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 “Y”= Real National Income (Output) 45o reference line AE=Y 45o AE C C is a function of real national income. Assume MPC = .8 2.5 Y axis called 2.0 Where “C” intersects the 45º Line, Consumption Expenditures equals Real National Income *all Income/Output Consumed EQUILIBRIUM! 1.5 Planned Consumption per Year ($ trillions) 1.0 Autonomous consumption 0.5 0.3 0.5 1.0 1.5 2.0 2.5 Real National Income per Year (Output) ($ trillions)

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

An Intro to Investments and its Determinants Starter- What is investment in the context of consumption and GDP? C+I+G+(X-M)=GDP 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” Investment depends on interest rate

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 Rate of Interest per Year (percent per year) ($ trillions) 15 .2 14 .3 13 .4 12 .5 11 .6 10 .7 9 .8 8 .9 7 1.0 6 1.1 i% up, Investment down i% down, Investment up

Planned Investment Just like demand, Investment increases as the price level or in this case the interest rate falls and vice versa! 15 I 14 13 12 11 10 Rate of Interest (percent per year) 9 8 7 6 .1 .2 .3 .4 .5 .6 .7 .8 .9 1.0 1.1 Planned Investment per Year ($ trillions)

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.

Graphing Changes in Investment/Increase Positive profit outlook Rate of Interest (percent per year) r1 I2 I1 I2 Planned Investment per Year ($ trillions)

Graphing Changes in Investment/Decrease Taxes Increase Rate of Interest (percent per year) r1 I1 I2 Planned Investment per Year ($ trillions)

Combining Consumption and Investment The second component of aggregate demand is investment spending, “I". $700 B. Investment per year is autonomous with respect to real national income. We will assume this investment is constant, regardless of the level of income I is autonomous Real Investment per Year ($ trillions) I 0.7 1 2 3 4 5 6 7 Real National Income per Year ($ trillions)

Combining Consumption and Investment 6.0 C + I 45o C + I = Y AE C 5.0 $.7 Trillion of auto. “I” 4.0 Planned Consumption per Year ($ trillions) 3.0 1) C + I = total planned expenditures (AE) 2) Equilibrium: C + I = Y 3) Equilibrium Y = $5 trillion 2.0 1.0 0.3 1.0 2.0 3.0 4.0 5.0 6.0 Real National Income per Year (Output) ($ trillions)

Combining Consumption and Investment RNI > C+I More savings/ less consumption causes Surplus of inventories cut back production! Income/Output > AE Combining Consumption and Investment 6.0 C + I RNI < C+I Less savings/more consumption causes Shortage of inventories.Business increase production! AE> I/O 45o AE C 5.0 4.0 Planned Consumption per Year ($ trillions) Why is this equilibrium? 3.0 2.0 1.0 0.3 1.0 2.0 3.0 4.0 5.0 6.0 Real National Income per Year (Output) ($ trillions)

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

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 In our model Autonomous Net Exports “X” is $.1 Trillion.

Combining Consumption and Investment 6.0 C + I 45o C + I = Y AE C 5.0 4.0 Add “G” and “X-M” Planned Consumption per Year ($ trillions) 3.0 2.0 OBSERVATIONS? 1.0 0.3 1.0 2.0 3.0 4.0 5.0 6.0 Real National Income per Year (Output) ($ trillions)

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