Aggregate Expenditure Components CHAPTER 24 © 2003 South-Western/Thomson Learning

Consumption Consumption both reflects income and depends on income There is a stable and positive relationship between consumption and income both for the household and for the economy Exhibit 1 shows the relationship between disposable income and consumption spending

Exhibit 1: Consumer Spending and Disposable Income The relationship between disposable income and consumption has been relatively stable. saving disposable income Saving is the difference between disposable income and consumption and is shown by the vertical distance between the two lines. consumption Source: based on annual estimates from Bureau of Economic Analysis, U.S. Dept of Commerce. Figures for 2001 were projected as of September. For the latest data, go to http://www.bea.doc.gov/bea/dn1.htm.

Exhibit 2: Dependence of Consumer Spending on Disposable Income 8 7 6 2001 5 1995 There is a clear and direct relationship between consumption and disposable income. 4 1986 3 Real Consumer Spending 2 1970 1 1 2 3 4 5 6 7 Real Disposable Income Source: based on estimates from the Bureau of Economic Analysis, U.S. Dept of Commerce. Point for 2001 was projected as of September. For the latest data, go to http://www.bea.doc.gov/bea/dn1.htm.

Consumption Function Because consumption depends on income, we say that consumption is a function of income Consumption is the dependent variable Disposable income is the independent variable Exhibit 3 presents a hypothetical consumption function showing the positive relationship between the level of disposable income and the amount spent on consumption, with other determinants of consumption assumed to be constant

Exhibit 3: The Consumption Function Both disposable income and consumption are measured in real terms, or in inflation-adjusted dollars .

Marginal Propensities to Consume and Save What happens to consumption and saving when income changes? Marginal Propensity to Consume, MPC equals the change in consumption divided by the change in income Marginal Propensity to Save, MPS equals the change in saving divided by the change in income MPC + MPS = 1 This equality exists because all disposable income must either be spent on consumption or saved

Exhibit 5a: Marginal Propensity to Consume Recall that the slope of a straight line is the vertical distance between any two points divided by the horizontal distance between those same two points In the case of the consumption function, the horizontal distance measures the change in disposable income while the vertical distance measures the change in consumption  the slope of the consumption function is the MPC Thus, in our example, the MPC is 4/5, or 0.8 or 80%  80% of any change in income is spent on consumption

Exhibit 5b: Marginal Propensity to Save The slope of the saving function is a measure of the change in saving relative to the change in income  the MPS  which in our example implies that saving will change by 20% of every dollar change in income. c d Real disposable income (trillions of dollars) D DI = 0.5 S = 0.1 MPS = = = a v i n g ( t r l o s f ) 0.1 0.5 1 5

Nonincome Determinants Along a given consumption function, consumer spending depends on the level of disposable income in the economy, other things constant What are these factors that could cause the entire consumption function to shift? Net Wealth Price Level Interest Rate Expectations

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  the consumption function would shift from C down to C’ in Exhibit 6 Increase in net wealth  increases consumption  consumption function would shift from C to C”

Exhibit 6: Shifts in the Consumption Function Increase in net wealth shifts consumption function from C to C" while a decrease in net wealth shifts it from C to C' C C' Real Consumption Real disposable income

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

Price Level Some household wealth is held in dollar-denominated assets such as bank accounts and cash Whenever the price level changes, the real value of these dollar-denominated financial assets 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 consumer more and save less

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

Expectations Expectations influence economic behavior in a variety of ways Changing expectations about price levels, interest rates, job security and other such factors influence consumer behavior If expectations become more pessimistic  consumption function shifts downward If expectations become more optimistic  consumption function shifts upward

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 the return is in the future, investors must estimate how much a particular investment will yield in all years of its productive life

Investment Firms buy new capital goods only if they expect this investment to yield a greater return than other possible uses of their funds Recall the distinction between Gross investment Net investment

Demand for Investment The expected rate of return equals the annual dollar earnings expected from the investment divided by the purchase price Exhibit 7 provides us with a comparison between the rates of return from various expenditures and the market interest rate

Exhibit 7: Rate of Return on Golf Carts and the Opportunity Cost of Funds Each cart costs $2,000 The first cart purchased is expected to generate Rental income of $400 per year. When combined with the cost, this gives us an expected rate of return of 20% per year ($400 / $2,000) 25 20 Expected rate The second cart generates $300 per year in rental income  a rate of return of $300 / $2,000 = 15%, and so on . Nominal Interest Rate (percent) 15 of return 10 8 Market rate of interest 5 $2,000 $4,000 $6,000 $8,000 $10,000 Investment

Investment Should the firm invest in golf carts, and if so, how many? Suppose they plan to borrow the money to buy the carts  the number of carts they purchase will depend on the interest rate they must pay to borrow the money If we now suppose that the market interest rate is 8% per year, the first three carts, all with expected rates of return exceeding 8%, would more than pay for themselves

