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Principles of Macroeconomics
Lecture 2
CONSUMPTION AND INVESTMENT
BUSINESS CYCLES AND AGGREGATE DEMAND
PART 1: CONSUMPTION
INVESTMENT
AND
Aims of Part 1
- To explain the concepts of consumption, saving
and investment and their attributes
- To explain the importance of these three
concepts for the output of an economy
WHAT IS CONSUMPTION?
- Consumption is spending on final goods
and services bought for the satisfaction
gained or needs met by their use
- It is the largest single component of GDP
What are the major components of
consumption?
- Housing
- Food
- Motor vehicles
- Medical care
- Entertainment and recreation
How is consumption related to income?
€20,000
Saving
€20,000
How is consumption related to income?
When income increases, saving increases more
than consumption
€22,000
€20,000
MARGINAL PROPENSITY TO CONSUME
(MPC)
-The amount of extra consumption generated by
an extra monetary unit of disposable income
- In graphic terms it is expressed by the slope of
the consumption function
CONSUMPTION
FUNCTION
C
A
.
CONSUMPTION
EXPENDITURES
.
.
G
.
F
C . E
.
B. . D
Z
450
DI
DISPOSABLE
INCOME
MPC = CZ / BZ
MARGINAL PROPENSITY TO CONSUME
(MPC)
- As Disposable Income increases, consumption
increases as well but with a diminishing pace for
each additional monetary unit of disposable
income
- In graphic terms it is expressed by the slope of
the consumption function
MARGINAL PROPENSITY TO SAVE (MPS)
-The amount of extra saving generated by an
extra monetary unit of disposable income
- In graphic terms it is expressed by the slope of
the savings function
- It holds that MPS = 1 - MPC
DETERMINANTS OF CONSUMPTION
- Current Disposable Income: It has been
empirically established that the course of
consumption follows the course of disposable
income
- Long run income trends: People choose
their consumption levels looking at both their
current income and the prospects for their future
income
- Wealth: Accumulated wealth plays a key role
in determining the level of consumption
A Consumption Function for the United States, 1966-1996
1996
C
6,000
1990
CONSUMPTION
EXPENDITURES
($blns)
3,000
FITTED
CONSUMPTION
FUNCTION
1980
C
1970
3,000
DISPOSABLE
INCOME ($blns)
6,000
What is investment?
In macroeconomics, investment is defined
as the additions to the stock of productive
assets of an economy.
What is investment?
Additions to the stock of productive assets
of an economy are considered to be
capital
goods
such
as
equipment,
structures and changes in stocks.
Determinants of investment
- Revenues: Investment depends upon the
revenues that will be generated by the state of
overall economic activity
- Costs: Investment depends upon its cost: the
price of the capital good and the interest rate
- Expectations: Investment is very sensitive in
expectations and business confidence
Determinants of investment
Demand for investment curve
Shifts in the investment demand curve
PART 2: BUSINESS
CYCLES AND
AGGREGATE DEMAND
Aims of Part 2
- To describe the short-term fluctuations in output,
employment and prices that characterize business
cycles in market economies
- To explain the concept of aggregate demand
and the differences from a single commodity
demand
Business Cycles
-are swings in total national output, income and
employment,
- are marked by widespread expansion or
contraction in many sectors of the economy,
-occur in all advanced market economies, and
- consist of four phases.
The Business Cycles Theory
Business Cycles Phases and Turning Points
PHASES
-Expansion: A period in which GDP increases
for two consecutive quarters
-Recession: A period in which GDP declines for
two consecutive quarters
TURNING POINTS
- Peak: The highest point of the expansion phase
- Trough: The lowest point of recession phase
Business Cycles Phases
- Characteristics of Expansion:
- Consumption rises
- Business inventories decrease
- Production is increased
- Real GDP rises
- Business investment rises
- Labour demand increases and unemployment falls
- Inflation becomes high
- Interest rate rises
Business Cycles Phases
- Characteristics of Recession:
- Consumption falls sharply
- Business inventories increase
- Production is reduced
- Real GDP falls
- Business investment falls
- Labour demand falls and unemployment rises
- Inflation slows
- Interest rate falls
Definition of Aggregate Demand
- Aggregate Demand (AD) is the total or aggregate
quantity of output that is willingly bought at a
given level of prices
- It has four components:
- Consumption
- Investment
- Government Purchases
- Net Exports
- Remember the GDP equation : Y= C+I+G+ (X-M)
Differences of AD with the micro demand
- AD curves relate overall spending on all
components of output to the overall price level
- AD is downward sloping mainly due to the
money-supply effect. That is when a rise in the
price level occurs, the real money supply is
reduced (all others held constant). Thus interest
rates rise, credit is difficult to obtain and total real
spending falls.
The Aggregate Demand (AD) Curve
Factors affecting Aggregate Demand
-Monetary and fiscal policy
-Exogenous variables such as foreign economic
activity, technological advances and shifts in asset
markets
- Changing these variables shifts the AD curve
Movements and Shifts in AD
Factors affecting Aggregate Demand
Key things to remember:
-A change at the price level leads to a
MOVEMENT along the AD curve
- A change in other underlying factors of AD leads
to a SHIFT of the AD curve
Helpful reading
Economics. Samuelson, & Nordhaus (2005) Ch. 22-23