Macroeconomics Lecture

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MacroeconomicsLecture 10

• Chapter 10
• Aggregate Expenditures

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Aggregate Expenditures

• Chapter 9 discussed how the price level affects
  aggregate expenditures .
• Now we will examine the non-price determinants of
  spending that shift the aggregate demand curve.
• In this chapter, we assume the price level is
  fixed, thus, we will use the Fixed-Price
  Keynesian Model.

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Fixed-Price Keynesian Model

• Since the Keynesian model assumes that the price
  level is fixed, the aggregate supply curve is a
  perfectly horizontal line.
• Aggregate demand will determine the equilibrium
  level of real GDP.

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Aggregate Demand and GDP

• We can understand what determines real GDP if we
  understand the determinants of aggregate demand
• Consumption
• Investment
• Government spending
• Net exports

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1. Consumption

• Households can do 3 things with their income
• Spend it (consumption)
• Save it
• Pay taxes
• Disposable income is what is left over after
  taxes have been paid, thus we can define it as
• Disposable Income consumption saving
• Or
• Yd C S

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Disposable Income Saving

• Since disposable income is the income households
  can actually spend, whatever is not spent is
  saved.
• Saving is not consuming, so saving is NOT a
  component of total spending (consumption).

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Saving and Savings

• Saving and savings are not the same thing.
• Saving is a flow concept it is measured over a
  unit of time like GDP.
• Savings are an amount accumulated at a particular
  point in time (stock concept).
• Example I am saving 100 a month and have 500
  in savings.

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Consumption Function

• The consumption function is the relationship
  between disposable income and consumption.
• The level of disposable income is the primary
  determinant of the level of consumption over any
  given period of time.
• The higher the disposable income, the more
  households are willing to spend.

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U.S. Consumption Disposable Income, 1947-2002

• The 45-degree line shows all points where Yd C
  are equal.
• The actual consumption function lies just below
  the 45-degree line indicating that consumption is
  not much less than disposable income.

Long-run Consumption Function
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The Consumption Function(Hypothetical Economy)
pg 220
Saving (S) Yd - C
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The Saving Function(Hypothetical Economy)
Saving (S) Yd - C
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Consumption Saving

• We observed that C is a positive function of Yd
  (C goes up as Yd rises).
• When households spend more than they earn, they
  are financing their spending through borrowing
  and/or using savings. This is called dissaving.
• The level of consumption that is not dependent on
  income is called autonomous consumption.

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Autonomous Consumption

• In our hypothetical example, the point of
  autonomous consumption is where C 30 Yd 0
  (the intercept of the C function).
• This is where consumption does not depend on
  income but will be affected by non-income
  determinants of consumption. Thus, autonomous
  consumption is 30.

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Total Consumption

• Total consumption equals autonomous consumption
  plus spending that is dependent on income.
• Total consumption will rise as disposable income
  rises.

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Marginal Propensity to Consume (MPC)

• The relationship between changes in disposable
  income and total consumption is the MPC
• MPC change in consumption
• change in disposable income
• The MPC is the slope of the consumption function.
  

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Marginal Propensity to Save (MPS)

• The relationship between changes in saving and
  disposable income is the MPS
• MPS change in saving
• change in disposable income
• The MPS is the slope of the saving function.

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MPC MPS
MPC MPS 1
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MPS MPC

• The MPC MPS determine the rate of consumption
  and saving as disposable income changes.
• The higher the MPC, the greater the portion of
  any additional disposable income that consumers
  will spend.
• If people spend a greater portion of extra
  disposable income, they save a smaller portion
  (Remember, MPS MPC 1, so if one increases,
  the other decreases).

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Marginal Propensity to Consume Save
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Average Propensity to Consume

• The MPC tells us the change in C as a proportion
  of the change in Yd.
• If we simply want to know the proportion of
  disposable income that is spent for consumption,
  we figure out the average propensity to consume
  (APC)
• APC consumption/disposable income
• or
• APC C/Yd

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Average Propensity to Save

• The MPS tells us the change in saving as a
  proportion of the change in disposable income.
• If we simply want to know the proportion of
  disposable income that is saved, we figure out
  the average propensity to save (APS)
• APS saving/disposable income
• Or
• APS S/Yd

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Average Propensity to Consume Save
APC APS 1
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Ch 10 - Worksheet

• Complete the first table on the worksheet.
• You may work in groups or individually.

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Determinants of Consumption

• Disposable income is not the only factor that
  influences consumption. Determinants of
  consumption include
• a. Disposable Income
• b. Wealth
• c. Expectations
• d. Demographics
• e. Taxation

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a. Disposable Income

• Household income is the primary determinant of
  consumption (this is why the consumption function
  is drawn with disposable income on the horizontal
  axis).
• A change in consumption caused by a change in
  disposable income is shown by movement along the
  consumption function.
• All other determinants of consumption shift the
  consumption function up or down (they change
  autonomous consumption).

