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CHAPTER NINE BUILDING THE AGGREGATE EXPENDITURES MODEL CHAPTER OVERVIEW The central purpose of this chapter is to introduce the basic analytical tools that will help us organize our thinking about macroeconomic theories and controversies. First, the historical backdrop of the aggregate expenditures model is established. Next, the focus is on the consumption-income and saving-income relationships that are part of the model. Third, investment is examined, and finally, the consumption, saving, and investment concepts are combined to explain the equilibrium levels of output, income, and employment in a private (no government), domestic (no foreign sector) economy. WHAT’S NEW This chapter has been condensed with a focus on “aggregate expenditures-aggregate output” approach. The previous “leakage-injection” approach has been eliminated here and in Chapter 10. The “historical backdrop” section has been converted to the Last Word section. Also, simplified terminology is used when discussing the role of inventory changes, by referring to “unplanned changes in inventories” for both increases and decreases in inventories. There is a greater stress on the wealth effect to reflect its current role as an important nonincome determinant of consumption. Finally, as stated, the new Last Word incorporates the content from previous editions on the historical backdrop to these theories. INSTRUCTIONAL OBJECTIVES After completing this chapter, students should be able to: 1. Recognize, construct, and explain the consumption, saving, and investment schedules. 2. Identify the determinants of the location of the consumption and saving schedules. 3. Differentiate between the average and marginal propensities to consume (and save). 4. Identify the immediate determinants of investment and construct an investment demand curve. 5. Identify the factors that may cause a shift in the investment-demand curve or schedule. 6. Describe the reasons for the instability in investment spending. 7. Explain verbally and graphically the equilibrium level of GDP. 8. Explain why above-equilibrium or below-equilibrium GDP levels will not persist. 9. Explain the basics of the classical view that the economy would generally provide full employment levels of output. 10. Trace the changes in GDP that will occur when there is a discrepancy between saving and planned investment. 11. Define and identify terms and concepts at the end of the chapter. COMMENTS AND TEACHING SUGGESTIONS 1. For those who feel that it is important for students to grasp the multiplier concept, it is possible to explain the multiplier concept without going into the theoretical discussions of Chapters 9 and 10. One suggestion would be to use the humorous Last Word for Chapter 10 and some simple roleplaying exercises mentioned in this manual for Chapter 10. 2. The Last Word for this chapter provides historical backdrop for Keynesian theory. Impress upon students that Keynes developed the theory that emphasizes the importance of aggregate demand for economic performance. You may want to point out that his theory changed the way economists viewed the modern capitalist system and that he has been credited with the development of macroeconomics as a separate field. Stress that debate still lingers over whether the system is selfcorrecting during periods of unemployment or inflation. 3. Data to update Figure 9-1 may be found in the most recent issue of Survey of Current Business or Economic Indicators. Web-based questions at the end of the chapter also point to sources. 4. Investment expenditures are the most volatile segment of aggregate expenditures. Ask students to research a particular industry to find out what factors are most likely to influence investment decisions for that industry, or have students interview a local business manager or owner about their decision to add capital equipment. Make a list of the factors that they consider when making their decisions. Are they similar to the reasons given in the text? How were they different? STUDENT STUMBLING BLOCKS 1. The concept of equilibrium GDP seems to be easy for students to grasp intuitively, but difficult for them to apply. Give them a lot of practice in finding equilibrium GDP using questions similar to the quantitative Key Questions at the end of the chapter. 2. Non-business majors may not be familiar with the term “inventory,” or with the idea that business inventories represent an investment expenditure to businesses. This is key to understanding the difference between actual and planned investment. Make sure the distinction is emphasized. 3. If your class is filled with struggling students consider using only one “macro model.” It is very difficult for beginning students to switch from one set of assumptions to another. The concept of equilibrium can be presented using Aggregate Expenditures or the ADAS model presented in Chapter 11. The model in this chapter uses income as the main determinant. ADAS emphasizes the price level. An emphasis on only one model may help students understand the macro economy better. LECTURE NOTES I. Introduction—What Determines GDP? A. This chapter and the next focus on the aggregate expenditures model. We use the definitions and facts from previous chapters to shift our study to the analysis of economic performance. The aggregate expenditures model is one tool in this analysis. Recall that “aggregate” means total. B. As explained in this chapter’s Last Word, the model originated with John Maynard Keynes (Pronounced Canes). C. The focus is on the relationship between income and consumption and savings. D. Investment spending, an important part of aggregate expenditures, is also examined. E. Finally, these spending categories are combined to explain the equilibrium levels output and employment in a private (no government), domestic (no foreign sector) economy. Therefore, GDP=NI=PI=DI in this very simple model. II. Simplifying Assumptions for this Chapter A. We assume a “closed economy” with no international trade. B. Government is ignored; focus is on private sector markets until next chapter. C. Although both households and businesses save, we assume here that all saving is personal. D. Depreciation and net foreign income are assumed to be zero for simplicity. E. There are two reminders concerning these assumptions. 