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Chapter 19

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Economics (Arts)
ECON 209
Mayssun El- Attar Vilalta

Economics Chapter 19 Summary - Macroeconomics: the study of how economy behaves in broad outline w/o dwelling on detail of markets for individual products. Study of determination of economic aggregates like total output, total employment etc. - To understand nature of macroeconomics, you must understand nature of short-run fluctuations (business cycles) as well as long run economic growths - 2 streams in macroeconomics: - Macroeconomics with an explicit basis of microeconomic foundations—building on models of economy populated by people who are optimizers; modelling their behaviour allows economists to aggregate choices of these agents and arrive at models for larger picture. Wages and prices are flexible and adjust quickly to clear markets. - Macroeconomics based an implicit basis on micro foundations. They don’t model choices of optimizing agents. They construct models using aggregate relationships for consumption, investment and employment which was empirically tested and represents firm and consumer behaviour. Prices and wages change slowly b/c of nature of well-established institutions in labour and product markets like labour unions making market stay in disequilibrium for much longer 19.1 Key Macroeconomic Variables Output and Income - National product: most comprehensive measure of nation’s overall level of economic activity is value of its total production of goods and services - Production of output generates income - Economics defines economic value produced belongs to someone in the form of income therefore national product is by definition equal to national income Aggregating Total Output - To measure total output we add the monetary value of each product - First multiplying number of units by price each unit is sold then sum values all across different goods produced in economy to give quantity of total output measured in dollars - Nominal (or current) national income is the total national income measured in dollars - Change in quantities or change in prices will cause this nominal national income to fluctuate - Economists use real national income (measures value of individual outputs not at current prices but at a set of prices prevailed in some base period—AKA constant-dollar national income)- denoted by the symbol Y - Real national income changes represent changes in the quantity of things produced instead of changes in their prices therefore provides measure of change in real output through several years National income: A recent History - Measure of national income= Gross domestic product (GDP)—real or nominal - A real national income function will show: the long-term economic growth (how its changing over time) and short term fluctuations (how it changes in short periods of time) - A country (like Canada) can show overall growth with many slight dips in the shorter periods - Business cycle: fluctuations of national income around its trend value that follow a more or less wavelike pattern - No two business cycles are the same: can vary in duration and magnitude Potential output and the output gap - National output represents what economy actually produces - Potential output: what economy would produce if all resources (land, labour and productive capacity) were employed at normal levels of utilization - Potential output (denoted by Y*) aka potential GDP - Output gap: difference between potential output and output gap (Y-Y*) - When output is less than potential output, the gap measures market value of goods and services that are not produced b/c economy’s resources aren’t fully employed—recessionary gap - When output exceeds potential output: gap measures market value of production in excess of what economy can produce sustainable. This can occur because we define potential output as the NORMAL use of factors of production but there are ways to exceed normal rates. Labourer can work longer hours for example. When this occurs it is an inflationary gap - Recession: downturn in level of economic activity. Often defined precisely as two consecutive quarters in which real GDP falls Why National Income Matters: - Long-term growth is more important than short term growth - While recessions cause suffering and job loss; inflationary periods are worrisome for governments trying to keep the inflation rates low - If income per person grows, each generation can expect to be better off than their predecessors - Economic growth doesn’t make every individual better due to distribution of income The terminology of Business Cycles - A trough: unemployed resources and a level of output that is low in relation to economy’s capacity to produce; business profits are low, confidence of economic prospects are lacking and firms are unwilling to invest - Recovery: economy moves out of trough; run-down or obsolete equipment is replaced; employment, income and consumer spending start rising; investors become more optimistic - Peak: top of the cycle: existing capacity is used to a high degree; labour shortages develop, costs begin to rise as well as prices; businesses remain profitable - Peaks lead to slowdowns in economic activity and can result in a recession - As output falls so do employment, incomes, profits, investments