Download CMC 2 Expenditure model

CMC Lesson Two: The Expenditure Model Four types of expenditures – Consumption, Investment, Government, and Net Exports So what determines employment, the price level, and economic growth? One way of answering this question is to look at four major categories of spending in the economy, consumers, businesses, governments, and foreign buyers of U.S. products. The purchase by households of goods and services is called consumption. When households save some of their income and put that portion in the banks, banks make the resources available for businesses. Businesses use the funds to expand their output by purchasing plant (factories and office buildings) and more capital equipment. The purchase by business of plant and capital equipment is called investment. The government uses taxes from households to purchases goods and services and distribute them back to households. And foreigners buy and sell products from and to U.S. citizens. So these four sectors, households, businesses, government and foreigners purchase U.S. goods and services. The sum of all of the production in the U.S. is called Gross Domestic Product (GDP). In trying to figure out where the economy is and where it is going (whether your students are likely to have trouble finding jobs, whether they will be paying high or low interest rates for their car loans, whether their paychecks are likely to keep up with inflation), it is helpful to look at the influences on the spending of these four groups. The equation that is used to represent spending is: E = C + I + G + (X-­‐M) Total spending (expenditures) in the economy (E) is composed of spending by households (C = consumption), spending by businesses (I = investment) and spending by governments at all levels (G) and the difference between U.S. goods and services sold abroad (X = exports) and foreign products bought by U.S. citizens (M = imports). [Note: If net exports are positive, the U.S. is exporting more than it is importing with a direct and positive effect on aggregate demand. If negative, the effect on aggregate demand is negative since some U.S. income is being used to purchase foreign as opposed to U.S. products.] Consumption Consumption (spending by households) is the largest component of the spending equation, accounting for about 2/3 of total spending in the economy. So if households increase or decrease their spending, that change will have a major effect on the overall economy – economic growth, jobs, interest rates, and price levels. While consumption is the elephant of the economy and most closely watched by analysts, “The Queen Mary can’t turn on a dime.” There aren’t a lot of surprises with consumption since it normally shows signs of change long before the changes occur. And it is fairly steady. Not surprisingly, the major influence on consumption is income. If we want to know how consumers are likely to behave, the first question to ask is what has happened to their income. If consumers have more income, they will spend more, and if they have less income they will spend less. Other influences are interest rates both short-­‐term and long-­‐term since they will have a significant influence on automobile, appliance, and house payments. In addition, it is important to know how consumers are feeling about the economy; are they confident that they will have jobs in the next year, are they confident that their incomes will keep up with expected inflation, are they feeling secure about international events? All of these are questions that must be addressed in order to estimate consumer spending. Investment Investment (defined as the purchase of plant, capital equipment and change in inventories by businesses) is a much smaller component of the spending equation, but still significant, comprising about 20 percent of total spending. The problem with investment is that it is much more volatile than consumption and can cause instability in product and financial markets. The major determinants of investment are interest rates, expected profit rates, and general business expectations about the economy. Business leaders considering an investment will use the principle of exchange – will the benefits from the investment outweigh the cost? What they hope to gain is profit on the investment. What they will give up is the opportunity cost of the funds used for the investment. (Either they will borrow the money and pay the current rate of interest, or they will use their own money and incur the opportunity cost of using that money.) Thus the investor compares the expected rate of return on a prospective investment to the cost of using the funds which is usually represented by the interest rate. What should be obvious is that the expected rate of return is an educated guess influenced by business expectations. The healthier the economy, the greater the profits of major corporations, and the more investment. Government Government spending Compared to household and business spending, government spending is relatively easy to predict since much of it involves high-­‐ticket long lasting contract-­‐driven purchases such as missiles, jets, and other defense equipment. Changes in spending often involve drawn-­‐out negotiations that make the nightly news. So government spending is relatively easy to predict in the short run but can have serious consequences on the economy. In fact, we will soon see that taxes have a major but indirect influence on spending and government spending has an obvious direct effect. The federal budget surplus or deficit is the difference between the revenue that the government collects in taxes and the government’s purchase of government goods and services. Government transfer payments such as social security, unemployment compensation, federal subsidies to individuals and organizations, and many other types of revenue outflows are not included in government expenditures since the government does not receive any goods and services for them. They are a use of tax revenues to assist particular groups which is why they are called transfer payments -­‐-­‐ they transfer revenue from one group to another. During times of high unemployment, government transfers on unemployment compensation and other poverty related programs increases and tax revenues decrease. The opposite occurs as the economy approaches full employment. These changes in government spending and tax receipts that occur as a result of the state of the economy are called “built in stabilizers” because they tend to give a boost to a contracting economy and reduce the speed of a growing economy. As a result, knowledge of the movement of the economy gives analysts a pretty good idea of where transfer payments and tax receipts are going. Net Exports The foreign sector is a much smaller part of the economy although it has become increasingly important in the last 20 years. The trade surplus or deficit is the difference between the goods and services produced by U.S. firms and sold to foreigners (exports) and foreign products bought by U.S. citizens (imports). The major determinant of imports is real personal income. As income goes up, households buy more goods and services of all kinds, including foreign products. Conversely, the major determinant of exports is income of foreign nations. As foreign income increases, people tend to buy more products of all kinds including U.S. products. An additional influence on exports and imports is the price of U.S. dollars in terms of foreign currencies (the exchange rate). If the dollar is expensive in terms of foreign currencies, foreigners won’t buy as many U.S. products. An expensive dollar means an inexpensive Euro, or British Pound, or other currency, which means that Americans are more likely to buy foreign