Section 2: Determinants of Aggregate Expenditure

Consumption Function

The relationship between consumption spending and disposable income. Since income expands most years, consumption generally follows a smooth, upward trend

Marginal Propensity to Consume (MPC)

The slope of the consumption function. It is the amount by which consumption spending changes when disposable income changes.

• $MPC = \frac{\Delta \text{Consumption}}{\Delta \text{Disposable Income}}$

Marginal Propensity to Save (MPS)

The amount by which saving changes when disposable income changes. Any change in income must be consumed or saved, so: $\boldsymbol{MPC + MPS = 1}$.

Current Disposable Income:

The main determinant; more income leads to more consumption

Household Wealth

• Higher wealth (assets minus liabilities) leads to higher consumption (the wealth effect).

Expected Future Income

People prefer to keep consumption stable (consumption smoothing), so expectations of higher future income increase current consumption.

Price Level

A rising price level decreases the real value of wealth, resulting in lower real consumption spending.

Interest Rate

Higher real interest rates encourage saving over spending, leading to lower consumption, especially for durable goods.

Expectations of Future Profitability

• Optimism about future profits encourages firms to build long-lived capital goods now.

Interest Rate

A higher real interest rate increases the cost of borrowing and financing capital, which reduces investment spending

Taxes

Higher corporate income taxes reduce funds available for reinvestment and diminish the expected profitability of investments

Cash Flow

Firms often pay for investments out of cash flow (cash revenues minus spending). Lower cash flow during recessions decreases the ability to finance investment.

U.S. vs. Foreign Price Levels:

• If U.S. prices rise faster, U.S. goods become relatively more expensive, causing imports to rise and exports to fall ($NX$ decreases).

U.S. vs. Foreign GDP Growth

• If U.S. GDP grows faster, U.S. demand for imports rises faster than foreign demand for exports ($NX$ decreases).

U.S. Dollar Exchange Rate

If the U.S. dollar rises in value, imports are cheaper, and exports are more expensive ($NX$ decreases).