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b. Wealth

• Wealth is the value of all assets owned by a
  household.
• If wealth increases, households have more
  resources available for spending, so consumption
  increases at every level of GDP.
• A decrease in wealth has the opposite effect.

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c. Expectations

• If consumers expect a recession, they will cut
  back consumption and increase saving.
• Conversely, if consumers are optimistic about the
  economy, the will increase consumption and
  decrease saving.
• Expectations are subjective and difficult to
  measure.

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d. Demographics

• Demographics have two components that effect
  consumption
• Population
• Consumption will rise with increases in
  population (shift the function up)
• Age
• Age will affect the slope of the consumption
  function (younger households tend to have higher
  MPCs than older households).

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e. Taxation

• We will discuss taxation in depth in Chapter 12.

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Autonomous Shifts in Consumption and in Saving
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2. Investment

• Investment is business spending on capital goods
  and inventories.
• Investment is the most variable component of
  total spending.
• In this analysis, we assume that investment is
  independent of real GDP (this means that
  investment remains constant as real GDP changes).
• In other words, if investment changes, it was
  changed by factors other than GDP.

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Investment as a Function of Income

• As a function of real GDP, autonomous investment
  is drawn as a horizontal line.
• This illustrates that real GDP does not cause
  investment to change, but other determinants of
  investment will cause it to change.

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Determinants of Investment

• Business investment is made in anticipation of
  earning a profit.
• The greater the expected profit, the greater the
  investment.
• The primary determinants of investment are
• Interest Rate
• Profit Expectations

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Interest Rates

• The interest rate is the cost of borrowed funds.
• Much of business spending is financed/borrowed.
• The higher the interest rate, the lower the rate
  of investment.
• As interest rates fall, investment will increase
  because the chance for greater profits increase
  (the cost of borrowed money falls).

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Profit Expectations

• Since firms cannot know exactly how much profit
  they can earn from an investment, they must
  forecast.
• They forecast costs and revenues to determine an
  appropriate level of investment.
• Thus, it is the expected rate of return that
  actually determines a firms level of investment.

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Other Determinants of Investment

• In addition to interest rates and profit
  expectations, other variables can also affect
  investment. They include
• Technological Change
• Cost of capital goods
• Capacity utilization

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Volatility of Investment

• Investment is the most variable component of
  total spending.
• This is because the determinants of investment
  fluctuate widely over the business cycle.

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3. Government Spending

• Government spending is the 2nd largest component
  of aggregate expenditures in the U.S.
• Government spending is set by govt. officials at
  whatever level they choose.
• Like investment, government spending is
  independent of real GDP (a change in real GDP
  will not change govt. spending).

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Govt. Expenditures as a Function of Real GDP
What causes government spending to increase or
decrease?
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4. Net Exports

• The last component of aggregate expenditures is
  net exports (spending in the international
  sector).
• Net exports equals exports minus imports.
• If net exports are positive, there is a surplus
  in the merchandise and service accounts.
• When net exports are negative, there is a deficit.

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Exports

• Exports are independent of real GDP (current
  domestic income does not affect exports).
• Factors that establish the actual value of
  exports include
• Foreign income
• Tastes
• Prices
• Government trade restrictions
• Exchange rates

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Imports

• The level of imports we bring in is determined
  by
• Tastes
• Trade restrictions
• Exchange rates
• Imports are a positive function of domestic real
  GDP (the greater the domestic GDP, the greater
  domestic imports).
• Why?

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Marginal Propensity to Import (MPI)

• Changes in imports in relation to changes in real
  GDP are measured by the MPI.
• MPI change in imports
• change in income

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Marginal Propensity to Import (MPI)
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Net Export Function

• The previous table illustrates that as domestic
  income rises, net exports decrease.
• The net export function is downward sloping,
  indicating that as real GDP increases, net
  exports will decrease.

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Net Exports as a Function of Real GDP

• Because imports increase with income, net exports
  fall as domestic real GDP rises.
• Note that net exports can positive or negative
  (net exports are the only component of aggregate
  expenditures that can have a negative value).
• Negative exports indicate that the economy is
  importing more than exporting.

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Aggregate Expenditures Function

• The aggregate expenditure function is the sum of
  the individual functions for each component of
  spending
• AE C I G X

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Aggregate Expenditures Function
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Worksheet

• Complete the rest of the Aggregate Expenditures
  Worksheet.
• You may work in groups or individually.

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Homework 8

• Page Ch 10, pg 241, 9, 10.