CSC 316 Chapter 2d, Spring 2004

Aggregate Expenditure and Equilibrium Output Consumption 1 Consumption What Determines the Level of Consumption? 2 The Role of Income Disposable Income: The current income you receive in your paycheck, after you pay taxes. Expected Future Income: The income you expect to receive in the future 3 The Role of Income Disposable Income: The current income you receive in your paycheck, after you pay taxes. Expected Future Income: The income you expect to receive in the future Higher Income Higher Income Higher Consumption Higher Consumption 4 Income = Consumption + Savings + Taxes Y = C + S + T Income Consumption Savings Taxes 5 Consumption Schedule Income 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Assuming Taxes=0 6 Consumption Schedule Income 0 1000 2000 3000 4000 Consumption 500 1250 2000 2750 3500 Saving -500 -250 0 250 500 = + 7 T F Consumption plus disposable income is equal to savings. 8 The statement is “FALSE” Consumption 4000 3000 2000 1000 9 Household Income Consumption 4000 3000 2000 1000 4000 2000 1000 3000 10 Household Income Consumption 4000 3000 2000 1000 4000 2000 1000 3000 45 o line 11 0 1000 2000 3000 4000 5000 0 1000 2000 3000 4000 Household Income Consumption 45o Con- sumption 12 0 1000 2000 3000 4000 5000 0 1000 2000 3000 4000 Consumption 45o C C Y Slope = C Y Household Income 13 0 1000 2000 3000 4000 5000 0 1000 2000 3000 4000 Consumption 45o C C=750 Y=1000 Slope = 0.75 Household Income 14 5000 5000 C = 500 + .75*Income People buy goods even when their income is zero 75% of each dollar of income is consumed 25% of each dollar is saved 0.75 is the Marginal Propensity to Consume (MPC) 15 What is the marginal propensity to consume, MPC, in the figure? a. 1.00 b. 0.90 c. 0.67 d. $3 million Disposable income (millions of dollars) 0 1 2 3 4 5 4 - 3 - 2 - 1 - ' ' ' ' ' Consumption Consumption expenditure (millions of dollars) 16 The correct answer is “c” Savings Savings = Income - Consumption MPS: marginal propensity to save MPS = 1 - MPC C = Ca + MPC ( Y ) S = Y - C = Y - Ca - MPC ( Y )  = - Ca + Y ( 1 - MPC )  = Sa + MPS ( Y ) 17 EXAM TYPE QUESTION Consumption expenditure increases when ……………… increases. a. the interest rate b. the price level c. real GDP d. saving The correct answer is “c” 18 Given the following schedule: __DI__ __C__ 100 110 200 120 300 130 400 140 500 150 Formulate the saving function, by setting numerical values where possible. __S__ -10 80 170 260 350 80= Sa + 90/100 ( 200 ) Sa = 80 - 0.9 ( 200 ) = -100 S = -100 + 0.9 ( DI ) 19 T F The part of each dollar which is not consumed is not necessarily saved. FALSE 20 Given the following schedule, DI S 200 10 300 20 400 30 500 40 600 50 Formulate the consumption function, by setting numerical values where possible. 190 = Ca + 0.9 ( 200 ) Ca = 190 - 180 = 10 C = 10 + 0.9 ( DI ) 21 23 30 20 10 0 -10 -20 100 200 300 400 500 Saving Saving Disposable Personal Income The higher the level of income, a. The smaller the APS b. The greater the APS c. The smaller the MPS d. The greater the MPS e. None of the above The correct answer is “b” 23 As income rises, what happens to a. The amount consumed? 