|ECON 232 CHAPTER NINE BUILDING THE AGGREGATE EXPENDITURES
|The central purpose of this chapter is to introduce the basic analytical
tools that will help us organize our thinking about macroeconomic theories
and controversies. First, the historical backdrop of the aggregate
expenditures model is established. Next, the focus is on the consumption-income
and saving-income relationships that are part of the model. Third,
investment is examined, and finally, the consumption, saving, and investment
concepts are combined to explain the equilibrium levels of output, income,
and employment in a private (no government), domestic (no foreign sector)
|I. Introduction—What Determines GDP?
A. This chapter and the next focus on the aggregate expenditures
model. We use the definitions and facts from previous chapters to
shift our study to the analysis of economic performance. The aggregate
expenditures model is one tool in this analysis. Recall that “aggregate”
B. As explained in this chapter’s Last Word, the model originated with
John Maynard Keynes (Pronounced Canes).
C. The focus is on the relationship between income and consumption and
D. Investment spending, an important part of aggregate expenditures,
is also examined.
E. Finally, these spending categories are combined to explain the equilibrium
levels output and employment in a private (no government), domestic (no
foreign sector) economy. Therefore, GDP = NI = PI = DI in
this very simple model. NI = "national income," PI = "private income,"
DI = "domestic income."
|II. Simplifying Assumptions for this Chapter
A. We assume a “closed economy” with no international trade.
B. Government is ignored; focus is on private sector markets until next
C. Although both households and businesses save, we assume here that
all saving is personal.
D. Depreciation and net foreign income are assumed to be zero for simplicity.
E. There are two reminders concerning these assumptions.
1. They leave out two key components of aggregate demand (government
spending and foreign trade), because they are largely affected by influences
outside the domestic market system.
2. With no government or foreign trade, GDP, national income
(NI), personal income (PI), and disposable income (DI) are all the same.
|III. Tools of Aggregate Expenditures Theory:
Consumption and Saving
A. The theory assumes that the level of output and employment
depend directly on the level of aggregate expenditures. Changes
in output reflect changes in aggregate spending.
B. Consumption and saving: Since consumption is the largest
component of aggregate spending, we analyze its determinants.
1. Disposable income is the most important determinant of consumer
spending (see Figure 9-1 in text which presents historical evidence).
a. What is not spent is called saving.
b. Therefore, DI – C = S or C + I = DI, disposable income (DI)
minus consumption (C) equals saving; or consumption (C) plus investment
(I) equal disposable income (DI). Investment and saving are assumed
to be equal because it is assumed that every dollar saved is always invested,
(which is not necessarily always the case.)
2. In Figure 9-1 we see a 45-degree line which represents all points
where consumer spending is equal to disposable income; other points represent
actual C, DI relationships for each year from 1980-2000.
3. If the actual graph of the relationship between consumption and
income is below the 45-degree line, then the difference must represent
the amount of income that is saved.
4. Look at 1996 where consumption was $5238 billion and disposable
income was $5678 billion. Hence, saving was $440 billion.
5. The graph illustrates that as disposable income increases both consumption
and saving increase.
6. Some conclusions can be drawn:
a. Households consume a large portion of their disposable income.
b. Both consumption and saving are directly related to the level of
C. The consumption schedule:
1. The dots in Figure 9-1 represent actual historical data.
2. A hypothetical consumption schedule (Table 9-1 and Key Graph
9-2a) shows that households spend a larger proportion of a small income
than of a large income.
3. A hypothetical saving schedule (Table 1, column 3) is illustrated
in Key Graph 9-2b.
4. Note that “dissaving” occurs at low levels of disposable income,
where consumption exceeds income and households must borrow or use up some
of their wealth.
D. Average and marginal propensities to consume and save:
1. Define average propensity to consume (APC) as the fraction
or % of income consumed (APC = consumption/income).
See Column 4 in Table 9-1.
2. Define average propensity to save (APS) as a the fraction
or % of income saved (APS = saving/income). See
Column 5 in Table 9-1.
3. Global Perspective 9-1 shows the APCs for several nations in 1999.
Note the high APC for both U.S. and Canada.
4. Marginal propensity to consume (MPC) is the fraction or proportion
of any change in income that is consumed. (MPC = change in consumption/change
in income.) See Column 6 in Table 9-1.
5. Marginal propensity to save (MPS) is the fraction or proportion
of any change in income that is saved. (MPS = change in saving/change
in income.) See Column 7 in Table 9-1.
6. Note that APC + APS = 1 and MPC + MPS = 1.
7. Note that Figure 9-3 illustrates that MPC is the slope of the
consumption schedule, and MPS is the slope of the saving schedule.