etc. - Entire fallings of cycle is a slump, entire rising of cycle is called a boom Employment, Unemployment and the Labour Force - Rise in employment= more people to be employed; rise in output= rise in output per person employed meaning rise in productivity - Short-run changes in productivity are small; so change in employment will have bigger effect - In the long run: changes in productivity and employment are significant - Employment denotes # of adult workers who have jobs - Unemployed: # of adult workers who are not employed but who are actively searching for a job - Labour force= total number of people who are employed or unemployed - Unemployment rate: # of unemployed/ # of labour force x 100 percent - Labour force and employment have grown steadily for past half-century - Unemployment causes costs in form of economic waste and human suffering Frictional, Structural and Cyclical Unemployment - When economy is at potential GDP= full employment (even if there’s still unemployment in economy)—when only unemployment is structural or frictional - Frictional unemployment: turnover of individuals and change in jobs; so if someone quit and is looking for a new job or when new people enter work force (students) - Structural unemployment: mismatch between structure of the supplies of labour and structure of the demands for labour—mismatch in what employers are looking for and employees have - Full employment= factors of production are being used at normal intensity - If GDP is below potential GDP- rise in unemployment; when GDP is above potential GDP- fall in unemployment - Cyclical unemployment: neither structural or frictional and is because of the ebb and flow of the business cycle - Seasonal fluctuations: workers only employed during certain seasons are unemployed when that season ends (staff at ski resorts) therefore Stats Can must seasonally adjust unemployment stats to remove these fluctuations Employment and Unemployment: Recent History - Unemployment in Canada has shown a slight upward trend over past 50 years with many booms and slumps associated with higher and lower unemployment respectively Why Unemployment Matters - Human effort tis the least durable of economic commodities; if 2 million people are unemployed this year that is a loss in potential output for one year that is lost forever - Loss of income is harmful b/c it pushes people into poverty, breaks the spirit of the individual leading them towards crime, mental illness and social unrest Productivity - Is the measure of the amount of output economy producer per unit of input - Due to many inputs in production (land, labour, capital), we can use labour productivity—level of real GDP divided by level of employment (or total hours worked) Productivity: Recent History - Two ways to measure labour productivity: per worker and per hour worked - Per hour worked is more accurate b/c average number of hours worked per worker changes over time whereas per workers does not - Productivity has significantly increased over the past 3 decades Why Productivity Matters - Single largest cause of rising material living standards over long periods of time - Short-run movements in avg. real incomes can be explained by ebb and flow of business cycles; during economic recovery= rise in incomes, during economic reduction- fall in incomes - But these fluctuations are dwarfed by steady upward trend in real GDP caused by rising productivity - This generation of Canadians are more productive than their older counterparts due to greater skills (being better physical capital) Inflation and the Price Level - Price level: avg. level of all prices in economy, expressed as an index number (denoted by P) - Inflation: rise in avg. level of all prices - Price level is measured w/ price index which averages prices of various commodities according to importance. Examples: Consumer Price Index (CPI)- measures avg. price of goods and services bought by typical Canadian household - Price index has no units - Price levels (measured in unit-less index values) have no value at specific times, rather they find meaning when compared to a value in a different time - Measuring a non-base change in price index: new price- old price/ old price x 100 percent How the CPI is constructed - Bring together a group of products used by consumers, calculate the cost in one year - Then calculate the cost in subsequent years - Using the first group as a base year, you can measure how much more or less the consumer must pay each year - This is done by dividing the subsequent year by the base year and multiplying it by 100. The base year has a value of 100 already so any change in that is how much percent change in price has occurred - For example: if the index number for year 2 is 115, then the cost of purchasing goods for that household has increased by 15% - Problems: doesn’t account for ongoing quality improvements of changes in consumers’ expenditure patterns Inflation: Recent History - Rate of inflation: measures annual rate of increase in the consumer price level - Though the increase in CPI over the years seems to be steadily increasing; it is quite volatile - Increases in inflation rate went to double digit levels due to increase in world price of oil and food and with loose monetary policy Why inflation matters - We value money for its purchasing power (amount of