1 Aggregate Expenditure Components CHAPTER 9 © 2003 South-Western/Thomson Learning

2 Exhibit 1: Consumer Spending consumption The relationship between disposable income and consumption has been relatively stable. consumption Saving is the difference between disposable income and consumption and is shown by the vertical distance between the two lines. and Disposable Income consumption disposable income saving 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

3 Exhibit 2: Dependence of Consumer Spending on Disposable Income There is a clear and direct relationship between consumption and disposable income Real Disposable Income Real Consumer Spending 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

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

5 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

6 Exhibit 5a: Marginal Propensity to Consume 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

7 Exhibit 5b: Marginal Propensity to Save c d 0 Real disposable income (trillions of dollars)  DI = 0.5  S = 0.1 MPS= = =  S  DI S a v i n g ( t r i l l i o n s o f d o l l a r s ) 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.

8 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

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

10 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 consume more and save less

11 Interest Rate Interest The reward savers earn for deferring consumption and, 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  consumption function shifts downward

12 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

13 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 The expected rate of return equals the annual dollar earnings expected from the investment divided by the purchase price

14 Exhibit 7: Rate of Return on Golf Carts and the Opportunity Cost of Funds $2,000 $4,000 $6,000$10, Expected rate of return 0 8 Market rate of interest $8,000 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) The second cart generates $300 per year in rental income  a rate of return of $300 / $2,000 = 15%, and so on. Investment Nominal Interest Rate (percent)

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

16 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

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

18 Market Interest Rate The Demand curve told us that 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"

19 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 a downward shift in the investment function from I to I’ On the other hand, if profit expectations become rosier, the investment function will shift upward

20 For the latest data, go to Exhibit 10: Annual Percentage Change in US Real GDP, Consumption, and Investment

21 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

22 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

23 Net Taxes For simplicity, we will assume that net taxes, NT, are autonomous, or independent of income Net taxes affect aggregate spending indirectly by changing disposable income, which in turn changes consumption

24 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

25 Net Export Function The net export function shows the relationship between net exports and the level of income in the economy, other things constant For simplicity, we will assume that net exports are autonomous and independent of the level of income

26 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

27 Exhibit 11: Autonomous Net Export Function –80 –100 –120 0 N e t e x p o r t s ( b i l l i o n s o f d o l l a r s ) X"– M" X – M X' – M' Real disposable income (trillions of dollars)