Module 7: Aggregate Expenditure

What is the definition Consumption

Spending on New Goods and Services

What is the definition of Saving

Income not used on consumption 

• broader than money in banks

• savings at the household level also excludes new housing

• not consumption nor investment (Physical Capital)

What is the primary determinant of spending (or saving)?

Disposable Income

Disposable Income (Equation)

Yd = Y - T OR Yd = C + S

• Yd is disposable income

• Y is GDP (national income)

• T is taxes

• C is Consumption

• S is Savings

What does the consumption function show?

The relationship between consumption and disposable income

Consumption Function (Equation)

Spending = Slope*(Disposable Income) + Constant

What is Marginal Propensity to Consume (MPC)

The ratio of the change in consumption to the change in disposable income

Marginal Propensity to Consume (Equation)

MPC = Δ Consumption / Δ Disposable Income (Yd)

Change in Consumption (Equation)

Δ C = MPC * Change in Yd

What is the MPC?

MPC = change in consumption / change in disposable income

(48000-42100) / (60000-49000)

How much is saved in year 1?

Savings = disposable income - consumptions

60000-48000=12000

What is the Marginal Propensity to Save (MPS)?

the ratio of the change in saving to the change in disposable income

Marginal Propensity to Save (Equation)

MPS = change in saving / change in real disposable income

MPS = 1 - MPS

What is dissaving?

Negative saving - when spending exceeds income

• When savings (s) < equilibrium (o)

What is Autonomous Consumption

Consumption that is independent of disposable income

• can be positive or negative

What is the consumption equation that INCLUDES Autonomous Consumption

Consumption = (MPC) * )Yd) + Auto. Cons.

What is the equilibrium equation for GDP?

GDP = Y = C + I + G + NX

Solve for Equilibrium (Y)

C= 0.8(Yd) + 0.7), I = 1.6, G = 1.5, T = 1.5, NX=-0.2

GDP is Y, and Y is in Yd, and Yd is composed of Y-T (taxes)

1. Build equation

   1. Y = 0.8(Yd) + 0.7 + 1.6 + 1.5 - 0.2

2. Add values

   1. Y = 0.8(Yd) + 3.6

3. Separate Yd into Y-T

   1. Y = 0.8(Y-T) + 3.6

4. Distribute

   1. Y = 0.8Y - 0.8T + 3.6

5. Add Tax Value and Multiply and Add

   1. Y = 0.8Y - 0.8(1.5) + 3.6

   2. Y = 0.8Y - 1.2 + 3.6

   3. Y = 0.8Y + 2.4

6. Move Y to left side of equation and subtract

   1. Y - 0.8Y = 2.4

   2. 0.2Y = 2.4

7. Solve for Y

   1. Y = 2.4/0.2 = 12

   2. Y = 12

What causes the consumption function to shift but NOT the AD

• non-income determinants of consumption 

  • Cost

  • this DOES NOT SHIFT AD

What causes the consumption function to shift AND the AD

• Population

• Wealth

• Expected Future Income

• Interest Rates

• Confidence

• Taxes

• Consumption Tax Expectations

How does an increase in population shift the consumption function?

• More people = more people consuming

• More people consuming → shifts AD right

How does an increase in wealth shift the consumption function?

• If liquidity increases → Consumption increases

• If Availability of credit increases → Consumption increases

How does an decrease in interest rates shift the consumption function?

• people are able to consume more with money that would otherwise be spent on interest rates

Do taxes increase or decrease if you want to shift the consumption function to the right?

Decrease - this leaves more money for people to consume

How do consumption tax expectations cause the consumption function to shift?

If they expect taxes to go up, they will consume more BEFORE it gets raised

What is planned investment?

New Physical Capital

• Actual Investment = Planned Investment + Unplanned Investment

What are investment shifters?

• Consumption shifters

• Expectations of Future Profitability

• Technology

What are other determinants of Investment?

• Autonomous

  • GDP not driving

  • Autonomous Consumption

• Interest Rates

  • changes investment more than GDP rates

• Production and Employment Stable in Equilibrium

What does Government stand for in the Aggregate Expenditure Approach

Federal, state, and local government

• does not include transfer payments

• autonomous

  • not driven by GDP

What is Lump-Sum Tax (T)?

a tax that does not depend on income or the circumstances of the taxpayer

• Autonomous

What is the Foreign Sector?

Next Exports (NX) = exports - imports

• Autonomous

• Depends on the economic conditions in each country

Autonomous variables are given and do not change with equilibrium

In planned Investment, what is short-run equilibrium

When aggregate expenditure equals aggregate production

• Assume the economy is not growing

• only consumption is a function of GDP since it is a function of disposable income

What does the Aggregate Expenditure equations look like in EQUILIBRIUM?

C + I + G + NX = GDP = Y

What does the aggregate expenditure equations look like when businesses have to change their inventories

• C + I + G + NX > GDP

• C + I + G + NX < GDP

How do businesses adjust back to equilibrium with inventory when the equation looks like the following: C + I + G + NX > GDP

• unplanned drop in inventories

  • businesses increase output

    • GDP increases & returns to equilibrium

How do businesses adjust back to equilibrium with inventory when the equation looks like the following: C + I + G + NX < GDP

• Unplanned rise in inventories

  • businesses cut output

    • GDP decreases and returns to equilibrium

How can $1.6 trillion of I generate $8 trillion of Y?

Autonomous spending multiplier

The Muliplier Effect - What is a multiplier?

ratio fo the change in the equilibrium level of real national income to the change in autonomous expenditures

(Spending) Multiplier (Equation)