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CHAPTER 11 : INCOME AND EXPENDITURE
TEXT READING:
You are responsible for everything in this chapter including the Appendix.
This chapter examines two important questions:
- Given a nation’s potential capacity to produce i.e. its current resources and state of technology, what determines its actual level of real GDP?
- What causes real GDP to fluctuate in the short run i.e. what determines business cycle fluctuations? To answer these questions, we introduce our first macroeconomic model called the Aggregate Expenditures (AE) or Income-Expenditure model (also known as the Keynesian Cross model). This model has its origins in the 1936 writings of British economist John Maynard Keynes who was seeking to understand why the Great Depression had happened and how it might be ended. The basic idea behind the model is that the amount of goods and services produced i.e. real GDP and therefore the level of employment, depend directly on the level of aggregate expenditures or total spending in the economy. Firms will produce only what they can profitably sell. If the market for their product shrinks, business will reduce production, lay off workers and idle their capital resources. The Income-Expenditure model is the simplest model of real GDP determination and relies on the following assumptions: a) The price level is fixed i.e. it does not change in response to changes in economic conditions. (Keynes observed that prices did not fall sufficiently during the Great Depression to boast spending.) b) There is no government sector, thus no government spending and no taxes. c) The economy does not trade. It is a closed economy, thus no imports or exports. d) The interest rate is fixed This chapter will examine the following:
- The aggregate consumption function which shows the relationship between current consumption expenditures and current disposable income
- The difference between autonomous and induced consumption spending
- The determinants of planned aggregate expenditure (consumption and investment) when the price level is fixed
- The difference between planned (desired) investment spending and unplanned (undesired) investment
- How the inventory adjustment process moves the economy to a new equilibrium level of real GDP given a change in autonomous expenditure
- Why investment spending is a leading indicator of future economic conditions
- The multiplier effect of a change in autonomous expenditure
Because the price level is fixed: Real GDP = Nominal GDP Because there is no government (no transfers or taxes): Real GDP = Disposable income
Real GDP = disposable income (YD)
For instance, if $500 billion worth of output is produced i.e. real GDP = $500B, households will receive exactly $500 billion in disposable income that they can either consume or save. Because we assume a closed economy with no government, there are only two components of aggregate expenditure in our simple income-Expenditure model: Consumption spending (C) and Investment spending (I). We develop our model by starting with the first component of aggregate expenditure, consumption spending. CONSUMPTION SPENDING and the AGGREGATE CONSUMPTION FUNCTION
The most important determinant of consumption spending is disposable income.
The marginal propensity to consume (MPC) measures the fraction of an additional dollar of disposable income received that is consumed: The marginal propensity to save (MPS) is the fraction of an additional dollar of disposable income that is saved. MPC + MPS = 1 For example, if 0.75 of additional disposable income is consumed, then 0.25 must be saved.
Movements Along vs. Shifts in Consumption Function The movement from one point to another along a consumption function is due to a change in disposable income. A shift in the consumption function is due to changes in one or more of the “non- disposable income” determinants of consumption spending. The consumption function shifts upward with an increase in wealth, greater optimism about future disposable incomes, and a fall in the interest rate. It shifts downward with a decrease in wealth, pessimism about future disposable incomes, and a rise in the interest rate. Autonomous vs. Induced Consumption Spending Even if disposable income is zero, there will still be some level of consumption spending. After all, people need to survive. This absolute minimum amount of spending is called autonomous consumption spending because it does not depend on the level of disposable income. However, most spending occurs due to disposable incomes. This spending is called induced consumption spending because it is induced, or brought about, by a change in disposable income. In the table below, the amount of autonomous consumption spending is $300B (spending when disposable income = zero). Induced spending varies with the level of income. In this example, for each additional $ 5 00 in disposable income, households will spend $300 more 𝑀𝑃𝐶 =
How is it possible to consume if disposable income is zero? Given no disposable income, households must use their savings (they will be dissaving ) or borrow money i.e. use someone else’s savings to consume. Algebraic form of aggregate consumption function: C = A + MPC x YD Where, A = Autonomous consumption = $ MPC x YD = Induced consumption = 0.6YD C = $300 + 0. 6 YD Example: When disposable income = $2,500B C = $300 + 0.6(2,500) = $1,800B
INVESTMENT SPENDING Recall from a previous chapter that there are 3 components to investment:
- Plant and equipment (capital)
- Residential construction and
- Inventory accumulation Investment spending is the most volatile component of GDP, and changes in investment spending are strongly correlated with business cycle fluctuations. The determinants of investment spending are the interest rate, expected future real GDP and the current level of production capacity. The Income-Expenditure model assumes that investment expenditures are autonomous i.e. they do not vary with real GDP. This is a realistic assumption since investment is undertaken by firms for future benefit, so the current level of real GDP does not have a significant effect on planned investment.