1. They leave out two key components of aggregate demand (government spending and foreign trade), because they are largely affected by influences outside the domestic market system. 2. With no government or foreign trade, GDP, national income (NI), personal income (PI), and disposable income (DI) are all the same. III. Tools of Aggregate Expenditures Theory: Consumption and Saving 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 saving: Since consumption is the largest component of aggregate spending, we analyze its determinants. 1. Disposable income is the most important determinant of consumer spending (see Figure 9-1 in text which presents historical evidence). a. What is not spent is called saving. b. Therefore, DI – C = S or C + I = DI 2. In Figure 9-1 we see a 45-degree line which represents all points where consumer spending is equal to disposable income; other points represent actual C, DI relationships for each year from 1980-2000. 3. If the actual graph of the relationship between consumption and income is below the 45-degree line, then the difference must represent the amount of income that is saved. 4. Look at 1996 where consumption was $5238 billion and disposable income was $5678 billion. Hence, saving was $440 billion. 5. The graph illustrates that as disposable income increases both consumption and saving increase. 6. Some conclusions can be drawn: a. Households consume a large portion of their disposable income. b. Both consumption and saving are directly related to the level of income. C. The consumption schedule: 1. The dots in Figure 9-1 represent actual historical data. 2. A hypothetical consumption schedule (Table 91 and Key Graph 9-2a) shows that households spend a larger proportion of a small income than of a large income. 3. A hypothetical saving schedule (Table 1, column 3) is illustrated in Key Graph 9-2b. 4. Note that “dissaving” occurs at low levels of disposable income, where consumption exceeds income and households must borrow or use up some of their wealth. D. Average and marginal propensities to consume and save: 1. Define average propensity to consume (APC) as the fraction or % of income consumed (APC = consumption/income). See Column 4 in Table 9-1. 2. Define average propensity to save (APS) as a the fraction or % of income saved (APS = saving/income). See Column 5 in Table 9-1. 3. Global Perspective 9-1 shows the APCs for several nations in 1999. Note the high APC for both U.S. and Canada. 4. Marginal propensity to consume (MPC) is the fraction or proportion of any change in income that is consumed. (MPC = change in consumption/change in income.) See Column 6 in Table 9-1. 5. Marginal propensity to save (MPS) is the fraction or proportion of any change in income that is saved. (MPS = change in saving/change in income.) See Column 7 in Table 9-1. 6. Note that APC + APS = 1 and MPC + MPS = 1. 7. Note that Figure 9-3 illustrates that MPC is the slope of the consumption schedule, and MPS is the slope of the saving schedule. 8. Test Yourself: Try the Self-Quiz below Key Graph 9-2. E. Nonincome determinants of consumption and saving can cause people to spend or save more or less at various income levels, although the level of income is the basic determinant. 1. Wealth: An increase in wealth shifts the consumption schedule up and saving schedule down. In recent years major fluctuations in stock market values have increased the importance of this wealth effect. 2. Expectations: Changes in expected inflation or future wealth can affect consumption spending today. 3. Household debt: Lower debt levels shift consumption schedule up and saving schedule down. 4. Taxation: Lower taxes will shift both schedules up since taxation affects both spending and saving, and vice versa for higher taxes. F. Shifts and stability: See Figure 9-4. 1. Terminology: Movement from one point to another on a given schedule is called a change in amount consumed; a shift in the schedule is called a change in consumption schedule. 2. Schedule shifts: Consumption and saving schedules will always shift in opposite directions unless a shift is caused by a tax change. 4. Stability: Economists believe that consumption and saving schedules are generally stable unless deliberately shifted by government action. G. Review these aggregate expenditures concepts with Quick Review 9-1. IV. Investment A. Investment, the second component of private spending, consists of spending on new plants, capital equipment, machinery, inventories, construction, etc. 1. The investment decision weighs marginal benefits and marginal costs. 2. The expected rate of return is the marginal benefit and the interest rate represents 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 expected rate of return. The text’s example gives $100 expected profit, $1000 investment for a 10% expected rate of return. Thus, the business would not want to pay more than 10% interest rate on investment. C. The real interest rate, i (nominal rate corrected for expected inflation), is the cost of investment. 