Chapter 9 Building the Aggregate Expenditures Model

2 important questions 1. what determines the level of GDP, given a nation’s production capacity? 2. what causes real GDP to rise in one period and fall in another? To answer we construct the AGGREGATE EXPENDITURES model

Chapter 9 pretends we are a “private closed economy” and only consists of Personal Consumption and Investment (we will add G and Xn in chapter 10)

Simplifying assumptions Savings consist only of personal savings Deprecation and net foreign factor income are zero GDP, NI (national income), PI (personal income) and DI (disposable income) are all equal

Tools of the Aggregate Expenditure Model Amount of goods and services produced depend directly on the level of aggregate expenditures (total spending) Businesses will only produce a level of output they think they can profitably sell Businesses will idle their workers and machinery when there are no markets for their goods and services We assume the economy has excess production capacity and unemployed labor- an increase in AE will increase real output and employment, but we will assume unless stated otherwise that PRICE LEVEL remains constant!

What do you think is the most significant determinant of consumer spending? A. Wealth B. Consumer expectations C. Disposable income D. Taxes

Consumption Most significant determinant of consumer spending is INCOME (in particular, DI) Households consume most of their income and both consumption and saving are directly related to income level

Consumption and Savings S = DI – C

Average Propensity to Consume and Save The fraction, or percentage, of total income that is consumed = APC = c/I saved = APS = s/ I APC + APS = 1

Example Income = 100,000 C= 80,000 Find APC A. 20% B. 40% C 80% D. 100%

Source: Statistical Abstract of the United States, 2006 Average Propensities to Consume Select Nations GDPs United States Canada United Kingdom Japan Germany Netherlands Italy France Average Propensities to Consume Global Perspective

Marginal Propensity to Consume and Save The fact that households consume a certain proportion of a particular income does not guarantee the same proportion of any change in income they might receive The proportion, or fraction, of any change in income consumed = mpc = change in c/ change in income savings = mps = change in s/ change in income MPC + MPS = 1

Example DICS

MPC and MPS as slopes The MPC is the numerical value of the slope of the consumption schedule and The MPS is the numerical value of the slope of the saving schedule

If Margy's MPC is.9, this means that she will: A. spend 90 cents out of every additional dollar of disposable income B. spend 90% of her total disposable income C. spend all her disposable income when her disposable income is $9000 D. save 10% of her total disposable income

A. spend 90 cents out of every additional dollar of disposable income The marginal propensity to consume (MPC) is the change in spending divided by the change in disposable income. In this example, this implies that for every additional dollar of disposable income, 90 cents will be spent.

45o [Income change, movement from point to point] Consumption Saving o o Consumption S C1C1C1C1 S DI 2 Disposable Income SAVING SAVING DISSAVING [Negative saving] DISSAVING So, the key to a change in QC ( QS ) is a change in ? Breakeven DI1DI1DI1DI1 DI3DI3DI3DI3 C2C2C2C2 Disposable Income

Remember, # 1 factor that determines C or S Income!!!!!!!!! Change in income will be a movement along a C or S line

Non-income determinants of Consumption and Saving (will shift entire curve) Wealth Expectations Taxation Household Debt

Non-income Determinants of C and S These will cause the C and S lines to SHIFT!!!! (up or down) Cheat sheet….Y means income!!! By wealth we mean real assets (house, car, other durables) and financial assets (cash, savings accounts, stocks, bonds)

Consumption Saving o o 45 o C1C1C1C1 S1S1S1S1 Disposable Income C2C2C2C2 S2S2S2S2 [shift/whole curve/non-income] Increases in consumptionmeans… Decrease in saving May be caused by : Increase in wealth Decrease in PL Expect. PL incr. Expect. of positive Y Expect. of shortages Decrease in debt (pay Off debt, have more to C) *Decrease in taxes Increase in debt *Decrease in taxes increases both C & S I’ll buy more and save even more.

Consumption Saving o o 45 o C1C1C1C1 S0S0S0S0 Disposable Income C2C2C2C2 S2S2S2S2 [shift/whole curve/non-income [shift/whole curve/non-income] Decreases in consumptionmeans… Increase in saving May be caused by : Decrease in wealth Increase in PL Expect. PL decrease Expect. neg. future Y Increase in debt *Increase in taxes decreases both C & S

Stability Although changes in non-income determinants can shift the c and s schedules, usually these schedules are relatively stable This may be because c-s decisions are strongly influenced by long-term considerations like s for emergencies or retirement

Investment Expenditures on new plants, capital equipment, machinery, inventories, etc Businesses will invest in all projects for which the expected rate of return exceeds the interest rate

2 basic determinants of investment spending 1. Expected Rate of Return: the increase in profit a firm anticipates it will obtain by purchasing capital; expressed as a percentage of the total cost of the investment activity 2. Real Interest Rate: interest rate adjusted for inflation * if the expected rate of return exceeds the real interest rate, firms will undertake investment Firms should invest in projects where r = I (rate of return = investment)

Positive profit expectationsreal interest Positive profit expectations and the real interest rate rate are the most important determinants of investment. Drill Press - $1,000 Drill Press - $1,000 Expected gross profits$1,10010% return A. Expected gross profits = $1,100 or a 10% return. [$100/$1,000 x 100 = 10%] 8 % invest in the drill12 % don’t invest [At 8 %, invest in the drill ; at 12 %, don’t invest ] Real interest rate B. Real interest rate [ nominal interest rate-inflation ] Single Firm

Investment (billions) Expected rate of return, r, and interest rate, i (percents) % 6 4 % QID (Interest rate change, point to point movement) DIDIDIDI Firms will undertake all investments [additions to plant, equipment, inventory, and residential construction] and residential construction] which have an expected rate of net profit greater than [or equal to] the real rate of interest. Monetary Policy Monetary Policy – by lowering interest rates, the Fed can increase Ig & employment. [Inverse r elationship b etween real interest r ate and Q I D] QID

# 1 factors that determine whether a business invest Expected rate of return and real interest rate--- causes a movement along the investment curve

Shifts in investment demand curve This will shift curve to the right or to the left Acquisition, maintenance, operating costs Business taxes Technological change Stock of capital goods on hand (if firms have too much, they will invest less) Expectations (on future sales)

8% QID 1 I1I1I1I1 I2I2I2I2 QID 2 Increase in Investment 1.Positive profit expectations 2.Scarcity of inventory 3.Technology [innovation] 4.Decrease in production costs 5.Decrease in business taxes

Investment is unstable (unlike consumption) Shifts significantly upward or downward quite often Investment is the most volatile component of total spending Why?

Durability of capital and variability of expectations Irregularity of innovation

Equilibrium GDP The output whose production creates total spending just sufficient to purchase the output The equilibrium level of GDP is the level at which the total quantity of goods produced (GDP) equals the total quantity of goods purchased (C +Ig) Above or below = disequilibrium

Other features of equilibrium GDP Savings represents a leakage of spending from the income-expenditures stream Investment can be thought as an injection of spending into the income-expenditures stream

#3 pg. 179 Explain how each of the following will affect the C and S schedules or the investment schedule Consumption (up/ down) Investment (left/right)

A. A large increase in the value of real estate, including private houses

If this simply means households have become more wealthy, then c will increase at each income level. The c schedule should shift upward and the saving schedule shift leftward. The investment schedule may shift rightward if owners of existing homes sell them and invest in construction of new homes more than previously

B. The threat of limited, non- nuclear war, leading the public to expect future shortages of consumer durables

This threat will lead people to stock up; the C schedule will shift up and the saving schedule down. If this puts pressure on the consumer goods industry, the investment schedule will shift up. The investment schedule may shift up again later because of increased military procurement orders

C. A decline in real interest rate

The decline in the real interest rate will increase interest-sensitive consumer spending; the C schedule will shift up and the saving schedule down. Investors will increase investment as they moved down the investment- demand curve; the investment schedule will shift upward

D. A sharp, sustained decline in stock prices

Though this did not happen after October 19, 1987, a sharp decline in stock prices can normally be expected to decrease consumer spending because of a decrease in wealth; the C schedule shifts down and the saving schedule upwards. Because of the depressed share prices and number of speculators forced out of the market, it will be harder to float new issues on the stock market. Therefore, investment schedule will shift downward

E. An increase in the rate of population growth

The increase in the rate of population growth will, over time, increase the rate of income growth. In itself this will not shift any of the schedules but will lead to movement upward to the right along the upward sloping investment schedule

F. The development of a cheaper method of manufacturing computer chips

This innovation will in itself shift the investment schedule upward. Also, as the innovation starts to lower the costs of producing everything using these chips, prices will decrease leading to increase quantities demanded. This, again, could shift he investment schedule upward

G. A sizable increase in the retirement age for collecting social security benefits

The postponement of benefits may cause households to save more if they planned to retire before they qualify for benefits; the saving schedule will shift upward, the consumption schedule downward. This impact is uncertain, however, if people continue to work and earn productive incomes.

H. The expectation that mild inflation will persist in the next decade

If this is a new expectation, the consumption schedule will shift upwards and the saving schedule downwards until people have stocked up enough. After about a year, if the mild inflation is not increasing, the household schedules will revert to where they were before.

I. An increase in the federal personal income tax

Because this reduces disposable income, consumption will decline in proportion to the marginal propensity to consume. Consumption will be less at each level of real output, and so the curve shifts down. The savings schedule will also fall because the disposable income has decrease at each level of output, so less would be saved.