↑↓→ Chapter 21 Consumption and Investment • Major components of national output and private spending- Consumption and Investment • Part of output not consumed- saving and investment • consumption grows ↑, total spending or aggregate demand increases ↑, SH!" !#$ output and emplo%ment ↑ &' Consumption and Saving • Personal consumption e(penditurese(penditures- e(penditures )% households on final goods and services • Saving - part of personal disposa)le income that is not consumed' • Consumption - largest single component of *+P Categories of consumption 1' +ura)le goods - motor vehicles, furniture 2' $ondura)le goods- food, energ% goods ' Services - housing, medical care I'
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udg udget etar ar% % .(pen (pendi ditu ture re Patt Patter erns ns &s income ↑, Proportion of total spending devoted to food declines ↓ &fter-ta( &fter-ta( income↑, .(penditure on clothing, recreation, and automo)iles increases more than proportionatel%↑ .ngel/s 0aws 0aws - &fter .rnst .ngel' "he average )ehavior of consumption e(penditure does change fairl% regularl% with income Saving rises ↑ as income increases ↑ Saving is the greatest lu(ur% of all' Cons Consum umpt ptio ion, n, Incom ncome, e, and and Sav Savin ing g Personal saving - part of +isposa)le Income that is not consumed +ISPS&0. I$CM. 3 S&4I$* 5 C$S#MP"I$ or S&4I$* 3 +I - C$S#MP"I$ Personal income is composed of wages, fringe )enefits, interests, rents, dividends, transfer pa%ments, and so forth +ISPS&0. P.!S$&0 I$CM. 3 P.!S$&0 I$CM. − P.!S$&0 P.!S$& 0 "&6.S "&6.S P.!S$&0 S&4I$* S&4I$* 3 +ISPS&0. P.!S$&0 I$CM. − P.!S$&0 #"0&7S consumption and interest Personal Saving !ate is e8ual to personal saving as a percent of disposa)le income Income is the primar% determinant of consumption and saving rea9-even point- household neither saves nor dissaves net saving )ut consumes all its income
III' "he Consumption :unction • Consumption :unction - shows the relationship )etween the level of consumption e(penditures and the level of disposa)le personal income • +isposa)le Income +I on the H!I;$"&0 ( a(is and Consumption C on the 4.!"IC&0 %a(is direct relationship, consumption ↑ rises with increases in +I ↑
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"he <=> line helps locate the )rea9-even point and helps our e%e measure net saving' a "he "he ?r ?rea ea99-.v .ven en?? Poi Point nt - consumption e(actl% e8uals the distance across from the vertical a(is disposa)le income
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whether consumption spending is e8ual to, greater than, or less than the level of disposa)le income
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it is the level of disposa)le income at which households just )rea9 even
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consumption e(penditures e(actl% e8ual disposa)le income
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the household is neither a )orrower nor a saver
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&mount of saving or dissaving is measured ) % the vertical distance )etween the consumption
function and the <=> line $ the <=° line, ;.! savings, C$S#MP"I$ 3 I$CM. &4. the <=° line, $.*&"I4. - savings, C$S#MP"I$ @ I$CM. .0A the <= ° line, PSI"I4. 5 savings, C$S#MP"I$ B I$CM. I4' "he Saving :unction
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Saving :unction shows the relationship )etween the level of saving and income
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Saving :unction 3 <=> line - consumption function verticall% Saving schedule 3 Income - Consumption '''' su)tract consumption from income
4' "he Marginal Propensit% to Consume
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e(tra amount that people consume when the% receive an e(tra dollar of disposa)le income' ?Marginal? means ?e(tra or additional? ?marginal cost? the additional cost of producing an e(tra unit of output ?Propensit% to consume? designates the desired level of consumption
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Marginal Propensit% to Consume as *eometrical Slope - slope of the consumption function is the same as the marginal propensit% to consume' :or curved lines, we calculate the slope as the slope of the tangent line at a point' "he slope of the consumption function, which measures the change in consumption per dollar change in disposa)le income, is the marginal propensit% to consume
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4I' "he Marginal Propensit% to Save
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defined as the fraction of an extra dollar of disposable income that goes to extra saving. Each extra dollar of disposable income must be divided between extra consumption and extra saving so MPS 5 MPC 3 1 &0A&7S
.(ample in the ta)le 1 +I :or column after 1 ta(es ( a(is & 2<, 2=, - & 2<, 31 2=,
2 Consumption C e(penditure % a(is 2<,2
2=,
:or column 2
MPC ∆% ∆(
2=, - & 2<,2 3 D
col' 2 D col' 1 1, 3 ' D constant
< $et saving +I-C <31-2 -2
= MPS ∆% -@ < ∆( -@ +I 1
2 1, 3 '2
2 1, 3 '2
VII. Brief Review of Denitions 1. The consumption function relates the level of consumption to the level of disposable income. 2. The savin function relates savin to disposable income. Because what is saved e!uals what is not consumed" savin and consumption schedules are mirror imaes. #. The marinal propensit$ to consume %&'() is the amount of e*tra consumption enerated b$ an e*tra dollar of disposable income. +raphicall$" it is iven b$ the slope of the consumption function.