8. Test Yourself: Try the Self-Quiz below Key Graph 9-2.
E. Non-income determinants of consumption and saving can cause people
to spend or save more or less at various income levels, although the level
of income is the basic determinant.
1. Wealth: An increase in wealth shifts the consumption schedule
up and saving schedule down. In recent years major fluctuations in
stock market values have increased the importance of this wealth effect.
2. Expectations: Changes in expected inflation or future wealth can
affect consumption spending today.
3. Household debt: Lower debt levels shift consumption schedule
up and saving schedule down.
4. Taxation: Lower taxes will shift both schedules up since taxation
affects both spending and saving, and vice versa for higher taxes.
F. Shifts and stability: See Figure 9-4.
1. Terminology: Movement from one point to another on a given
schedule is called a change in amount consumed; a shift in the schedule
is called a change in consumption schedule.
2. Schedule shifts: Consumption and saving schedules will always
shift in opposite directions unless a shift is caused by a tax change.
4. Stability: Economists believe that consumption and saving
schedules are generally stable unless deliberately shifted by government
G. Review these aggregate expenditures concepts with Quick Review
A. Investment, the second component of private spending, consists
of spending on new plants, capital equipment, machinery, inventories,
1. The investment decision weighs marginal benefits and marginal
2. The expected rate of return is the marginal benefit and the interest
rate represents the marginal cost. The interest rate is either paid
to creditors or is the opportunity cost of using the firm's own funds to
build new capital instead of lending the funds to someone else.
B. Expected rate of return is found by comparing the expected
economic profit (total revenue minus total cost) to cost of investment
to get expected rate of return. The text’s example gives $100 expected
profit, $1000 investment for a 10% expected rate of return. Thus,
the business would not want to pay more than 10% interest rate on investment.
C. The real interest rate, i (nominal rate corrected for expected inflation),
is the cost of investment.
1. Interest rate is either the cost of borrowed funds or the cost of
investing your own funds, which is income forgone.
2. If real interest rate exceeds the expected rate of return,
the investment should not be made.
D. Investment demand schedule, or curve, shows an inverse
relationship between the interest rate and amount of investment.
1. As long as expected return exceeds interest rate, the investment
is expected to be profitable (see Table 9?2 example).
2. Key Graph 9-5 shows the relationship when the investment rule is
followed. Fewer projects are expected to provide high return, so
less will be invested if interest rates are high.
3. Test yourself with Quick Quiz 9-5.
E. Shifts in investment demand occur when any determinant apart
from the interest rate changes.
1. Greater expected returns create more investment demand; shift
curve to right. The reverse causes a leftward shift.
a. Acquisition, maintenance, and operating costs of capital goods
b. Business taxes may change.
c. Technology may change.
d. Stock of capital goods on hand will affect new investment.
e. Expectations can change the view of expected profits.
F. In addition to the investment demand schedule, economists also define
an investment schedule that shows the amounts business firms collectively
intend to invest at each possible level of GDP or DI.
1. In developing the investment schedule, it is assumed that investment
is independent of the current income. The line Ig (gross investment)
in Figure 9?7b shows this graphically related to the level determined by
2. The assumption that investment is independent of income is a simplification,
but will be used here.
3. Table 9-3 shows the investment schedule from GDP levels given in
G. Investment is a very unstable type of spending; I is more volatile
than GDP (See Figure 9-8).
1. Capital goods are durable, so spending can be postponed or not.
This is unpredictable.
2. Innovation occurs irregularly.
3. Profits vary considerably.
4. Expectations can be easily changed.
|V. Equilibrium GDP: Expenditures-Output
A. Look at Table 9-4, which combines data of Tables 9-1 and
B. Real domestic output in column 2 shows ten possible levels that producers
are willing to offer, assuming their sales would meet the output planned.
In other words, they will produce $370 billion of output if they expect
to receive $370 billion in revenue.
C. Ten levels of aggregate expenditures are shown in column 6.
The column shows the amount of consumption and planned gross investment
spending (C + Ig) forthcoming at each output level.
1. Recall that consumption level is directly related to the level of
income and that here income is equal to output level.
2. Investment is independent of income here and is planned or intended
regardless of the current income situation.
D. Equilibrium GDP is the level of output whose production will create
total spending just sufficient to purchase that output. Otherwise
there will be a disequilibrium situation.
1. In Table 9-4, this occurs only at $470 billion.
2. At $410 billion GDP level, total expenditures (C + Ig) would be
$425 = $405(C) + $20 (Ig) and businesses will adjust to this excess demand
by stepping up production. They will expand production at any level
of GDP less than the $470 billion equilibrium.
