6.1 Desired Aggregate Expenditure

Question 1

What is desired expenditure?

Answer 1

Desired expenditure does not refer, however, to what people would like to do under imaginary circumstances; it refers to what people desire to spend out of the resources they actually have.

Question 2

What does the subscript “a” mean when examining variuous expenditure catagories?

Answer 2

the subscript “a” denotes the actual values of the various expenditure categories.

Question 3

Who are the four main groups of decision makers?

Answer 3

Instead, it is sufficient to consider four main groups of decision makers: domestic households, firms, governments, and foreign purchasers of domestically produced commodities.

Question 4

What is desired aggregate expenditure? (AE)

Answer 4

Desired aggregate expenditure (AE)

      The sum of desired or planned spending on domestic output by households, firms, governments, and foreigners.

Desired expenditure need not equal actual expenditure, either in total or in any individual category.

Question 5

What are some examples of when desired expenditure does not equal actual expenditure?

Answer 5

For example, firms might not plan to invest in inventory accumulation this year but might do so unintentionally if sales are unexpectedly low—the unsold goods that pile up on their shelves are undesired inventory accumulation. In this case, actual investment expenditure, , will exceed desired investment expenditure, I. Or households may plan a certain amount of consumption expenditure and be unable to purchase all they want because sellers do not have enough supplies available to sell. In this case, actual consumption, , will be less than desired consumption, C.

Question 6

Do national income accounts measure desired or actuial expenditure?

Answer 6

National income accounts measure actual expenditures in each of the four expenditure categories. Our model of the macro economy deals with both actual and desired expenditures.

Question 7

What are Autonomous expenditures?

Answer 7

Autonomous expenditures

      Elements of expenditure that do not change systematically with national income.

Autonomous expenditures can and do change, but such changes do not occur systematically in response to changes in national income.

Question 8

What are Induced expenditures?

Answer 8

Induced expenditures

      Any component of expenditure that is systematically related to national income.
				
				Desired consumption is a good example of an induced expenditure, as most households spend more when their incomes rise.

Question 9

What are some important simplifications that we make in order to develop the simplest possible modle of national income determination?

Answer 9

-There is no trade with other countries—that is, the economy we are Studying is a closed economy

There is no government—and hence no taxes

-The price level is constant.

Question 10

What do we define disposible income as?

Answer 10

The amount of income households receive after paying the taxes they owe is called disposable income.

Question 11

What do we define “saving” as?

Answer 11

Saving

      All disposable income that is not spent on consumption.

Question 12

What are the two possible uses of disposible income?

Answer 12

By definition, there are only two possible uses of disposable income—consumption and saving. When the nation’s households decide how much to put to one use, they have automatically decided how much to put to the other use.

Question 13

What is the definition of The Consumption Function?

Answer 13

Consumption function

      The relationship between desired consumption and all the variables that determine it. In the simplest case, it is the relationship between desired consumption and disposable income.

Question 14

What are the key factors influencing desired consumption?

Answer 14

-Disposable income
-Wealth
-Interest rates
-Expectations about the future

Question 15

How does an increase in disposible income influence desired consumption?

Answer 15

Holding constant other determinants of desired consumption, an increase in disposable income is assumed to lead to an increase in desired consumption.

Question 16

What is Average propensity to consume? (APC)

Answer 16

Average propensity to consume (APC)

Desired consumption divided by disposable income

Question 17

What is The Marginal Propensity to consume?

Answer 17

The marginal propensity to consume (MPC) tells us how much of one additional dollar of income gets spent on consumption. It is equal to the change in desired consumption divided by the change in disposable income that brings it about

Question 18

What is the slope of the consumption function equal to?

Answer 18

The marginal propensity to consume (MPC)

Question 19

What does the positive and constant slope of the consumption function tell us?

Answer 19

The positive slope of the consumption function shows that the MPC is positive; increases in disposable income lead to increases in desired consumption expenditure. The constant slope of the consumption function shows that the MPC is the same at any level of disposable income.

Question 20

What is the “break-even” level of income?

Answer 20

along which . The consumption function intersects this 45° line when income is $150 billion; this is called the “break-even” level of income.

Question 21

What is happening when we are below the break even point on the consumption function?

Answer 21

When disposable income is less than $150 billion, desired consumption exceeds disposable income. In this case, desired saving must be negative; households are financing their consumption either by spending out of their accumulated saving or by borrowing funds.

Question 22

What is happening when we are above the break-even point of the consumption function?

Answer 22

When disposable income is greater than $150 billion, desired consumption is less than disposable income and so desired saving is positive.

Question 23

What is happening at the exact point of the break-even point?

Answer 23

At the break-even level of disposable income, desired consumption exactly equals disposable income and so desired saving is zero.

Question 24

What is the average propensity to save? (APS)

Answer 24

Average propensity to save (APS)

      Desired saving divided by disposable income.

Question 25

What is the Marginal propensity to save? (MPS)

Answer 25

Marginal propensity to save (MPS)

      The change in desired saving divided by the change in disposable income that brought it about.

Question 26

What does APC and APS sum to? MPC and MPS? Why is this?

Answer 26

APC and APS must sum to 1, and MPC and MPS must also sum to 1. Because all disposable income is either spent or saved, it follows that the fractions of income consumed and saved must account for all income

Question 27

What does the positive slpe of the saving function mean?

Answer 27

Notice that it is positively sloped, indicating that increases in disposable income lead to an increase in desired saving.

Question 28

What does the vertical distance between the consumption function and the 45 degree line represent?

