ECON 201 - CHAPTER 11

Aggregate

1. (n.) a whole or total (The three branches of the U.S. Government form an aggregate much more powerful than its individual parts.) 2. (v.) to gather into a mass (The dictator tried to aggregate as many people into his army as he possibly could.) aka TOTAL

Accelerator Principle

A higher expected future growth rate of real GDP results in a higher level of planned investment spending, but a lower expected future growth rate of real GDP leads to lower planned investment spending. --> This can potentially accelerate an economy's slide into recession similar to the effects of the 2006 housing boom crisis. The effects of the accelerator principle play an important role in "investment spending slumps," otherwise known as periods of low investment spending.

Consumption Function (MICROECONOMIC)

An equation showing how an individual household's consumer spending varies with the household's current disposable income. Current disposable income and consumer spending have a positive relationship, meaning the higher the disposable income the higher the spending. Simplest Version: c = a + (MPC * yd) -> c = individual household consumer spending -> yd = individual household current disposable income -> MPC = Marginal Propensity to Consume (amount by which consumer spending rises if current disposable income rise by $1) -> a = Individual household autonomous consumer spending (the amount of spending a household would do if it had zero disposable income) --> We assume that a is greater than 0 (if 0 then house can fund consumption with savings and borrowing) GRAPH: -> Y-Intercept: Autonomous Consumer Spending (a) = Consumer Spending (c) when Disposable Income (yd) = 0 -> Slope: MPC (rise over run) MPC = change in consumer spending/change in disposable income MPC = ∆c/∆yd ∆yd * MPC = ∆c Meaning that when disposable (yd) income goes up by $1, consumer spending (c) goes up by MPC * $1

Autonomous Change in Aggregate Spending

An initial rise or fall in the desired aggregate spending (spending by firms, households, or gov.) at a given level of real GDP. Autonomous -> Self-Governing -> B/c its the cause, not result of the chain reaction. ex. household, business, government, and foreign expenditures -> not affected by changes in spending because they are the changes ____________________________________________________________ Change in the desired level of spending by firms, households, and government at any given level of real GDP (--> stray away from gov. on these assumptions)

End of Section 11-1 Extras

Change in investment spending arises from a change in expectation! Initial change in real GDP (consumption + investment) leads to changes in consumer spending -> chain reaction. Total change in aggregate (total) output is multiple of the initial change in investment spending. Any autonomous change in aggregate spending is is not caused by the real GDP -> Generates similar chain reaction. Total size of change in real GDP depends on size of multiplier. No taxes and no trade, the multiplier is: (1/(1-MPC)) with MPC meaning Marginal Propensity to Consume. Total change in real GDP, ∆Y is equal to (1/(1-MPC)) * ∆AAS

End of Section 11-3 Extras

Consumer spending is larger than investment spending. However, booms and busts in investment spending are what drives the business cycle. -> Fall in recessions generally caused by decreased investment spending Due to multiplier (chain reaction) process, economists believe that declines in consumer spending are the result of a process that begins with a slump in investment spending. Planned investment spending is negatively related to the interest rate and positively related to expected future real GDP. According to accelerator principle, positive relationship between planned investment spending and expected future growth rate of real GDP. Firms hold inventories, inventories are investments. The only investments can be negative. Actual Investment Spending = Planned Investment Spending + Unplanned Inventory Investment Spending ----> Done to account for alterations in investments due to varying inventory factors that are difficult to determine sometimes.

Inventories

Def: Stocks of goods held to satisfy future sales. - Held so firms can quickly satisfy buyers. - Businesses hold inventories of their inputs to be sure they have a steady supply of necessary materials and spare parts. A firm that increases its inventories is engaging in a form of investment spending.

Keynesian Cross

Diagram identifies income-expenditure equilibrium as the point where the planned aggregate spending like crosses the 45-degree line.

End of Section 11-2 Extras

Disposable Income = Income after taxes are paid and government transfers are received. Consumption function shows relationship between individual household's (microeconomics) current disposable income and its consumer spending. Aggregate consumption function shows relationship between disposable income and its consumer spending across the economy (macroeconomics). --> This function can shift based on expected future disposable income and changes in aggregate wealth.

Actual Investment Spending

In any given period, the sum of planned investment spending and unplanned inventory investment changes. Relationship: I = I(unplanned) + I(planned)

End of Section 11-4 Extras

Income-Expenditure Model Recall assumptions underlying the multiplier process: 1. Changes in overall spending lead to changes in aggregate output. Changes in spending thus change to changing in output rather than overall altering prices. This means nominal GDP and real GDP can be used interchangeably. 2. The interest rate is fixed. Rate is predetermined and cannot be effected. 3. Taxes and government transfers/purchases are all zero. 4. Exports and imports are all zero. ************ In this economy, only two sources of aggregate spending: consumer spending (C) and Investment Spending (I). ---> GDP = C + I No taxes/gov. transfer so aggregate disposable income is equal to nominal/real GDP: the total value of final sales of goods and services ultimately accrues to households as income. ---> YD = GDP Aggregate Consumption Function(relationship between disposable income and consumer spending): ---> C = A + MPC*YD

Unplanned Inventory Investment

Occurs when actual sales are more or less than businesses expected, leading to unplanned changes in inventories. They represent investment spending, positive or negative, that occurred but was unplanned. When this occurs, businesses with adjust to progress of sales and unplanned inventory. Rising Inventories: Indicate positive unplanned inventory investment and a slowing economy as sales are less forecast. Falling Inventories: Indicate negative unplanned inventory investment and a growing economy as sales are greater than forecast.