3. At levels of GDP above $470 billion, such as $510 billion, aggregate
expenditures will be less than GDP. At $510 billion level, C + Ig
= $500 billion. Businesses will have unsold, unplanned inventory
investment and will cut back on the rate of production. As GDP declines,
the number of jobs and total income will also decline, but eventually the
GDP and aggregate spending will be in equilibrium at $470 billion.
E. Graphical analysis is shown in Figure 9-9 (Key Graph). At $470
billion it shows the C + Ig schedule intersecting the 45-degree line which
is where output = aggregate expenditures, or the equilibrium position.
1. Observe that the aggregate expenditures line rises with output and
income, but not as much as income, due to the marginal propensity to consume
(the slope) being less than 1.
2. A part of every increase in disposable income will not be spent
but will be saved.
3. Test yourself with Quick Quiz 9-9.
|VI. Two Other Features of Equilibrium GDP
A. Savings and planned investment are equal.
1. It is important to note that in our analysis above we spoke of “planned”
investment. At GDP = $470 billion in Table 9-4, both saving and planned
investment are $20 billion.
2. Saving represents a “leakage” from spending stream and causes C
to be less than GDP.
3. Some of output is planned for business investment and not consumption,
so this investment spending can replace the leakage due to saving.
a. If aggregate spending is less than equilibrium GDP as it is in Table
9-4, line 8 when GDP is $510 billion, then businesses will find themselves
with unplanned inventory investment on top of what was already planned.
This unplanned portion is reflected as a business expenditure, even though
the business may not have desired it, because the total output has a value
that belongs to someone—either as a planned purchase or as an unplanned
b. If aggregate expenditures exceed GDP, then there will be less inventory
investment than businesses planned as businesses sell more than they expected.
This is reflected as a negative amount of unplanned investment in inventory.
For example, at $450 billion GDP, there will be $435 billion of consumer
spending, $20 billion of planned investment, so businesses must have experienced
a $5 billion unplanned decline in inventory because sales exceed that expected.
B. In equilibrium there are no unplanned changes in inventory.
1. Consider row 7 of Table 9-4 where GDP is $490 billion, here C +
Ig is only $485 billion and will be less than output by $5 billion.
Firms retain the extra $5 billion as unplanned inventory investment.
Actual investment is $25 billion or more than $20 billion planned. So $490
billion is an above-equilibrium output level.
2. Consider row 5, Table 9-4. Here $450 billion is a below-equilibrium
output level because actual investment will be $5 billion less than planned.
Inventories decline below what was planned. GDP will rise to $470
C. Quick Review: Equilibrium GDP is where aggregate expenditures
equal real domestic output. (C + planned Ig = GDP)
1. A difference between saving and planned investment causes a difference
between the production and spending plans of the economy as a whole.
2. This difference between production and spending plans leads to unintended
inventory investment or unintended decline in inventories.
3. As long as unplanned changes in inventories occur, businesses will
revise their production plans upward or downward until the investment in
inventory is equal to what they planned. This will occur at the point
that household saving is equal to planned investment.
4. Only where planned investment and saving are equal will there be
no unintended investment or disinvestment in inventories to drive the GDP
down or up.
|VII. Last Word: Say’s Law, The Great
Depression, and Keynes
A. Until the Great Depression of the 1930, most economists
going back to Adam Smith had believed that a market system would ensure
full employment of the economy’s resources except for temporary, short-term
B. If there were deviations, they would be self-correcting. A
slump in output and employment would reduce prices, which would increase
consumer spending; would lower wages, which would increase employment again;
and would lower interest rates, which would expand investment spending.
C. Say’s law, attributed to the French economist J. B. Say in the early
1800s, summarized the view in a few words: “Supply creates its own
D. Say’s law is easiest to understand in terms of barter. The
woodworker produces furniture in order to trade for other needed products
and services. All the products would be traded for something, or
else there would be no need to make them. Thus, supply creates its
E. Reformulated versions of these classical views are still prevalent
among some modern economists today.
F. The Great Depression of the 1930s was worldwide. GDP fell by
40 percent in U.S. and the unemployment rate rose to nearly 25 percent
(when most families had only one breadwinner). The Depression seemed
to refute the classical idea that markets were self-correcting and would
provide full employment.
G. John Maynard Keynes in 1936 in his General Theory of Employment,
Interest, and Money, provided an alternative to classical theory, which
helped explain periods of recession.
1. Not all income is always spent, contrary to Say’s law.
2. Producers may respond to unsold inventories by reducing output rather
than cutting prices.
3. A recession or depression could follow this decline in employment
4. The modern aggregate expenditures model is based on Keynesian economics
or the ideas that have arisen from Keynes and his followers since.
It is based on the idea that saving and investment decisions may not be
coordinated, and prices and wages are not very flexible downward.
Internal market forces can therefore cause depressions and government should
play an active role in stabilizing the economy.