goods and services that can be purchased w a unit of money - We measure economic values in terms of money and use it to conduct economic affairs - Purchasing power of money is negatively related to price level. If price level doubles, a dollar will buy only have as much. If price level halves, dollar will buy twice as much - Inflation reduces real value of anything whose price if fixed in dollar terms. Real value of $20, savings account, balanced owed on student loan is reduce by inflation - Anticipated inflations: the adjusting of nominal prices and wages to maintain their real values once households and firm anticipate inflation in coming year. Inflation has fewer real effects - Unanticipated inflation: leads to more changes in real value of prices and wages. Economy’s allocation of resources will be affected more than when inflation is anticipated - In reality, inflation is rarely fully anticipated or unanticipated Interest Rates - The price paid per $ borrowed per period of time, expressed as a proportion or as a percentage - Prime interest rates: interest rates charged to the best customers of a bank due to the fact that they are more likely to be repaid their money - Prime interest rates are noteworthy b/c when prime rate changes, most other rates change in same direction - Bank rate: interest rate Bank of Canada (Canada’s central bank) charges on short-term loans to commercial banks. Interest rate Canadian gov’t pays on its short-term borrowing is also a rate that garners attention Interest Rates and Inflation - Nominal interest rate: price paid per dollar borrowed per period of time - Principal: the original loan - Real interest rate: the nominal rate of interest adjusted for change in purchasing power of money. Equal to nominal interest rate minus the rate of inflation - If the real rate of interest increases more than nominal interest rate then whoever you are repaying the loan to will be worse off and able to purchase less than if they just kept their money - Burden of borrowing depends on the real NOT the nominal rate of interest - Nominal rate of 8 % combined with a 2 % rate of inflation is a greater burden on borrowers than a nominal rate of 16% combined w/ 14% inflation rate. This is because the real interest rate being paid for the first is 6% whereas the second is only 2%. - For the 1 say you take out $100, you must pay w/ nominal interest rate: $108 at the end of the year, but ndur own money’s purchasing power will cover $2, so you still have to pay $106 - For the 2 say you repeat process, you must pay w/ nominal interest rate: $116 at the end however your own money’s purchasing power covers $14 so in the end you only pay $102 Interest rates and ―Credit Flows‖ - Loan= flow of credit btwn lenders & borrowers w/ interest rate representing price of this credit - Banks make credit market by channelling funds from those who have to give to those who need - During smooth times, the flow of credit is not noticed - However when there is any crises, the banks will not want to lend to anyone other than the safest borrowers for fear they won’t get their money back - This restriction of credit negatively affects firms who need to borrow money so they restrict production and fire workers to save money which causes much turmoil Why interest rates Matter - Changes in real interest rates affect standard of living of savers and borrowers - Retirees and savers will benefit if real interest rates rise b/c the money they are saving will have increased purchasing power - Borrowers are better off when interest rates fall so they can borrow more for less - During 1970s real interest rate was negative, indicating inflation rate exceeded nominal interest rate - Real interest rates are important determinant of level of investment by firms The International Economy - 2 variables reflecting importance of global economy to Canada: exchange rate and net exports The exchange rate: - The number of units of domestic currency required to purchase on unit of foreign currency - Foreign exchange: foreign currencies traded on foreign exchange market - Foreign exchange market: market in which different national currencies are traded—at a price expressed by the exchange rate - In this textbook: number of Canadian dollars needed to purchase one unit of foreign currency Depreciation and Appreciation - Depreciation: rise in exchange rate meaning more Canadian dollars are required to purchase one unit of foreign currency - Appreciation: a fall in exchange rate meaning less Canadian dollars are required to purchase one unit of foreign currency - Commodity prices are driven by changes in global economic growth which proves that events globally can have effects on Canadian exchange rate Exports and Imports - Net exports: exports- imports (AKA trade balance) - More trade agreements would lead to there being more exports than imports which would widen the net exports in Canadian favour 19.2 Growth versus Fluctuations Long-term Economic Growth - Has more importance than short-term fluctuations but less media attention for society’s living standards from generation to generation - Some believe that gov’t policy that encourages low and stable inflation will lead to economic growth, others argue moderate inflation is more conducive to growth - Some believe if gov’ts spend less then they raise tax revenue and have budget