Income-Expenditure Equilibrium

Only situation in which firms wont have an incentive to change output is when planned aggregate spending on final goods and services equals aggregate output (real GDP) in the current period. ---> aka Real GDP = Planned Aggregate Spending (AE(planned)). No unplanned inventory investment. Firms will constantly move to adjust inventory output in order to compensate for unplanned inventory investments, however that is not the case in this situation. GRAPHING: -> X-Axis: Real GDP -> Y-Axis: Planned Aggregate Spending -> Slope: MPC -> Y-Intercept: Autonomous Consumer Spending (A) + Planned Investment (I(planned)) ---> (c=a+MPC*yd so when YD = 0 b/c output = 0 then you need to add what the planned investment to the consumer spending (c) will be!) -> Solid Line: Planned Aggregate Spending Line ----> Shows: AE(planned) = C + I(planned) and depends on real GDP ---> (real GDP = C) -> Dashed Line: Goes through origin; 45-Degrees; MPC = 1 ----> Shows: All the possible points at which planned aggregate spending is equal to real GDP INTERPRETATION OF GRAPH: -> Income-Expenditure Equilibrium lies where Real GDP and Planned Aggregate Spending lines intersect. -> Income-Expenditure Equilibrium GDP (Y*) is the x-coordinate of where the Real GDP and Planned Aggregate Spending lines intersect. -> No Income-Expenditure Equilibrium if Real GDP and Planned Aggregate Spending don't intersect. -> Negative Unplanned Inventory Investment Spending when the Real GDP lies below the Income-Expenditure Equilibrium GDP because that is where the Planned Aggregate Spending lies above the 45-Degree line and AE(planned) exceeds real GDP (remember, negative if Real GDP < AE(planned)). ----> RESULT IN ECONOMY: As a consequence, real GDP will rise. -> Positive Unplanned Inventory Investment Spending when the Real GDP lies above the Income-Expenditure Equilibrium GDP because that is where the Planned Aggregate Spending lies below the 45-Degree line and AE(planned) does NOT exceed real GDP (remember, positive if Real GDP > AE(planned)). ----> RESULT IN ECONOMY: The unanticipated accumulation of inventory will lead to a fall in real GDP. ___________________________________________________________ ~ Two Possible Reasons for Shift in AE(spending) Line: 1) A change in planned investment spending (I(planned)) ---> Change in interest rate -> Change in I(planned) 2) Shift of the Aggregate Consumption Function (CF) ---> Change in Y-Intercept ---> Change in aggregate wealth ---> When this line shifts, there is an Autonomous Change in Planned Aggregate Spending

Planned Investment Spending

Spending on investment projects that firms voluntarily decided whether or not to undertake is based on the interest rate and expected future real GDP. Planned Investment Spending is negatively related to interest rates, the higher the rate, the lower the investments and vice versa. **Factors that determine investment spending: interest rate and expected future real GDP. -> Clearest effect on investment spending on residential construction aka construction of homes. Home owners only build houses they can sell and considering houses are more affordable when interest rates are low, they are more likely to attract customers. --> Other investments affected: Firms will only go ahead with an investment project if they expect a higher rate of return. ---> As interest rates rise for loans for projects, harder to earn a larger rate of return therefore less projects are passed. Thus, investment spending decrease.-----> If retained earnings are used on investment projects then you still need to factor in opportunity cost of profit. --> Retained Rate of Return vs. Market Interest Rate ----> Rise in MIR results in a less profitable project, fall in rate would allow some investment projects to become profitable. -> Expected future real GDP The level of investment spending businesses ACTUALLY carry out is sometimes not the same level as "planned investment spending."

Income-Expenditure Equilibrium GDP

The LEVEL of real GDP at which real GDP equals planned aggregate output (planned aggregate spending).

Marginal Propensity to Consume (MPC)

The increase in consumer spending when disposable income rises by $1 When consumer spending changes because of a rise or fall in disposable income, MPC is: (change in consumer spending)/(change in disposable income) Number between 1 and 0.