,. The marinal propensit$ to save %&') is the e*tra savin enerated b$ an e*tra dollar of disposable income. +raphicall$" this is the slope of the savin schedule. . Because the part of each dollar of disposable income that is not consumed is necessaril$ saved" &'/ 1- &'(. VIII. 0ational (onsumption Behavior • hort run- consumption is a maor component of areate spendin" will aect output and emplo$ment throuh the 3D • Consumption and saving behavior are key to understanding economic growth and business cycles. I6' +eterminants of Consumption 1' +isposa)le Income ↑↓→ • Increases in +I ta( cuts ↑, stimulate consumption growth ↑ • +I declines in recessions ↓, consumption usuall% follows the decline ↓ 2' Permanent Income and the 0ife-C%cle Model of Consumption e(pectations of future income • Permanent Income - income after removing temporar% or transient influences due to windfall gains or losses • Permanent-income theor% - consumption responds primaril% to permanent income and consumers do not respond e8uall% to all income shoc9s' If transitor% one-time )onus larger amount of income ma% )e saved • 0ife-c%cle h%pothesis- people save in order to smooth their consumption over their life- time' Social Securit% provides an income supplement for retirement' ' Aealth and ther Influences • Aealth effect- Higher wealth leads to higher consumption 6' "he $ational Consumption :unction
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4itted consumption function - shows how closely consumption has followed
disposable income over the period shown 'otential (auses for a sharp decline in the 'ersonal avins Rate %'R() 1. ocial securit$ %less need to save for retirement because overnment collects social securit$ ta*es and pa$s out social securit$ benets) 2. 4inancial &ar5ets - new loan instruments li5e credit cards encouraed people to borrow #. Rapid rowth in paper wealth - stoc5 mar5et boom" rise is stoc5 prices and prices of e*istin assets % could not convert their paper wealth into consumption) 6I. 3lternative &easures of avin • 0ational- accounts measure of savin / DI %e*cludin capital ains) consumption • Balance-sheet measure of savin shows how closely consumption has
followed disposable income over the period shown B. Investment • 2 roles in macroeconomics
1. investment often leads to chanes in areate demand and aects the business c$cle %short-run output throuh its impact on 3D) 2. leads to capital accumulation (long-run output growth on potential output and
aggregate supply) •
7Investment7 in 8conomics- additions to the stock of productive assets or capital goods
I' +eterminants of Investment
1. Revenues- overall level of output (or GDP 2. (osts- interest rates and ta*es in9uence costs #. 8*pectations- prot e*pectations and business condence II. Investment Demand (urve • To show the relationship between interest rates and investment • Demand-for-investment schedule - amount of investment at each interest rate is •
DOWNWARD Shifts in the Investment Demand Curve a. Higher output or higher level of GDP - SHIFT OUT (RIGHT) ⇒ b. Higher Taxes on capital income- SHIFT IN (LEFT) ⇐ c. Business euphoria or new business - SHIFT OUT (RIGHT) ⇒
(hapter 22 Business ($cles and 3reate Demand 3. :;3T 3R8 B<I08 (=(>8? • econom$ wide 9uctuations in total national output" income" and emplo$ment" usuall$ lastin for a period of 2 to 1@ $ears" mar5ed b$ widespread e*pansion or contraction in most sectors of the econom$. • 2 main phases a. Recession- recurring period of decline in total out- put, income, and
employment, usually lasting from 6 to 12 months and marked by contractions in many sectors of the economy. when real GDP has declined for two consecutive calendar quarters. *Depression - A recession that is large in both scale and duration b. Expansion (haracteristics of a recessionA 1. Investment usually falls sharply 2. Employment usually falls sharply 3. As output falls, inflation slows and the demand for crude materials declines, and
materials’ prices tumble. 4. Business profits fall sharply 5. the Federal Reserve begins to lower short-term interest rates to stimulate investment, and other interest rates decline as well.
