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Chapter 21

Economics 102: Chapter 21

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University of British Columbia
ECON 102
Robert Gateman

Economics 102: Principles of Macroeconomics Chapter 21 21.1 Desired Aggregate Expenditure (AE)  Desired/planned spending on output by households, firms, governments and foreigners o  Actual expenditure does not need to equal desired (unforeseen circumstances)  National income accounts measure actual expenditure in the four expenditure categories  National income theory deals with desired expenditure in each of the four categories Autonomous Versus Induced Expenditure:  Autonomous expenditure: elements of expenditure that don't change systematically with national income o Changes do occur, but not in response to changes in national income  Induced expenditure: any component of expenditure that is systematically related to national income Important Simplifications:  Consumption is 55-60% of GDP and is the largest component of aggregate expenditure  Investment includes accumulation of inventories plus additions to stock/physical capital o Makes up 20% of GDP, but is very volatile  Closed economy: economy that has no foreign trade in goods, services or assets (no trade) Desired Consumption Expenditure:  In the simplified model, disposable income ( is equal to national income (Y) o Saving: all disposable income that is not spent on consumption  Household savings, as a part of disposable income, has been declining since the 1980's The Consumption Function:  Relationship between desired consumption expenditure and variables that determine it o Relationship between desired consumption expenditure and disposable income  Desired consumption is influenced by disposable income, wealth, interest rates and future expectations  Holding determinants of desired income constant, and increase in disposable income is assumed to lead to an increase in desired consumption o Consumption function cuts the 45° line at the break-even level of disposable income o Slope (z) of the consumption function is equal to the marginal propensity to consume o Autonomous consumption is the vertical intercept of the consumption function o Induced consumption occurs as disposable income changes  Illustrated by movements along the consumption function Average and Marginal Propensities to Consume:  Average propensity to consume (APC): desired consumption divided by disposable income o  Economics 102: Principles of Macroeconomics The Slope of the Consumption Function:  The slope is represented by MPC o Increases in income leads to increases in desired consumption expenditure o Constant slope leads to the same level of disposable income 45° Line:  Consumption function cuts the 45° line at the break-even point  Consumption function above 45° line: desired consumption exceeds disposable income  Consumption function below 45° line: desired consumption is less than disposable income The Saving Function:  If we know the relationship between desired consumption and disposable income, we automatically know the relationship between desired saving and disposable income  Average propensity to save (APS): desired saving divided by disposable income o   APC + APS and, MPC + MPS must equal one (disposable income is either spent or saved)  Increases in disposable income are assumed to lead to an increase in desired savings Shifts of the Consumption Function:  Changes in disposable income lead to movements along the consumption function  Changes in the other function factors will shift the consumption function A Change in Household Wealth:  o Household assets: savings, accounts, mutual funds, stocks, RRSPs, homes, cars etc. o Household debts: home mortgages, car loans, lines of credit etc.  Increase in aggregate wealth leads to an increase in desired aggregate consumption o Increase in household wealth shifts the consumption function up o Decrease in household wealth shift the consumption function down A Change in Interest Rates:  Household consumption can be divided into consumption of durable/non-durable goods  Durable goods: goods that deliver benefits for years (cars, houses, appliances etc.) o Often expensive and purchased on credit to finance the purchase  Non-durable goods: goods that deliver benefits for a short time (food, clothing etc.)  Fall in interest rates generally increases desired consumption expenditure o Affects people at any disposable income level (more impact on durable goods) o Consumption function shifts up and the saving function shifts down A Change in Expectations:  Fears about the economy will lead households to increase saving in anticipation o Savings function shifts up, consumption function shifts down  Positive expectations about the economy lead to increased consumption, reduced savings o Upward shift of the consumption function, downward shift of the savings function Economics 102: Principles of Macroeconomics Summary:  Desired consumption is assumed to be positively related to disposable income o Slope of the consumption function is the marginal propensity to consume (MPC)  There are both autonomous and induced components of desired consumption  Movement along the consumption function shows changes in consumption induced by changes in disposable income o Shifts of the consumption function shows autonomous changes in consumption  Increases in household wealth and economic optimism or low interest rates increases consumption  All disposable income is either consumed or saved (both related)  Shift in the consumption function, the savings function will shift be the same amount (opposite direction) Desired Investment Expenditure:  Investment categories: inventory, residential, and new plant and equipment investment  Investment expenditure is the most volatile component of GDP o Changes in investment are associated with aggregate economic fluctuations  Investment expenditure determinants: real interest rate, level of sale changes, and business confidence Desired Investment and Real Interest Rates:  Rise in real interest rates reduces the amount of desired investment expenditure  Real interest rates reflect the opportunity cost associated with investment o The higher the real interest rate, the higher the opportunity cost of investment Inventories:  Changes in inventory represent a small portion of investment in year (within 2% of GDP) o Higher the real interest rate, the h
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