Marginal Propensity to Save (MPS)

The increase in household savings when disposable income rises by $1. The additional disposable income that consumers don't spend, because consumers normally only use part of their disposable income. 1 - MPC

Multiplier

The ratio of the total change in real GDP caused by the autonomous change in the aggregate spending to the size of that change. B/c no taxes and international trade assumed, each $1 increase in aggregate spending raises both real GDP and disposable income by $1. This would develop into a cycle-chain reaction leading to our "Total increase in Real GDP" formula: (1/(1-MPC)) * $$$ ∆Y = Change in Real GDP ∆AAS = Autonomous Change in Aggregate Spending ∆Y = (1/(1-MPC)) * ∆AAS So, Multipler = Change in Real GDP/Autonomous Change in Aggregate Spending -> Multipler = ∆Y/∆AAS = (1/(1-MPC)) Size of the multiplier depends on MPC -> Higher the MPC, higher the multiplier -> Higher the MPC, the less disposable income "leaks out" into the savings at each round of expansion -> Less MPS -> And vice-versa Multiplier effects magnifies the size of an initial change in aggregate spending in our economy. **Remember, assuming no taxes, no international trade, and increases in both investment spending and consumer spending are accounted for. ---> When taxes ARE included, expression for multiplier becomes more complicated. It also becomes smaller! ***For analysis we assume: 1. Producers are willing to supply additional output at a field price (prices will not drive up). Changes in aggregate spending translate into changes in aggregate output. 2. Interest rate is given 3. No gov spending and taxes 4. Exports and imports are zero.

Aggregate Consumption Function (MACROECONOMIC)

The relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending. C = A + MPC*YD -> C = (Aggregate) Consumer Spending -> YD = (Aggregate) Disposable Income -> MPC = Marginal Propensity to Consumer -> A = (Aggregate) Autonomous (self-governing) Consumer Spending (the amount of consumer spending when disposable income equals zero) GRAPH (SHIFTS): -> When things other than disposable income change, the aggregate consumption function shifts -> 2 MAIN REASONS FOR SHIFTS: --> 1) Changes in expected future disposable income ---> Knowing higher disposable income is coming (up) ---> May get fired/lose job, less spending (down) People with higher incomes tend to save more. In general, if higher income then you are having unusually good year (surge in investments). Low income, having unusually bad year (laid-off). If income is high, you same more because your expected disposable income is to decrease. ------ Thus, higher current incomes lead to higher savings today, but higher expected future income leads to less savings today. MEANING: Weak relationship between current income and savings rate b/c previous statements contradict one another. **Permanent Income Hypothesis -> Consumer spending ULTIMATELY depends mainly on the income people expect to have over the long term rather than on their current income --> 2) Changes in aggregate wealth: YD constant, the higher the wealth, the more consumer spending (up) ---> Rise in aggregate wealth, increases autonomous consumer spending (shifts up) -> (ex. booming stock market) ---> Decline in aggregate wealth, decrease autonomous consumer spending (shifts down) -> (ex. fall in house prices) **Life-Cycle Hypothesis -> Consumers plan their spending over a life time, not just in response to their current disposable income. As a result, people try to smooth their consumption over lifetimes.

Planned Aggregate Spending

The total amount of planned spending in the economy. The sum of consumer spending and planned investment spending. AE(planned) = Planned Aggregate Spending AE(planned) = C + I(planned) GRAPH/TABLE: Aggregate Consumption Function and Planned Aggregate Spending (linear) -> Consumer Spending (C) relies on real GDP. -> Planned Aggregate Spending (AE(planned)) corresponds to the Aggregate Consumption Function (CF) shift (up or down) by the amount of Planned Investment (I(planned)). -> Planned Aggregate Spending (AE(planned)) relies on Real GDP. -> Both AE(planned) and I(planned) have the same slope, MPC. Planned aggregate spending can differ from real GDP for brief periods of time ONLY if there is unplanned inventory investment in the economy. ***Note: Households don't take unintended actions like unplanned inventory investment spending into consideration. ****In a graph, CF is the Aggregate Consumption Function __________________________________________________________ If a positive unplanned inventory Investment (real GDP > AE(planned)) then sales were overestimated and produced too much inventory. (and vice versa.) ----> Real GDP > AE(planned) = Positive I(unplanned) ----> Real GDP < AE(planned) = Negative I(unplanned)

Inventory Investment

The value of the change in total inventories held in the economy during a given period. This can be negative unlike other investments. I.e., if the auto industry reduces its inventory over the course of a month, it has engaged in "negative inventory investment." Excess inventories can be bad as well, products may go waste or be overwhelming (for ppl, space of store, etc.)

EXTRA NOTES

~ Important feature of macroeconomy: When planned spending by households and firms does not equal the current aggregate output by firms, this difference shows up in changes in inventories! ~ Changes in inventories are a leading indicator of future economic activity. ~ Multiplier: B/c MPC is less than 1, each increase in disposable income and each increase in consumer spending is smaller than in the previous round. B/c at each round, some of the disposable income is leaked in savings (MPS). ---> GDP grows in each round, however amount of increase does diminish gradually. Increase becomes negligible at some point and the economy converges to a new income-expenditure equilibrium GDP at Y*2. ~ PARADOX OF THRIFT: In macro, the outcome of many individual actions can generate a result that is different from and worse than the simple sum of those individual actions. In a POT, households and firms cut back spending in anticipation of future tough economic times. These actions depress the economy, leaving everyone worse off. ----> Paradox: a situation, person, or thing that combines contradictory features or qualities. ~ An autonomous change in planned aggregate spending leads to a change in income-expenditure equilibrium GDP, both directly and through an induced change in consumer spending - remains valid! ~ AN EXAMPLE OF AUTONOMOUS SPENDING IS INVENTORIES. ~ Consumption function has a tendency to increase over time.