1. Interest rate is either the cost of borrowed funds or the cost of investing your own funds, which is income forgone. 2. If real interest rate exceeds the expected rate of return, the investment should not be made. D. Investment demand schedule, or curve, shows an inverse relationship between the interest rate and amount of investment. 1. As long as expected return exceeds interest rate, the investment is expected to be profitable (see Table 92 example). 2. Key Graph 9-5 shows the relationship when the investment rule is followed. Fewer projects are expected to provide high return, so less will be invested if interest rates are high. 3. Test yourself with Quick Quiz 9-5. E. Shifts in investment demand occur when any determinant apart from the interest rate changes. 1. Greater expected returns create more investment demand; shift curve to right. The reverse causes a leftward shift. a. Acquisition, maintenance, and operating costs of capital goods 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. In addition to the investment demand schedule, economists also define an investment schedule that shows the amounts business firms collectively intend to invest at each possible level of GDP or DI. 1. In developing the investment schedule, it is assumed that investment is independent of the current income. The line Ig (gross investment) in Figure 97b shows this graphically related to the level determined by Figure 9-7a. 2. The assumption that investment is independent of income is a simplification, but will be used here. 3. Table 9-3 shows the investment schedule from GDP levels given in Table 9-1. G. Investment is a very unstable type of spending; I is more volatile than GDP (See Figure 9-8). 1. Capital goods are durable, so spending can be postponed or not. This is unpredictable. 2. Innovation occurs irregularly. 3. Profits vary considerably. 4. Expectations can be easily changed. V. Equilibrium GDP: Expenditures-Output Approach A. Look at Table 9-4, which combines data of Tables 9-1 and 9-3. B. Real domestic output in column 2 shows ten possible levels that producers are willing to offer, assuming their sales would meet the output planned. In other words, they will produce $370 billion of output if they expect to receive $370 billion in revenue. C. Ten levels of aggregate expenditures are shown in column 6. The column shows the amount of consumption and planned gross investment spending (C + Ig) forthcoming at each output level. 1. Recall that consumption level is directly related to the level of income and that here income is equal to output level. 2. Investment is independent of income here and is planned or intended regardless of the current income situation. D. Equilibrium GDP is the level of output whose production will create total spending just sufficient to purchase that output. Otherwise there will be a disequilibrium situation. 1. In Table 9-4, this occurs only at $470 billion. 2. At $410 billion GDP level, total expenditures (C + Ig) would be $425 = $405(C) + $20 (Ig) and businesses will adjust to this excess demand by stepping up production. They will expand production at any level of GDP less than the $470 billion equilibrium. 3. At levels of GDP above $470 billion, such as $510 billion, aggregate expenditures will be less than GDP. At $510 billion level, C + Ig = $500 billion. Businesses will have unsold, unplanned inventory investment and will cut back on the rate of production. As GDP declines, the number of jobs and total income will also decline, but eventually the GDP and aggregate spending will be in equilibrium at $470 billion. E. Graphical analysis is shown in Figure 9-9 (Key Graph). At $470 billion it shows the C + Ig schedule intersecting the 45-degree line which is where output = aggregate expenditures, or the equilibrium position. 1. Observe that the aggregate expenditures line rises with output and income, but not as much as income, due to the marginal propensity to consume (the slope) being less than 1. 2. A part of every increase in disposable income will not be spent but will be saved. 3. Test yourself with Quick Quiz 9-9. VI. Two Other Features of Equilibrium GDP A. Savings and planned investment are equal. 1. It is important to note that in our analysis above we spoke of “planned” investment. At GDP = $470 billion in Table 9-4, both saving and planned investment are $20 billion. 2. Saving represents a “leakage” from spending stream and causes C to be less than GDP. 3. Some of output is planned for business investment and not consumption, so this investment spending can replace the leakage due to saving. a. If aggregate spending is less than equilibrium GDP as it is in Table 9-4, line 8 when GDP is $510 billion, then businesses will find themselves with unplanned inventory investment on top of what was already planned. This unplanned portion is reflected as a business expenditure, even though the business may not have desired it, because the total output has a value that belongs to someone—either as a planned purchase or as an unplanned inventory. b. If aggregate expenditures exceed GDP, then there will be less inventory investment than businesses planned as businesses sell more than they expected. This is reflected as a negative amount of unplanned investment in inventory. For example, at $450 billion GDP, there will be $435 billion of consumer spending, $20 billion of planned investment, so businesses must have experienced a $5 billion unplanned decline in inventory because sales exceed that expected. B. In equilibrium there are no unplanned changes in inventory. 1. Consider row 7 of Table 9-4 where GDP is $490 billion, here C + Ig is only $485 billion and will be less than output by $5 billion. Firms retain the extra $5 billion as unplanned inventory investment. Actual investment is $25 billion or more than $20 billion planned. So $490 billion is an above-equilibrium output level. 2. Consider row 5, Table 9-4. Here $450 billion is a below-equilibrium output level because actual investment will be $5 billion less than planned. Inventories decline below what was planned. GDP will rise to $470 billion. C. Quick Review: Equilibrium GDP is where aggregate expenditures equal real domestic output. (C + planned Ig = GDP) 1. A difference between saving and planned investment causes a difference between the production and spending plans of the economy as a whole. 2. This difference between production and spending plans leads to unintended inventory investment or unintended decline in inventories. 3. As long as unplanned changes in inventories occur, businesses will revise their production plans upward or downward until the investment in inventory is equal to what they planned. This will occur at the point that household saving is equal to planned investment. 4. Only where planned investment and saving are equal will there be no unintended investment or disinvestment in inventories to drive the GDP down or up. VII. Last Word: Say’s Law, The Great Depression, and Keynes A. Until the Great Depression of the 1930, most economists going back to Adam Smith had believed that a market system would ensure full employment of the economy’s resources except for temporary, short-term upheavals. B. If there were deviations, they would be self-correcting. A slump in output and employment would reduce prices, which would increase consumer spending; would lower wages, which would increase employment again; and would lower interest rates, which would expand investment spending. C. Say’s law, attributed to the French economist J. B. Say in the early 1800s, summarized the view in a few words: “Supply creates its own demand.” D. Say’s law is easiest to understand in terms of barter. The woodworker produces furniture in order to trade for other needed products and services. All the products would be traded for something, or else there would be no need to make them. Thus, supply creates its own demand. E. Reformulated versions of these classical views are still prevalent among some modern economists today. F. The Great Depression of the 1930s was worldwide. GDP fell by 40 percent in U.S. and the unemployment rate rose to nearly 25 percent (when most families had only one breadwinner). The Depression seemed to refute the classical idea that markets were self-correcting and would provide full employment. G. John Maynard Keynes in 1936 in his General Theory of Employment, Interest, and Money, provided an alternative to classical theory, which helped explain periods of recession. 1. Not all income is always spent, contrary to Say’s law. 2. Producers may respond to unsold inventories by reducing output rather than cutting prices. 3. A recession or depression could follow this decline in employment and incomes. H. The modern aggregate expenditures model is based on Keynesian economics or the ideas that have arisen from Keynes and his followers since. It is based on the idea that saving and investment decisions may not be coordinated, and prices and wages are not very flexible downward. Internal market forces can therefore cause depressions and government should play an active role in stabilizing the economy. ANSWERS TO END-OF-CHAPTER QUESTIONS 9-1 Explain what relationships are shown by (a) the consumption schedule, (b) the saving schedule, (c) the investmentdemand curve, and (d) the investment schedule. (a) The consumption schedule or curve shows how much households plan to consume at various levels of disposable income at a specific point in time, assuming there is no change in the nonincome determinants of consumption, namely, wealth, the price level, expectations, indebtedness, and taxes. A change in disposable income causes movement along a given consumption curve. A change in a nonincome determinant causes the entire schedule or curve to shift. (b) The saving schedule or curve shows how much households plan to save at various levels of disposable income at a specific point in time, assuming there is no change in the nonincome determinants of saving, namely, wealth, the price level, expectations, indebtedness, and taxes. A change in disposable income causes movement along a given saving curve. A change in a nonincome determinant causes the entire schedule or curve to shift. (c) The investmentdemand curve shows how much will be invested at all possible interest rates, given the expected rate of net profit from the proposed investments, assuming there is no change in the noninterestrate determinants of investment, namely, acquisition, maintenance, operating costs, business taxes, technological change, the stock of capital goods on hand, and expectations. A change in any of these will affect the expected rate of net profit and shift the curve. A change in the interest rate will cause movement along a given curve. (d) The investment schedule shows how much businesses plan to invest at each of the possible levels of output or income. 9-2 Precisely how are the APC and the MPC different? Why must the sum of the MPC and the MPS equal 1? What are the basic determinants of the consumption and saving schedules? Of your own level of consumption? APC is an average whereby total spending on consumption (C) is compared to total income (Y): APC = C/Y. MPC refers to changes in spending and income at the margin. Here we compare a change in consumer spending to a change in income: MPC = change in C / change in Y. When your income changes there are only two possible options regarding what to do with it: You either spend it or you save it. MPC is the fraction of the change in income spent; therefore, the fraction not spent must be saved and this is the MPS. The change in the dollars spent or saved will appear in the numerator and together they must add to the total change in income. Since the denominator is the total change in income, the sum of the MPC and MPS is one. The basic determinants of the consumption and saving schedules are the levels of income and output. Once the schedules are set, the determinants of where the schedules are located would be the amount of household wealth (the more wealth, the more is spent at each income level); expectations of future income, prices and product availability; the relative size of consumer debt; and the amount of taxation. Chances are that most of us would answer that our income is the basic determinant of our levels of spending and saving, but a few may have low incomes, but with large family wealth that determines the level of spending. Likewise, other factors may enter into the pattern, as listed in the preceding paragraph. Answers will vary depending on the student’s situation. 9-3 Explain how each of the following will affect the consumption and saving schedules or the investment schedule: a. A large increase in the value of real estate, including private houses. b. The threat of limited, non-nuclear war, leading the public to expect future shortages of consumer durables. c. A decline in the real interest rate. d. A sharp, sustained decline in stock prices. e. An increase in the rate of population growth. f. The development of a cheaper method of manufacturing computer chips. g. A sizable increase in the retirement age for collecting social security benefits. h. The expectation that mild inflation will persist in the next decade. i. An increase in the Federal personal income tax. (a) If this simply means households have become more wealthy, then consumption will increase at each income level. The consumption schedule should shift upward and the saving schedule shift leftward. The investment schedule may shift rightward if owners of existing homes sell them and invest in construction of new homes more than previously. (b) This threat will lead people to stock up; the consumption schedule will shift up and the saving schedule down. If this puts pressure on the consumer goods industry, the investment schedule will shift up. The investment schedule may shift up again later because of increased military procurement orders. (c) The decline in the real interest rate will increase interestsensitive consumer spending; the consumption schedule will shift up and the saving schedule down. Investors will increase investment as they move down the investmentdemand curve; the investment schedule will shift upward. (d) Though this did not happen after October 19, 1987, a sharp decline in stock prices can normally be expected to decrease consumer spending because of the decrease in wealth; the consumption schedule shifts down and the saving schedule upwards. Because of the depressed share prices and the number of speculators forced out of the market, it will be harder to float new issues on the stock market. Therefore, the investment schedule will shift downward. (e) The increase in the rate of population growth will, over time, increase the rate of income growth. In itself this will not shift any of the schedules but will lead to movement upward to the right along the upward sloping investment schedule. (f) This innovation will in itself shift the investment schedule upward. Also, as the innovation starts to lower the costs of producing everything using these chips, prices will decrease leading to increased quantities demanded. This, again, could shift the investment schedule upward. (g) The postponement of benefits may cause households to save more if they planned to retire before they qualify for benefits; the saving schedule will shift upward, the consumption schedule downward. This impact is uncertain, however, if people continue to work and earn productive incomes. (h) If this is a new expectation, the consumption schedule will shift upwards and the saving schedule downwards until people have stocked up enough. After about a year, if the mild inflation is not increasing, the household schedules will revert to where they were before. (i) Because this reduces disposable income, consumption will decline in proportion to the marginal propensity to consume. Consumption will be less at each level of real output, and so the curve shifts down. The saving schedule will also fall because the disposable income has decreased at each level of output, so less would be saved. 9-4 Explain why an upward shift in the consumption schedule typically involves an equal downshift in the saving schedule. What is the exception? If, by definition, all that you can do with your income is use it for consumption or saving, then if you consume more out of any given income, you will necessarily save less. And if you consume less, you will save more. This being so, when your consumption schedule shifts upward (meaning you are consuming more out of any given income), your saving schedule shifts downward (meaning you are consuming less out of the same given income). The exception is a change in personal taxes. When these change, your disposable income changes, and, therefore, your consumption and saving both change in the same direction and opposite to the change in taxes. If your MPC, say, is 0.9, then your MPS is 0.1. Now, if your taxes increase by $100, your consumption will decrease by $90 and your saving will decrease by $10. 9-5 (Key Question) Complete the accompanying table (top of next page). a. Show the consumption and saving schedules graphically. b. Locate the breakeven level of income. How is it possible for households to dissave at very low income levels? c. If the proportion of total income consumed (APC) decreases and the proportion saved (APS) increases as income rises, explain both verbally and graphically how the MPC and MPS can be constant at various levels of income. Level of Outputand income (GDP = DI) Consumption Saving APC APS MPC MPS $240260280300320340360380400 $ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____ $-40481216202428 _____________________________________________ _____________________________________________ _____________________________________________ _____________________________________________ Data for completing the table (top to bottom). Consumption: $244; $260; $276; $292; $308; $324; $340; $356; $372. APC: 1.02; 1.00; .99; .97; .96; .95; .94; .94; .93. APS: -.02; .00; .01; .03; .04; .05; .06; .06; .07. MPC: 80 throughout. MPS: 20 throughout. (a) See the graphs. (b) Break-even income = $260. Households dissave borrowing or using past savings. (c) Technically, the APC diminishes and the APS increases because the consumption and saving schedules have positive and negative vertical intercepts respectively. (Appendix to Chapter 1). MPC and MPS measure changes in consumption and saving as income changes; they are the slopes of the consumption and saving schedules. For straight-line consumption and saving schedules, these slopes do not change as the level of income changes; the slopes and thus the MPC and MPS remain constant. 9-6 What are the basic determinants of investment? Explain the relationship between the real interest rate and the level of investment. Why is the investment schedule less stable than the consumption and saving schedules? The basic determinants of investment are the expected rate of net profit that businesses hope to realize from investment spending and the real rate of interest. When the real interest rate rises, investment decreases; and when the real interest rate drops, investment increases—other things equal in both cases. The reason for this relationship is that it makes sense to borrow money at, say, 10 percent, if the expected rate of net profit is higher than 10 percent, for then one makes a profit on the borrowed money. But if the expected rate of net profit is less than 10 percent, borrowing the money would be expected to result in a negative rate of return on the borrowed money. Even if the firm has money of its own to invest, the principle still holds: The firm would not be maximizing profit if it used its own money to carry out an investment returning, say, 9 percent when it could lend the money at an interest rate of 10 percent. For the great majority of people, their only saving is to buy a house and to make the mortgage payments on it. Apart from that, practically their entire income is consumed. Since for the majority of people their incomes are quite stable and since almost all their income is consumed, the consumption and saving schedules are also quite stable. After all, most consumption is for the essentials of food, shelter, and clothing. These cannot vary much. Investment, on the other hand, is variable because, unlike consumption, it can be put off. In good times, with demand strong and rising, businesses will bring in more machines and replace old ones. In times of economic downturn, no new machines will be ordered. A firm can continue for years with, say, a tenth of the investment it was carrying out in the boom. Very few families could cut their consumption so drastically. New business ideas and the innovations that spring from them do not come at a constant rate. This is another reason for the irregularity of investment. Profits and the expectations of profits also vary. Since profits, in the absence of easy access to borrowed money, are essential for investment and since, moreover, the object of investment is to make a profit, investment, too, must vary. 9-7 (Key Question) Assume there are no investment projects in the economy which yield an expected rate of return of 25 percent or more. But suppose there are $10 billion of investment projects yielding expected rate of return of between 20 and 25 percent; another $10 billion yielding between 15 and 20 percent; another $10 billion between 10 and 15 percent; and so forth. Cumulate these data and present them graphically, putting the expected rate of net return on the vertical axis and the amount of investment on the horizontal axis. What will be the equilibrium level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent, and (c) 5 percent? Explain why this curve is the investmentdemand curve. See the graph on following page. Aggregate investment: (a) $20 billion; (b) $30 billion; (c) $40 billion. This is the investment-demand curve because we have applied the rule of undertaking all investment up to the point where the expected rate of return, r, equals the interest rate, i. 9-8. Explain graphically the determination of the equilibrium GDP for a private closed economy. Explain why the intersection of aggregate expenditures schedule and the 45-degree line determines the equilibrium GDP. These two approaches must always yield the same equilibrium GDP because they are simply two sides of the same coin, so to speak. Equilibrium GDP is where aggregate expenditures equal real output. Aggregate expenditures consist of consumer expenditures (C) + planned investment spending (Ig). If there is no government or foreign sector, then the level of income is the same as the level of output. In equilibrium, Ig makes up the difference between C and the value of the output. If we let Y be the value of the output, which is also the value of the real income, then whatever households have not spent is Y - C = S. But at equilibrium, Y - C also equals Ig so at equilibrium the value of S must be equal to Ig. This is another way of saying that saving (S) is a leakage from the income stream, and investment is an injection. If the amount of investment is equal to S, then the leakage from saving is replenished and all of the output will be purchased which is the definition of equilibrium. At this GDP, C + S = C + Ig, so S = Ig. Alternatively, one could explain why there would not be an equilibrium if (a) S were greater than Igor (b) S were less than Ig. In case (a), we would find that aggregate spending is less than output and output would contract; in (b) we would find that C + Ig would be greater than output and output would expand. Therefore, when S and Ig are not equal, output level is not at equilibrium. The 45-degree line represents all the points at which real output is equal to aggregate expenditures. Since this is our definition of equilibrium GDP, then wherever aggregate expenditure schedule coincides (intersects) with the 45-degree line, there is an equilibrium output level. 9-9 (Key Question) Assuming the level of investment is $16 billion and independent of the level of total output, complete the following table and determine the equilibrium levels of output and employment which this private closed economy would provide. What are the sizes of the MPC and MPS? Possible levelsof employment(millions) Real domesticoutput (GDP=DI)(billions) Consumption(billions) Saving(billions) 404550556065707580 $240260280300320340360380400 $244260276292308324340356372 $ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____$ _____ Saving data for completing the table (top to bottom): $-4; $0; $4; $8; $12; $16; $20; $24; $28. Equilibrium GDP = $340 billion, determined where (1) aggregate expenditures equal GDP (C of $324 billion + I of $16 billion = GDP of $340 billion); or (2) where planned I = S (I of $16 billion = S of $16 billion). Equilibrium level of employment = 65 million; MCP = .8; MPS = .2. 9-10 (Key Question) Using the consumption and saving data given in question 9 and assuming the level of investment is $16 billion, what are the levels of saving and planned investment at the $380 billion level of domestic output? What are the levels of saving and actual investment at that level? What are saving and planned investment at the $300 billion level of domestic output? What are the levels of saving and actual investment? Use the concept of unplanned investment to explain adjustments toward equilibrium from both the $380 and $300 billion levels of domestic output. At the $380 billion level of GDP, saving = $24 billion; planned investment = $16 billion (from the question). This deficiency of $8 billion of planned investment causes an unplanned $8 billion increase in inventories. Actual investment is $24 billion (= $16 billion of planned investment plus $8 billion of unplanned inventory investment), matching the $24 billion of actual saving. At the $300 billion level of GDP, saving = $8 billion; planned investment = $16 billion (from the question). This excess of $8 billion of planned investment causes an unplanned $8 billion decline in inventories. Actual investment is $8 billion (= $16 billion of planned investment minus $8 billion of unplanned inventory disinvestment) matching the actual of $8 billion. When unplanned investments in inventories occur, as at the $380 billion level of GDP, businesses revise their production plans downward and GDP falls. When unplanned disinvestments in inventories occur, as at the $300 billion level of GDP; businesses revise their production plans upward and GDP rises. Equilibrium GDP—in this case, $340 billion—occurs where planned investment equals saving. 9-11 Why is saving called a leakage? Why is planned investment called an injection? Are unplanned changes in inventories rising, falling, or constant at equilibrium GDP? Explain. Saving is like a leakage from the flow of aggregate consumption expenditures because saving represents income not spent. Planned investment is an injection because it is spending on capital goods that businesses plan to make regardless of their current level of income. At equilibrium GDP there will be no changes in unplanned inventories because expenditures will exactly equal planned output levels which include consumer goods and services and planned investment. Thus there is no unplanned investment including no unplanned inventory changes. 9-12 “Planned investment is equal to saving at all levels of GDP; actual investment equals saving only at the equilibrium GDP.” Do you agree? Explain. Critically evaluate: “The fact that households may save more than businesses want to invest is of no consequence, because events will in time force households and businesses to save and invest at the same rates.” You should not agree. The statement is backward—reverse the placement of the planned investment and actual investment. Actual investment is always present—it is the amount that actually takes place at any output level because it includes unintended changes in inventories (a type of investment) as well as the level of planned investment. If saving is greater than planned investment, the total level of aggregate spending will not be enough to support the existing level of output, causing businesses to reduce their output. If saving is less than planned investment, the total level of aggregate expenditures will be greater than the existing output level and inventories will drop below the planned level of inventory investment, causing businesses to increase their output to replenish their inventories. The only stable output level will be the equilibrium level, at which saving and planned investment are equal. The events described in the second quote are predictable, but most would argue that this is of great consequence. When households save more than businesses want to invest, it means they are consuming less. This, in turn, means that aggregate spending (consumption plus investment) will be less than the level of output and current real income. Businesses will experience unplanned inventory buildup and will cut their output levels, which means a decline in employment. The resulting unemployment is not inconsequential—especially to those who lose their jobs, but also in terms of lost potential output for the entire economy. 9-13 Advanced analysis: Linear equations (see appendix to Chapter 1) for the consumption and saving schedules take the general form C = a + bY and S = a + (1 b)Y, where C, S, and Y are consumption, saving, and national income respectively. The constant a represents the vertical intercept, and b is the slope of the consumption schedule. a. Use the following data to substitute specific numerical values into the consumption and saving equations. National Income (Y) Consumption (C) $ 0100200300400 $ 80140200260320 b. What is the economic meaning of b? Of (1 b)? c. Suppose the amount of saving that occurs at each level of national income falls by $20, but that the values for b and (1 b) remain unchanged. Restate the saving and consumption equations for the new numerical values and cite a factor which might have caused the change. (b) Since b is the slope of the consumption function, it is the value of the MPC. (In this case the slope is 6/10, which means for every $10 increase in income (movement to the right on the horizontal axis of the graph), consumption will increase by $6 (movement upwards on the vertical axis of the graph). (1 - b) would be 1 - .6 = .4, which is the MPS. Since (1 b) is the slope of the saving function, it is the value of the MPS. (With the slope of the MPC being 6/10, the MPS will be 4/10. This means for every $10 increase in income (movement to the right on the horizontal axis of the graph), saving will increase by $4 (movement upward on the vertical axis of the graph). (c) A factor that might have caused the decrease in saving—the increased consumption—is the belief that inflation will accelerate. Consumers wish to stock up before prices increase. Other factors might include a sudden decline in wealth or increase in indebtedness, or an increase in personal taxes. 9-14 Advanced analysis: Suppose that the linear equation for consumption in a hypothetical economy is C = $40 + .8Y. Also suppose that income (Y) is $400. Determine (a) the marginal propensity to consume, (b) the marginal propensity to save, (c) the level of consumption, (d) the average propensity to consume, (e) the level of saving, and (f) the average propensity to save. (a) (b) (c) (d) (e) (f) 9-15 Advanced analysis: Assume that the linear equation for consumption in a hypothetical private closed economy is C = 10 + .9Y, where Y is total real income (output). Also suppose that the equation for investment is Ig = Ig0 = 40, meaning that Ig is 40 at all levels of real income (output). Using the equation Y = C + Ig, determine the equilibrium level of Y. What are the total amounts of consumption, saving, and investment at equilibrium Y? To obtain these results, recognize that at equilibrium aggregate demand (C + Ig) must equal Y which represents output. Therefore the solution for equilibrium Y is where: Since saving equals Investment at equilibrium, S = 40 9-16 (Last Word) What is Say’s law? How does it relate to the view held by classical economists that the economy generally will operate at a position on its production possibilities curve (Chapter 2). Use production possibilities to demonstrate Keynes’s view on this matter. Say’s law states that “supply creates its own demand.” People work in order to earn income to and plan to spend the income on output – why else would they work? Basically, the classical economists would say that the economy will operate at full employment or on the production possibilities curve because income earned will be recycled or spent on output. Thus the spending flow is continuously recycled in production and earning income. If consumers don’t spend all their income, it would be redirected via saving to investment spending on capital goods. The Keynesian perspective, on the other hand, suggests that society’s savings will not necessarily all be channeled into investment spending. If this occurs, we have a situation in which aggregate demand is less than potential production. Because producers cannot sell all of the output produced at a full employment level, they will reduce output and employment to meet the aggregate demand (consumption plus investment) and the equilibrium output will be at a point inside the production possibilities curve at less than full employment.