Chapter 9 macro

Chapter 9Chapter 9

Aggregate Expenditure and Aggregate Expenditure and Aggregate DemandAggregate Demand

Aggregate Expenditure and Aggregate Expenditure and Aggregate DemandAggregate Demand

ConsumptionConsumptionConsumptionConsumption

• Consumption tends to reflect income.• The positive and stable relationship between

consumption and income– This is true for the household and for the

economy as a whole.

LO1

Disposable Income, Consumption, and Saving in the United StatesExhibit 1

The Consumption FunctionThe Consumption Function

• Based on Disposable Income, households decide how much to save and how much to consume.

• Dependent Variable: Consumption– This means consumption depends on income.

• Independent Variable: Disposable Income

U.S. Consumption Depends on Disposable Income

LO1

Exhibit 2

LO1

The Consumption Function

Exhibit 3

0 1 2 3 4 5 76 8 9 10 14131211

Real disposable income (trillions of dollars)

12345

76

89

1011

Rea

l con

sum

ptio

n (t

rillio

ns o

f do

llars

)

C

The consumption function, C, shows the relationship between consumption and disposable income, other things constant.

Marginal Propensities to Consume and to Save

Marginal Propensities to Consume and to Save

Marginal propensity to consume, MPC

Fraction of additional income that is spent

Change in consumption / change in incomeChange in consumption / change in income

Marginal propensity to save, MPS

Fraction of additional income that is saved

Change in saving / change in incomeChange in saving / change in income

MPC + MPS = 1 The sum of all disposable income, 100%- either saved or

consumed.

MPC, MPS, and the SlopesMPC, MPS, and the Slopes

MPC

The slope of the Consumption function

MPS

The slope of the Saving function

DI

CMPC

DI

SMPS

Marginal Propensities to Consume and to Save

The slope of the C function equals the marginal propensity to consume. For the straight-line C function in (a), the slope is the same at all levels of income and is given by the change in consumption divided by the change in disposable income that causes it: MPC=4/5.The slope of the S function in (b) equals the marginal propensity to save, MPS=1/5.

LO1 Exhibit 4R

eal c

onsu

mpt

ion

(tril

lions

of d

olla

rs)

Rea

l sav

ing

(tril

lions

of d

olla

rs)

0

Real disposable income (trillions of dollars)0

(a) Consumption function (b) Saving function

a

b

cd

∆C=0.4∆S=0.1

∆DI=0.5∆DI=0.5

MPC=∆C/∆DI=0.4/0.5=4/5

MPS=∆S/∆DI=0.1/0.5=1/5

Non-income Determinants of Consumption

Non-income Determinants of Consumption

• Net Wealth and Consumption– The value of all assets that each household owns

minus an liabilities or debt.– It is a stock variable.– May include a home, furnishings, automobiles,

bank accounts, stocks and bonds.

Non-income Determinants of Consumption

Non-income Determinants of Consumption

• The Price Level:– When price level changes, so does the real value

of cash and bank accounts.– An INCREASE in the price level reduces the

purchasing power of money holdings, causing households to consume less and save more at each income level.

– BUT, if the price level DECREASES-the opposite will happen.

Non-income Determinants of Consumption

Non-income Determinants of Consumption

• The Interest Rate:– The reward savers earn for deferring consumption

and the cost borrowers pay for current spending power.

– The higher the interest rate, the less is usually spent on credit.

– The lower the interest rate, the more is usually spent on credit.

Non-income Determinants of Consumption

Non-income Determinants of Consumption

• Expectations:– Future income increases would increase current

consumption.– Future price level increases would increase

current consumption.– Future interest rate increase would increase

current consumption.

A downward shift of the consumption function, such as from C to C’, can be caused by a decrease in net wealth, an increase in the price level, an unfavorable change in consumer expectations, or an increase in the interest rate.

Shifts of the Consumption Function

C

C’

C’’

Real disposable income

Rea

l con

sum

ptio

n An upward shift, such as from C to C’’, can be caused by an increase in net wealth, a decrease in the price level, an favorable change in consumer expectations, or a decrease in the interest rate.

0

LO1 Exhibit 5

The Life-Cycle HypothesisThe Life-Cycle Hypothesis

• Do people with high incomes save a larger fraction of their income than those with low incomes?– Theory and evidence support this– On average, net savings over a lifetime is usually

little or nothing.

