1 مكونات الطلب الكلي والدخل التوازني Aggregate Demand Components and Equilibrium income د. إقبال الرحماني 2001 الجزء السادس

2 Keynes believed that the government should intervene to smooth the sharp fluctuations of the business cycle. This intervention can be done through fiscal and monetary policies, that affect directly and indirectly the aggregate demand. Otherwise, the economy would face undesired levels of unemployment and inflation. Recall: To understand how can the government policies affect AD, we need to further understand the different components of AD, and what are the determinants of each component. Recall, AD = C + I + G + (X - M)

3 First, Consumption expenditure Consumption expenditure is the largest component in AD. Therefore, understanding the determinants of consumption is critical to understanding forces affecting AD; and hence the required policies to change income and output. Note: Total consumption expenditure amounted to about 63% of total GDP in Kuwait, (65% private & 35% government).

4 The main determinants of consumption expenditure: Income: Households increase spending on goods & services, when their income rises. Wealth: An increase in household wealth (assets) will increase consumption. Taxes : Higher taxes will lower disposable income of the household and reduce consumption.

5 Expectations: expectations regarding future economic growth, jobs, social & political instability, price levels..etc. affect consumption levels now. Demographic change: population growth and its distribution affect consumption levels. (younger and older households generally consume more and save less than middle - aged groups. Emulation: The impact of the demonstration effect, keeping up with others’ level of consumption.

6 Interest rate : When interest rates increase it encourages more savings and hence reduced spending. Advertisement & consumer loans: Increased levels of advertisements encourages more spending. The availability of consumer loans finance further consumption.

7 Keynes emphasized the impact of income on consumption. Assuming other factors constant, there is a positive relationship between income and consumption. Higher income levels are associated with higher levels of consumption and saving. Hence we can say that consumption is induced by income (induced consumption ) In the simple Keynsian consumption function, consumption consists of two parts : autonomous consumption + induced consumption Q: What is the consumption level when income equals zero?

8 C = a + b Y Note : we are assuming other factors constant including taxes Since Y = C + S S = Y - C S = Y - a + b Y Then, the saving function : S = -a + (1- b) Y C = a + Δ C / Δ Y * Y Or: Then,

9 Note: If fixed taxes are applied, then: C = a + b (Y- T) Disposable income (y) = Y - T S = -a + (1- b) (Y- T) And,

C Y Example: The Silver Moon Economy C C Y Y C C Y Y - S +S Note the consumption function : C = b Y

C Y S Y Y S S S S - S +S Saving function ْ Note : S= ( 1-b) Y or Δ S / Δ Y* Y

12 Average propensity to consume and save Average propensity to consume : The fraction of total income that households spend on consumption APC = C / Y Average propensity to save: The fraction of total income that the households save APS = S / Y

APS APC S C Y Example: Q 1: What happens to APC and APS as income increases? Q 2: Why does APC + APS = 1 at all levels of income?

14 Marginal propensity to consume and save Marginal propensity to consume : The additional (change) consumption that results from an additional (change) unit of income MPC = Δ C / Δ Y Marginal propensity to save: The saving that results from an additional unit of income. MPS = Δ S / Δ Y

Δ S MPS MPC - 50 Δ C Δ Y S C Y Example: The Silver Moon Economy Note: C = YAnd, S = Y

16 Note 1: MPC + MPS = 1 always why? Note 2: 0 ≤ MPC ≤ 1 always why? Note 3: 0 ≤ MPS ≤ 1 always why? Q 1: From the previous example what is the consumption level when income = 1000 ? Note 4: MPC represents the slope of the consumption function

17 Q 2: Which is higher MPC for low income households (countries) or for high income groups (countries) ? Y Y C C1 C2 MPC 2 > MPC 1 (lower income) > (higher income)

18 1: if income increased from KD 500 m to 600 m. and as a result consumption level increased from KD 300 m. to 360 m., what is the value of MPC & MPS ? Examples (assuming taxes = 0) 2: if C = Y what is the value of APC at Y = 400 ? 3: if C1 = 340, C2 = 500 when Y1 = 400 & Y2 = 600 what is the consumption and saving functions?

19 Answers: 1: MPC = 60% MPS = 40% 2: C = (400) = 350 APC = 350 / 400 = : b = 160 / 200 = 0.8 C = a + b Y 340 = a (400) a = 20 C = Y S = Y

20 Movement along the consumption curve vs. movement of the curve Y Y C C Y1 Y2 C1 C2 Q : What happens to consumption when: b) taxes decrease ? c) consumer expectations about future price level change ? a) income increases? C2 C3 C4 d) consumer loans increase, what is the short-term and long-term effect ? Note: all changes affecting consumption function affect AD

21 Second, Investment expenditure Investment is business spending on capital goods and inventories. Unlike consumption expenditure, investment is the least stable component of AD. Investment spending decision, generally, depends on the expected profitability of such spending. There are many factors that affect this expectation, which in turn, affect investment expenditure.

22 The main determinants of investment expenditure: Real interest rate: Investment is negatively related to interest rate (which is the cost of borrowed funds). As interest falls (other things being equal), investment increases Technology: New technologies stimulate investment expenditure. Taxes & Subsidies: Higher corporate taxes will increase costs of production and lower investment (subsidies will reduce costs and increase investment.