1. Interest Rate
- When interest rates are high, it is more expensive for firms to borrow money to invest in plant and equipment. Also, firms with available cash on hand may earn higher returns in money markets e.g. by buying bonds, than the rate of return received on investment in physical capital. The higher the interest rate, the lower will be investment in plant and equipment.
- Most homes are purchased with borrowed funds; thus, interest rate variations will have a significant effect on the demand for residential housing.
- The higher the interest rate, the higher the opportunity cost of using money, either borrowed or retained earnings, for investment purposes. When a firm ties up money in inventories, that money is not available for other purposes such as lending it out and earning interest. The higher the interest rate, the higher the opportunity cost of holding inventories so firms will desire to hold smaller inventories.
2. Expected Future Real GDP and Current Level of Production Capacity
A change in real GDP brings about a change in spending and sales. Firms usually have some target, desired level of inventories that depends on their normal level of sales. Any increase in real GDP and sales will induce an increase in the level of desired inventories held. Similarly, an increase in consumption spending requires an increase in investment in new plant and equipment if the higher demand cannot be met with existing production capacity. If a firm currently has unused production capacity and does not expect sales to increase, its investment in new plant and equipment will be lower. According to the accelerator principle:
- A higher rate of growth in real GDP leads to higher desired, or planned, investment spending.
- A lower rate of growth in real GDP leads to lower desired, or planned, investment spending.
Example:
Consumption function: C = 30 0 + 0. 6 Y
Investment function: I = 500
AE function: AE = C + I = 300 + 0.6 Y + 500 = 800 + 0.6Y
Note: YD is replaced by Y to denote real GDP. We do this because disposable income equals real GDP when the price level is assumed to be fixed and there are no transfers or taxes. Given a closed economy with no government, the slope of the AE function is the same as the slope of the aggregate consumption function and equals MPC. This is because we assume that investment spending does not vary with current real GDP. What Determines Equilibrium Real GDP?
- When planned aggregate expenditure exceeds actual real GDP, households and firms wish to spend more than what the economy is producing. Inventories will fall and firms respond by increasing production. Consequently, actual real GDP rises to match planned AE.
- When planned aggregate expenditure falls short of actual real GDP, households and firms wish to spend less than what economy is producing. Inventories will rise and firms respond by cutting production. Consequently, real GDP falls to match planned AE. Equilibrium real GDP occurs where planned aggregate expenditure = actual real GDP i.e. the amount that households and firms wish to spend equals what the economy is producing.
Income-Expenditure Equilibrium Equation
(note that all C spending is planned spending)
If we know the AE function, we can solve for equilibrium real GDP: In equilibrium, Y = AE Y = 800 + 0.6Y Y – 0.6Y = 800 0.4Y = 800 thus Y = 800 ÷ 0.4 = $2, 000 Equilibrium real GDP = $2,000 billion Real GDP = C + I(Planned) + I (Unplanned) Real GDP = AE (Planned) + I (Unplanned)
- When real GDP exceeds AE (Planned) → I (Unplanned) > 0 → Real GDP FALLS
- When real GDP is less than AE (Planned) → I (Unplanned) < 0 → Real GDP RISES
The Multiplier Simply put, the idea of the multiplier is that an increase in autonomous spending can impact real GDP well in excess of that spending. The multiplier is the ratio of the change in real GDP to the change in the autonomous expenditure that caused it. In a closed economy with no government, the simple spending multiplier is:
- Larger is MPC, the larger is the multiplier and the larger will be the change in real GDP
- Larger is MPS, the smaller is the multiplier and the smaller will be the change in real GDP
Example:
Suppose MPC = 0.
