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Aggregate Expenditure Components <ul><li>Chapter 24 </li></ul>© 2006 Thomson/South-Western
Exhibit 1:  Disposable Income, Consumption, and Saving <ul><li>The relationship between disposable income and consumption ...
Exhibit 2:  U.S. Consumption Depends on Disposable Income
The Consumption Function <ul><li>The relationship between consumption and income, other things constant </li></ul><ul><ul>...
Exhibit 3: The Consumption Function <ul><li>Both disposable income and consumption are measured in real terms, or in infla...
Exhibit 4a:  Marginal Propensity to Consume <ul><li>Slope of the consumption function equals the marginal propensity to co...
Exhibit 4b: Marginal Propensity to Save <ul><li>Income that is not spent is saved </li></ul><ul><li>Here, saving increases...
Nonincome Determinants <ul><li>What are these factors that could cause the entire consumption function to shift? </li></ul...
Net Wealth <ul><li>Net wealth is the value of all assets that households own minus any liabilities, or debts owed </li></u...
Exhibit 5: Shifts in the Consumption Function 0 C Real disposable income <ul><li>Increase in net wealth shifts consumption...
Shifts and Movements Along <ul><li>Difference between a movement along the consumption function and a shift of the consump...
Price Level <ul><li>When price level changes, real value of dollar-denominated financial assets (bank accounts, cash) also...
Interest Rate <ul><li>Interest </li></ul><ul><ul><li>The reward savers earn for deferring consumption  </li></ul></ul><ul>...
Expectations <ul><li>Changing expectations about price levels, interest rates, job security and other such factors influen...
Investment <ul><li>Investment consists of spending on </li></ul><ul><ul><li>New factories and new equipment </li></ul></ul...
Demand for Investment <ul><li>Firms buy new capital goods only if they expect this investment to yield a greater return th...
Exhibit 6: Rate of Return on Golf Carts and the Opportunity Cost of Funds
Exhibit 7: Investment Demand Curve for the Economy <ul><li>Shows the inverse relationship between the quantity of investme...
Planned Investment and Income <ul><li>Investment depends more on interest rates and on business expectations than on the p...
Investment Function <ul><li>The investment function isolates the relationship between the level of income in the economy a...
Market Interest Rate <ul><li>A decline in the rate of interest, other things remaining constant, will reduce the cost of b...
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 o...
Business Expectations <ul><li>The primary determinant of investment is business expectations </li></ul><ul><li>If firms be...
Business Expectations <ul><li>Factors that could affect business expectations – and investment – include: </li></ul><ul><u...
Exhibit 9:  Annual Percentage Change in U.S. Real GDP, Consumption, Investment
Government Purchase Function <ul><li>Government purchase function relates government purchases to the level of income in t...
Transfer Payments <ul><li>Transfer payments are another government outlay  </li></ul><ul><ul><li>Outright gifts from gover...
Net Taxes <ul><li>Governments impose taxes to fund expenditures </li></ul><ul><li>Net taxes equal taxes minus transfers an...
Net Exports and Income <ul><li>How do imports and exports relate to the level of income in the economy? </li></ul><ul><ul>...
Net Export Function <ul><li>Shows the relationship between net exports and the level of income in the economy, other thing...
Nonincome Determinants of Net Exports <ul><li>Factors assumed constant along the net export function include:   </li></ul>...
