Aggregate expenditure 1. Autonomous versus induced

expenditure2. The consumption function3. The theory of investment4. Government purchase function5. The net export function

Autonomous versus induced Expenditure

•Autonomous expenditure: The components of aggregate expenditure that do not change when real GDP changes.

•Induced expenditure: The components of aggregate expenditure that change when real GDP changes.

The consumption function

The consumption function reveals the relationship between

consumption and disposable income, other things constant.

4

Disposable income, consumption, and saving in US

5

US consumption depends on disposable income

Keynes’s fundamental lawof consumption

People show a tendency, as a rule and on average, to increase their consumption when their income increases—but not by as much as the increase in income.

Marginal propensities to consume (MPC) and save (MPS)

MPC: The fraction of the change in income that is spent on consumption.

DI

CMPC

MPS: The fraction of the change in income that is saved

DI

SMPS

Keynes’s fundamental law implies that:

10 MPC

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The consumption function

0 1 2 3 4 5 76 8 9 10 14131211

Real disposable income (trillions of dollars)

12345

76

89

1011

Real

con

sum

ption

(tril

lions

of d

olla

rs)

C

The consumption function, C, shows the relationship between consumption and disposable income, other things constant.

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Marginal propensities to consume and saveRe

al c

onsu

mpti

on (t

rillio

ns o

f dol

lars

)

Real

sav

ing

(tril

lions

of d

olla

rs)

0

Real disposable income (trillions of dollars)0

(a) Consumption function (b) Saving function

a

b

cd

∆C=0.4∆S=0.1

∆DI=0.5∆DI=0.5

MPC=∆C/∆DI=0.4/0.5=4/5

MPS=∆S/∆DI=0.1/0.5=1/5

The slope of the C function equals the marginal propensity to consume. For the straight-line C function in (a), the slope is the same at all levels of income and is given by the change in consumption divided by the change in disposable income that causes it: MPC=4/5.

The slope of the S function in (b) equals the marginal propensity to save, MPS=1/5.

Determinants of consumption

Consumption

Interest Rates

Net Wealth

Disposable Income

Expectations

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Shifts of the consumption function

C

C’

C’’

Real disposable income

Real

con

sum

ption An upward shift, such as from C

to C’’, can be caused by an increase in net wealth, a decrease in the price level, an favorable change in consumer expectations, or a decrease in the interest rate.

A downward shift of the consumption function, such as from C to C’, can be caused by a decrease in net wealth, an increase in the price level, an unfavorable change in consumer expectations, or an increase in the interest rate.

The crash of ‘08

Let’s take out a loan so we can “cash out” some home equity.

Rising home values have stimulated household borrowing and consumption in the past decade.

Consumer Confidence has fluctuated lately

Debtor nation

Theory of Investment

Why do firms purchase things like new offshore drilling platforms, food processing plants, or bulldozers? Because they expect they can

make a profit by doing so.

Investment Function

),( rfI Let

Where:

•I is gross investment

• is the expected profit of investment; and

•r is the interest rate.

The Investment Decision

Acquisition cost of a tractor–trailer rig . . . . . . . . $150,000.00

Useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 years

Expected (extra) sales revenue per yearfrom the use of the asset . . . . . . . . . . . . . . . . . 200,000.00

Expected costs per year to operate the asset . . $180,000.00

Diesel fuel $38,000 Driver salary & benefits 68,000 Depreciation 50,000 Repairs (including tires) 19,000 Misc. (fees, fines, etc.) 5,000

Expected net sales revenue per year from the use of the asset . . . . . . . . . . . . . . . . . . $20,000.00

Computing expected profit ()

100Good Capital theofCost n Acquisitio

YearPer Revenue SalesNet Expected

000,149$

000,30$

To compute expected profit in percentage terms:

Thus we have:

%7.13100000,146$

000,20$

We would consider the tractor-trailer rig a

sound investment if the interest rate were less than 13.7 percent.

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Rates of return on golf carts and the opportunity cost of funds

0 $2,000 $4,000 $6,000 $8,000 $10,000

Investment

58

10

15

20

25

Nom

inal

inte

rest

rate

(per

cent

)

Market rate of interest

Expected rate of return

An individual firm invests in any project with a rate of return that exceeds the market interest rate.At an interest rate of 8%, Hacker Haven purchases three golf carts, investing $6,000.

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Investment demand curve for the economy

0 0.9 1.0 1.1 Investment(trillions of dollars)

6

8

10

Nom

inal

inte

rest

rate

(per

cent

)

D

The investment demand curve for the economy sums the investment demanded by each firm at each interest rate.At lower interest rates, more investment projects become profitable for individual firms, so total investment in the economy increases.

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Investment function

0.9

1.0

1.1

Inve

stm

ent (

trill

ions

of d

olla

rs)

I

0 2.0 4.0 6.0 8.0 10.0Real disposable income(trillions of dollars)

12.0 14.0

I’

I’’

Investment is assumed to be independent of income, as shown by horizontal lines. Thus, investment is assumed to be autonomous.

An increase in the interest rate or less favorable business expectations would decrease investment at every level of income, as shown by the downward shift from I to I’.

A decrease in the interest rate or more upbeat business expectations would increase investment at every level of income, as shown by the upward shift from I to I’’.

Annual percentage change in US real GDP, consumption, and investment

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Government purchase function

Because government purchases are controlled by public

officials, we treat them as autonomous—that is,

determined independent of income

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Net export function

-420

-400

-380

Net

exp

orts

(bill

ions

of d

olla

rs)

X-M

0 2.0 4.0 6.0 8.0 10.0Real disposable income(trillions of dollars)

12.0 14.0

X’-M’

X’’-M’’

Net exports here are assumed to be independent of disposable income, as shown by the horizontal lines. X-M is the net export function when autonomous net exports equal -$400 billion.

An increase in the value of the dollar relative to other currencies would decrease net exports at each level of income, as shown by the shift down to X’-M’.

A decrease in the value of the dollar would increase net exports at each level of income, as shown by the shift up to X’’-M’’.

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US spending components as percentages of GDP since 1959