surplus, lead to reduced need for borrowing drives down interest rates and stimulates investment by private sector, higher stock of physical capital for future production and increase in economic growth - Some believe private sector alone can produce inventions and innovations to guarantee satisfactory rate of long-term growth - Others believe that almost all major new technology were supported by public funds Short-term fluctuations - Understanding business cycles means understanding monetary policy - Gov’t budget deficits and surpluses enter discussion of business cycles - In recessionary years, gov’t should increase spending and reduce taxes to stimulate economic activity - Taxes should be raised to slow a booming economy Economics Chapter 20 Summary 20.1 National Output and Value Added - Production occurs in stages: firms produce outputs that are used as inputs by others and these firms produce outputs that are inputs by yet another firm so it isn’t as simple as just adding up the output of each firm to find total economic output - Double counting: adding up values of all sales, the same output would be counted every time it was sold by one firm to another - Intermediate goods: outputs of some firms used as inputs by other firms - Final goods: products not used as inputs by other firms, not in same time pd. under consideration - Distinguishing the two would, in theory, solve the problem of double counting - It is difficult to distinguish b/c no firm, once their product is sold, knows what use it goes into. If steel sold to a car company is for building purposes or reselling it in the form of a car - Value added must be used instead which is: amount of value firms and workers add to their products over and above costs of intermediate goods. In other words: Revenue- cost of intermediate goods - Payments made to factors of production like wages or profits paid to owner are not purchases from other firms thus aren’t subtracted from firm’s revenue when computing value added - Firms revenue equals cost of intermediate goods plus payments to factors of production, value added is exactly equal to sum of these factor payments - Therefore value added= payments to factors of production (land, labour and capital) - The sum of all values added in an economy is a measure of the economy’s total output Value Added Through Stages of Production - Value added is how much more the firm is selling a product for than it bought its inputs for - So if the firm buys 1000 dollars’ worth of steel to produce a $1500 car, then its value added would be the $500 extra it tacked onto the $1000 intermediate input which is due to some means of production, so this $500 may go towards rebuilding capital, paying workers, paying off investors, etc. any factors of production 20.2 National Income Accounting: the Basics - National Income and Expenditure Accounts (NIEA)- based on circular flow of income and measures national income and national product - Value of domestic output is equal to value of expenditure on that output and is equal to total income claims generated by producing that output - National income= national product - Injections into circular flow of income= money coming into system (exports, investment and gov’t purchases) - Withdrawals= money leaving system (imports, savings, and taxes) - Circular flow suggests 3 ways to measure national income: - 1.) add up value of all goods and services produced – requiring value added: GDP by value added - 2.) add up total flow of expenditure on final domestic output: GDP on the expenditure side - 3.) add total flow of income generated by flow of domestic production: GDP on the income side - They all yield the GDP GDP from the Expenditure side - Adding up expenditures needed to purchase final output produced in that year - The sum of consumption, investment, gov’t purchases and net exports 1.) Consumption Expenditure - Expenditure on all goods and services sold to their final users during the year; durable, semi- durable, and non-durable goods as well as services - C aenotes actual measured consumption expenditure 2.) Investment Expenditure - Expenditure on goods not for present consumptions, including inventories, capital goods (like factories, machines) and residential housing—these are called investment goods Changes in Inventories - Stocks of raw materials, goods in process and finished goods held by firms to mitigate effect of short-term fluctuations in production or sales—steady stream of production despite interruptions in deliveries of inputs bought from other firms - Accumulation of inventory= positive investment b/c it reps goods produced but not consumed; included at market value which includes wages, other costs firm incurred in producing them and profit firm will make when they are sold - Decumulation counts as negative investment b/c it reps a reduction in stock of finished goods available to be sold New Plants and Equipment - Capital stock: aggregate quantity of capital goods - Creating new capital goods is investment called business fixed investment (AKA fixed investment) New Residential Housing - durable asset yielding utility over long period of time - building new houses are new investment rather than consumption - when an individual purchases a house though, since it is an existing asset being transferred, transaction is not part of national