Transcript Module 16C-"Investment and Real National Income"

The Investment Function and
Consumption as a Function of Real
National Income
J.A.SACCO
Consumption Function of Real National Income



We’ve looked at
consumption based
on the level of RDI
per year.
This was an analysis
of one person/family
Now must create a
consumption
function model for
entire
macroeconomy
Must make
adjustments to RDI
to RNI (Output)
The Consumption
and Saving Functions
C=Yd
20,000
Saving
K
16,000
Planned Real Consumption
(C, dollars per year)

J
I
Break-even
income
12,000
Autonomous
consumption
H
F
G
Consumption
function
E
8,000
D
C
B
4,000
2,000
0
A
Dissaving
450
4,000 8,000 12,000 16,000 20,000
Real Disposable Income (Yd dollars per year)
Economics Today Chapter 12: Consumption, Income, and the Multiplier
Slide # 1
7
Consumption as a Function
of Real National Income “Y”= Real
Planned Consumption per Year
($ trillions)
AE 2.5
Y axis called
AE=Y
C is a function of
real national income.
Assume MPC = .8
2.0
C
National Income
(Output)
Where “C” intersects the
45º Line, Consumption
Expenditures equals
Real National Income
*all Income/Output
Consumed
Autonomous
consumption EQUILIBRIUM!
1.5
1.0
0.5
0.3
0
45o
0.5
1.0
1.5
2.0
2.5
Real National Income per Year (Output)
($ trillions)
X axis called
3
Keynesian Expenditure Model
Now let’s build the Keynesian
macroeconomic model
 First must look at “I” component

AD  C  I  G  X
Historically
Investment has been more volatile than
consumption
Why?
4
An Intro to Investments and its Determinants
Starter- What is investment in the context of consumption and GDP?
C+I+G+(X-M)=GDP
Real Consumption
 Less variable/more consistent
 Consumption expenditures are
less subject on how economy
looks in future
 People will always spend
Real Investment
 More variable over time
 Based on decisions of business
people on variable/subjective
elements of economy
 Expectations play a role on the
investment function-accounts for
instability of investment over
time.
 Large impact on GDP- Change in
“I” often affects “C”
 Investment depends on interest
rate
5
Planned Investment Function
Investment depends on the interest rate
 Remember the “Classical Economists”
Interest Rate High/ Investment Low
Interest Rate Low/Investment High
 Businesses have an array of investment
opportunities with rates of return that are low
and some high.
 When do you Invest? Investment is profitable if
the rate of return is greater than the
opportunity cost (interest rate) of the
investment.

Decision to Invest



The decision of a firm to invest on machinery or
construction is simply a decision based upon marginal
benefits and marginal costs.
Marginal Benefit of an Investment -is the expected real
rate of return (R) the firm anticipates receiving on the
expenditure.
Marginal Cost of an Investment- is the real rate of
interest (I), or the cost of borrowing.
Rule of Thumb
If Rate of Return% >Real Rate of Interest %, make the
investment.
If Rate of Return% < Real Rate of Interest %, don’t make
investment.
Planned Investment Schedule
Rate of Interest
(percent per year)
15
14
13
12
11
10
9
8
7
6
Planned investment
per Year
($ trillions)
.2
.3
.4
.5
.6
.7
.8
.9
1.0
1.1
i% up, Investment down
i% down, Investment up
8
Rate of Interest (percent per year)
Planned Investment
Just like demand, Investment
increases as the price level or in this
case the interest rate falls and vice
versa!
15
14
13
12
11
10
9
8
7
6
I
0
.1
.2
.3
.4
.5
.6
.7
.8
.9
1.0
1.1
Planned Investment per Year ($ trillions)
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Non- Interest Rate Determinants of
Investment
What Causes the Investment Function to Shift?
 When any non-interest rate determinant of
investment changes, the investment function (I)
will shift.
1) Expectations/ Changes in GDP
2) Productive technology- Need to invest in
capital goods to keep up with increased sales
3) Business taxes