InvestmentInvestment

1) New factories, office buildings, malls, and new equipment

2) New housing3) Net increases in inventories

It is NOT stocks and bonds!!!

Investment

LO2

Gross private domestic investment New physical capital New housing Net increases to inventories

Firms purchase new capital Expect higher return

Market interest rate Opportunity cost of investing in capital

Rates of Return on Golf Carts and the Opportunity Cost of Funds

0 $2,000 $4,000 $6,000 $8,000 $10,000

Investment

58

10

15

20

25

Nom

inal

inte

rest

rat

e (p

erce

nt)

Market rate of interest

Expected rate of return

An individual firm invests in any project with a rate of return that exceeds the market interest rate.At an interest rate of 8%, Hacker Haven purchases three golf carts, investing $6,000.

LO2 Exhibit 6

Investment

LO2

Investment demand curve Inverse relationship

Quality of investment demanded Market interest rate

Other things constant Business expectations

Optimistic expectations Investment demand increases

Investment Demand Curve for the Economy

The investment demand curve for the economy 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.

LO2 Exhibit 7

0 0.9 1.0 1.1Investment

(trillions of dollars)

6

8

10

Nom

inal

inte

rest

rat

e (p

erce

nt)

D

Investment and Disposable IncomeInvestment and Disposable Income

• How does investment vary with income in the economy?– The link between investment and income is

weaker than investment and consumption.– Investment depends more on interest rates and

on business expectations than on income levels.

Investment FunctionInvestment Function

• The investment function assumes that investment is unrelated to disposable income.

• Investment is assumed to be autonomous with respect to disposable income.

Investment Function

Investment is assumed to be independent of income, as shown by horizontal lines. Thus, investment is assumed to be autonomous.

An increase in the interest rate or less favorable business expectations would decrease investment at every level of income, as shown by the downward shift from I to I’.

A decrease in the interest rate or more upbeat business expectations would increase investment at every level of income, as shown by the upward shift from I to I’’.

LO2 Exhibit 8

0.9

1.0

1.1

Inve

stm

ent

(tril

lions

of

dolla

rs)

I

0 2.0 4.0 6.0 8.0 10.0Real disposable income

(trillions of dollars)

12.0 14.0

I’

I’’

Non-income Determinants of Investment

Non-income Determinants of Investment

• The interest rate– An increase in interest rate will cause a decrease in

investment.• Higher opportunity cost

– An decrease in interest rate will cause an increase in investment.

• Lower opportunity cost• Business Expectations

– Investment plans– Wars– Tax changes

Annual Percentage Change in U.S. Real GDP, Consumption, and Investment

LO2

Exhibit 9

Government Purchase FunctionGovernment Purchase Function Government purchases of goods and services Government purchase function:

Government purchases unrelated to DI Autonomous Increase in government purchases

Upward shift of G function

Government PurchasesGovernment Purchases

• Transfer Payments:– Outright grants from government to households– Vary inversely with DI

• Net Taxes:– Transfer Payments minus taxes

Net Exports

LO4

Net exports = Exports – Imports Income increases: imports increase Autonomous of income If Imports > Exports: Net exports < 0 If Exports > Imports: Net exports > 0

Non-income determinants of net exports Price level (U.S. and foreign) Interest rates (U.S. and foreign) Foreign income Exchange rate

Net Export Function

-420

-400

-380

Net

exp

orts

(bi

llion

s of

dol

lars

)

X-M

0 2.0 4.0 6.0 8.0 10.0Real disposable income(trillions of dollars)

12.0 14.0

X’-M’

X’’-M’’

Net exports here are assumed to be independent of disposable income, as shown by the horizontal lines. X-M is the net export function when autonomous net exports equal -$400 billion.

An increase in the value of the dollar relative to other currencies would decrease net exports at each level of income, as shown by the shift down to X’-M’.

A decrease in the value of the dollar would increase net exports at each level of income, as shown by the shift up to X’’-M’’.

