Economics: Notes for Teachers The Level of Economic Activity The Level of Economic Activity Academic PowerPoint

Introduction - The cornerstone of Keynesian economics is that the level of economic activity is determined by the level of aggregate expenditure. - Aggregate expenditure can be defined as the amount that firms, households, government and overseas plan to spend on goods and services at each level of income.

Components of Aggregate Expenditure AE = C + I + G + (X-M) The components of aggregate expenditure are: - Consumption [C] – expenditure on goods and services - Investment [I] – expenditure on new capital equipment for production - Government expenditure [G] - Exports [X] – goods and services to overseas - Imports [M] – goods and services from overseas

Consumption There is a positive relationship between consumption and disposable income. Expenditure on household necessities is relatively stable, but that on consumer durables such as a lounge suite or new colour TV can vary according to the state of the economy.

Consumption - Other factors which may determine the level of consumption include: Consumer sentiment or expectations – if people are optimistic about the future, they are far more likely to spend. Cost and availability of credit Government policy such as tax reform Consumption is easily the largest component of aggregate expenditure and therefore has the largest influence on economic activity.

Investment Investment may be defined as expenditure on capital goods (building and equipment). It must be an addition to capital stock, including any involuntary movements in inventory. The single biggest determinant of investment is business expectations of future profits.

Investment Factors which will influence businessmen’s expectations include: Interest rates (the cost of investment) Level of past profits Government policy and stability Technological change

Government Expenditure Economics: Notes for Teachers The Level of Economic Activity Government Expenditure In general, government expenditure is highly stable. This is because a large proportion of funds is allocated to major spending areas such as health, defence, education and social security. Some payments are cyclical, such as welfare payments. Academic PowerPoint

Net Exports The value of exports is most affected by the level of world income. When world economic growth and income is high, the demand for exports increases. The value of imports is most affected by the level of domestic income. When domestic economic growth is high, the demand for imports increases. Other factors influencing net exports are exchange rates, tariffs and quotas and our competitive position with other countries.

The Consumption Function This examines the relationship between consumption and income in a closed economy without the government sector. We can deduce that the consumption function is of the form C = a + bY where a is autonomous (not dependent on) to income. Because income can only be consumed or saved, we can now put in the savings function as S = -a + (1-b)Y. This can be illustrated in the diagram on the next slide.

The Consumption Function Aggregate Expenditure a -a Point where C=Y 45° C = a + bY S = -a + (1-b)Y B.E. Income/Output a = minimum expenditure necessary to survive b = gradient (marginal propensity to consume) or MPC Y = income earned B.E. = break even point

The Consumption Function At income levels up to break even, consumption is greater than income and savings are negative. At income levels above break even, consumption is less than income and net savings occur. Provided the consumption function is known, the break even point can always be calculated. Average propensity to consume (APC) measures the proportion of total income that is consumed. APC = C/Y. Marginal propensity to consume (MPC) is the fraction of the last (marginal) dollar of income which is spend on consumption. MPC = ΔC/ΔY. Average propensity to save (APS) = S/Y. Marginal propensity to save (MPS) = ΔS/ΔY.

The Full Aggregate Expenditure Level of Income We now add the financial sector, government sector and the international sector. We assume that investment, government expenditure and exports (injections) are independent of income, whereas savings, taxation and imports (withdrawals) are dependent on income. Equilibrium will take place where the aggregate expenditure line crosses the 45° line and where injections equals withdrawals. The full model can be seen in the diagram on the next slide.

The Full Aggregate Expenditure Level of Income 45° AE = C + I + G + (X-M) W J Income/Output

Changes in the Level of Aggregate Expenditure A change in the level of planned injections will lead to a change in the level of income which is greater than the initial change in planned injections. In other words, the change is multiplied. This is because one man’s spending is another man’s income. The multiplier can be stated in formula. Multiplier, k = 1/MPW [MPW is marginal propensity to withdraw] Since MPW + MPC = 1 k = 1/(1-MPC) = ΔY/ΔJ hence k x ΔJ = ΔY

Changes in the Level of Aggregate Expenditure - The concept of the multiplier can also be demonstrated on the Keynesian model as can be seen in the diagram below: 45° AE1 Aggregate Expenditure AE ΔJ ΔY Y Y1 Income/Output

Changes in the Level of Aggregate Expenditure An increase in injections moves aggregate expenditure from AE to AE1. This will lead income to rise from Y to Y1 which is greater than the original increase in injections. Hence the multiplier is denoted by the formula k = ΔY/ΔJ

The Paradox of Thrift Society views savings as a good and virtuous activity. Savings are an important part of a modern economy. Paradoxically however, a desire to save more by society may actually lead to society saving less. This is because savings are a withdrawal and an increase in savings may cause income to fall.

The Paradox of Thrift Expenditure I Y2 Y1 Income S2 – High MPS S1 – Low MPS I Y2 Y1 Income

The Paradox of Thrift An upwards shift in savings patterns (from S1 to S2) creates an excess of saving over planned investment, which will lead to a reduction in the level of income in the economy from Y1 to Y2. - If the increase in savings leads to a corresponding reduction in imports and/or tax, then the level of income will not fall. Extra savings may also stimulate investment (although this is very unlikely).

The Accelerator In the Keynesian model, we assume that investment is autonomous. In reality, this is not the case and investment is related to income or more accurately, changes in sales. Such investment is induced. As sales increase, investment will be induced as businessmen attempt to create capacity. When sales become static, there is zero change in investment (existing machinery is replaced). When sales fall, there will be negative investment (worn out machinery is not replaced).

The business/trade cycle - Empirical evidence suggests that there is a cyclical or regular nature to the level of business activity. The so called trade cycle can be see below: Level of Economic Activity Boom Long term growth trend Downswing Upswing Recession Time

Interaction between multiplier and accelerator -The multiplier and accelerator interact together and help to explain the volatility of the business cycle. - When autonomous investment rises, the effect will be multiplied to a higher level of income – this leads to a greater level of consumption which will itself induce further investment. This raises income still further which will increase consumption and additional investment. At the peak of the cycle, inflationary forces will be greater and investment rates will be rising or high. Business and consumer confidence will fall, leading to the downswing of the cycle.

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