2. The Aggregate Expenditure Model

3. I. Tools of the Aggregate Expenditures Model: Aggregate expenditures – refers to the economy’s total spending. The Aggregate expenditure model was developed by John Maynard Keynes. The basic premise of the AE model (also known as the consumption function graph) states, the amount of goods and services produced depend directly on the level of AE (total spending). In other words, when AE fall, total output (GDP) and employment decrease; when AE rises, total output (GDP) and employment increase.

4. It’s a measurement of GDP performance. An illustration of the relationship between consumption and savings in the entire economy (aggregate). Savings is defined as “not spending” or that part of DI not consumed. Savings = DI – C (consumption)

5. o 45 o C + I g 390470 370 390 410 430 450 470 490 510 530 550 $530 510 490470 450 430 410 390 370 Right now we are going to assume that the U.S. is a closed economy and the only two variables are personal consumption & gross investment spending. We’ll deal with government spending & net exports later.

6. Consumption and DI from 1988-2000 DISPOSABLE INCOME (billions of dollars per year) $1000200030004000 Actual consumer spending 6000 5000 4000 3000 2000 1000 0 500060007000 45° $7000 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 CONSUMPTION (billions of dollars per year) C = DI The 45 degree line represents C = DI. The vertical distance between actual consumption and the 45 degree line represents the amount saved.

7. Consumption Consumption (billions of dollars) o 45 o C onsumption Disposable Income (billions of dollars) 390 370 390 410 430 450 470 490 510 530 550 $530 510 490 470 450 430 410390 370 Consumption Schedule [direct relationship between income & consumption] [direct relationship between income & consumption] Our consumption line is upward sloping; because when DI increases, then consumption increases.

8. , The Consumption Function, measures different consumption and saving levels at different GDP (total output) levels.

9. APC = C/Y = $48,000/$50,000 =.96 APS = S/Y = $2,000/$50,000 =.04 1 APC = C/Y = $52,000/$50,000 = 1.04 APS = S/Y = -$2,000/$50,000 = -.04 1 APC - percentage of income (Y) that is consumed. APS – percentage of income (Y) that is saved APS = S/Y APC APS APC and APS Since there are only two things you can do with income (C or S), the sum of APC & APS equals 1.

10. But what if total output changes (increase)? How do we calculate the percentage of this new income that will be consumed and the percentage that will be saved? MPC, & MPS MPC - percentage change in income consumed. MPS - percentage change in income saved. Let’s say income increase by $1,000, and consumption increase by 2/3; MPC = C/ Y = $750/$1,000 =.75 MPS = S/ Y = $250/$1,000 =.25 1 Since there are only two things you can do with the increased income, the sum of MPC & MPS equals 1.

11. Consumption o 45oConsumption C1C1C1C1 F SAVING E C2C2C2C2 S Disposable Income B C D A H Dissaving So far we have been looking at how changes in DI effect C & S, which is illustrated by moving points on a fixed consumption curve. The more we have the more we consume and save.

12. o 45 o C1C1C1C1 C2C2C2C2 470 370 390 410 430 450 470 490 510 530 550 $530 510 490470 450 430 410 390 370 Real GDP Consumption of savings But there are certain non- income determinants that can increase or decrease consumption, thus shifting the entire curve up or down. WHET The determinants are called WHET.

13. Non-income Determinants: WealthWealth; the greater the wealth of households, the larger their consumption. Wealth means real assets (house, cars, T.V.) and financial assets (stocks, bonds, insurance policies). Household debt Household debt; increasing debt means increasing consumption. Expectation Expectation; future expectations about rising prices or income can increase consumption. Taxation Taxation; a tax decrease will increase both consumption and savings.

14. Consumption Saving o o 45 o C1C1C1C1 S1S1S1S1 Disposable Income C2C2C2C2 S2S2S2S2 Increase in Consumption (Decrease in Saving) Increases in consumptionmeans… Decrease in saving Any increase in consumption will mean an equal decrease in savings. Because you can only do one of the two with a dollar.

15. Consumption Saving o o 45 o C1C1C1C1 S1S1S1S1 Disposable Income C2C2C2C2 S2S2S2S2 Increase in Consumption (Decrease in Saving) Increases in consumptionmeans… Increase in saving I’ll buy more and save more. The exception is a change in taxes. A decrease in taxes will increase DI, which is subject to MPS/MPC rules. Some of the new income will be consumed and some saved.