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I. B<I08-(=(>8 T;8RI8 8*oenous- outside the economic system Internal- within the economic system itself II. 4inancial (rises and Business ($cles 1. 'anics of 8arl$ (apitalism 2. ;$perin9ation occurs when prices rise at 1@@ per- cent or more per month #. The 0ew-8conom$ Bubble - speculative boom in new- econom$ stoc5s ,. The ;ousin Bubble- nancial Csecuritiation.7 home mortae was sold on securities mar5ets. &an$ securities lost value 7un5 bonds7 B. 3++R8+3T8 D8&30D 30D B<I08 (=(>8 I. T;8 T;8R= 4 3++R8+3T8 D8&30D • Aggregate demand (or AD) is the total or aggregate quantity of output that is
willingly bought at a given level of prices, other things held constant 4 Components
• 1. (onsumption - disposable income" which is personal income less ta*es. - real consumption %that is" nominal or dollar consumption divided b$ the price inde* for consumption). 2. Investment - can aect monetary policy. 3. Government purchases ,. 0et e*ports -
THE DOWNWARD-SLOPING AGGREGATE DEMAND CURVE II.
- level of real spending declines as the overall price level in the economy rises. - Personal income might be set in nominal dollar terms— government transfer payments,
the minimum wage, and company pensions - price level goes up, real disposable income falls - The AD curve slopes downward. This downward slope implies that real spending declines as the price level rises, other things held constant. Real spending declines with a higher price level primarily because of the effect of higher prices on real incomes and real wealth. III. Shifts in Aggregate Demand Variable
Impact on AD Policy Variables (government control)
Monetary Policy (CB)
Monetary Expansion may lower interest rates and loosen credit conditions. higher levels of investment and consumption of durable goods.
Fiscal Policy (Taxes and government
Increases in government purchases of goods and services directly increase spending; tax reductions or increases in transfers raise disposable income and induce higher consumption. Tax incentives like an investment tax credit can induce higher spending in a particular sector.
expenditures)
Variable
Exogenous Variables
Foreign output
Output growth abroad leads to an increase in net exports.
Asset values
Rise in stock market increases household wealth and thereby increases consumption; also, higher stock prices lower the cost of capital and thereby increase business investment.
Advances in technology
Technological advances can open up new opportunities for business investment.
Others
Weather -lower food prices, increase in world oil production and lowers oil prices, defeat government stimulates foreign investment,
Reminder 1. Demand Curve - has the price of an individual commodity on the vertical axis and production of that commodity on the horizontal axis, with all other prices and total consumer incomes held constant.
3reate Demand (urve- the eneral price level is on the vertical a*is" while total output and incomes var$ alon the horiontal a*is. microeconomic demand curve- total incomes and output are held constant
IV. Business ($cles and 3reate Demand - a hiher price level with iven nominal mone$ incomes lowers real disposable incomeE this leads to hiher interest rates and declinin spendin on interest-sensitive investment and consumption %&V8&80T 3>0+ T;8 3D (TI'>I8R &D8> - used to e*plain how output is determined in the short run - 7&ultiplier7 each dollar chane in e*oenous e*penditures %such as investment) leads to more than a dollar chane %or a multiplied chane) in +D' I. 86'80DIT
IV. T;8 &<>TI'>I8R - The multiplier is the impact of a 1-dollar chane in e*oenous e*penditures on total output. In the simple ( I model" the multiplier is the ratio of the chane in total output to the chane in investment. - 7&ultiplier7 - the chane in output per unit chane in e*oenous e*penditure. :e are ta5in certain components of spendin as iven outside the model. If the &' were 1L*" the multiplier would be *. multiplier is alwa$s the inverse" or reciprocal" of the marinal propensit$ to save. It is thus e!ual to 1L %1- &'(). 4ormulaA V. The &ultiplier &odel (ompared with the 3-3D &odel - 3 curve that becomes completel$ vertical when output e!uals potential output. - 3D shifts to the riht when investment increases" e!uilibrium output rises D. 4I(3> '>I(= I0 T;8 &<>TI'>I8R &D8> - use the multiplier model to show how overnment purchases aect output. I. ;: +V8R0&80T 4I(3> '>I(I8 3448(T ump-sum ta*es- ta*es that do not chane with income or other economic variables - +D' e!uals disposable income plus ta*es. :e can plot (( consumption schedule aainst +D' rather than DI - pile on top. if $ou compute +D' to be / ( I + / T8. 8 moves upward II. Impact of Ta*ation on 3reate Demand - &ultiplier model - hiher ta*es %net ta*es/ ta*es- transfer pa$ments) without increases in overnment purchases will tend to reduce real +D' III.
FISCAL-POLICY MULTIPLIERS
government expenditure multiplier - increase in GDP resulting from an increase of $1 in government purchases of goods and services expenditure multipliers - government expenditure multiplier is exactly the same number as the investment multi- plier
Government purchases of goods and services ( G ) are an important force in determining output and employment. In the multiplier model, if G increases, output will rise by the increase in G times the expen- diture multiplier. Government purchases therefore have the potential to increase or decrease output over the business cycle.
IV. Impact
of Taxes
Tax changes are a powerful weapon in affecting output. But the tax multiplier is smaller than the expenditure multiplier by a factor equal to the MPC: Tax multiplier MPC X expenditure multiplier
V. The Multiplier Model and the Business Cycle
