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Chapter 24
Aggregate Expenditure
Components
© 2006 Thomson/South-Western
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Exhibit 1: Disposable Income, Consumption,
and Saving
The relationship
between disposable
income and
consumption has
been relatively
constant and stable
over time
Saving is the
difference between
disposable income
and consumption
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Exhibit 2: U.S. Consumption Depends on
Disposable Income
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The Consumption Function
The relationship between consumption
and income, other things constant
 Consumption
is the dependent variable
 Disposable income is the independent
variable.
Because consumption depends on
income, it is a function of income
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Exhibit 3: The Consumption Function
Both disposable
income and
consumption are
measured in real
terms, or in
inflation-adjusted
dollars
Consumption
increases with
disposable income,
assuming other
determinants of
consumption
remain constant
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Exhibit 4a: Marginal Propensity to Consume
Slope of the
consumption
function equals the
marginal propensity
to consume
In this case, the
change in
consumption is $0.4
trillion and the
change in income is
$0.5 trillion: the
marginal propensity
to consume = 0.4 /
0.5 or 4/5
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Exhibit 4b: Marginal Propensity to Save
Income that is not spent is saved
Here, saving increases by $0.1 trillion as a result of a $0.5 trillion increase
in income
The marginal propensity to save, MPS, equals 0.1 / 0.5, or 1/5
Generally, MPC + MPS = 1
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Nonincome Determinants
What are these factors that could cause the
entire consumption function to shift?
Net wealth and consumption
Price level
Interest rate
Expectations
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Net Wealth
Net wealth is the value of all assets that
households own minus any liabilities, or
debts owed
A decrease in net wealth would make
consumers less inclined to spend, more
inclined to save
Increase in net wealth increases
consumption
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Exhibit 5: Shifts in the Consumption Function
C"
•Increase in
net wealth
shifts
consumption
function from
C to C''
•Decrease in
net wealth
shifts it from
C to C'
C
C'
0
Real disposable income
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Shifts and Movements Along
Difference between a movement along the
consumption function and a shift of the
consumption function
Movement along the consumption function
results from a change in income
Shift of the consumption function results from a
change in one of the nonincome determinants of
consumption
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Price Level
When price level changes, real value of
dollar-denominated financial assets (bank
accounts, cash) also changes
Increase in the price level reduces the
purchasing power of wealth held in fixed
dollar assets – households consume less and
save more
Decreases in the price level increase the
purchasing power of wealth held in fixed
assets – households consume more and save
less
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Interest Rate
Interest
The reward savers earn for deferring consumption
The cost paid by borrowers for current spending
power
The higher the interest rate, the less is spent on
items purchased on credit (households save
more and borrow less) and the consumption
function shifts downward
Conversely, a lower interest rate shifts the
consumption function upward
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Expectations
Changing expectations about price levels, interest
rates, job security and other such factors
influence consumer behavior
If expectations become more pessimistic, then
consumption function shifts downward
If expectations become more optimistic, then
consumption function shifts upward
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Investment
Investment consists of spending on
New factories and new equipment
New housing
Net change in inventories
Firms invest in capital goods now in the
expectation of a future return
Since return is in the future, investors must
estimate how much a particular investment will
yield in all years of its productive life
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Demand for Investment
Firms buy new capital goods only if they
expect this investment to yield a greater
return than other possible uses of their
funds
The expected rate of return equals the
annual dollar earnings expected from the
investment divided by the purchase price
Market interest rate is the opportunity
cost of investing in capital
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Exhibit 6: Rate of Return on Golf Carts and the
Opportunity Cost of Funds
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Exhibit 7: Investment Demand Curve for the
Economy
•Shows the inverse
relationship between the
quantity of investment
demanded and the
market interest rate,
other things constant.
•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.
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Planned Investment and Income
Investment depends more on interest rates
and on business expectations than on the
prevailing level of income
Thus, the investment decision is said to be
“forward looking,” based more on expected
profit than on current levels of income and
output
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Investment Function
The investment function isolates the
relationship between the level of income
in the economy and planned investment –
the amount firms would like to invest,
other things constant
Two determinants of investment assumed
to be constant are
The market interest rate
Business expectations
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Market Interest Rate
A decline in the rate of interest, other things
remaining constant, will reduce the cost of
borrowing and increase planned investment:
investment function shifts upward
Conversely, when the interest rate increases,
the planned investment function shifts
downward
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Real planned investment
(trillions of dollars)
Exhibit 8: Planned Investment Function
1.1
I"
1.0
I
0.9
I'
0
2.0
4.0
6.0
8.0
The horizontal
investment
functions
imply that
planned
investment
does not vary
with real
disposable
income, it is
autonomous
10.0 12.0 14.0
Real disposable income
(trillions of dollars)
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Business Expectations
The primary determinant of investment is
business expectations
If firms become pessimistic about profit
prospects, planned investment will decrease at
every level of income
On the other hand, if profit expectations
become rosier, the investment function will shift
upward
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Business Expectations
Factors that could affect business
expectations – and investment –
include:
Wars
Technological change
Changes in the tax structure
Other destabilizing events that make
long-term planning more uncertain
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Exhibit 9: Annual Percentage Change in U.S.
Real GDP, Consumption, Investment
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Government Purchase Function
Government purchase function
relates government purchases to the
level of income in the economy, other
things constant
Decisions about government
purchases do not depend directly on
the level of income in the economy
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Transfer Payments
Transfer payments are another government
outlay
Outright gifts from governments to households and
are thus not considered part of aggregate
expenditure
Social Security
Welfare benefits and Unemployment benefits
Make up about a third of government outlays
Transfer payments vary inversely with income
– as income increases, transfer payments
decline
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Net Taxes
Governments impose taxes to fund
expenditures
Net taxes equal taxes minus transfers and are
independent of income
Taxes tend to increase with income while
transfers decrease with income
Net taxes affect aggregate spending indirectly
by changing disposable income, in turn
changing consumption
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Net Exports and Income
How do imports and exports relate to the
level of income in the economy?
When their incomes rise, Americans spend
more on everything including exports and
when incomes decline, Americans spend less
on imports
 The exports purchased by the rest of the
world depends on the income of foreigners,
not on the U.S. level of income
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Net Export Function
Shows the relationship between net exports and
the level of income in the economy, other things
constant
Exports are relatively insensitive to level of U.S.
income, but imports tend to increase with
income
 Net
exports (exports minus imports) tend to decline
as U.S. income increases
For simplicity, assume that net exports are
autonomous and independent of the level of
income
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Nonincome Determinants of Net Exports
Factors assumed constant along the net
export function include:
The U.S. price level
Price levels in other countries
Interest rates here and abroad
Foreign income levels
Exchange rates between the dollar and
foreign currencies
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Exhibit 10: Net Export Function
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Exhibit 11: U.S. Spending Components as
Percentages of GDP Since 1959
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