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CHAPTER NINE NOTES-AP
I. WHAT DETERMINES GDP?
A. THE NEXT TWO CHAPTERS FOCUS ON THE
AGGREGATE EXPENDITURES MODEL. DEFINITIONS
AND FACTS FROM PREVIOUS CHAPTERS ARE USED TO
SHIFT OUR STUDY TO THE ANALYSIS OF ECONOMIC
PERFORMANCE. THE AE MODEL IS ONE TOOL USED IN
THE ANALYSIS.
B. THE MODEL ORIGINATED WITH JOHN MAYNARD
KEYNES. THUS IT IS ALSO CALLED THE KEYNESIAN
MODEL.
C. THE FOCUS IS ON THE RELATIOSHIP BETWEEN INCOME
CONSUMPTION AND SAVINGS.
D. INVESTMENT SPENDING, AN IMPORTANT PART OF
AGGREGATE EXPENDITURES, IS ALSO EXAMINED.
E. FINALLY, THESE SPENDING CATEGORIES ARE
COMBINED TO EXPLAIN EQUILIBRIUM LEVELS OUTPUT
AND EMPLOYMENT IN A PRIVATE (NO GOVERNMENT),
DOMESTIC (NO FOREIGN TRADE). THEREFORE,
GDP=NI=PI=DI IN THIS VERY SIMPLE MODEL.
II. SIMPLIFYING ASSUMPTIONS FOR THIS CHAPTER.
A. A “CLOSED ECONOMY” WITH NO FOREIGN TRADE.
B. GOVERNMENT IS IGNORED, FOCUS IS ON PRIVATE
SECTOR.
C. ALTHOUGH BOTH HOUSEHOLDS AND BUSINESSES
SAVE, WE ASSUME THAT ALL SAVINGS IS PERSONAL.
D. DEPRECIATION AND NET FOREIGN INCOME ARE
ASSUMED TO BE ZERO FOR SIMPLICITY.
E. WITH NO GOVERNMENT AND FOREIGN TRADE THE
EQUATION IN IE IS CORRECT.
III. TOOLS OF AGGREGATE EXPENDITURES THEORY
A. THE THEORY ASSUMES THAT THE LEVEL OF OUTPUT
AND EMPLOYMENT DEPEND DIRECTLY ON THE LEVEL
OF AGGREGATE EXPENDITURES. CHANGES IN OUTPUT
REFLECT CHANGES IN AGGREGATE SPENDING.
B. CONSUMPTION AND SAVINGS: SINCE CONSUMPTION
IS THE LARGEST COMPONENT OF AGGREGATE
SPENDING, WE ANALYZE ITS DETERMINANTS.
1. DISPOSABLE INCOME IS THE MOST
IMPORTANT DETERMINANT OF CONSUMER
SPENDING
a. WHAT IS NOT SPENT IS CALLED
SAVING
b. THEREFORE: DI – C = S OR C +I =
DI
2. SEE FIGURE BELOW:
45 0 LINE
C
C
0
DI
FORTY FIVE DEGREE LINE REPRESENTS ALL POINTS AT
WHICH CONSUMER SPENDING IS EQUAL TO DISPOSABLE
INCOME. OTHER POINTS REPRESENT ACTUAL C, DI
RELATIONSHIPS.
3. THE GRAPH ILLUSTRATES THAT AS
DISPOSABLE INCOME INCREASES SO
DO CONSUMPTION AND SAVING.
4. SOME CONCLUSIONS
a. HOUSEHOLDS CONSUME A
LARGER PORTION OF THEIR
INCOME.
