12.1 © 2005 Prentice Hall, Inc. Economics for Managers by Paul Farnham Chapter 12: Spending by...

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Economics for Managersby Paul Farnham

Chapter 12:Spending by Individuals,

Firms, and Governments on Real Goods and Services

Focus on the Short-Run

Potential GDP: maximum amount of output that can be produced

Depends on size of labor force, number of structures and amount of equipment in the economy, and state of technology

Policy goal is managing aggregate expenditure to keep economy close to potential output without starting inflation

Managers tend to focus on short-run

Real Versus Nominal Terms

Real terms: measuring expenditures and income with price level held constant

Nominal terms: measuring expenditures and income with price level allowed to vary

Components of Aggregate Expenditure

Aggregate expenditure: sum of personal consumption, investment, government, and net export expenditures on total amount of real output produced

Personal consumption expenditure: sum of durable goods, nondurable goods, and services

Personal Consumption Expenditure and Income

Keynesian consumption function: assumes that as disposable income increases, consumption spending increases by smaller amount• Marginal propensity to consume

(MPC)• Marginal propensity to save (MPS)

Saving: amount of disposable income households do not spend on consumption

Level of Personal Taxes

Level of taxes affects consumption spending• Economic Growth and Tax Relief

Act of 2001

• Tax cut of 2003 Taxes can be cut or increased

temporarily or permanently

Real Interest Rate

Changes in interest rate affect spending, especially in durables• Real interest rate

• Nominal interest rate Lenders charge borrowers

nominal rate (i) based on the real rate (r) and the expected rate of inflation

Consumer Confidence

University of Michigan’s Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI)

Some debate as to whether these confidence indices predict changes in consumer spending

Consumer Credit andLevel of Debt

Federal Reserve Board monitors use of consumer credit

Increased consumer credit may have restraining influence on consumption

Consumption function:• C = f (Y, Tp, r, CC, W, CR, D)• C = C0 + c1 Y

Consumption Function

Autonomous consumption expenditures: determined by factors other than level of real income in the economy

Induced consumption expenditures: result from changes in level of real income in the economy

Figure 12.5a and 12.5b

Consumption

0 Y1 Y2

Investment

Government

Exports

Figure 12.5c and 12.5d

Figure 12.5e

0 Y1 Y2

M0 Y M

Imports Consumption, investment, and import spending are assumed to be a function of the level of real income.

Government and export spending are determined by factors other than the level of real income.

Consumption, investment, and import spending are assumed to be a function of the level of real income.

Government and export spending are determined by factors other than the level of real income.

Gross Private Domestic Investment

GPDI: total amount of spending on nonresidential structures, equipment, software, residential structures, and business inventories in a given time

Variety of factors influence GPDI

Factors Influencing GPDI

Business investment spending and real income

Real interest rate Business taxes

• Relative prices: cost of capital versus cost of other inputs

Expected profits and business confidence

Factors Influencing GPDI

Capacity utilization • Rates are prepared monthly by

Fed for manufacturing, mining, and electric/gas utilities industries

Residential investment spending Inventory investment

• Inventory investment function:

I = f (Y, r, TB, PR, CU)

Government Expenditure

Includes total amount of spending by federal, state, and local governments on consumption outlays, depreciation, and investment capital outlays

Determined by legislative and executive institutions of all levels of government

Fiscal policy: use of expenditure and taxation policy to pursue macroeconomic goals of high employment and low inflation• G = f (Y, Policy) • G = G0

Both equations assume spending is determined only by policy and not by real income in economy

Net export expenditure: difference between export spending on domestically produced goods and services by individuals in other countries and import spending on foreign produced goods and services by domestic residents

X = F (Y, Y*, R)

Currency exchange rate: rate at which one nation’s currency can be exchanged for another (is determined in foreign exchange markets)

Import expenditures• M = f (Y, R)

• M = M0 + m1 Y

Aggregate Expenditure and Equilibrium

Aggregate expenditure (E): planned spending on currently produced goods and services by all sectors of the economy• E = C + I + G + X – M

Aggregate expenditure function: relationship between aggregate expenditure and income, all other variables constantE = f (Y, TP, r, CC, W, CR, D, TB, PR, CU G, Y*, R)

Aggregate Expenditure Function

E0 Slope = (c1 + i1 – m1)

E0 represents autonomous aggregate expenditure determined by factors other than real income

Equilibrium Level ofIncome and Output

Level of income where desired spending equals value of aggregate output and income received from that production

Injections: supplement to consumer spending that increases domestic aggregate output and income

Leakages: uses of current income for purposes other than purchasing currently produced domestic goods and services

Adjustment Toward Equilibrium

Slope = c1 (assuming i1 = m1 = 0)

Only at this level of income and output is desired expenditure just equal to value of output produced and income generated.

Adjustment Toward Equilibrium

At income level Ye1, individuals want to purchase more goods and services than are currently produced

Firms then have to draw down on their existing inventories of goods (called unplanned inventory decrease)

Changes in Equilibrium

Figure 12.10

0 YE1 YE2

The Multiplier

Multiplier: change in income and output resulting from a change in autonomous expenditure

Multiplier effect: results from fact that increase in autonomous expenditure represents an injection of new spending in circular flow of economic activity

End result is multiple increase in income determined by size of MPC and the term [ 1 / (1 – MPC)]

Investment-Saving (IS) Curve

Shows alternative combinations of real interest rate and real income

Theoretical construct focusing on relationship between interest rate and level of real income and output

Summarizes the relationship between real interest rate and real spending

Interest-Related Expenditure Function

Shows planned consumption and investment spending as a function of real interest rate

Points downward showing an inverse relationship between interest rate and planned consumption and investment expenditure

IRE Function Summarized

Figure 12.11

0 Y1 Y2

Shifting the IS Curve

Changes in any factor influencing autonomous aggregate expenditure causes IS curve to shift

IS: Y = f (r, TP, CC, W, CR, D, TB, PR, CU, G, Y*, R)

Summary of Key Terms

Aggregate expenditure function Autonomous consumption expenditures Capacity utilization rates CCI and CSI Consumption function Currency exchange rate Equilibrium level of income and output Fiscal policy and government expenditure

Gross private domestic investment Induced consumption expenditures Injections IRE function and IS curve Investment spending function Leakages Marginal propensity to consume and to

save (MPC) and (MPS) Multiplier

Net export expenditure Nominal interest rate and real interest

rate Personal consumption expenditure Potential GDP Real terms and relative prices Saving Unplanned inventory increase and

unplanned inventory decrease

Do you have any questions?

12.1 © 2005 Prentice Hall, Inc. Economics for Managers by Paul Farnham Chapter 12: Spending by...

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