Exhibit 10: Net Export Function
Exhibit 11:  U.S. Spending Components as Percentages of GDP Since 1959
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Aggregate Expenditure Components

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Aggregate Expenditure Components

  1. 1. Aggregate Expenditure Components <ul><li>Chapter 24 </li></ul>© 2006 Thomson/South-Western
  2. 2. Exhibit 1: Disposable Income, Consumption, and Saving <ul><li>The relationship between disposable income and consumption has been relatively constant and stable over time </li></ul><ul><li>Saving is the difference between disposable income and consumption </li></ul>
  3. 3. Exhibit 2: U.S. Consumption Depends on Disposable Income
  4. 4. The Consumption Function <ul><li>The relationship between consumption and income, other things constant </li></ul><ul><ul><li>Consumption is the dependent variable </li></ul></ul><ul><ul><li>Disposable income is the independent variable. </li></ul></ul><ul><li>Because consumption depends on income, it is a function of income </li></ul>
  5. 5. Exhibit 3: The Consumption Function <ul><li>Both disposable income and consumption are measured in real terms, or in inflation-adjusted dollars </li></ul><ul><li>Consumption increases with disposable income, assuming other determinants of consumption remain constant </li></ul>
  6. 6. Exhibit 4a: Marginal Propensity to Consume <ul><li>Slope of the consumption function equals the marginal propensity to consume </li></ul><ul><li>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 </li></ul>
  7. 7. Exhibit 4b: Marginal Propensity to Save <ul><li>Income that is not spent is saved </li></ul><ul><li>Here, saving increases by $0.1 trillion as a result of a $0.5 trillion increase in income </li></ul><ul><li>The marginal propensity to save, MPS, equals 0.1 / 0.5, or 1/5 </li></ul><ul><li>Generally, MPC + MPS = 1 </li></ul>
  8. 8. Nonincome Determinants <ul><li>What are these factors that could cause the entire consumption function to shift? </li></ul><ul><ul><li>Net wealth and consumption </li></ul></ul><ul><ul><li>Price level </li></ul></ul><ul><ul><li>Interest rate </li></ul></ul><ul><ul><li>Expectations </li></ul></ul>
  9. 9. Net Wealth <ul><li>Net wealth is the value of all assets that households own minus any liabilities, or debts owed </li></ul><ul><li>A decrease in net wealth would make consumers less inclined to spend, more inclined to save </li></ul><ul><li>Increase in net wealth increases consumption </li></ul>
  10. 10. Exhibit 5: Shifts in the Consumption Function 0 C Real disposable income <ul><li>Increase in net wealth shifts consumption function from C to C'' </li></ul><ul><li>Decrease in net wealth shifts it from C to C' </li></ul>Real Consumption C&quot; C'
  11. 11. Shifts and Movements Along <ul><li>Difference between a movement along the consumption function and a shift of the consumption function </li></ul><ul><ul><li>Movement along the consumption function results from a change in income </li></ul></ul><ul><ul><li>Shift of the consumption function results from a change in one of the nonincome determinants of consumption </li></ul></ul>
  12. 12. Price Level <ul><li>When price level changes, real value of dollar-denominated financial assets (bank accounts, cash) also changes </li></ul><ul><ul><li>Increase in the price level reduces the purchasing power of wealth held in fixed dollar assets – households consume less and save more </li></ul></ul><ul><ul><li>Decreases in the price level increase the purchasing power of wealth held in fixed assets – households consume more and save less </li></ul></ul>
  13. 13. Interest Rate <ul><li>Interest </li></ul><ul><ul><li>The reward savers earn for deferring consumption </li></ul></ul><ul><ul><li>The cost paid by borrowers for current spending power </li></ul></ul><ul><li>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 </li></ul><ul><li>Conversely, a lower interest rate shifts the consumption function upward </li></ul>
  14. 14. Expectations <ul><li>Changing expectations about price levels, interest rates, job security and other such factors influence consumer behavior </li></ul><ul><li>If expectations become more pessimistic, then consumption function shifts downward </li></ul><ul><li>If expectations become more optimistic, then consumption function shifts upward </li></ul>
  15. 15. Investment <ul><li>Investment consists of spending on </li></ul><ul><ul><li>New factories and new equipment </li></ul></ul><ul><ul><li>New housing </li></ul></ul><ul><ul><li>Net change in inventories </li></ul></ul><ul><li>Firms invest in capital goods now in the expectation of a future return </li></ul><ul><li>Since return is in the future, investors must estimate how much a particular investment will yield in all years of its productive life </li></ul>
  16. 16. Demand for Investment <ul><li>Firms buy new capital goods only if they expect this investment to yield a greater return than other possible uses of their funds </li></ul><ul><li>The expected rate of return equals the annual dollar earnings expected from the investment divided by the purchase price </li></ul><ul><li>Market interest rate is the opportunity cost of investing in capital </li></ul>