b. BOTH CONSUMPTION AND
SAVING ARE DIRECTLY RELATED
RELATED TO THE LEVEL OF
INCOME
C. AVERAGE AND MARGINAL PROPENSITIES TO CONSUME AND
SAVE
APC = C/I
APS= S/I
MPC = CHANGE IN C / CHANGE IN I
MPS = CHANGE IN S / CHANGE IN I
D. NONINCOME DETERMINANTS OF CONSUMPTION AND SAVING
1. WEALTH – INCREASE IN WEALTH SHIFTS C UP AND
S DOWN
2. EXPECTATIONS – CHANGES IN EXPECTED INFLATION
CAN AFFECT CONSUMPTION TODAY
3. HOUSEHOLD DEBT – INCREASE SHIFTS C DOWN AND
UP; DECREASE SHIFTS C UP AND S DOWN
4. TAXES – DECREASE SHIFTS BOTH UP AND INCREASE
SHIFTS BOTH DOWN
E. SHIFTS AND STABILITY
1. MOVEMENT FROM ONE POINT ON CURVE TO ANOTHER
IS CALLED CHANGE IN AMOUNT CONSUMED. A SHIFT
IN SCHEDULE IS CALLED A CHANGE IN C SCHEDULE
2. SCHEDULE SHIFTS-C AND S SCHEDULES WILL ALWAYS
SHIFT IN OPPOSITE DIRECTIONS UNLESS CAUSED
BY A CHANGE IN TAXES.
3. STABILITY-ECONOMISTS BELIEVE THAT C AND S ARE
GENERALLY STABLE UNLESS DELIBERATELY CHANGED
BY A GOVERNMENT ACTION
IV. INVESTMENT
A INVESTMENT CONSISTS OF BUILDING NEW PLANTS,
CAPITAL EQUIPMENT, MACHINERY, INVENTORIES,
CONSTRUCTION, ETC.
1. THE INVESTMENT DECISION WEIGHS
MARGINAL COSTS AND MARGINAL BENEFITS
2. THE EXPECTED RATE OF RETURN IS THE
MARGINAL BENEFIT AND THE INTEREST
RATE IS THE MARGINAL COST.
B.EXPECTED RATE OF RETURN IS FOUND BY COMPARING
THE EXPECTED ECONOMIC PROFIT (TOTAL REVENUE
MINUS TOTAL COST) TO COST OF INVESTMENT TO
GET RATE OF RETURN (SEE TEXT EXAMPLE)
C. THE REAL INTEREST RATE, i, IS THE COST OF
OF INVESTMENT
1. INTEREST RATE IS EITHER THE COST OF
BORROWED FUNDS OR THE COST OF
INVESTING YOUR OWN FUNDS (INCOME
FOREGONE)
2. IF INTEREST RATE EXCEEDS THE EXPECTED
RATE OF RETURN, THE INVESTMENT
SHOULD NOT BE MADE.
D. INVESTMENT DEMAND SCHEDULE SHOWS AN
INVERSE RELATIONSHIP BETWEEN THE INTEREST
RATE AND AMOUNT OF INVESTMENT
(SEE GRAPH)
E. SHIFTS IN INVESTMENT SCHEDULE-SHIFTS IN INVESTMENT
DEMAND OCCUR WHEN ANY DETERMINANT APART FROM
INTEREST RATE CHANGES
1. GREATER EXPECTED RATE OF RETURNS CREATE
MORE INVESTMENT DEMAND (SHIFT CURVE TO THE
RIGHT)
a. ACQUISITION, MAINTENANCE, AND
OPERATING COSTS MAY CHANGE
b. BUSINESS TAXES MAY CHANGE
c. TECHNOLOGY MAY CHANGE
d. STOCK OF CAPITAL GOODS ON HAND
WILL AFFECT NEW INVESTMENT
e. EXPECTATIONS CAN CHANGE THE VIEW
OF EXPECTED PROFITS
F. INVESTMENT IS A VERY UNSTABLE TYPE OF SPENDING, IT IS
MORE VOLATILE THAN GDP
1. CAPITAL GOODS ARE DURABLE GOODS SO SPENDING
CAN BE POSTPONED OR NOT
2. INNOVATION OCCURS IRREGULARY
3. PROFITS VARY CONSIDERABLY
4. EXPECTATIONS CAN BE EASILY CHANGED
G. EQUILIBRIUM GDP AND GDP GAPS
C
DI
Leakages-injections approach
Injections: investment, exports,
government spending, consumption
Leakages: savings, taxes, imports,