income; only when new house is built Gross and Net Investment - Replacement investment is 1 of 2 parts of gross investment: amount of investment required to replace part of capital stock lost through process of depreciation (amount by which capital stock is depleted through production process) - Net investment (part 2 of gross investment): equals gross investment minus depreciation - When net investment is positive: economy’s capital stock is growing and vice versa - All gross investment is included in calculation of national income - Actual Investment Expenditure is denoted by I a 3.) Gov’t Purchases - When gov’t provides goods and services that households ant they add to the sum total of valuable output in the economy - All gov’t purchases (gov’t expenditure on currently produced goods and services, exclusive of gov’t transfer payments) is included, denoted by G or G for actaal gov’t purchases Cost Versus market Value - Gov’t output is valued at cost not market value; what is market value of law courts for example - But it costs money to build and sustain it so we value gov’t output at their cost of production - Problem: if one civil worker replaces that of another and the other goes to work in the private sector—it costs gov’t less so they’re cost goes down but they may be contributing more - Similarly if 2 are sent to do the job of 1, then it costs gov’t more so the value goes up but they’re not necessarily doing more so it’s an overestimate of their contribution to national income - Both of these cause changes in national income though how much they produce hasn’t changed Gov’t Purchases versus Gov’t Expenditure - What the gov’t buys is included in GDP but not what the gov’t spends money on - For ex: if they transfer money from income from tax payers to holders of gov’t bonds, this is a transfer payment, they’re allocating money from one area to another thus not adding to national income - This is why transfer payments (payment to an individual or institution not made in exchange for a good or service)- is not included in GDP - If the person at the receiving end then takes the money to buy things it is put as consumption 4.) Net Exports - Import: value of domestically produced goods and services purchased from firms, households or gov’ts in other countries - Exports: value of all goods and services sold to firms, households and gov’ts in other countries Imports: - Country’s national income is total value of final goods produced in that country so if you buy a car from Japan, it doesn’t rep Canadian production - If parts of something are made from imported goods, the parts that aren’t made from imported goods is what is included in our own GDP, the rest is included in foreign GDP - The value of actual imports is represented by symbol IM a Exports - If Canada sells good to German households, goods are part of German consumption expenditure but constitute expenditure on Canadian output - Value of exports is X a - Net exports is (X – Ia ) andais denoted by NX a - If exports exceeds imports, NX is posative, if imports exceeds exports NX is negative a Total Expenditures - GDP= C + I a G +a(X – Ia ) a a GDP from the Income side - Conventions of national income accounting ensure production of a nation’s output generates income= to value of that production - Must add up factor incomes and other claims on value of output until all value is accounted for 1.) Factor Incomes - 3 main components: wages and salaries, interest and business profits Wages and Salaries - Payment for services of labour—is pre-tax labour earnings - Represent value of production paid to labour Interest: - Interest earned on bank deposits, loans to firms and other investment incomes - Excludes interest income earned from loans to Canadian gov’t Business Profits - Some profits are paid out as dividends to owners and the rest is held by firms (retained earnings) - Dividends and retained earnings are included in calculation of GDP - Total profits include: corporate profits, incomes of unincorporated business (small business, farmers), profits of gov’t business enterprises and Crown corporations (Canada Post) - Interest+ business profits is value of payment for the use of capital Net Domestic Income - Sum of wages and salaries, interest and profits is net domestic income at factor cost - Net b/c excludes value of output used as replacement investment (money offsetting depreciation) - Domestic income b/c it is income accruing to domestic factors of production - At factor cost b/c it reps only part of value of final output that accrues to factors in form of payments due to them for their services 2.) Non- factor payments: when someone spends $10, less than $10 is generated as income due to indirect tax and depreciation Indirect taxes and subsidies - Indirect taxes: taxes on production and sale of goods and services - Gov’t tax on goods and services is added to GDP - When gov’t gives subsidies we must subtract value from GDP since it allows factor incomes to exceed market value of output (if gov’t gives $2 per unit of a $5 good, then it really costs the producer $3 to produce so we must subtract the subsidy given to get how much it actually cost them) Depreciation - Value of capital used up in production process to final output - Is a part of gross (total) profits b/c it compensates for capital used in production process but is