*Change of Interest rate will not shift the
investment function.You will only move
up and down the function.
10
Rate of Interest (percent per year)
Graphing Changes
in Investment/Increase
Positive profit
outlook
r1
I1
I1
I2
I2
Planned Investment per Year ($ trillions)
11
Rate of Interest (percent per year)
Graphing Changes
in Investment/Decrease
Taxes
Increase
r1
I2
I2
I1
I1
Planned Investment per Year ($ trillions)
12
Real Investment per Year
($ trillions)
Combining Consumption
and Investment
The second component of
aggregate demand is investment
spending, “I".
0.7
0
I
1
2
3
4
5
6
7
$700 B. Investment per
year is autonomous with
respect to real national
income. We will assume
this investment is
constant, regardless of
the level of income
I is autonomous
Real National Income per Year
($ trillions)
13
Combining Consumption
and Investment
Planned Consumption per Year
($ trillions)
AE
6.0
C+I
C+I=Y
C
5.0
$.7 Trillion
of auto. “I”
4.0
3.0
1) C + I = total planned
expenditures (AE)
2) Equilibrium: C + I = Y
3) Equilibrium Y = $5 trillion
2.0
1.0
0.3
0
45o
1.0
2.0
3.0
4.0
5.0
6.0
Real National Income per Year (Output)
($ trillions)
14
Keynesian Equilibrium with
Government and the Foreign Sector Added

Government (G) - C + I + G
◦ Federal, state, & local
 Does not include transfer payments
 Is autonomous
 Lump-sum taxes

Lump-sum tax
◦ A tax that does not depend on income or the
circumstances of the taxpayer
In our model Autonomous Government
Spending “G” is $1Trillion dollars
15
Keynesian Equilibrium with
Government and the Foreign Sector Added

The Foreign Sector -- C + I + G + X
◦ Net exports (X) = exports - imports
◦ Autonomous
◦ Depends on the economic conditions in each
country
In our model Autonomous Net Exports “X”
is $.1 Trillion.
16
The Determination of Equilibrium
Real National Income with Net Exports
1
2
3
“C”
4
4+5 Inc. Auto “C”
Real
Taxes
Real
National
Disposable
Planned
Income/
Income
Consumption
Output
(“X” axis)
5
3-4
“I”
“G”
“X”
8
9
Auto
Auto
Auto
4+6+7+8
6
7
Net Exports Total Planned
Planned Planned Government (exports- Expenditures
Saving Investment Spending
imports)
(“Y’ axis)
10
Direction
1-9
of Change
Unplanned in Real
Inventory National
Changes
Income
2.0
1.0
1.0
1.1
-.1
.7
1.0
.1
2.9
-.9
Increase
2.5
1.0
1.5
1.5
0
.7
1.0
.1
3.3
-.8
Increase
3.0
1.0
2.0
1.9
.1
.7
1.0
.1
3.7
-.7
Increase
4.0
1.0
3.0
2.7
.3
.7
1.0
.1
4.5
-.5
Increase
5.0
1.0
4.0
3.5
.5
.7
1.0
.1
5.3
-.3
Increase
6.0
1.0
5.0
4.3
.7
.7
1.0
.1
6.1
-.1
Increase
6.5
1.0
5.5
4.7
.8
.7
1.0
.1
6.5
0
7.0
1.0
6.0
5.1
.9
.7
1.0
.1
6.9
+.1 Decrease
8.0
1.0
7.0
5.9
1.1
.7
1.0
.1
7.7
+.3 Decrease
Neither
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The Equilibrium Level
of Real National Income
C + I + G + (X-M)
Consumption, Investment, Government
Purchases, and Net Exports
($ trillions)
AE
7.0
RNI < C+I+G+X-M
E’
C
Less savings/more
consumption causes
shortage. Business
increase output!
6.0
5.0
4.0
RNI > C+I+G+X-M
More savings/ less
consumption causes
surplus. Cut back
Production!
AE> I/O
3.0
Income/Output > AE.
I
E
1.0
0.3
0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Real National Income/Output per
Year (Y)
($ trillions)
8.0
18
The Equilibrium Level
of Real National Income

Observations
◦ If C + I + G + X (AE) = Y (RNIncome/Output)
 Equilibrium
◦ If C + I + G + X (AE) > Y (RNIncome/Output)




unplanned drop in inventories (shortage/negative)
“Negative Unplanned Inventory Investment”
businesses increase output
Y returns to equilibrium
◦ If C + I + G + X (AE) < Y(RNIncome/Output)
 unplanned rise in inventories (surplus/positive)
 “Positive Unplanned Inventory Investment”
 businesses cut output
 Y returns to equilibrium
*Note equilibrium IS NOT full employment/potential of
the economy
19
The Equilibrium Level
of Real National Income

How does our study of Consumption,
Real National Income, and Equilibrium
help in Macroeconomics?
The Keynesian Cross