16. Consumption Saving o o 45 o C1C1C1C1 S1S1S1S1 Disposable Income C2C2C2C2 S2S2S2S2 Decrease in Consumption Decreases in consumptionmeans… Decrease in saving However, an increase in taxes, will decrease DI, thus decreasing consumption and savings.

17. o 45 oC C + I g I g = $20 Billion 390470 370 390 410 430 450 470 490 510 530 550 C =$450 Billion $530 510 490470 450 430 410 390 370 Real GDP Now let’s add gross investments to the topic and see how it will affect aggregate expenditures.

18. Investments = the expenditures on new capital goods. An investments marginal benefits = the expected rate of return a business expects from its investment. An investments marginal cost = the expected cost of making the investment. An investment project will be profitable if its expected rate or return (r) exceeds the expected cost (interest rate). Businesses will invest if r >or = i. Investment:

19. Should A New Drill Press Be Purchased? Drill Press - $1,000 Drill Press - $1,000 A.Expected returns (profits)$1,10010% A.Expected returns (profits) = $1,100 or a 10% return return. [$100/$1,000 = 10%] B. Nominal interest rate = 12%, C. Inflation rate = 4%

20. NominalInterestRate RealInterestRate AnticipatedInflation - 12 % 5%5%5%5% 7%7%7%7% = Remember, that nominal interest rate minus anticipated inflation rates equal real interest rates. It is the real interest rate that determines the expected cost of an investment.

21. interest rate (i) 16 14 12 10 8 % 6 4 % 2 0 2030 510 15 20 25 30 35 40 QMQM QM QM DIgDIg So firms will undertake all investments which have an expected real interest rate less than [or equal to] the investments expected return. There is an inverse relationship between (i) and Qm Lowing the real interest rate means that investments are more profitable; thus demand for investment funds are greater.

22. interest rate (i) 16 14 12 10 8 % 6 4 % 2 0 2030 510 15 20 25 30 35 40 QMQM QM QM DIgDIg The quantity of money demanded for investments increases as interest rates decrease. This is illustrated as a movement from point to point on a fixed investment demand curve.

23. Qm 1 Qm 2 100 20025% 20 % 15%10%5%050150 250 taste But there are non-interest rate factors that can change the quantity demanded for investment money. Thus shifting the entire investment demand curve to the right or left, it is called taste.

24. Non-interest rate determinants; Technology Technology; the development of new technology shifts the investment demand curve to the right, as businesses upgrade. Acquisition of operation cost Acquisition of operation cost; when production cost fall, expected rates of return from prospective investments rise shifting the demand curve to the right. Stock of inventory Stock of inventory; businesses with dwindling inventories will invest in expansion, thus shifting the demand curve right. Taxes Taxes; lower business taxes increases the expected profitability of investments, and shift the demand curve right. Expectation Expectation; optimism about future profits increase investments and shift the demand curve right.

25. Voltility of Investment Volatility of Investment R R R R R R R DIE! Investment is the most volatile part of aggregate expenditures, because of DIE!

26. Durability of Capital; some machines are more durable than other. The more durable them capital the less need for replacing it.Durability of Capital; some machines are more durable than other. The more durable them capital the less need for replacing it. Reasons for Investment Volatility

27. Irregularity of innovations; new products and processes stimulate investment but they occur irregularly.Irregularity of innovations; new products and processes stimulate investment but they occur irregularly.

28. Expectations; pessimism about future profits will cause firms to keep older equipment and avoid investment.Expectations; pessimism about future profits will cause firms to keep older equipment and avoid investment. Reasons for Investment Volatility

29. o 45 o C + I g 390470 370 390 410 430 450 470 490 510 530 550 $530 510 490470 450 430 410 390 370 Real GDP The equilibrium level of GDP occurs where the total output, measured by GDP, and aggregate expenditures, C + I g are equal. Consumption

30. Consumption o 45 o Actual AE ProjectedAE Equilibrium + 10 Spending gap Real GDP When consumption is less then GDP (below equilibrium), the result is under spending, leading to increased inventories of goods in the economy (called a recessionary spending gap).

31. Consumption o 45 o AE 1 Equilibrium When consumption is greater than GDP (above equilibrium), the result is over spending, leading to decreased inventory of goods in the economy (called an inflationary spending gap). Inflationary Spending gap Real GDP AE 2