal interest rate-inflation]
(percents)
and interest rate,
i
r,
Expected rate of return,
D
(Interest rate change, point to point movement)
16
I
Firms will undertake all investments
[additions to plant, equipment, inventory,
14
and residential construction] which have an
expected rate of net profit greater than
[or equal to] the real rate of interest.
12
10
Monetary Policy – by lowering
interest rates, the Fed can
increase Ig & employment.
8%
6
4%
2
0
1
10
15 20 25 30 35 40
Investment (billions)
QID
QID
[Inverse relationship between real interest rate and QID]
# 1 factors that determine whether
a business invest
• Expected rate of return and real interest
rate--- causes a movement along the
investment curve
Shifts in investment demand curve
•
•
•
•
•
This will shift curve to the right or to the left
Acquisition, maintenance, operating costs
Business taxes
Technological change
Stock of capital goods on hand (if firms
have too much, they will invest less)
• Expectations (on future sales)
Increase in Investment
1.
2.
3.
4.
5.
I1
Positive profit expectations
Scarcity of inventory
Technology [innovation]
Decrease in production costs
Decrease in business taxes
I2
8%
QID1 QID2
Investment is unstable (unlike
consumption)
• Shifts significantly upward or downward
quite often
• Investment is the most volatile component
of total spending
• Why?
• Durability of capital and variability of
expectations
• Irregularity of innovation
Equilibrium GDP
• The output whose production creates total
spending just sufficient to purchase the output
• The equilibrium level of GDP is the level at
which the total quantity of goods produced
(GDP) equals the total quantity of goods
purchased (C +Ig)
• Above or below = disequilibrium
Other features of equilibrium GDP
• Savings represents a leakage of spending
from the income-expenditures stream
• Investment can be thought as an injection
of spending into the income-expenditures
stream
#3 pg. 179
• Explain how each of the following will
affect the C and S schedules or the
investment schedule
• Consumption (up/ down)
Investment (left/right)
A. A large increase in the value of
real estate, including private
houses
• If this simply means households have
become more wealthy, then c will increase
at each income level. The c schedule
should shift upward and the saving
schedule shift leftward. The investment
schedule may shift rightward if owners of
existing homes sell them and invest in
construction of new homes more than
previously
B. The threat of limited, nonnuclear war, leading the public to
expect future shortages of
consumer durables
• This threat will lead people to stock up; the
C schedule will shift up and the saving
schedule down. If this puts pressure on
the consumer goods industry, the
investment schedule will shift up. The
investment schedule may shift up again
later because of increased military
procurement orders
C. A decline in real interest rate
• The decline in the real interest rate will
increase interest-sensitive consumer
spending; the C schedule will shift up and
the saving schedule down. Investors will
increase investment as they moved down
the investment- demand curve; the
investment schedule will shift upward
D. A sharp, sustained decline in
stock prices
• Though this did not happen after October 19,
1987, a sharp decline in stock prices can
normally be expected to decrease consumer
spending because of a decrease in wealth; the
C schedule shifts down and the saving schedule
upwards. Because of the depressed share
prices and number of speculators forced out of
the market, it will be harder to float new issues
on the stock market. Therefore, investment
schedule will shift downward
E. An increase in the rate of
population growth
• The increase in the rate of population
growth will, over time, increase the rate of
income growth. In itself this will not shift
any of the schedules but will lead to
movement upward to the right along the
upward sloping investment schedule
F. The development of a cheaper
method of manufacturing computer
chips
• This innovation will in itself shift the
investment schedule upward. Also, as the
innovation starts to lower the costs of
producing everything using these chips,
prices will decrease leading to increase
quantities demanded. This, again, could
shift he investment schedule upward
G. A sizable increase in the
retirement age for collecting social
security benefits
• The postponement of benefits may cause
households to save more if they planned
to retire before they qualify for benefits;
the saving schedule will shift upward, the
consumption schedule downward. This
impact is uncertain, however, if people
continue to work and earn productive
incomes.
H. The expectation that mild
inflation will persist in the next
decade
• If this is a new expectation, the
consumption schedule will shift upwards
and the saving schedule downwards until
people have stocked up enough. After
about a year, if the mild inflation is not
increasing, the household schedules will
revert to where they were before.
I. An increase in the federal
personal income tax
• Because this reduces disposable income,
consumption will decline in proportion to
the marginal propensity to consume.
Consumption will be less at each level of
real output, and so the curve shifts down.
The savings schedule will also fall
because the disposable income has
decrease at each level of output, so less
would be saved.