Chapter 12: Spending by Individuals, Firms, and Governments on Real Goods and Services

1. Chapter 12: Spending by Individuals, Firms, and Governments on Real Goods and Services

2. Focus on the Short-Run • Potential GDP: maximum amount of output that can be produced • Depends on size of labor force, number of structures and amount of equipment in the economy, and state of technology • Policy goal is managing aggregate expenditure to keep economy close to potential output without starting inflation • Managers tend to focus on short-run

3. Real Versus Nominal Terms • Real terms: measuring expenditures and income with price level held constant • Nominal terms: measuring expenditures and income with price level allowed to vary

4. Components of Aggregate Expenditure • Aggregate expenditure: sum of personal consumption, investment, government, and net export expenditures on total amount of real output produced • Personal consumption expenditure: sum of durable goods, nondurable goods, and services

5. Personal Consumption Expenditure and Income • Keynesian consumption function: assumes that as disposable income increases, consumption spending increases by smaller amount • Marginal propensity to consume (MPC) • Marginal propensity to save (MPS) • Saving: amount of disposable income households do not spend on consumption

6. Level of Personal Taxes • Level of taxes affects consumption spending • Economic Growth and Tax Relief Act of 2001 • Tax cut of 2003 • Taxes can be cut or increased temporarily or permanently

7. Real Interest Rate • Changes in interest rate affect spending, especially in durables • Real interest rate • Nominal interest rate • Lenders charge borrowers nominal rate (i) based on the real rate (r) and the expected rate of inflation

8. Consumer Confidence • University of Michigan’s Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI) • Some debate as to whether these confidence indices predict changes in consumer spending

9. Consumer Credit andLevel of Debt • Federal Reserve Board monitors use of consumer credit • Increased consumer credit may have restraining influence on consumption • Consumption function: • C = f (Y, Tp, r, CC, W, CR, D) • C = C0 + c1 Y

10. Consumption Function • Autonomous consumption expenditures: determined by factors other than level of real income in the economy • Induced consumption expenditures: result from changes in level of real income in the economy

11. C I C2 I2 C1 I1 I C Y Y C0 I0 0 0 Y1 Y2 Y1 Y2 Y Y Components of Aggregate Expenditure Figure 12.5a and 12.5b Consumption Investment

12. G X G0 X0 0 0 Y Y Components of Aggregate Expenditure Figure 12.5c and 12.5d Government Exports

13. M M2 M1 M Y M0 0 Y1 Y2 Y Components of Aggregate Expenditure Figure 12.5e Consumption, investment, and import spending are assumed to be a function of the level of real income. Government and export spending are determined by factors other than the level of real income. Imports

14. Gross Private Domestic Investment • GPDI: total amount of spending on nonresidential structures, equipment, software, residential structures, and business inventories in a given time • Variety of factors influence GPDI

15. Factors Influencing GPDI • Business investment spending and real income • Real interest rate • Business taxes • Relative prices: cost of capital versus cost of other inputs • Expected profits and business confidence

16. Factors Influencing GPDI • Capacity utilization • Rates are prepared monthly by Fed for manufacturing, mining, and electric/gas utilities industries • Residential investment spending • Inventory investment • Inventory investment function: I = f (Y, r, TB, PR, CU)

17. Government Expenditure • Includes total amount of spending by federal, state, and local governments on consumption outlays, depreciation, and investment capital outlays • Determined by legislative and executive institutions of all levels of government

18. Government Expenditure • Fiscal policy: use of expenditure and taxation policy to pursue macroeconomic goals of high employment and low inflation • G = f (Y, Policy) • G = G0 • Both equations assume spending is determined only by policy and not by real income in economy

19. Government Expenditure • Net export expenditure: difference between export spending on domestically produced goods and services by individuals in other countries and import spending on foreign produced goods and services by domestic residents X = F (Y, Y*, R)

20. Government Expenditure • Currency exchange rate: rate at which one nation’s currency can be exchanged for another (is determined in foreign exchange markets) • Import expenditures • M = f (Y, R) • M = M0 + m1 Y

21. Aggregate Expenditure and Equilibrium • Aggregate expenditure (E): planned spending on currently produced goods and services by all sectors of the economy • E = C + I + G + X – M • Aggregate expenditure function: relationship between aggregate expenditure and income, all other variables constant E = f (Y, TP, r, CC, W, CR, D, TB, PR, CU G, Y*, R)

22. E E0 0 Y Aggregate Expenditure Function E0 represents autonomous aggregate expenditure determined by factors other than real income Slope = (c1 + i1 – m1)

23. Equilibrium Level ofIncome and Output • Level of income where desired spending equals value of aggregate output and income received from that production • Injections: supplement to consumer spending that increases domestic aggregate output and income • Leakages: uses of current income for purposes other than purchasing currently produced domestic goods and services

24. E A EE E1 E0 45o 0 YE Y Adjustment Toward Equilibrium Slope = c1 (assuming i1 = m1 = 0) Only at this level of income and output is desired expenditure just equal to value of output produced and income generated.

25. Adjustment Toward Equilibrium • At income level Ye1, individuals want to purchase more goods and services than are currently produced • Firms then have to draw down on their existing inventories of goods (called unplanned inventory decrease)

26. B E11 EE2 C F E1 E1 E EE1 A Y E0 45o 0 YE1 Y YE2 Changes in Equilibrium Figure 12.10

27. The Multiplier • Multiplier: change in income and output resulting from a change in autonomous expenditure • Multiplier effect: results from fact that increase in autonomous expenditure represents an injection of new spending in circular flow of economic activity • End result is multiple increase in income determined by size of MPC and the term [ 1 / (1 – MPC)]

28. Investment-Saving (IS) Curve • Shows alternative combinations of real interest rate and real income • Theoretical construct focusing on relationship between interest rate and level of real income and output • Summarizes the relationship between real interest rate and real spending

29. Interest-Related Expenditure Function • Shows planned consumption and investment spending as a function of real interest rate • Points downward showing an inverse relationship between interest rate and planned consumption and investment expenditure

30. r A D r1 C B r2 IS 0 Y1 Y2 Y IRE Function Summarized Figure 12.11

31. Changes in any factor influencing autonomous aggregate expenditure causes IS curve to shift IS: Y = f (r, TP, CC, W, CR, D, TB, PR, CU, G, Y*, R) Shifting the IS Curve

32. Aggregate expenditure function Autonomous consumption expenditures Capacity utilization rates CCI and CSI Consumption function Currency exchange rate Equilibrium level of income and output Fiscal policy and government expenditure Summary of Key Terms

33. Gross private domestic investment Induced consumption expenditures Injections IRE function and IS curve Investment spending function Leakages Marginal propensity to consume and to save (MPC) and (MPS) Multiplier Summary of Key Terms

34. Net export expenditure Nominal interest rate and real interest rate Personal consumption expenditure Potential GDP Real terms and relative prices Saving Unplanned inventory increase and unplanned inventory decrease Summary of Key Terms

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