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