Chapter 21 Consumption and Investment

Major components of national output and private spending- Consumption and Investment
Part of output not consumed- saving and investment
consumption grows , total spending or aggregate demand increases , SHORT RUN output and
employment
A. Consumption and Saving
Personal consumption expenditures- expenditures by households on final goods and services
Saving - part of personal disposable income that is not consumed.
Consumption - largest single component of GDP
Categories of consumption
1. Durable goods - motor vehicles, furniture
2. Nondurable goods- food, energy goods
3. Services - housing, medical care
I.

II.

Budgetary Expenditure Patterns

As income , Proportion of total spending devoted to food declines
After-tax income, Expenditure on clothing, recreation, and automobiles increases more than
proportionately
Engels Laws - After Ernst Engel. The average behavior of consumption expenditure does change fairly
regularly with income
Saving rises as income increases (Saving is the greatest luxury of all.)
Consumption, Income, and Saving
Personal saving - part of Disposable Income that is not consumed
DISPOSABLE INCOME = SAVING + CONSUMPTION or SAVING = DI - CONSUMPTION
Personal income is composed of wages, fringe benefits, interests, rents, dividends, transfer payments, and
so forth
DISPOSABLE PERSONAL INCOME = PERSONAL INCOME PERSONAL TAXES
PERSONAL SAVING = DISPOSABLE PERSONAL INCOME PERSONAL OUTLAYS (consumption
and interest)
Personal Saving Rate is equal to personal saving as a percent of disposable income
Income is the primary determinant of consumption and saving
Break-even point- household neither saves nor dissaves (net saving) but consumes all its income

III. The Consumption Function

Consumption Function - shows the relationship between the level of consumption expenditures and the
level of disposable personal income
Disposable Income (DI) on the HORIZONTAL (x) axis and Consumption (C) on the VERTICAL (y)axis
(direct relationship, consumption rises with increases in DI )
The 45 line helps locate the break-even point and helps our eye measure net saving.
a) The "Break-Even" Point
- consumption exactly equals the distance across from the vertical axis (disposable income)
- whether consumption spending is equal to, greater than, or less than the level of disposable
-

income
it is the level of disposable income at which households just break even
consumption expenditures exactly equal disposable income
the household is neither a borrower nor a saver
Amount of saving or dissaving is measured by the vertical distance between the consumption

function and the 45 line

ON the 45 line, ZERO savings, CONSUMPTION = INCOME
ABOVE the 45 line, NEGATIVE (-) savings, CONSUMPTION > INCOME
BELOW the 45 line, POSITIVE + savings, CONSUMPTION < INCOME
IV. The Saving Function
Saving Function shows the relationship between the level of saving and income
Saving Function = 45 line (-) consumption function vertically
Saving schedule = Income (-) Consumption .... subtract consumption from income
V. The Marginal Propensity to Consume
extra amount that people consume when they receive an extra dollar of disposable income.
"Marginal" means "extra or additional"
"marginal cost" the additional cost of producing an extra unit of output
"Propensity to consume" designates the desired level of consumption
Marginal Propensity to Consume as Geometrical Slope
- slope of the consumption function is the same as the marginal propensity to consume. For curved
lines, we calculate the slope as the slope of the tangent line at a point.
The slope of the consumption function, which measures the change in consumption per dollar change in
disposable income, is the marginal propensity to consume
VI. The Marginal Propensity to Save

definedasthefractionofanextradollarofdisposableincomethatgoestoextra
saving.
Eachextradollarofdisposableincomemustbedividedbetweenextra
consumptionandextrasavingsoMPS + MPC = 1 ALWAYS
Example in the table
(1) DI For column
(after
(1)
taxes)
x axis
A 24,00
B 25,000
0
(-) A 24,000
=1000
B 25,00
0

(2) Consumption
(C) expenditure
y axis
24,200
25,000

For
column (2)

(3) MPC
y
x

B 25,000
(-) A 24,200
= 800

(col. 2) 800
(col. 1) 1,000
= 0. 80 (constant)

(4) Net
saving
DI-C
(4)=(1)-(2)
-200

(5) MPS
y -> (4)
x -> DI (1)

200
1,000 = 0.20

200
1,000 = 0.20

VII. Brief Review of Definitions

1. The consumption function relates the level of consumption to the level of
disposable income.
2. The saving function relates saving to disposable income. Because what is
saved equals what is not consumed, saving and consumption schedules
are mirror images.
3. The marginal propensity to consume (MPC) is the amount of extra
consumption generated by an extra dollar of disposable income.
Graphically, it is given by the slope of the consumption function.