23 Capacity utilization: As firms approach their full production capacity, more investment expenditure is required to expand output (excess capacity reduces investment expenditure). Costs of production: Higher costs of production will lower expected profitability and hence reduce investment. Expectations: Investors expectations about future such as about demand, social and political stability, costs of production would affect their decisions and hence investment expenditure.

24 Unlike consumption expenditure, investment is not generally stable mainly to the different factors affecting investors’ confidence. The high changes in investment is the main reason for changes in the business cycle. Note: in this course we will assume that investment expenditure is constant. time I I

I S C Y (Silver Moon economy) Example: (Silver Moon economy) Y I I

AE 100 I S C Y Q: if there were only two sectors, at which level of income does equilibrium occurs? Recall, AS = Y = AE AS= Y = C + I or S = I Q: What is the tendency of GDP (Y) direction at non equilibrium levels ?

AE 100 I S C Y C C Y Y C C Y(AS) I I AE Y Y e e

Y Y S S S S I Y e Y at S = I e

29 ِ Determination of equilibrium income through equilibrium equations Note: since AS = AE at equilibrium Y = C + I Y = a +b Y + I then, Y - bY = a + I Y (1- b)= a + I Then, Y = a + I 1-b e Note, For the silver Moon economy : Y = = For the special case of a two sectors economy:

30 Third, government expenditure Government expenditure on goods and services is an important component of AD. The relative share of this component is influenced by available resources & finance, political and social orientation of the government, the economic conditions of the economy and degree of its development. Changes in government spending (fiscal policies) would affect AD directly. Note 1: in this course we will also assume that government expenditure is constant (independent of current income). Note 2: When we introduce taxes it will only be fixed taxes (Lump-sum taxes). Note 3: Changes in government spending and taxes are important tools of the Fiscal policy.

I S C Y G (Silver Moon economy) Example: (Silver Moon economy) Y G G

32 Q: if there were only three sectors, at which level of income does equilibrium occurs? AE I S C Y G Recall, AS = Y = AE C + S = C + I + G or S = I + G (assuming no taxes)

AE Y(AS) G G AE 2 Y Y e e AE Y Y 700

34 ِ Determination of equilibrium income through equilibrium equations Then, Y = a + I + G 1-b e Note, For the silver Moon economy : Y = = For the special case of a three sectors economy with no taxes:

35 Note: since AS = AE Y = C + I + G Y = a +b Y + I then, Y - bY = a + I + G Y (1- b)= a + I + G Then, Y = a + I + G 1-b e Appendix:

36 ِ Determination of equilibrium income through equilibrium equations Y e = a - bT+ I + G 1-b Note, Silver Moon economy : Y = (100) = For the special case of a three sectors economy with fixed taxes:

37 Note: since AS = AE Y = C + I + G Y = a +b ( Y - T) + I + G Y = a + b Y - bT + I + G then, Y - bY = a- bT + I + G Y (1- b)= a - bT + I + G Then, Y = a - bT+ I + G 1-b e e Appendix:

38 Forth, Net exports Exports are mainly determined by conditions in other countries such as income level, tastes, exchange rates, expectations, government policy, and other political factors; while imports are determined mainly by similar domestic factors. Exchange rate ( سعر الصرف ): The price in one country’s of one unit of another country’s currency. (e.g: 1K.D = $ 3.3 = 12 Egyptian Pounds …etc. ) A depreciation of the domestic currency will make domestic goods cheaper and make foreign goods relatively more expensive, hence would increase net exports. Q: What is the role of WTO in affecting international trade?

39 For the Kuwaiti economy ( )(million KD): Total exports (93% oil exports) = Total imports = The balance of trade = ( حجم التجارة الخارجية ) Total external trade (X + M) = 6334 GDP = The degree of openness of the Kuwaiti economy ( درجة انفتاح الاقتصاد ) : = (Total external trade / GDP ) x 100 = 73.8

40 Export is mainly determined by exogenous factors. In this course we will assume it constant. Imports on the other hand, is similar to consumption expenditure ( of foreign goods). Hence, M = m 0 + m 1 Y m1 = Δ M / Δ Y (marginal propensity to import) X = X

41 (Silver Moon economy) Example: (Silver Moon economy) Y X, M X-M M X Y 700 M 10 X

42 Q: if there were four sectors, at which level of income does equilibrium occurs? AE I C Y G Recall, AE = C + I + G + (X-M) and at equilibrium: AS = Y = AE X-M 65 - Note: equilibrium income for the four-sectors is less than for the three-sectors Silver Moon economy. Why?

AE Y Y AE 3 Y Y e e AE Y Y 700 AE2:Closed economy AE3: Open economy

44 ِ Determination of equilibrium income through equilibrium equations Y = a + I + G + X - m 0 1-b + m 1 e For the case of a four sectors (open ) economy with no taxes: Note, Silver Moon economy : Y = = e Q: What is Y for an open economy with fixed taxes ? e

45 Note: since AS = AE Y = C + I + G + (X- M) Y = a +b Y + I +G +X - m 0 - m 1 Y then, Y - bY + m 1 Y = a + I + G +X- m 0 Y (1- b + m 1 ) = a + I + G +X- m 0 Then, Y = a + I + G + X - m 0 1-b + m 1 e Appendix: