1. 1 Aggregate Expenditure Components Chapter 24 © 2006 Thomson/South-Western

2. 2 Exhibit 1: Disposable Income, Consumption, and Saving  The relationship between disposable income and consumption has been relatively constant and stable over time  Saving is the difference between disposable income and consumption

3. 3 Exhibit 2: U.S. Consumption Depends on Disposable Income

4. 4 The Consumption Function  The relationship between consumption and income, other things constant  Consumption is the dependent variable  Disposable income is the independent variable.  Because consumption depends on income, it is a function of income

5. 5 Exhibit 3: The Consumption Function  Both disposable income and consumption are measured in real terms, or in inflation-adjusted dollars  Consumption increases with disposable income, assuming other determinants of consumption remain constant

6. 6 Exhibit 4a: Marginal Propensity to Consume  Slope of the consumption function equals the marginal propensity to consume  In this case, the change in consumption is $0.4 trillion and the change in income is $0.5 trillion: the marginal propensity to consume = 0.4 / 0.5 or 4/5

7. 7 Exhibit 4b: Marginal Propensity to Save  Income that is not spent is saved  Here, saving increases by $0.1 trillion as a result of a $0.5 trillion increase in income  The marginal propensity to save, MPS, equals 0.1 / 0.5, or 1/5  Generally, MPC + MPS = 1

8. 8 Nonincome Determinants  What are these factors that could cause the entire consumption function to shift?  Net wealth and consumption  Price level  Interest rate  Expectations

9. 9 Net Wealth  Net wealth is the value of all assets that households own minus any liabilities, or debts owed  A decrease in net wealth would make consumers less inclined to spend, more inclined to save  Increase in net wealth increases consumption

10. 10 Exhibit 5: Shifts in the Consumption Function 0 C Real disposable income C" C' Increase in net wealth shifts consumption function from C to C'' Decrease in net wealth shifts it from C to C' Real Consumption

11. 11 Shifts and Movements Along  Difference between a movement along the consumption function and a shift of the consumption function  Movement along the consumption function results from a change in income  Shift of the consumption function results from a change in one of the nonincome determinants of consumption

12. 12 Price Level  When price level changes, real value of dollar-denominated financial assets (bank accounts, cash) also changes  Increase in the price level reduces the purchasing power of wealth held in fixed dollar assets – households consume less and save more  Decreases in the price level increase the purchasing power of wealth held in fixed assets – households consume more and save less

13. 13 Interest Rate  Interest  The reward savers earn for deferring consumption  The cost paid by borrowers for current spending power higher the interest rate  The higher the interest rate, the less is spent on items purchased on credit (households save more and borrow less) and the consumption function shifts downward  Conversely, a lower interest rate shifts the consumption function upward

14. 14 Expectations  Changing expectations about price levels, interest rates, job security and other such factors influence consumer behavior  If expectations become more pessimistic, then consumption function shifts downward  If expectations become more optimistic, then consumption function shifts upward

15. 15 Investment  Investment consists of spending on  New factories and new equipment  New housing  Net change in inventories  Firms invest in capital goods now in the expectation of a future return  Since return is in the future, investors must estimate how much a particular investment will yield in all years of its productive life

16. 16 Demand for Investment  Firms buy new capital goods only if they expect this investment to yield a greater return than other possible uses of their funds  The expected rate of return equals the annual dollar earnings expected from the investment divided by the purchase price  Market interest rate is the opportunity cost of investing in capital

17. 17 Exhibit 6: Rate of Return on Golf Carts and the Opportunity Cost of Funds

18. 18 Exhibit 7: Investment Demand Curve for the Economy Shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant. 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.

19. 19 Planned Investment and Income  Investment depends more on interest rates and on business expectations than on the prevailing level of income  Thus, the investment decision is said to be “forward looking,” based more on expected profit than on current levels of income and output

20. 20 Investment Function  The investment function isolates the relationship between the level of income in the economy and planned investment – the amount firms would like to invest, other things constant  Two determinants of investment assumed to be constant are  The market interest rate  Business expectations

21. 21 Market Interest Rate  A decline in the rate of interest, other things remaining constant, will reduce the cost of borrowing and increase planned investment: investment function shifts upward  Conversely, when the interest rate increases, the planned investment function shifts downward

22. 22 Exhibit 8: Planned Investment Function 1.0 0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 Real disposable income (trillions of dollars) I 1.1 I" 0.9 I' The horizontal investment functions imply that planned investment does not vary with real disposable income, it is autonomous Real planned investment ( trillions of dollars)

23. 23 Business Expectations  The primary determinant of investment is business expectations  If firms become pessimistic about profit prospects, planned investment will decrease at every level of income  On the other hand, if profit expectations become rosier, the investment function will shift upward

24. 24 Business Expectations  Factors that could affect business expectations – and investment – include:  Wars  Technological change  Changes in the tax structure  Other destabilizing events that make long-term planning more uncertain

25. 25 Exhibit 9: Annual Percentage Change in U.S. Real GDP, Consumption, Investment

26. 26 Government Purchase Function  Government purchase function relates government purchases to the level of income in the economy, other things constant  Decisions about government purchases do not depend directly on the level of income in the economy

27. 27 Transfer Payments  Transfer payments are another government outlay  Outright gifts from governments to households and are thus not considered part of aggregate expenditure  Social Security  Welfare benefits and Unemployment benefits  Make up about a third of government outlays  Transfer payments vary inversely with income – as income increases, transfer payments decline

28. 28 Net Taxes  Governments impose taxes to fund expenditures  Net taxes equal taxes minus transfers and are independent of income  Taxes tend to increase with income while transfers decrease with income  Net taxes affect aggregate spending indirectly by changing disposable income, in turn changing consumption

29. 29 Net Exports and Income  How do imports and exports relate to the level of income in the economy?  When their incomes rise, Americans spend more on everything including exports and when incomes decline, Americans spend less on imports  The exports purchased by the rest of the world depends on the income of foreigners, not on the U.S. level of income

30. 30 Net Export Function  Shows the relationship between net exports and the level of income in the economy, other things constant  Exports are relatively insensitive to level of U.S. income, but imports tend to increase with income  Net exports (exports minus imports) tend to decline as U.S. income increases  For simplicity, assume that net exports are autonomous and independent of the level of income

31. 31 Nonincome Determinants of Net Exports  Factors assumed constant along the net export function include:  The U.S. price level  Price levels in other countries  Interest rates here and abroad  Foreign income levels  Exchange rates between the dollar and foreign currencies

32. 32 Exhibit 10: Net Export Function

33. 33 Exhibit 11: U.S. Spending Components as Percentages of GDP Since 1959