Principles of Macroeconomics

Lecture 2

CONSUMPTION AND INVESTMENT

BUSINESS CYCLES AND AGGREGATE DEMAND

PART 1: CONSUMPTION AND INVESTMENT

Aims of Part 1

- To explain the concepts of consumption, saving

and investment and their attributes

- To explain the importance of these three

concepts for the output of an economy

WHAT IS CONSUMPTION?

- Consumption is spending on final

goods and services bought for

the satisfaction gained or needs

met by their use

- It is the largest single

component of GDP

What are the major components of consumption?

- Housing

- Food

- Motor vehicles

- Medical care

- Entertainment and recreation

How is consumption related to income?

Saving

€20,000

€20,000

How is consumption related to income?

When income increases, saving increases more than consumption

€20,000

€22,000

MARGINAL PROPENSITY TO CONSUME (MPC)

-The amount of extra consumption generated by an extra monetary unit of disposable income

- In graphic terms it is expressed by the slope of the consumption function

DISPOSABLE INCOME

CONSUMPTION EXPENDITURES

AB

CD

E FG

C

DI450

CONSUMPTION FUNCTION

.

.. .

....

Z

MPC = CZ / BZ

MARGINAL PROPENSITY TO CONSUME (MPC)

- As Disposable Income increases, consumption increases as well but with a diminishing pace for each additional monetary unit of disposable income

- In graphic terms it is expressed by the slope of the consumption function

MARGINAL PROPENSITY TO SAVE (MPS)

-The amount of extra saving generated by an extra monetary unit of disposable income

- In graphic terms it is expressed by the slope of the savings function

- It holds that MPS = 1 - MPC

DETERMINANTS OF CONSUMPTION

- Current Disposable Income: It has been empirically established that the course of consumption follows the course of disposable income

- Long run income trends: People choose their consumption levels looking at both their current income and the prospects for their future income

- Wealth: Accumulated wealth plays a key role in determining the level of consumption

DISPOSABLE INCOME ($blns)

CONSUMPTION EXPENDITURES ($blns)

FITTED CONSUMPTION FUNCTION

6,0003,000

3,000

6,000

C

C1996

1990

1980

1970

A Consumption Function for the United States, 1966-1996

What is investment?

In macroeconomics, investment

is defined as the additions to the

stock of productive assets of an

economy.

What is investment?

Additions to the stock of

productive assets of an economy

are considered to be capital

goods such as equipment,

structures and changes in

stocks.

Determinants of investment

- Revenues: Investment depends

upon the revenues that will be

generated by the state of overall

economic activity

- Costs: Investment depends upon

its cost: the price of the capital good

and the interest rate

- Expectations: Investment is very

sensitive in expectations and

business confidence

Determinants of investment

Demand for investment curve

Shifts in the investment demand curve

PART 2: BUSINESS CYCLES AND AGGREGATE DEMAND

Aims of Part 2

- To describe the short-term fluctuations

in output, employment and prices that

characterize business cycles in market

economies

- To explain the concept of aggregate

demand and the differences from a

single commodity demand

Business Cycles

-are swings in total national output,

income and employment,

- are marked by widespread

expansion or contraction in many

sectors of the economy,

-occur in all advanced market

economies, and

- consist of four phases.

The Business Cycles Theory

Business Cycles Phases and Turning PointsPHASES-Expansion: A period in which GDP increases for two consecutive quarters

-Recession: A period in which GDP declines for two consecutive quarters

TURNING POINTS- Peak: The highest point of the expansion phase - Trough: The lowest point of recession phase

Business Cycles Phases

- Characteristics of Expansion:

- Consumption rises

- Business inventories decrease

- Production is increased

- Real GDP rises

- Business investment rises

- Labour demand increases and unemployment falls

- Inflation becomes high

- Interest rate rises

Business Cycles Phases

- Characteristics of Recession:

- Consumption falls sharply

- Business inventories increase

- Production is reduced

- Real GDP falls

- Business investment falls

- Labour demand falls and unemployment rises

- Inflation slows

- Interest rate falls

Definition of Aggregate Demand

- Aggregate Demand (AD) is the total or aggregate quantity of output that is willingly bought at a given level of prices

- It has four components:- Consumption

- Investment- Government Purchases- Net Exports

- Remember the GDP equation : Y= C+I+G+ (X-M)

Differences of AD with the micro demand

- AD curves relate overall spending on all components of output to the overall price level

- AD is downward sloping mainly due to the money-supply effect. That is when a rise in the price level occurs, the real money supply is reduced (all others held constant). Thus interest rates rise, credit is difficult to obtain and total real spending falls.

The Aggregate Demand (AD) Curve

Factors affecting Aggregate Demand

-Monetary and fiscal policy

-Exogenous variables such as foreign economic activity, technological advances and shifts in asset markets

- Changing these variables shifts the AD curve

Movements and Shifts in AD

Factors affecting Aggregate Demand

Key things to remember:

-A change at the price level leads to a MOVEMENT along the AD curve

- A change in other underlying factors of AD leads to a SHIFT of the AD curve

Helpful reading

Economics. Samuelson, & Nordhaus (2005) Ch. 22-23