aggregate expenditure model consumption, saving & investment

Macroeconomics in Macroeconomics in Asia-Pacific Asia-Pacific

Aggregate Expenditure ModelAggregate Expenditure Model

Part 1Part 1Consumption, Saving & InvestmentConsumption, Saving & Investment

GECO6400GECO6400

Recall our first Lecture Developed the Circular Flow of Income Model.

Illustrated the importance of assumptions and definitions. The Circular Flow of Income underpins estimation of

GDP.

Three methods of estimating GDP: Production (VA), Expenditure; & Income.

We examined both unemployment and inflation.

Unemployment Types Measurement

Inflation Measurement CPI

Recall our Second Lecture

Building a model of the economy that attempts to explain the motivation of each of the sectors within the Circular Flow of Income.

3 factors important: Disposable Income Planned expenditure; and business expectations.

This is the Aggregate Expenditure model.

Today…

The Keynesian Conception of Macroeconomic ActivityOutput can be analysed in various ways. Some analysis holds output constant and lets all other variable change around it.

Another way allows output to vary, output itself being an influential factor in determining how the economy runs.

John Maynard Keynes used this type of approach and allowed output (or income) to be a factor which influenced other macroeconomic variables.

AGGREGATE EXPENDITURE MODEL

Output and Aggregate Expenditure

Keynes conceived macroeconomic activity as being highly dependent on his conception of Aggregate Expenditure, which in turn was dependent on output.

AE=C+I+G+(X-M)Where:C=ConsumptionI=InvestmentG=Government ExpenditureX=ExportsM=Imports


Output and Aggregate Expenditure

DefinitionConsumption Consumption expenditure is the amount that households

plan to consume out of their disposable income. Consumption depends on disposable income Disposable income (Yd)=Income minus taxation (Y-T) There is no government sector in this model so all

income is disposable (Y=Yd)


Consumption and SavingAE=C

Households can do two things with total income (Y):Consume (C) or Save (S).

Y=C+SC=Y-SS=Y-C

Both are dependent on (or a function of) income (Y). C=f(Y)S=f(Y)


Model Assumptions

Consumption Function: C= a+ßYdWhere:a: autonomous consumption (the Y-axis intercept). This represents Consumption that does not depend on (or is independent of ) output or income.

ß: induced consumption (the slope of the line). This represents Consumption that does depend on (or is dependent on) output or income. This in calculated as the Marginal Propensity to Consume (MPC).

MPC=ΔC/ΔY

Yd= disposable income = (Y - T) but since T = 0, Yd =Y

The Average Propensity to Consume (APC) is that amount of income that is spent on consumption.

APC=C/Y


Consumption

AGGREGATE EXPENDITURE

($)

INCOME ($)0

C= a+ßYd


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Consumption

a

GDP & the 450 reference line Recall that the GDP could be estimated from actual data

by three methods. The two methods used here are the Income method and

the Expenditure method. Remember that these methods had to yield the same

value as they refer to the same actual output. This information is captured in the 450 reference line.


AGGREGATE EXPENDITURE

($)

INCOME ($)0

C= a+ßYd

Consumption Function represents spending

plans


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45o line represents production

Consumption

a

DefinitionSaving Saving is the amount that households plan to

save out of their disposable income. Since households can only consume or save

their income, S = Y – C.


Savings Function: S= -a+ßYdWhere:a: autonomous Saving (the Y-axis intercept). This represents Saving that does not depend on (or is independent of ) output or income.

ß: induced Saving (the slope of the line). This represents Saving that does depend on (or is dependent on ) output or income. This in calculated as the Marginal Propensity to Save (MPS).

MPS=ΔS/ΔY

Yd= disposable income

The Average Propensity to Save (APS) is that amount of income that is saved. Algebraically, it can be represented as:

S/Y


Savings

S= -a+ßYdSAVINGS

INCOME0


Savings

-a

450

GDP

Aggregate Expenditure

C= a+ßY

AE<Y

AE>Y

EQUILIBRIUM INCOME

S= -a+ßY

GDP

Aggregate Savings

a

-a

S=0

AE=Y

S<0

S>0



The components of Aggregate Expenditure are: Y = C + I + G + NX Consumption expenditure is the most stable;

investment is most volatile.

The Simple Model

Assumptions Household sector interacts with Firm Sector a closed private economy - no government or

international sectors. Households consume and save out of their

disposable income – Y=C+S


The Simple Model

Assumptions Firms invest Investment defines as capital goods plus

change in inventories. investment responds to real interest rates. prices and wages are fixed.