Multiplier =
1 1 − 0. 75
Given an increase in investment spending of $50M to build a new factory, how large will be
the final increase in real GDP?
Suppose that in one month, the $50M goes to build the factory and becomes income to different suppliers e.g. contractors, plumbers, and electricians. These suppliers will spend a part of their new disposable income. In fact, they will spend 75% of it since MPC = 0.75. This amounts to $37.5M. They might buy a new vehicle or do some home renovations, buy new clothes for their kids, or go on a trip etc. Their spending then becomes income to the car dealerships, companies who did the renos on their homes, and so on. And then 75% of these new incomes will be spent… and so on and so on. Final change in real GDP and income = $50M x Multiplier = $50M x 4 = $200M Note that the multiplier also works in reverse. A fall in autonomous expenditure will generate a magnified decline in real GDP and incomes. If, instead of an increase in investment spending, autonomous consumption spending increased due to a fall in interest rates, increase in wealth or expectations of higher future disposable incomes, the final change in real GDP would also equal $200M. 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 (𝑌) 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝑢𝑡𝑜𝑛𝑜𝑚𝑜𝑢𝑠 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 1 1 − 𝑀𝑃𝐶 = 1 𝑀𝑃𝑆
The Economic Circle
This funny essay by humorist Art Buchwald illustrates the concept of the multiplier.
Hofberger, a Ford salesman in Tomcat, Va., called up Littleton of Littleton Menswear &
Haberdashery, and told him that a new Ford had been set aside for Littleton and his wife.
Littleton said he was sorry, but he couldn’t buy a car because he and Mrs. Littleton were getting a
divorce.
Soon afterward, Bedcheck the painter called Hofberger to ask when to begin painting the
Hofbergers’ home. Hofberger said he couldn’t, because Littleton was getting a divorce, not buying
a new car, and, therefore, Hofberger could not afford to paint his house.
When Bedcheck went home that evening, he told his wife to return their new television set to
Gladstone’s TV store. When she returned it the next day, Gladstone immediately called his travel
agent and canceled his trip. He said he couldn’t go because Bedcheck returned the TV set because
Hofberger didn’t sell a car to Littleton because Littletons are divorcing.
Sandstorm, the travel agent, tore up Gladstone’s plane tickets, and immediately called his banker,
Gripsholm, to tell him that he couldn’t pay back his loan that month.
When Rudemaker came to the bank to borrow money for a new kitchen for his restaurant, the
banker told him that he had no money to lend because Sandstorm had not repaid his loan yet.
Rudemaker called his contractor, Eagleton, who had to lay off eight men.
Meanwhile, Ford announced it would give a rebate on its new models. Hofberger called Littleton
to tell him that he could probably afford a car even with the divorce. Littleton said that he and his
wife had made up and were not divorcing. However, his business was so lousy that he couldn’t
afford a car now. His regular customers, Bedcheck, Gladstone, Sandstorm, Gripsholm, Rudemaker,
and Eagleton had not been in for over a month!
Arthur Buchwald (October 20, 1925 – January 17, 2007) wrote a column in The Washington Post
which focused on political satire and commentary. His column was also carried as a syndicated
column in many other newspapers.
EXERCISE # 1
In general, AE = A + MPC x GDP where A includes autonomous C and IPLANNED AE = (200 + 100) + 0.75 x YD AE = 300 + 0.75YD
In equilibrium, Y = AE Y = 300 + 0.75Y (replace YD with Y) Y – 0.75Y = 300 0.25Y = 300, so Y = $1,200 billion Equilibrium level of real GDP = $1,200 billion
ANSWERS # 2
1. If MPS = 0.3 what is the value of the spending multiplier? Note: MPC = 1 - MPS
2. Suppose investment spending increases by $20B and MPC = 0.75. Compute the first
four rounds of spending in the economy. Also compute the final change in real GDP.
Round 1: Increase in investment spending = $20 billion Round 2: Increase in induced consumer spending = 0.75 × $20 billion = $15 billion Round 3: Increase in induced consumer spending = 0.75 x $15 billion = $11.25 billion Round 4: Increase in induced consumer spending = 0.75 × $11.25 billion = $8.4375 billion
3. Increase in real GDP = Change in investment x Multiplier = $20B x 4 = $ 80 billion
