Zara Mahmood Oct 1 2013 EC102 Lecture 8 Aggregate Expenditure and Output in the Short Run Economy experiences a business cycle around the long run upward trend in real GDP Business cycle is the ups and downs in an economy Aggregate Expenditure AE Total spending in the economy the sum of consumption planned investment government purchases and net exports When AE and production of goods and services increase by the same amount o Firms will sell what about what they are expected to sell o Probably will not increase decrease production or workers hired When AE increases more than production of goods and services o Firms will increase production and hire more workers When AE does not increase as much as total production o Firms cut back on production and lay off workers recession AGGREGATE EXPENDITURE MODEL Aggregate Expenditure Model A macroeconomic model that focuses on the short run relationship between total spending and real GDP assuming that the price level is constant Level of GDP is determined mainly by the level of aggregate expenditure Aggregate Expenditure Relationship between changes in aggregate expenditure and changes in real GDP 4 components of aggregate expenditure that equal GDP o Consumption Planned Investment Government Purchases Net Exports o AE C I G NX What is Investment Plant and Equipment 78 of all investment Housing 19 of all investment Inventories 2 of all investment o Finished goods not yet sold o Raw materials not yet sold o Unfinished goods still in the production process Determinants of Investment Expectations of future profitability o Optimism or pessimism Taxes o Higher taxes means less investment Zara Mahmood Oct 1 2013 EC102 o Corporate income tax o Investment tax incentives Cash flow Real interest rate o R increases then investment decreases More expensive for firms developers to borrow Financing Alternatives What are a firm s financing alternatives Borrow the money 9 external o Bank loans o Bonds o Stocks Sell ownership shares in the company 2 external Use their own savings 75 internal o Retained earnings The Difference between Planned Investment and Actual Investment Inventories Goods that have been produced but not yet sold Changes in inventories are included as part of investment spending o Business amount plan to spend may be different from amount actual spent Spending on machinery equipment office buildings and factories also included o Business actually spends planned amount on this Changes in inventories depend on sales of goods firms cant always predict Actual Investment will equal planned investment only when there is no unplanned change in inventories o Unplanned inventory increase actual investment spending greater o Unplanned inventory decrease actual investment spending less Macroeconomics Equilibrium Macroeconomics equilibrium occurs when total spending AE equals total production GDP AE GDP Determining the Level of Aggregate Expenditure in the Economy Consumption Consumption follows a smooth upward trend Only during periods of recession does the growth in consumption decline Zara Mahmood Oct 1 2013 EC102 Current Disposable Income Total current income GDP after taxes are taken out and after transfer payments are added Abbreviate YD Y T tax TR transfer 5 most important variables that determine level of consumption Current disposable income o Higher the disposable income the more they spend o Lower the disposable income the less they spend o Consumption increases when current disposable income increases Household wealth o Wealth is the value of its assets minus the value of its liabilities o Assets stock bonds bank accounts Liabilities loans o Wealth of household increases consumption increases o Rise in stock prices consumption increases Expected future income consumption o Looking at current income difficult to estimate current o People cut back and save based on income of the year o Current income is good indicator of consumption when it is normal compared to future incomes o Y T TR e The price level o Measures the average prices of goods and services in the economy o Affect consumption through effects on household wealth o Price level rises real value of your wealth and consumption decline The interest rate o Interest rate high reward for saving increases and consumption o Consumption spending depends on the real interest rate o Interest rate changes most affect spending on durable goods car decreases interest o Real interest rate nominal inflation o R increase then C decrease Costs more to borrow to finance consumption There is more incentive to save The Consumption Function The relationship between consumption spending and disposable income Changes in consumption depend on changes in disposable income o Consumption is a function of disposable income Slope change in consumption change in disposable income Marginal Propensity to Consume The slope of the consumption function The amount by which consumption spending changes when disposable income changes MPC Change in consumption Change in disposable income Zara Mahmood Oct 1 2013 EC102 C YD C YD x MPC The Relationship between Consumption and National Income Similar relationship exists between consumption spending and GDP GDP and national income used interchangeably Disposable income national income government transfer payments taxes o Disposable income National income Net taxes o National income GDP Disposable income Net taxes National income and disposable income differ by a constant amount o Changes in the two numbers always give us the same value Can graph consumption function using national income Can calculate MPC using either national or disposable income Income Consumption and Saving Y National income GDP C Consumption S Savings T Taxes Y C S T Y C S T o National income change must mean C S or T change o Taxes are always constant amount T 0 Y C S Marginal Propensity to Save MPS The amount by which saving changes when disposable income changes Change in savings change in disposable income 1 MPC MPS Y Y C Y S Y o When taxes are constant MPC MPS must always 1