Investment The step like relationship indicates the amount to be invested in golf carts at each interest rate When the interest rate is 8%, profit will be maximized when $6,000 is invested in the carts The market interest rate is the opportunity cost of investing in capital

From Micro to Macro Other things constant, more is invested when the opportunity cost of borrowing is lower With some modifications, the downward sloping demand curve for the entire economy can be derived from a horizontal summation of all industries’ downward sloping investment demand curves

Exhibit 8: Investment Demand Curve The economy’s investment demand curve shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant. D 8 6 10 Investment spending (trillions of dollars) N o m i n a l t e r s ( p c ) 0.7 0.9 0.8

Planned Investment and Income Investment depends more on interest rates and on business expectations than on the prevailing level of income One reason for this is that some investments take years to complete Additionally, investment, once in place, is expected to last for years Thus, the investment decision is said to be “forward looking,” based more on expected profit than on current levels of income and output

Investment Function The simplest investment function assumes that planned investment is unrelated to the current level of disposable income That is, investment is assumed to be autonomous with respect to income  planned investment does not vary even though real disposable income does This situation is presented in Exhibit 9

Exhibit 9: Autonomous Investment Function The horizontal investment functions imply that planned investment does not vary with real disposable income t n e ) m s t r s a e l l v o n d 0.9 I" i f d o e 0.8 I n s n 0.7 I' n a o l i l p l i l r a t ( e R 0 2.0 4.0 6.0 8.0 10.0 12.0 Real disposable income (trillions of dollars)

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 of the determinants of investment that are assumed to be constant are The market interest rate Business expectations

Market Interest Rate In Exhibit 8, when the interest rate was 8%, planned investment is $0.8 trillion  shown as I A decline in the rate of interest from, say 8% to 6%, other things remaining constant, will reduce the cost of borrowing and increase planned investment from $0.8 to $0.9 trillion  investment function shifts upward from I to I"

Business Expectations The primary determinant of investment is business expectations If firms become more pessimistic about profit prospects, planned investment will decrease at every level of income as shown by the shift in the investment function from I to I’ in Exhibit 9 On the other hand, if profit expectations become rosier, the investment function will shift upward from I to I”

Business Expectations Factors that could affect business expectations hence investment would include Wars Technological change Changes in the tax structure Other destabilizing events that make long-term planning more uncertain

Exhibit 10: Annual Percentage Change in US Real GDP, Consumption, and Investment For the latest data, go to http://www.bea.gov

Government Purchase Function Government purchases in 2001 accounted for about 18% of GDP One-third of the total was by the federal government Two-thirds by state and local governments The government purchase function relates government purchases to the level of income in the economy, other things constant

Government Purchase Function Because decisions about government purchases are largely under the control of public officials, they do not depend directly on the level of income in the economy Therefore, we assume that government purchases, G, are autonomous, or independent of the level of income

Transfer Payments Government purchases represent only one of the components of government outlays The other is transfer payments 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

Net Taxes To fund government outlays, governments impose taxes Taxes vary directly with income  as income increase, so do taxes Net taxes equal taxes minus transfers Since taxes tend to increase with income while transfers decrease with income, we will assume that net taxes, NT, are autonomous, or independent of income

Net Taxes Net taxes affect aggregate spending indirectly by changing disposable income, which in turn changes consumption In our discussion of the circular flow that by subtracting net taxes, we transform real GDP into disposable income

Net Exports The rest of the world affects aggregate expenditure through imports and exports The United States, with only one-twentieth of the world’s population – accounts for about one-sixth of the world’s imports and one-eighth of the world’s exports

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 How does the value of U.S. exports relate to the economy’s level of income? The exports purchased by the rest of the world depends on the income of foreigners, not on the U.S. level of income

Net Export Function The net export function shows the relationship between net exports and the level of income in the economy, other things constant Since exports are relatively insensitive to the level of U.S. income but our imports tend to increase with income, net exports – Exports minus imports – tend to decline as U.S. income increase However, for simplicity, we will assume that net exports are autonomous and independent of the level of income

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 Exhibit 11 illustrates the effect of a change in one of these factors, the value of the dollar

Exhibit 11: Autonomous Net Export Function –80 –100 –120 N e t x p o r s ( b i l n f d a ) X"– M" X – M X' – M' 2.0 4.0 6.0 8.0 10.0 12.0 Real disposable income (trillions of dollars)

Components as a Percentage of GDP Exhibit 12: U.S. Spending Components as a Percentage of GDP Consumption’s share of GDP has remained relatively stable from year to year, but the long-term trend shows a slight increase. Net Exports Government Purchases Investment has bounced around the most from year to year, with a slight upward trend. Investment Government purchases have generally declined as a percent of GDP. Consumption Net exports have generally been negative  sum of spending on consumption, investment, and government purchases exceed GDP.