The Simple Model

Defining Equilibrium GDPEquilibrium GDP refers to that level of total output

where planned Aggregate Expenditure is equal to actual output & there is no incentive to change output.

Equilibrium GDP is identified where: Planned AE = Actual Y Injections = Leakages Unplanned investment is zero.


Defining Equilibrium GDPWe can demonstrate equilibrium GDP either by:

tabular analysis – expenditure-output, leakages-injections, unplanned investment;

graphical analysis – expenditure-output, leakages-injections, unplanned investment or

algebraic analysis.


Y C S0 100 -100

250 300 -50

500 500 0

750 700 50

1000 900 100


Illustrating Equilibrium GDP

Propensities to Consume & Save Average propensity to consume = C/Y Average propensity to save = S/Y APS gives us the Household saving ratio APC + APS = 1 Marginal propensity to consume = C/Y Marginal propensity to save = S/Y MPC + MPS = 1


Y C S APC APS MPC MPS0 100 -100 - - - -

250 300 -50 1.20 -0.20 0.8 0.2

500 500 0 1.00 0.00 0.8 0.2

750 700 50 0.90 0.07 0.8 0.2

1000 900 100 0.93 0.10 0.8 0.2


Propensities to Consume & Save

Consumption

In our model, this equation becomes:C = 100 + 0.8Y

That is, Households will spend a $100 on consumption irrespective of income (driven by factors other than income) and an extra 80 cents out of each additional dollar earned.

Therefore if total income (Y) was $1000, then:

C = 100 + 0.8 (1000)C = 100 + 800C = 900


Plotting the Consumption Function

Income (Y) 0 500 1000 1500 2000

Expenditure

500

1000

1500 C = 100 + 0.8Y

100


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Y=C+SS=Y-C

S=-C+sYS=-C+sY S=-100+0.2Y=-100+0.2Y

C=C+cY

S=Y-(C+cY)S=Y-C-cY

S=-C+Y-cY

S=-C+(1-c)Y

General Form

C =100+0.8Y

S=Y-(100+0.8Y)

S=Y-100-0.8Y

S=-100+Y-0.8Y

S=-100+(1-0.8)Y

Numerical Example


Modelling savings

100

500

1000

1500

2000

500 1000 1500 2000

-100

Consumption & Saving Schedules

-500


S=-100+0.2Y

C=100+0.8Y

Ye=500

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Non-Income Determinants of Consumption & Saving

Wealth Price level Expectations Consumer indebtedness & availability of credit. Taxation. The effects of these variables are captured in the

autonomous components of consumption & saving

Changes in these variables cause a shift (up or down) in the curves.


100

500

1000

1500

2000

500 1000 1500 2000

-100

-500

Impact of an Increase in Autonomous Consumption(decrease in Autonomous

Saving)


C=100+0.8Y

S=-100+0.2YS=-500+0.2Y

C=500+0.2Y

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100

500

1000

1500

2000

500 1000 1500 2000

-100

-500

Impact of an Increase in MPC(decrease in MPS)

C = 100 + 0.9Y

S = -100 + 0.1Y


C = 100 + 0.8Y

S = -100 + 0.2Y

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Alternate consumption theoriesBe aware that there are alternate consumption theories.

Absolute Income Hypothesis Consumption will increase but not as much as income.

AIH implied constant MPC but an APC that declines as income increases (the rich consume less of their income).

Life cycle Hypothesis Argues that consumption is a function of net present

value of lifetime income. Thus will be prepared to borrow in youth (against future expected higher income), save during prime working years to pay off debt & accumulate for old age, and run savings/wealth down in retirement.

Permanent Income Hypothesis Permanent income is that portion of your actual income

that you view as stable, expected or predicted. Transitory income is random or unexpected income received in the current period.

InvestmentThe purchases of new buildings, new plant and new

equipment, together with additions to inventories or increases in stocks is gross investment. It serves to increase the PPF. (It does not include financial assets.)

In the National Accounts, gross investment is called private gross fixed capital formation.

It excludes public or government investment. Gross investment = replacement investment + net

investment


Adding Investment

DefinitionInvestment Our interest is in Planned Investment – or the

intentions/plans of the business sector to invest. Businesses will plan both additions to capital goods

plus have some desired or planned level of inventories in readiness to meet sales’ requests.

