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Chapter 21

ECO100Y1 Chapter 21 Notes
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Department
Economics
Course
ECO102H1
Professor
Robert Gazzale
Semester
Winter

Description
ECO100Y1 Textbook Notes Chapter 21 21.1 Desired Aggregate Expenditure  Desired expenditure refers to what people desire to spend out of the resources that they actually have (not imaginary circumstances).  Desired aggregate expenditure (AE): the sum of desired or planned spending on domestic output by households, firms, governments, and foreigners.  National income accounts measure actual expenditures in each of the four expenditure categories. National income theory deals with desired expenditures in each of these four categories.  Autonomous expenditure: elements of expenditure that do not change systematically with national income. o These expenditures can and do change, but the changes aren’t systematic to changes in national income.  Induced expenditure: any component of expenditure that is systematically related to national income.  Consumption is typically between 55-60% of GDP (largest component of aggregate expenditure).  Investment includes the accumulation of inventories plus expenditure on new machines or factories, which add to the stock of physical capital. o It is typically 20% of GDP.  Closed economy: an economy that has no foreign trade in goods, services, or assets.  Disposable income: the amount of income households receive after deducting what they pay in taxes and adding what they receive in transfers.  In the simplified model (no tax and no government), disposable income, Y D is equal to national income, Y.  Saving: all disposable income that is not spent on consumption.  By definition, there are only two possible uses of disposable income – consumption and saving. When the household decides how much to put to one use, it has automatically decided how much to put to the other use.  The factors that influence the decision on how much to save/consume are summarized in the consumption function and the saving function.  Consumption function: the relationship between desired consumption expenditure and all the variables that determine it; in the simplest case, the relationship between desired consumption expenditure and disposable income.  Key factors are assumed to be: o Disposable income o Wealth o Interest rates o Expectations about the future  Monthly saving: money that will accumulate and help finance future vacations, education, home purchases, or even retirement.  Holding constant other determinants of desired consumption, an increase in disposable income is assumed to lead to an increase in desired consumption.  The autonomous consumption is said to be the y-intercept of the consumption function because it is independent of the level of income.  The induced consumption is said to the slope part of the consumption function (i.e. DY ) because it is induced by a change in income (moving along the x-axis)  Consumption smoothing: when fluctuations in current monthly income have little effect on a household’s consumption expenditure.  Keynesian consumption function (developed by John Maynard Keyes 1883- 1946: a consumption function based on the assumption that a households’ current level of expenditure and saving depends on their current level of income.  Life-cycle/permanent-income theory (developed by Franco Modigliani & Milton Friedman): theory that analyzes the behaviour of forward-looking households.  Average propensity to consumer (APC): desired consumption divided by the level of disposable income.  Marginal propensity to consume (MPC): the change in desired consumption divided by the change in disposable income that brought it about.  The slope of the example consumption function is which is, by definition, the marginal propensity to save. o Positive slope = increases in income lead to increases in desired consumption expenditure.  45° line is a useful reference line. o It is constructed by connecting all points where desired consumption equals disposable income. o Intersection point of the consumption function and the 45° line is called the “break-even” level of income.  If the consumption function is above the 45° line, desired consumption > disposable income.  Desired saving must be negative.  If the consumption function is below the 45° line, desired consumption < disposable income.  Desired saving must be positive.  Once the relationship between desired consumption and disposable income is known, the relationship between desired saving and disposable income is automatically known as well.  Average propensity to save (APS): desired saving divided by disposable income.  Marginal propensity to save (MPS): the change in desired saving divided by the change in disposable income that brought it about.  Since all disposable income is either spent or saved, the fractions of income consumed and saved must account for all income (APC + APS = 1).  Since the fractions of any increment to income consumed and saved must account for all that increment (MPC + MPS = 1).  The amount of desired saving I s always equal to the vertical distance between the consumption function and the 45° line.  Changes in disposable income will lead to movements along the consumption function.  Changes in wealth, interest rates, and households’ expectations about the future, will cause shifts of the consumption function.  Household wealth: the value of all accumulated assets minus accumulated debts. o Most common assets:  Savings accounts  Mutual funds (portfolios of stocks or bonds)  Registered Retirement Savings Plans (RRSPs)  The ownership of homes and cars o Most common debts:  Home mortgages  Car loans  Outstanding lines of credit from banks  An increase in household wealth shifts the consumption function up (saving function down); a decrease in wealth shifts the consumption function down (saving function up). o I.e. a rising stock market leads to an increase in aggregate household wealth (permanent); less income needs to be saved for the future, therefor households will spend a larger fraction of their current income. o Current estimates suggest that an increase in aggregate wealth of $1 billion leads to an increase in desired aggregate consumption of approximately $50 million.  Two types of goods: o Durable goods  Goods that deliver benefits for several years (i.e. cars). o Non-durable goods  Consumption goods that deliver benefits to households for only short periods of time (i.e. groceries).  Durable goods are normally purchased on credit where interest rates are paid.  A fall in interest rates usually leads to an increase in desired consumption (typically for durable goods) at any level of disposable income; the consumption function shifts up.  A rise in interest rates shifts the consumption function down.  Expectations about the future state of the economy influence desired consumption. o Optimism leads to an upward shift in the consumption function. o Pessimism leads to a downward shift in the consumption function. Summary 1. Desired consumption is assumed to be positively related to disposable income. In a graph, this relationship is shown by the positive slope of the consumption function, which is equal to the marginal propensity to consumer (MPC). 2. There are both autonomous and induced components of desired consumption. A movement along the consumption function shows changes in consumption induced by changes in disposable income. A shift of the consumption function shows autonomous changes in consumption. 3. An increase in household wealth, a fall in interest rates, or greater optimism about the future are all assumed to lead to an increase in desired consumption and thus an upward shift of the consumption function. 4. By definition, all disposable income is either consumed or saved. Therefore, there is a saving function associated with the consumption function. Any event that causes the consumption function to shift must also cause the saving function to shift by an equal amount in the opposite direction.  Investment expenditure is the most volatile component of GDP, and changes in investment are strongly associated with aggregate economic fluctuations. o The recessions in 1982 and 1991 saw investment, as a share of GDP, fall about 5% from its normal 20% of GDP.
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