Download The consumption function

1. Autonomous versus induced
expenditure
2. The consumption function
3. The theory of investment
4. Government purchase function
5. The net export function
Autonomous versus induced
Expenditure
•Autonomous expenditure: The components of
aggregate expenditure that do not change when real
GDP changes.
•Induced expenditure: The components of aggregate
expenditure that change when real GDP changes.
The consumption function reveals
the relationship between
consumption and disposable
income, other things constant.
Disposable income, consumption, and saving in US
4
US consumption depends on disposable income
5
People show a tendency, as a rule and
on
average,
to
increase
their
consumption
when
their
income
increases—but not by as much as the
increase in income.
MPC: The fraction of the change in income that is spent on
consumption.
C
MPC 
DI
Keynes’s fundamental law implies that:
0  MPC  1
MPS: The fraction of the change in income that is saved
MPS 
S
DI
Real consumption (trillions of dollars)
The consumption function
C
11
10
9
8
7
6
5
4
3
2
1
0
The consumption function, C,
shows the relationship
between consumption and
disposable income, other
things constant.
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Real disposable income (trillions of dollars)
8
Marginal propensities to consume and save
MPC=∆C/∆DI=0.4/0.5=4/5
b
∆C=0.4
a
∆DI=0.5
0
(b) Saving function
Real saving (trillions of dollars)
Real consumption (trillions of dollars)
(a) Consumption function
MPS=∆S/∆DI=0.1/0.5=1/5
d
c
∆S=0.1
0
∆DI=0.5
Real disposable income (trillions of dollars)
The slope of the C function equals the marginal propensity to consume.
For the straight-line C function in (a), the slope is the same at all levels of
income and is given by the change in consumption divided by the change in
disposable income that causes it: MPC=4/5.
The slope of the S function in (b) equals the marginal propensity to
save, MPS=1/5.
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Disposable
Income
Net Wealth
Consumption
Interest Rates
Expectations
Shifts of the consumption function
C’’
Real consumption
C
C’
An upward shift, such as from C
to C’’, can be caused by an
increase in net wealth, a
decrease in the price level, an
favorable change in consumer
expectations, or a decrease in the
interest rate.
Real disposable income
A downward shift of the consumption function, such as from C to C’, can be caused by a
decrease in net wealth, an increase in the price level, an unfavorable change in consumer
expectations, or an increase in the interest rate.
11
Let’s take out a loan so
we can “cash out” some
home equity.
Rising home values have
stimulated household
borrowing and
consumption in the past
decade.
Consumer Confidence has fluctuated lately
Theory of Investment
Why do firms purchase
things like new
offshore drilling
platforms, food
processing plants, or
bulldozers? Because
they expect they can
make a profit by doing
so.
Investment Function
Let
I  f ( , r )
Where:
•I is gross investment
• is the expected profit of investment; and
•r is the interest rate.
The Investment Decision
Acquisition cost of a tractor–trailer rig . . . . . . . . $150,000.00
Useful life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 years
Expected (extra) sales revenue per year
from the use of the asset . . . . . . . . . . . . . . . . . 200,000.00
Expected costs per year to operate the asset . . $180,000.00
Diesel fuel
Driver salary & benefits
Depreciation
Repairs (including tires)
Misc. (fees, fines, etc.)
$38,000
68,000
50,000
19,000
5,000
Expected net sales revenue per year
from the use of the asset . . . . . . . . . . . . . . . . . . $20,000.00
Computing expected profit ()
To compute expected profit in percentage terms:
Expected Net Sales Revenue Per Year

100
Acquisitio n Cost of the Capital Good
Thus we have:
$20,000

100  13.7%
$146,000
We would consider the
tractor-trailer rig a
sound investment if
the interest rate were
less than 13.7 percent.
Nominal interest rate (percent)
Rates of return on golf carts and the
opportunity cost of funds
25
20
An individual firm invests in
any project with a rate of
return that exceeds the
market interest rate.
At an interest rate of 8%,
Hacker Haven purchases
three golf carts, investing
$6,000.
Expected rate
of return
15
10
8
5
0
Market rate
of interest
$2,000 $4,000
$6,000 $8,000 $10,000
Investment
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Nominal interest rate (percent)
Investment demand curve for the economy
10
8
6
D
0
0.9 1.0 1.1
The investment demand curve for
the economy sums the
investment demanded by each
firm at each interest rate.
At lower interest rates, more
investment projects become
profitable for individual firms, so
total investment in the economy
increases.
Investment
(trillions of dollars)
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Investment (trillions of dollars)
Investment function
1.1
I’’
1.0
I
0.9
I’
0
2.0
4.0
6.0
8.0 10.0 12.0 14.0
Real disposable income
(trillions of dollars)
A decrease in the interest rate
or more upbeat business
expectations would increase
investment at every level of
income, as shown by the
upward shift from I to I’’.
An increase in the interest
rate or less favorable
business expectations
would decrease investment
at every level of income, as
shown by the downward
shift from I to I’.
Investment is assumed to be independent of income, as shown by horizontal lines.
Thus, investment is assumed to be autonomous.
23
Annual percentage change in US real GDP,
consumption, and investment
24
Because government purchases
are controlled by public
officials, we treat them as
autonomous—that is,
determined independent of
income
Net exports (billions of dollars)
Net export function
0
2.0
4.0
6.0
8.0 10.0 12.0 14.0
Real disposable income
(trillions of dollars)
-380
X’’-M’’
-400
X-M
-420
X’-M’
A decrease in the value
of the dollar would
increase net exports at
each level of income, as
shown by the shift up to
X’’-M’’.
An increase in the value of the dollar relative to other currencies would
decrease net exports at each level of income, as shown by the shift down to X’M’.
Net exports here are assumed to be independent of disposable income, as
shown by the horizontal lines. X-M is the net export function when
autonomous net exports equal -$400 billion.
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US spending components as percentages of
GDP since 1959
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