not part of net profits—not income earned by any factor of production 3.) Total National Income - From income side, GDP is sum of factor incomes plus indirect taxes (net of subsides) plus depreciation - Statistical discrepancy—fudge factor to make sure independent measures of income and expenditure come to the same total (if income-side of GDP comes to $100 but expenditure side of GDP comes to $105 then the fudge factor is 5% tacked onto 100 so that income= expenditure side) - We can use income-side of GDP to find out distribution of income between labour and capital - Importance of consumption and investment—we can use expenditure approach - Important to be consistent with rules so that changes in GDP reflect actual economic changes Arbitrary Decisions in National Income Accounting - Goods finished in inventor are valued at market value thereby anticipating their sale even though they haven’t been sold yet - Goods in process are treated as costs (not market value) - They must make arbitrary decisions to maintain consistency - Any sophistications or changes in these arbitrary decisions don’t really cause too much change 20.3 National Income Accounting: Some Further Issues GDP and GNP - A measure of national input related to GDP is GNP (Gross National Product) - Difference between GDP and GNP is income produced and income received - GDP = total value of income produced in Canada and total income generated as a result - GNP= total amount of income received by Canadian residents no matter where income was generated - For ex: if a factory in Canada produced $100, then the GDP is higher by $100 but if $5 goes to foreign owners then GNP is only higher by $95 - Same applies to a Canadian business outside of Canada, value added contributes to GDP in foreign countries but not Canada, if profits are remitted to Canadian owners profits become a part of income of Canadian residents thus a part of Canadian GNP - GDP measures value of production located in Canada no matter who receives income - GNP measures income received by Canadian residents no matter where production occurred - Canada has been a net debtor (value of foreign located assets owned by Canadian residents is less than value of Canadian located assets owned by foreigners—foreign-generated income received by Canadians is less than Canadian generated income going to foreigners) - Makes GNP less than GDP but difference is small Which Measure is better? - GDP is superior to GNP as a measure of domestic economic activity. GNP is superior as a measure of income of domestic residents - Ease of finding jobs, if factors working double shifts, if new buildings are going up—GDP - How much income available to residents—GNP (counts income earned abroad and subtracts income generated at home that goes to foreigners) Disposable Personal Income - Disposable personal income: part of national income accruing to households & available to spend/save - Easiest way to calculate: subtract from GNP parts of GNP not available to households—aka all taxes, depreciation, retained earnings, and interest paid to institutions, then add transfer payments made to households Real and Nominal GDP - Nominal values: dollar values of outputs, expenditures, or incomes - Nominal fails to say if changes occur over the years b/c of changes in price or changes in quantity produced - Value of output in each period is computed using base-period prices - Total GDP valued at current prices is nominal GDP. GDP valued at base prices is real GDP - Change in nominal GDP= change in quantity and change in price - Real income holds the change in price constant to see if quantity has really gone up or down - Nominal GDP tells us about money value of output - Real GDP tells us about quantity of physical output GDP deflator - If nominal and real GDP change by different amounts over given time, prices must have changed - If nominal GDP increases 6% and real GDP only increases 4%, then price increased by 2% - This implies changes in price of goods, but isn’t an explicit price index - GDP deflator = GDP at current price/ GDP at base period x100= Nominal GDP/Real GDP x 100 - GDP deflator: index number derived by dividing nominal and real GDP. Change measure average change in price of all items in GDP GDP Deflator vs. the CPI - GDP deflator doesn’t necessarily change in line with changes in the CPI—measure 2 different things; CPI measure change in price of consumer goods, GDP reflect change in price of all goods Omissions from GDP - Illegal activities: even though they are business activities, they aren’t included but should be b/c the drug trade alone is worth billions; some illegal income is reported due to fear of imprisonment on grounds of income-tax evasion - The underground economy: not reported transactions that are perfectly legal; taking payments in cash to avoid paying the gov’t - Home Production and Non-Market Activities: if a homeowners does his own repairs etc., voluntary work, leisure (reducing time at work must have exceeded lost wages so there’s economic well-being being increased but measured GDP has fallen) - Economic ―bads‖: the bad things that come from our output like pollution Do the Omissions Matter? - Unless importance of unmeasured market activity changes rapidly, changes in GDP will probably do a satisfactory job of measuring changes in economic opportunities. GDP and