4. The marginal propensity to save (MPS) is the extra saving generated by

an extra dollar of disposable income. Graphically, this is the slope of the
saving schedule.
5. Because the part of each dollar of disposable income that is not
consumed is necessarily saved, MPS= 1- MPC.
VIII. National Consumption Behavior
Short run- consumption is a major component of aggregate spending,
will affect output and employment through the AD
Consumptionandsavingbehaviorarekeytounderstandingeconomicgrowthand

businesscycles.
IX. Determinants of Consumption
1. Disposable Income
Increases in DI ( tax cuts) , stimulate consumption growth
DI declines in recessions , consumption usually follows the decline
2. Permanent Income and the Life-Cycle Model of Consumption (expectations of future income)
Permanent Income - income after removing temporary or transient influences due to windfall gains or
losses
Permanent-income theory - consumption responds primarily to permanent income and consumers do not
respond equally to all income shocks. If transitory (one-time bonus) larger amount of income may be saved
Life-cycle hypothesis- people save in order to smooth their consumption over their life- time. Social
Security provides an income supplement for retirement.
3. Wealth and Other Influences
Wealth effect- Higher wealth leads to higher consumption
X. The National Consumption Function

Fitted consumption function - showshowcloselyconsumptionhasfollowed

disposableincomeovertheperiodshown
Potential Causes for a sharp decline in the Personal Savings Rate (PRC)
1. Social security (less need to save for retirement because government
collects social security taxes and pays out social security benefits)
2. Financial Markets - new loan instruments like credit cards encouraged
people to borrow
3. Rapid growth in paper wealth - stock market boom, rise is stock prices and
prices of existing assets (couldnotconverttheirpaperwealthintoconsumption)
XI. Alternative Measures of Saving
National- accounts measure of saving = DI (excluding capital gains) consumption
Balance-sheet measure of saving showshowcloselyconsumptionhas

followeddisposableincomeovertheperiodshown
B. Investment
2 roles in macroeconomics

1. investment often leads to changes in aggregate demand and affects

the business cycle (short-run output through its impact on AD)
2. leadstocapitalaccumulation(longrunoutputgrowthonpotentialoutputand

aggregatesupply)

"Investment" in Economics- additionstothestockofproductiveassetsorcapital

goods

I. Determinants of Investment

1. Revenues- overalllevelofoutput(orGDP
2. Costs- interest rates and taxes influence costs
3. Expectations- profit expectations and business confidence
II. Investment Demand Curve
Toshowtherelationshipbetweeninterestratesandinvestment
Demandforinvestmentscheduleamountofinvestmentateachinterestrateis

DOWNWARD
ShiftsintheInvestmentDemandCurve
a. HigheroutputorhigherlevelofGDPSHIFTOUT(RIGHT)
b. HigherTaxesoncapitalincomeSHIFTIN(LEFT)
c. BusinesseuphoriaornewbusinessSHIFTOUT(RIGHT)
Chapter 22 Business Cycles and Aggregate Demand
A. WHAT ARE BUSINESS CYCLES?
economy wide fluctuations in total national output, income, and
employment, usually lasting for a period of 2 to 10 years, marked by
widespread expansion or contraction in most sectors of the economy.
2 main phases
a. Recession- recurringperiodofdeclineintotaloutput,income,and

employment,usuallylastingfrom6to12monthsandmarkedbycontractionsin
manysectorsoftheeconomy.whenrealGDPhasdeclinedfortwoconsecutive
calendarquarters.*DepressionArecessionthatislargeinbothscaleandduration
b. Expansion
Characteristics of a recession:

1. Investmentusuallyfallssharply
2. Employmentusuallyfallssharply
3. Asoutputfalls,inflationslowsandthedemandforcrudematerialsdeclines,and

materialspricestumble.
4. Businessprofitsfallsharply
5. theFederalReservebeginstolowershortterminterestratestostimulate
investment,andotherinterestratesdeclineaswell.

1.
2.

I. BUSINESS-CYCLE THEORIES
Exogenous- outsidetheeconomicsystem
Internal- withintheeconomicsystemitself
II. Financial Crises and Business Cycles
1. Panics of Early Capitalism
2. Hyperinflation occurs when prices rise at 100 per- cent or more per month
3. The New-Economy Bubble - speculative boom in new- economy stocks
4. The Housing Bubble- financial securitization." home mortgage was sold
on securities markets. Many securities lost value "junk bonds"
B. AGGREGATE DEMAND AND BUSINESS CYCLES
I. THE THEORY OF AGGREGATE DEMAND
Aggregatedemand(orAD)isthetotaloraggregatequantityofoutputthatis

willinglyboughtatagivenlevelofprices,otherthingsheldconstant
4Components

1. Consumption - disposable income, which is personal income less taxes.

- real consumption (that is, nominal or dollar consumption divided by the
price index for consumption).
2. Investment - can affect monetarypolicy.
3. Governmentpurchases
4. Net exports -

THEDOWNWARDSLOPINGAGGREGATEDEMAND
CURVE
II.

levelofrealspendingdeclinesastheoverallpricelevelintheeconomyrises.
Personalincomemightbesetinnominaldollartermsgovernmenttransferpayments,

theminimumwage,andcompanypensions
pricelevelgoesup,realdisposableincomefalls
TheADcurveslopesdownward.Thisdownwardslopeimpliesthatrealspending
declinesasthepricelevelrises,otherthingsheldconstant.Realspendingdeclineswitha
higherpricelevelprimarilybecauseoftheeffectofhigherpricesonrealincomesand
realwealth.
III.ShiftsinAggregateDemand
Variable

ImpactonADPolicyVariables(government
control)

MonetaryPolicy(CB)

MonetaryExpansionmaylowerinterestrates
andloosencreditconditions.higherlevelsof
investmentandconsumptionofdurable
goods.

FiscalPolicy(Taxesandgovernment
expenditures)

Increasesingovernmentpurchasesofgoods
andservicesdirectlyincreasespending;tax
reductionsorincreasesintransfersraise
disposableincomeandinducehigher
consumption.Taxincentiveslikean
investmenttaxcreditcaninducehigher
spendinginaparticularsector.

Variable

ExogenousVariables

Foreignoutput

Outputgrowthabroadleadstoanincreasein
netexports.

Assetvalues

Riseinstockmarketincreaseshousehold
wealthandtherebyincreasesconsumption;
also,higherstockpriceslowerthecostof
capitalandtherebyincreasebusiness
investment.

Advancesintechnology

Technologicaladvancescanopenupnew
opportunitiesforbusinessinvestment.

Others

Weatherlowerfoodprices,increasein
worldoilproductionandlowersoilprices,
defeatgovernmentstimulatesforeign
investment,

Reminder
1.DemandCurvehasthepriceofanindividualcommodityontheverticalaxisand
productionofthatcommodityonthehorizontalaxis,withallotherpricesandtotalconsumer
incomesheldconstant.
Aggregate Demand Curve- the general price level is on the vertical axis,
while total output and incomes vary along the horizontal axis.
microeconomic demand curve- total incomes and output are held constant

IV. Business Cycles and Aggregate Demand

- a higher price level with given nominal money incomes lowers real
disposable income; this leads to higher interest rates and declining spending
on interest-sensitive investment and consumption (MOVEMENT ALONG THE
AD CURVE)
- other things are no longer constant. Changes in variables underlying AD
such as the money supply, tax policy, or military spendinglead to changes
in total spending at a given price level. This leads to a SHIFT OF the AD
curve.
C. THE MULTIPLIER MODEL
- used to explain how output is determined in the short run
- "Multiplier" each dollar change in exogenous expenditures (such as
investment) leads to more than a dollar change (or a multiplied change) in
GDP
I. OUTPUT DETERMINED BY TOTAL EXPENDITURES
Total Expenditure approach - analyzes how investment and consumption
spending interact with incomes to determine national output.
Consumption function- shows the desired consumption corresponding to
each level of income. Omitted taxes, transfers, and other items, so that
personal income equals national income, and national income equals GDP
Keynesian cross - output equals expenditure when the expenditure curve
crosses the 45 line
Total expenditure curve (TE) - shows the level of expenditure desired or
planned by consumers and businesses corresponding to each level of output.
The economy is in equilibrium at the point where the TE= C+ I curve crosses
the 45 lineat point E. Point E is the macroeconomic equilibrium because at
that point, the level of desired expenditure on consumption and investment
exactly equals the level of total output.
II. Reminder on the Meaning of Equilibrium
Equilibrium- level of output is one where the different forces of spending and
output are in balance
III. The Adjustment Mechanism
Adjustment of output - a discrepancy between total planned expenditure and
total output
Equilibrium- sales are equal to their forecasts
The equilibrium level of GDP occurs at point E, where planned spending
equals planned production. Only when the level of actual output in column
(5) exactly equals planned expenditure (TE) in column (6) will the economy
be in equilibrium. In equilibrium, and only in equilibrium, business sales will
be exactly sufficient to justify the current level of aggregate output. In
equilibrium, GDP will neither expand nor contract.

IV. THE MULTIPLIER

- The multiplier is the impact of a 1-dollar change in exogenous expenditures
on total output. In the simple C I model, the multiplier is the ratio of the
change in total output to the change in investment.
- "Multiplier" - the change in output per unit change in exogenous
expenditure. We are taking certain components of spending as given outside
the model. If the MPS were 1/x, the multiplier would be x. multiplier is always
the inverse, or reciprocal, of the marginal propensity to save. It is thus equal
to 1/ (1- MPC).
Formula:
V. The Multiplier Model Compared with the AS-AD Model
- AS curve that becomes completely vertical when output equals potential
output.
- AD shifts to the right when investment increases, equilibrium output rises
D. FISCAL POLICY IN THE MULTIPLIER MODEL
- use the multiplier model to show how government purchases affect output.
I. HOW GOVERNMENT FISCAL POLICIES AFFECT OUTPUT
- TE= C+ I+ G
- Lump-sum taxes- taxes that do not change with income or other economic
variables
- GDP equals disposable income plus taxes. We can plot CC consumption
schedule against GDP rather than DI
- pile on top. if you compute GDP to be = C + I + G = TE. E moves upward
II. Impact of Taxation on Aggregate Demand
- Multiplier model - higher taxes (net taxes= taxes- transfer payments)
without increases in government purchases will tend to reduce real GDP
III.

FISCALPOLICYMULTIPLIERS

governmentexpendituremultiplierincreaseinGDPresultingfromanincreaseof$1
ingovernmentpurchasesofgoodsandservices
expendituremultipliersgovernmentexpendituremultiplierisexactlythesamenumber
astheinvestmentmultiplier
Governmentpurchasesofgoodsandservices(G)areanimportantforceindetermining
outputandemployment.Inthemultipliermodel,ifGincreases,outputwillrisebythe
increaseinGtimestheexpendituremultiplier.Governmentpurchasesthereforehave
thepotentialtoincreaseordecreaseoutputoverthebusinesscycle.

IV.ImpactofTaxes

Taxchangesareapowerfulweaponinaffectingoutput.Butthetaxmultiplierissmaller
thantheexpendituremultiplierbyafactorequaltotheMPC:
TaxmultiplierMPCXexpendituremultiplier

V.TheMultiplierModelandtheBusinessCycle