LO4 Exhibit 10

Composition of Aggregate Expenditure

LO5

Consumption, C Stable; long term trend: increase

Investment, I Fluctuates

Government purchase, G Long-term trend: declined

Net exports, X-M Last decade: -4%

U.S. Spending Components as Percentages of GDP Since 1959

LO5 Exhibit 11

Aggregate Expenditure and IncomeAggregate Expenditure and Income A dollar spent (expenditure)=A dollar earned (income) Aggregate expenditure components

Consumption, C – varies with income Investment, I – autonomous Government purchases, G – autonomous Net exports, (X-M) - autonomous

Government budget: balanced G = Net taxes

Aggregate Expenditure and IncomeAggregate Expenditure and Income AE = C + I + G + (X – M) Aggregate expenditure line

Planned spending At each level of real GDP (aggregate output;

aggregate income) Given price level

Slope of AE line = MPC, since all other components are autonomous

Aggregate Expenditure and IncomeAggregate Expenditure and Income Income – Expenditure model

AE line, given price level 45-degree line

Spending = real GDP Aggregate output demanded (real GDP)

AE = real GDP

Aggregate Expenditure and IncomeAggregate Expenditure and Income If spending > real GDP

Decrease inventories Increase

Production and employment Income and spending

If real GDP > spending Unsold goods: increase inventories Decrease

Production and employment Income and spending

Total Output(Real GDP- measured in

trillions)

PlannedAggregate

Expenditures

Tendency of Output

$12.40 $12.70 Expand

12.70 12.85 Expand

13.00 13.00 Equilibrium

13.30 13.15 Contract

13.60 13.30 Contract

LO1

Deriving the Real GDP Demanded for a Given Price Level

C + I + G + (X - M)

e

a

d

13.0 14.0 15.00 Real GDP(trillions of dollars)

13.0

13.2

14.0

14.8

15.0

Agg

rega

te e

xpen

ditu

re (

trill

ions

of

dolla

rs)

45°

Real GDP demanded for a given price level is found where aggregate expenditure equals aggregate output – that is, where spending equals the amount produced, or real GDP.This occurs at point e, where the aggregate expenditure line intersects the 45-degree line.

b

c

Exhibit 1

The Spending Multiplier EffectThe Spending Multiplier EffectThe Spending Multiplier EffectThe Spending Multiplier Effect

• Keynes also argued that even a minor disturbance would often be amplified into a major disruption.

• The multiplier indicates that changes in autonomous expenditures, those that don’t vary with income, will exert an amplified impact on output and income.

The Spending Multiplier EffectThe Spending Multiplier Effect

• The spending multiplier is the ratio of the change in real GDP to the initial change in any component of aggregate expenditures, including consumption, investment, government spending, and net exports.

The Spending Multiplier EffectThe Spending Multiplier EffectThe Spending Multiplier EffectThe Spending Multiplier Effect

MPCMultiplierSpending

1

1

endituresaggregateinchangeinital

GDPmequilibriuinchangeMultiplierSpending

exp

Stage Additional Income

Additional Consumption

Marginal Propensity to

ConsumeRound 1 1,000,000 750,000 3/4Round 2 750,000 562,500 3/4Round 3 562,500 421,875 3/4Round 4 421,875 316,406 3/4Round 5 316,406 237,305 3/4Round 6 237,305 177,979 3/4Round 7 177,979 133,484 3/4Round 8 133,484 100,113 3/4Round 9 100,113 75,085 3/4

Round 10 75,085 56,315 3/4All Others 225,253 168,939 3/4

Total 4,000,000 3,000,000 3/4Spending Multiplier= 1/ (1-MPC) = 4

This implies that the account injected into the economy will be four times greater than the monetary value.

Aggregate Demand for Goods and Services

Aggregate Demand for Goods and Services

• Quantity: the output of the entire economy– Real GDP

• Price: the price level in the entire economy– Price Index: CPI, GDP deflator

• Since demand in the goods and services market aggregates, then the purchases of all consumers, investors, government, and foreigners is called Aggregate Demand (AD).

Aggregate Demand CurveAggregate Demand Curve• Aggregate Demand (AD) Curve: Shows the

various quantities of domestically produced goods and services consumers are willing to buy at different price levels in the economy.

• It shows the level of real GDP purchased by Households, government, and foreigners (net exports) at different possible price levels during a time period– Example of the Curve

• What does it mean to be downward sloping?– Is this the same as individual demand?

Example of AD Curve

Price Level

Real GDP

AD

Why is it downward sloping Why is it downward sloping

Three major reasons1. A lower price level will increase the

purchasing power of money ( Real Balances Effect)

2. The interest rate effect3. Domestic goods become cheaper than

foreign goods (the net exports effect)

Non-price Determinants of ADNon-price Determinants of AD

• Changes in Consumption• Changes in Investment• Changes in Government Purchases• Net Exports