So planned investment = planned purchase of capital goods +/- planned change in inventories.


Defining Investment However if actual sales exceed (fall short of)

expectations, then actual investment will be less than (more than) planned investment due to the unplanned depletion (addition) in inventories.

Unplanned investment = unintended changes in inventory levels.

So actual investment = planned investment +/- unplanned investment.


Determinants of Investment Expected rate of net profits that businesses hope to

realise from investment spending. Firms motivated by profit. Firms invest if they expect a net profit from this

investment. The real rate of interest

Inflation adjusted cost associated with borrowing money. Equals nominal interest rate minus the inflation rate.

Investment projects will only be undertaken if net expected profit rate exceeds real interest rate.


Investment Demand Curve Shows graphically the investment–interest rate

relationship. Shows cumulative levels of investment at

possible levels of interest rates at some point in time.


Investment Demand Curve

Investment (billions of dollars)

Expected rate of net profit (r)

and interest rate (i) %

16

14

12

10

8

6

4

2

05 10 15 20 25 30 35 40


Shifts in Investment DemandOther determinants of investment: Acquisition, operation and maintenance costs Business taxes Technological change Business expectations (animal spirits) Stock of capital goods on hand

Changes in these factors Changes in these factors shiftshift the the investment demand curveinvestment demand curve


Investment Demand Curve

Investment (billions of dollars)

16

14

12

10

8

6

4

2

05 10 15 20 25 30 35 40

Expected rate of net profit (r)

and interest rate (i) %


Investment and IncomeWe need to be able to add Investment

expenditure to Consumption expenditure. Autonomous investment

desired level of investment based upon long-term profit expectations


Instability of Investment Consumption (especially non-durables) is

relatively stable BUT Investment is unstable: Why?

Durable and therefore postponable purchases Irregularity of innovation Profit variability Variable expectations


I = IAGeneral Form

I = 200Numerical Example

In our simple income determination model we assume that all investment is independent of changes in Real GDP (that is investment expenditure is autonomous).


Modelling Planned Investment

GDP


Investment

I=A

Investment is Autonomous

0

45o

GDP

Aggregate Expenditure

AD<Y

AD>Y

EQUILIBRIUM INCOME

S

I

Aggregate Saving and Investment

S<I

S>I

AE=C


AE=C+I

Y C I AE0 100 200 300

500 600 200 800

1000 900 200 1100

1500 1300 200 1500

2000 1700 200 1900

Determining Aggregate Expenditure:

Planned AE = planned C + planned I


100

500

1000

1500

500 1000 1500 2000

-100

Consumption & Saving Schedules

200

300


AE=C+I

SI

AE=C

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EQUILIBRIUM BY TABULAR ANALYSIS

Equilibrium GDP by tabular analysis – Expenditure-output

Actual

Y C IS AEUnplanned

I*Y

change

0

500

1000

1500

2000

100 -100

500 0 700 -200

900

1300

1700

100

200

300

-100

1900

1500

1100

0

100

200 300 -300

200

200

200

200

Equilibrium

*Unplanned Investment refers to a build-up or run-down of inventories

Equilibrium GDP by tabular analysis – Leakages - Injections

Y C IS AEUnplanned

I*Y

change

0

500

1000

1500

2000

100 -100

500 0 700 -200

900

1300

1700

100

200

300

-100

1900

1500

1100

0

100

200 300 -300

200

200

200

200

Equilibrium


Equilibrium GDP by tabular analysis – Unplanned Investment

Y C IS C + IUnplanned

I*Y

change

0

500

1000

1500

2000

100 -100

500 0 700 -200

900

1300

1700

100

200

300

-100

1900

1500

1100

0

100

200 300 -300

200

200

200

200

Equilibrium


EQUILIBRIUM BY ALGEBRAIC ANALYSIS

C=100+0.8Y I=200 AE=C+I AE=100+0.8Y+200 AE=300+0.8Y

EQUILIBRIUM IDENTITYY=AE

Y=300+0.8YY-0.8Y=3000.2Y=300Y=300/0.2

Y=1500


Determining Equilibrium Income

Next Week We will add government & the external sector into

the Aggregate Expenditures Model.

Review Mc Taggart ch 24, especially understanding about multipliers pp. 500 -507

Read Mc Taggart Ch 25 Fiscal Policy

aggregate expenditure model consumption, saving & investment

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