  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 <ul><li>Shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant. </li></ul><ul><li>Sums the investment demanded by each firm at each interest rate. </li></ul><ul><li>At lower interest rates, more investment projects become profitable for individual firms, so total investment in the economy increases. </li></ul>
  19. 19. Planned Investment and Income <ul><li>Investment depends more on interest rates and on business expectations than on the prevailing level of income </li></ul><ul><li>Thus, the investment decision is said to be “forward looking,” based more on expected profit than on current levels of income and output </li></ul>
  20. 20. Investment Function <ul><li>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 </li></ul><ul><li>Two determinants of investment assumed to be constant are </li></ul><ul><ul><li>The market interest rate </li></ul></ul><ul><ul><li>Business expectations </li></ul></ul>
  21. 21. Market Interest Rate <ul><li>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 </li></ul><ul><li>Conversely, when the interest rate increases, the planned investment function shifts downward </li></ul>
  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 The horizontal investment functions imply that planned investment does not vary with real disposable income, it is autonomous Real planned investment ( trillions of dollars) 1.1 I&quot; 0.9 I'
  23. 23. Business Expectations <ul><li>The primary determinant of investment is business expectations </li></ul><ul><li>If firms become pessimistic about profit prospects, planned investment will decrease at every level of income </li></ul><ul><li>On the other hand, if profit expectations become rosier, the investment function will shift upward </li></ul>
  24. 24. Business Expectations <ul><li>Factors that could affect business expectations – and investment – include: </li></ul><ul><ul><li>Wars </li></ul></ul><ul><ul><li>Technological change </li></ul></ul><ul><ul><li>Changes in the tax structure </li></ul></ul><ul><ul><li>Other destabilizing events that make long-term planning more uncertain </li></ul></ul>
  25. 25. Exhibit 9: Annual Percentage Change in U.S. Real GDP, Consumption, Investment
  26. 26. Government Purchase Function <ul><li>Government purchase function relates government purchases to the level of income in the economy, other things constant </li></ul><ul><li>Decisions about government purchases do not depend directly on the level of income in the economy </li></ul>
  27. 27. Transfer Payments <ul><li>Transfer payments are another government outlay </li></ul><ul><ul><li>Outright gifts from governments to households and are thus not considered part of aggregate expenditure </li></ul></ul><ul><ul><li>Social Security </li></ul></ul><ul><ul><li>Welfare benefits and Unemployment benefits </li></ul></ul><ul><ul><li>Make up about a third of government outlays </li></ul></ul><ul><li>Transfer payments vary inversely with income – as income increases, transfer payments decline </li></ul>
  28. 28. Net Taxes <ul><li>Governments impose taxes to fund expenditures </li></ul><ul><li>Net taxes equal taxes minus transfers and are independent of income </li></ul><ul><li>Taxes tend to increase with income while transfers decrease with income </li></ul><ul><li>Net taxes affect aggregate spending indirectly by changing disposable income, in turn changing consumption </li></ul>
  29. 29. Net Exports and Income <ul><li>How do imports and exports relate to the level of income in the economy? </li></ul><ul><ul><li>When their incomes rise, Americans spend more on everything including exports and when incomes decline, Americans spend less on imports </li></ul></ul><ul><ul><li>The exports purchased by the rest of the world depends on the income of foreigners, not on the U.S. level of income </li></ul></ul>
  30. 30. Net Export Function <ul><li>Shows the relationship between net exports and the level of income in the economy, other things constant </li></ul><ul><li>Exports are relatively insensitive to level of U.S. income, but imports tend to increase with income </li></ul><ul><ul><li>Net exports (exports minus imports) tend to decline as U.S. income increases </li></ul></ul><ul><li>For simplicity, assume that net exports are autonomous and independent of the level of income </li></ul>
  31. 31. Nonincome Determinants of Net Exports <ul><li>Factors assumed constant along the net export function include: </li></ul><ul><ul><li>The U.S. price level </li></ul></ul><ul><ul><li>Price levels in other countries </li></ul></ul><ul><ul><li>Interest rates here and abroad </li></ul></ul><ul><ul><li>Foreign income levels </li></ul></ul><ul><ul><li>Exchange rates between the dollar and foreign currencies </li></ul></ul>
  32. 32. Exhibit 10: Net Export Function
  33. 33. Exhibit 11: U.S. Spending Components as Percentages of GDP Since 1959

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