1.
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The context for the development of
the aggregate expenditures model developed in this chapter is historical debate between
classical and Keynesian economics.
- Classical economics concluded that the economy
would automatically tend to full employment of resources and maximum output and that
laissez faire is the best policy for the government to pursue. These employment and output
conclusions are based on Say’s law
which states that supply creates its own demand.
If there were an excess supply of goods or an excess supply of labor
price and wages
would fall until the excesses were eliminated and full employment and maximum output were
again achieved.
- The Great Depression and the ideas of J. M.
Keynes
in The General Theory of Employment
Interest and Money
laid the foundation for a
rejection of classical economics and the development of the aggregate expenditures model.
Keynes challenged Say’s law and showed that an economy can be inherently unstable and
experience a long period of recession. Wages and prices are inflexible downward
and
saving and investment decisions may not be coordinated
so there is no guarantee of full
employment and maximum output. The economy is not self-regulating
so government policies
are necessary to counteract economic instability.
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| 2. |
To simplify the explanation of the aggregate
expenditures model
four assumptions are made: The economy is “closed
”
government neither spends nor collects taxes
all saving is personal saving
and
depreciation and net foreign factor income earned in the United States are zero. These
assumptions have two important implications: Only consumption and investment are
considered in the model
and output or income measures (GDP
NI
PI
DI) are treated as
equal to each other.
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| 3. |
3. Aggregate output and employment in the
aggregate expenditures theory are directly related to the level of total or aggregate
expenditures in the economy. To understand what determines the level of total expenditures
at any time
it is necessary to explain the factors which determine the levels of
consumption and investment expenditures.
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| 4. |
Consumption is the largest component of
aggregate expenditures
and saving is disposable income not spent for consumer goods.
- Disposable income is the most important
determinant of both consumption and saving; the relationships between income and
consumption and between income and saving are both direct (positive) ones.
- The consumption schedule shows the amounts that
households plan to spend for consumer goods at various levels of income
given a price
level.
- The saving schedule indicates the amounts
households plan to save at different income levels
given a price level.
- The average propensity to consume (APC) and the
average propensity to save (APS) and the marginal propensity to consume (MPC) and the
marginal propensity to save (MPS) can be computed from the consumption and saving
schedules.
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- The APC and the APS are
respectively
the
percentages of income spent for consumption and saved
and their sum is equal to 1.
- The MPC and the MPS are
respectively
the
percentages of additional income spent for consumption and saved; and their sum is equal
to 1.
- The MPC is the slope of the consumption schedule
and the MPS is the slope of the saving schedule when the two schedules are graphed.
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- In addition to income
there are several other
important determinants of consumption and saving
and changes in these nonincome
determinants will cause the consumption and saving schedules to change. The four nonincome
determinants include wealth
expectations
household debt
and taxation.
- Three other considerations need to be noted:
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- A change in the amount consumed (or saved) is not
the same thing as a change in the consumption (or saving) schedule.
- Changes in wealth
expectations
and household
debt shift consumption and saving schedules in opposite directions; taxation shifts them
in the same direction.
- Both consumption and saving schedules tend to be
stable over time.
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| 5. |
The two important determinants of the level of
investment spending in the economy are the expected rate of return (r) from the purchase
of additional capital goods and the real rate of interest (i).
- The expected rate of return is directly related
to the net profits (revenues less operating costs) that are expected to result from an
investment. It is the marginal benefit of investment for a business.
- The rate of interest is the price paid for the
use of money. It is the marginal cost of investment for a business. When the expected real
rate of return is greater (less) than the real rate of interest
a business will (will
not) invest because the investment will be profitable (unprofitable).
- For this reason
the lower (higher) the real rate
of interest
the greater (smaller) will be the level of investment spending in the
economy; the investment demand curve (schedule) indicates this inverse relationship
between the real rate of interest and the level of spending for capital goods. The amount
of investment by the business sector is determined at the point where the marginal benefit
of investment (r) equals the marginal cost (i).
- There are at least five noninterest determinants
of investment demand
and a change in any of these determinants will shift the investment
demand curve (schedule). These determinants include acquisition
maintenance
and
operating costs; business taxes; technological change; the stock of capital on hand; and
expectations.
- The investment decisions of businesses in an
economy can be aggregated to form an investment schedule which shows the amounts business
firms collectively plan to invest at each possible level of GDP. A simplifying assumption
is made that investment is independent of disposable income or real GDP.
- Investment is inherently unstable
and the
investment schedule will shift up or down. Factors that contribute to this variability are
the durability of capital goods
innovations
changes in profits
and altered
expectations.
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| 6. |
Employing the aggregate expenditures –
domestic output approach
the equilibrium real GDP is the real GDP at which
- aggregate expenditures (consumption plus planned
investment) equal the real GDP
or in graphical terms
the aggregate expenditures curve
crosses the 45 degree line and its slope is equal to the marginal propensity to consume.
-
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| 7. |
Using the leakages-injections approach
the
equilibrium real GDP is the real GDP at which
- saving and planned investment are equal
or in
graphical terms
the saving schedule crosses the planned investment schedule.
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| 8. |
The investment schedule indicates what
investors plan to do. Actual investment consists of both planned and unplanned investment
(unintended changes in inventory investment).
- At above equilibrium levels of GDP
saving is
greater than planned investment
and there will be unintended or unplanned investment
through increases in inventories. At below equilibrium levels of GDP
planned investment
is greater than saving
and there will be unintended or unplanned disinvestment through a
decrease in inventories.
- Equilibrium is achieved when planned investment
equals saving and there is no unplanned investment.
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