24 C Y Exp. Rises b. The amount saved? S Y S Rises As income rises, what happens to c. Proportion of consumption to income? Assume an MPC of 0.9. Assume when income was 800, consumption was 750. APC = 750 ÷ 800 = 0.9375 If income rises by 200, up to 1,000, consumption shall rise by 0.9 x 200 = 180, up to 930. APC’ = 930 ÷ 1,000 = 0.93 < 0.9375 So the proportion of consumption to income falls. d.Proportion of savings to income? MPS = 1 - 0.9 = 0.1 When income was 800, saving was 50. APS = 50 ÷ 800 = 0.0625 If income rises by 200, up to 1,000, saving shall rise by 0.1 x 200 = 20, up to 70. APS’ = 70 ÷ 1,000 = 0.07 > 0.0625 So the proportion of savings to income rises. If people save a higher proportion of their income than they consume, what type of a relationship can be derived in terms of propensities? APS > APC 26 Consumption 45o Consumption Function Y C S Household Income 27 Exp. Y = DI Y = DI 0 0 500 -500 S S 45º line C BE 2000 Y2 Y1 YBE a b c b' a' c’ SAVING DISSAVING Y1 C1 Y2 C2 CBE YBE 28 The saving function a. Shows what households plan to save at various income levels. b. Slopes upward to the right because saving increases as income increases. c. Has a slope equal to the MPS d. Can be derived from the consumption function. e. Is characterized by all of the above. The correct answer is 29 “e” a. Show on the diagram, the area of positive savings. Positive savings b. Are the very poor able to save? Why? Show a possible income level for the poor on the diagram, and the level of savings thereon. The very poor are not able to save. Because their income is low, almost enough for them to survive. A possible income level for the poor. Y The level of dissavings at Y. 30 BREAK-EVEN BREAK-EVEN BREAK-EVEN IS WHEN Y = C DIFFERENTLY SPEAKING, WHEN S = 0 YBE = C = Ca + MPC ( Y BE ) YBE - MPC ( YBE ) = Ca YBE ( 1 - MPC ) = Ca YBE = ___Ca__ = _Ca_ 1 - MPC MPS IN OUR EXAMPLE: YBE = 500 = 2,000 0.25 31 Our assumptions concerning consumption and saving include all of the following except: a. The MPS and MPC are both positive and less than one b. The APC falls as income rises c. The APS rises as income rises d. The MPC is negative below the break-even level of income The correct answer is “d” Increase in MPC An increase in the MPC increases the slope of the consumption function… 33 Consumption 45o Consumption Function Increase in MPC Household Income 34 Increase in the Constant An increase in the constant shifts the entire consumption function upward, parallel to the original. A shift in the consumption function will take place due to a change in one of the exogenous variables of consumption. 35 Consumption 45o Consumption Function Increase in Constant Household Income 36 EXOGENOUS VARIABLES OF CONSUMPTION EXOGENOUS VARIABLES OF CONSUMPTION STOCKS OF LIQUID ASSETS STOCKS OF DURABLE GOODS ON HAND EXPECTATIONS CONSUMER INDEBTEDNESS ATTITUDES TOWARD THRIFT TAXATION 37 STOCKS OF LIQUID ASSETS STOCKS OF LIQUID ASSETS LIQUID ASSETS ARE LIKE CASH AND SECURITIES AS THE STOCKS OF LIQUID ASSETS WITH PEOPLE RISE THROUGHOUT TIME CONSUMERS FEEL MORE SECURE FINANCIALLY THEY CONSUME MORE AND SAVE LESS CONSUMPTION RISES INCOME HELD CONSTANT, SAVING FALLS 38 Exp. Y = DI Y = DI 0 0 S S 45º line C BE YBE C’ S’ BE’ YBE’ WE RECOGNIZE THAT AS CONSUMPTION RISES, AND SAVING FALLS, ‘‘B.E.’’ CHANGES BUT THE PARALLELITY OF ‘‘YBE’’ ON THE TWO DIAGRAMS STAYS 39 STOCKS OF DURABLE GOODS ON HAND STOCKS OF DURABLE GOODS ON HAND DURABLE GOODS ARE THOSE GOODS THAT ARE USEFUL FOR LONGER THAN A YEAR AS THE STOCKS OF DURABLE GOODS RISE THE NEED TO BUY ADDITIONAL DURABLE GOODS FALLS CONSUMPTION FALLS, AND SAVING RISES 40 EXPECTATIONS EXPECTATIONS PRICES PRICES: AS PEOPLE EXPECT PRICES TO : AS PEOPLE EXPECT PRICES TO RISE IN THE FUTURE, RISE IN THE FUTURE, THEY PLAN TO BUY MORE NOW, BEFORE THEY PLAN TO BUY MORE NOW, BEFORE PRICES HAVE RISEN, PRICES HAVE RISEN, STORE THE EXCESSIVE GOODS PURCHASED, STORE THE EXCESSIVE GOODS PURCHASED, AND USE THEM IN THE FUTURE, AND USE THEM IN THE FUTURE, BY THIS THEY AVOID PAYING THE BY THIS THEY AVOID PAYING THE EXPECTED FUTURE HIGH PRICES. EXPECTED FUTURE HIGH PRICES. CONSUMPTION RISES, SAVING FALLS CONSUMPTION RISES, SAVING FALLS 41 SHORTAGES: AS PEOPLE EXPECT POSSIBLE SHORTAGES IN THE FUTURE, THEY PLAN TO BUY MORE NOW, STORE THE EXCESSIVE GOODS, AND USE THEM IN THE FUTURE, TO AVOID THE PROBLEM OF SHORTAGES CONSUMPTION RISES, SAVING FALLS 42 INCOMES: AS PEOPLE EXPECT THEIR INCOMES TO RISE IN THE FUTURE, THEY FEEL SAFER ABOUT THE FUTURE, THEIR NEED FOR SAVING LOSES GROUND, THEY SAVE LESS, SO THEY CONSUME MORE CONSUMPTION RISES, SAVING FALLS 43 If people expect incomes to fall in the future, what shall be the impact of such an expectation upon consumption and savings? Demonstrate graphically. c s c’ s’ 44 CONSUMER INDEBTEDNESS CONSUMER INDEBTEDNESS AS PEOPLE FIND OUT THAT THEIR INDEBTEDNESS HAS INCREASED THROUGHOUT TIME, THEY PLAN TO SAVE MORE, TO BE ABLE TO SETTLE THEIR DEBTS, SAVING RISES, SO CONSUMPTION FALLS 45 ATTITUDES TOWARD THRIFT ATTITUDES TOWARD THRIFT AS A SOCIETY BECOMES MORE THRIFTY, PEOPLE PLAN TO SAVE MORE, SO TO CONSUME LESS, CONSUMTPION FALLS, SAVING RISES 46 TAXATION TAXATION DI = Y - T AS TAXATION RISES, DI FALLS DI = C + S AS DI FALLS, CONSUMPTION FALLS AND SAVING FALLS 47 Exp. Y = DI Y = DI 0 0 S S 45º line C BE YBE C’ S’ BE’ YBE’ WE RECOGNIZE THAT THE PARALLELITY OF “YBE” ON THE TWO DIAGRAMS HAS BEEN VIOLATED. 48 YBE’ A reduction in personal income taxes is likely to cause which of the following changes in the components of total spending? a. Increased consumption b. Increased investment c. Decreased government expenditures d. Increased exports e. Decreased imports The correct answer is 49 “a” Exp. Y C C C’ SHIFT Demonstrate graphically the difference between a shift in consumption and a change in the level of consumption. 50 CHANGE IN THE LEVEL Exp. Y Which of the following would cause the saving function to shift downward? a. A downward shift in the consumption function b. An increase in the interest rate c. An increase in the MPS d. A decrease in the MPS e. An increase in personal income taxes The correct answer is “e” 51 Aggregate Expenditure and Equilibrium Output Investment 52 Investment 53 What Determines the Level of Planned Investment? Real interest rates Expected future profits, That is, the expected rate of return. 54 EXAMPLE EXAMPLE Assume a one year investment project costs $10,000 The expected return is $12,000 Then, the net return would be $2,000 The expected rate of return would be 20% If the real interest rate is less than 20%, the investment project will be taken 55 What Determines the Level of Planned Investment? Real interest rates Expected future profits Lower Interest Rates Lower Interest Rates Higher Expected Future Profits More Investment (I) 56 THE INVESTMENT DEMAND THE INVESTMENT DEMAND _In_ ERR 0 50% 5 45% 10 40% 15 35% 20 30% 25 25% __i__ 50% 45% 40% 35% 30% 25% 57 THE INVESTMENT DEMAND CURVE THE INVESTMENT DEMAND CURVE i 0 In 50% i1 i2 In1 In2 50 ID MONEY MARKET i $ SM DM 0 i1 SM’ DM’ E E’ i2 a b 58 Which of the following is required to determine the investment function? a. The saving function b. The interest rate c. The consumption function d. The investment demand curve e. b and d The correct answer is “e” 59