Living Standards - Livings standards: purchasing power or real income - Real GDP can however rise b/c of increased land, labour and capital used as inputs or these inputs can become more productive - Real GDP per person isn’t any better; if real GDP rises b/c more people are employed real GDP per person won’t necessarily change - If real GDP rises b/c existing labour force becomes more productive, then average real incomes will also rise which is why economists believe productivity growth is an important determinant of living standards - To those who believe living standards mean freedom, quality of community life etc. GDP omits that so it doesn’t necessarily relate to this kind of living standard Chapter 21 21.1 Desired Aggregate Expenditure - Desired expenditure refers to what people would like to buy with the resources they have, not under imaginary unlimited resources - Instead of subscripting an ―a‖ to represent desired expenditure, there is no letter so C, G, I, G and (X- IM) - We look at 4 main decision makers: domestic households, firms, gov’t and foreign purchasers - Desire aggregate expenditure or AE= C + I + G + (X- IM) - National income accounts measures actual expenditures in each of four expenditure categories. National income theory deals with desired expenditure in these 4 categories Autonomous versus Induced Expenditure - Autonomous expenditure: elements of expenditure that don’t change systematically w/ national income. They change but not b/c of national income - Induced expenditure: elements of expenditure that is systematically related to national income Important simplifications - We’re only focusing on consumption and investment in this chapter - Consumption is largest component of AE and provides most important link between desired aggregate expenditure and real national income - Investment: accumulation of inventories plus expenditure on new capital, small than consumption but more volatile (important for understanding fluctuations in GDP) - Closed economy: no foreign trade in goods, services or assets Desired Consumption Expenditure - Saving: all disposable income not spent on consumption - Only two possible uses of disposable income—consumption and saving. When deciding on how to put to use one, it has automatically decided how much to put to the other use - Distance between real per capita disposable income and real per capita consumption is real per capita savings; consumption is a function of income and they are positively related so they move together The Consumption Function - Consumption function: relationship between desired consumption expenditure and all variables that determine it; for ex: relationship between desired consumption expenditure and disposable income - Key factors influencing desired consumption: disposable income, wealth, interest rates and expectations about the future - Holding constant all other determinants of desired consumption, an increase in disposable income is assumed to lead to an increase in desired consumption - Consumption that occurs when there is zero disposable income is autonomous consumption b/c it doesn’t rely on level of income—people have to eat, survive, live somewhere (even if they can’t afford it)—y- intercept - The disposable income slope is induced consumption b/c it’s brought about by change in income The theory of the Consumption Function - Imagine 2 households: 1 short-sighted (spending everything earned) and other forward looking (put money aside for everything) - Consumption smoothing—having little fluctuations in consumption even with changes in income - Keynesian Consumption Function: any function based on the assumption that the household’s current level of expenditure and saving depended on their current level of income Average and Marginal Propensities to Consume - Average Propensity to Consume (APC)—desired consumption expenditure divided by disposable income: APC= C/ Y —coDsumption per dollar of disposable income - Marginal Propensity to Consume (MPC)—relates change in desired consumption to change in disposable income. MPC = change in C/ change in Y D The slope of the Consumption Function - The slope of the consumption function is change in C/ change in disposable income therefore it is the MPC - Positive slope means MPC is positive, increases in income= increase in desired consumption - Constant slope means MPC is same at any level of disposable income (horizontal line) The 45 degree line - A line connecting where desired consumption equals disposable income—slope of 1 if both axes are given in same units - It is a reference line - Where consumption function cuts 45 degree line is ―break even‖ level of income; disposable income= desired consumption so savings are zero - If consumption function > 45 degree line, desired consumption exceeds disposable income— desired savings is neg. b/c households are spending out accumulating savings/borrowing funds - If consumption function < 45 degree line, desired consumption is less than disposable income so savings are positive, households are paying debt or accumulating assets The Saving Function - Deciding on consuming decides automatically on savings, once we know relationship btwn consumption & income we’ll know relationship btwn desired saving & disposable income - Average Propensity to Save (APS
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