The Investment Function and Consumption as a Function of Real National Income J.A.SACCO

Consumption Function of Real National Income We’ve looked at consumption based on the level of RDI per year. This was an analysis of one person/family Now must create a consumption function model for entire macroeconomy Must make adjustments to RDI to RNI (Output)

Consumption as a Function of Real National Income 3 C Autonomous consumption Real National Income per Year (Output) ($ trillions) Planned Consumption per Year ($ trillions) o reference line AE=Y 45 o C is a function of real national income. Assume MPC =.8 “Y”= Real National Income (Output) Where “C” intersects the 45º Line, Consumption Expenditures equals Real National Income *all Income/Output Consumed EQUILIBRIUM! AE Y axis called

Keynesian Expenditure Model Now let’s build the Keynesian macroeconomic First must look at “I” component 4 Historically Investment has been more volatile than consumption Why?

An Intro to Investments and its Determinants Real Consumption Less variable/more consistent Consumption expenditures are less subject on how economy looks in future People will always spend Real Investment More variable over time Based on decisions of business people on variable/subjective elements of economy Expectations play a role on the investment function-accounts for instability of investment over time. Large impact on GDP- Change in “I” often affects “C” 5 Starter- What is investment in the context of consumption and GDP? C+I+G+(X-M)=GDP

Planned Investment Function Investment depends on the interest rate Remember the “Classical Economists” Interest Rate High/ Investment Low Interest Rate Low/Investment High Businesses have an array of investment opportunities with rates of return that are low and some high. When do you Invest? Investment is profitable if the rate of return is greater than the opportunity cost (interest rate) of the investment.

Decision to Invest The decision of a firm to invest on machinery or construction is simply a decision based upon marginal benefits and marginal costs. Marginal Benefit of an Investment -is the expected real rate of return (R) the firm anticipates receiving on the expenditure. Marginal Cost of an Investment- is the real rate of interest (I), or the cost of borrowing. Rule of Thumb If Rate of Return% >Real Rate of Interest %, make the investment. If Rate of Return% < Real Rate of Interest %, don’t make investment.

Planned Investment Schedule 8 Planned investment Rate of Interestper Year (percent per year)($ trillions) i% up, Investment down i% down, Investment up

Planned Investment Planned Investment per Year ($ trillions) Rate of Interest (percent per year) I Just like demand, Investment increases as the price falls. As interest rate falls more investment opportunities become more profitable, and vice-versa.

Non- Interest Rate Determinants of Investment What Causes the Investment Function to Shift? When any non-interest rate determinant of investment changes, the investment function (I) will shift. 1) Expectations/ Changes in GDP 2) Productive technology- Need to invest in capital goods to keep up with increased sales 3) Business taxes *Change of Interest rate will not shift the investment function. You will only move up and down the function. 10

11 Graphing Changes in Investment/Increase Planned Investment per Year ($ trillions) Rate of Interest (percent per year) I1I1 r1r1 I1I1 I2I2 Positive profit outlook I2I2

12 I2I2 Graphing Changes in Investment/Decrease Planned Investment per Year ($ trillions) Rate of Interest (percent per year) I1I1 r1r1 I1I1 Taxes Increase I2I2

Combining Consumption and Investment 13 Real Investment per Year ($ trillions) Real National Income per Year ($ trillions) I 0.7 $700 B. Investment per year Autonomous with respect to real national income. We will assume this investment is constant, regardless of the level of income I is autonomous The second component of aggregate demand is investment spending, “I".

Combining Consumption and Investment 14 C Real National Income per Year (Output) ($ trillions) Planned Consumption per Year ($ trillions) o C + I = Y C + I 1) C + I = total planned expenditures (AE) 2) Equilibrium: C + I = Y 3) Equilibrium Y = $5 trillion AE $.7 Trillion of auto. “I”

Keynesian Equilibrium with Government and the Foreign Sector Added Keynesian Equilibrium with Government and the Foreign Sector Added Government (G) - C + I + G ◦ Federal, state, & local  Does not include transfer payments  Is autonomous  Lump-sum taxes Lump-sum tax ◦ A tax that does not depend on income or the circumstances of the taxpayer In our model Autonomous Government Spending “G” is $1Trillion dollars 15

Keynesian Equilibrium with Government and the Foreign Sector Added The Foreign Sector -- C + I + G + X ◦ Net exports (X) = exports - imports ◦ Autonomous ◦ Depends on the economic conditions in each country 16 In our model Autonomous Net Exports “X” is $.1 Trillion.

The Determination of Equilibrium Real National Income with Net Exports Direction 4+5 Inc. Auto “C” 3-4AutoAutoAuto of Change RealTaxesRealNet ExportsTotal PlannedUnplannedin Real NationalDisposablePlannedPlannedPlannedGovernment(exports-ExpendituresInventoryNational Income/ Income Consumption Saving Investment Spending imports) (“Y’ axis) Changes Income Output (“X” axis) Increase Neither Decrease 8 “C”“I”“G”“X”

The Equilibrium Level of Real National Income 18 C + I + G + (X-M) C Real National Income/Output per Year (Y) ($ trillions) Consumption, Investment, Government Purchases, and Net Exports ($ trillions) E E’ RNI > C+I+G+X-M More savings/ less consumption causes surplus. Cut back Production! Income/Output > AE. RNI < C+I+G+X-M Less savings/more consumption causes shortage. Business increase output! AE> I/O AE I

The Equilibrium Level of Real National Income Observations ◦ If C + I + G + X (AE) = Y (RNIncome/Output)  Equilibrium ◦ If C + I + G + X (AE) > Y (RNIncome/Output)  unplanned drop in inventories (shortage/negative)  “Negative Unplanned Inventory Investment”  businesses increase output  Y returns to equilibrium ◦ If C + I + G + X (AE) < Y(RNIncome/Output)  unplanned rise in inventories (surplus/positive)  “Positive Unplanned Inventory Investment”  businesses cut output  Y returns to equilibrium *Note equilibrium IS NOT full employment/potential of the economy 19

The Equilibrium Level of Real National Income How does our study of Consumption, Real National Income, and Equilibrium help in Macroeconomics?