Answer 28

Note also that the amount of desired saving is always equal to the vertical distance between the consumption function and the 45° line. When desired consumption exceeds income, desired saving is negative; when desired consumption is less than income, desired saving is positive.

Question 29

What are causes of Shifts in the consumption function?

Answer 29

-A Change in Household Wealth
-A Change in Interest Rates
-A Change in Expectations

Question 30

Definition of household wealth?

Answer 30

Household wealth is the value of all accumulated assets minus accumulated debts.

Question 31

What are the most common types of household assets?

Answer 31

The most common types of household assets are savings accounts, mutual funds, portfolios of stocks or bonds, Registered Retirement Savings Plans (RRSPs), Tax Free Savings Accounts (TFSAs) and the ownership of homes.

Question 32

What are the most common household debts?

Answer 32

The most common household debts are home mortgages, car loans, credit-card debt, and other types of loans, like personal lines of credit.

Question 33

Why would an increase in household wealth cause a shift in the consumption and saving function?

Answer 33

If households expect this increase in wealth to persist, less current income needs to be saved for the future, and households will therefore tend to spend a larger fraction of their current income. The consumption function will shift up, and the saving function down,

Question 34

What direction does the consumption function shift with an increase/decrease in household wealth?

Answer 34

An increase in household wealth shifts the consumption function up at any level of disposable income; a decrease in wealth shifts the consumption function down.

Question 35

What two catagories can household consumption be divided into?

Answer 35

Durable and non-durable goods.

Durable goods are goods that deliver benefits for several years, such as cars, furniture, and household appliances.

Non-durable goods are consumption goods that deliver benefits to households for only short periods of time, such as groceries, restaurant meals, and clothing.

Since many durable goods are also expensive, many of them are purchased on credit—that is, households borrow in order to finance their purchases.

Question 36

How does interest rate effect the consumption function?

Answer 36

A fall in interest rates usually leads to an increase in desired consumption at any level of disposable income; the consumption function shifts up. A rise in interest rates shifts the consumption function down.

Question 37

How do expectations about the future state of the economy influence desired consumption and the consumption function?

Answer 37

Expectations about the future state of the economy often influence desired consumption. Optimism leads to an upward shift in the consumption function; pessimism leads to a downward shift in the consumption function.

Question 38

What are the three catagories of investment?

Answer 38

Recall from Chapter 5 the three categories of investment:

-inventory accumulation
-residential construction
-new plant and equipment

Question 39

What is the most volatile component of GDP?

Answer 39

Investment expenditure is the most volatile component of GDP, and changes in investment are strongly associated with short-run fluctuations in national income.

Question 40

What percent of GDP does private-sector investment fluctuate around in Canada?

Answer 40

private-sector investment in Canada fluctuates around an average of about 19 percent of GDP

Question 41

What percent of the GDP does government and non-profit investment roughly amount to?

Answer 41

Investment by government and non-profit institutions, which combined are quite stable and amount to about 4 percent of GDP

Question 42

What catagory of investment is intellectual property (IP) products placed in?

Answer 42

Note that the category “plant and equipment” includes investment in intellectual property (IP) products, which result from research and development (R&D) activities.

Question 43

What are three important determinants of desired investment expenditure?

Answer 43

-The real interest rate
-Changes in the level of sales
-Business confidence

Question 44

What are the one or two places that the money a firm or households uses for new investment expenditure must come from?

Answer 44

Money that a firm or household uses for new investment expenditure must come from one of two places: either it is borrowed from a bank or other lender or the firm or household already has these funds in some form of an interest-earning asset, like a bank deposit.

Question 45

What does the real interest rate represent in terms of investment purposes?

Answer 45

Either way, the real interest rate represents the opportunity cost of using this money for investment purposes.

A rise in the interest rate makes investment expenditure “cost more,” and a fall in the interest rate makes investment expenditure “cost less.”

As a result, a rise in the real interest rate reduces the amount of desired investment expenditure; a fall in the real interest rate increases the amount of desired investment.

Question 46

What are the tree components of investment?

Answer 46

-Inventories
-Residential construction
-New plant and equipment

Question 47

What percentage of GDP is inventory investment typically?

Answer 47

As shown by the bottom line in Figure 6-4, inventory investment has been between –2 percent and 2 percent of GDP over the past 40 years.

Question 48

Why is the average amount of inventory investment not an adequate measure of its importance?

Answer 48

But the average amount of inventory investment is not an adequate measure of its importance. Since inventory investment is quite volatile, it has an important influence on fluctuations in investment expenditure.

Question 49

How can tieing up funds inventories be harmful?

Answer 49

When a firm ties up funds in inventories, those same funds cannot be used elsewhere to earn income. As an alternative to holding inventories, the firm could lend the money out at the going rate of interest. Hence, the higher the real rate of interest, the higher the opportunity cost of holding an inventory of a given size. Other things being equal, the higher the opportunity cost, the smaller the inventories that will be desired.

Question 50

How is expenditure on newly built houses and interest rate closly ocnnected?

Answer 50

Expenditure on newly built residential housing is also volatile. Most houses are purchased with money that is borrowed by means of mortgages. Interest on the borrowed money typically accounts for more than one-half of the purchaser’s annual mortgage payments; the remainder is repayment of the original loan, called the principal. Because interest payments are such a large part of mortgage payments, variations in interest rates exert a substantial effect on the demand for housing.

Question 51

What is the connection between real interest rate and firms willingnes to buy and replace new plants and equipment?

Answer 51

The real interest rate is also a major determinant of firms’ investment in factories, equipment, and a whole range of durable capital goods that are used for production. When interest rates are high, it is expensive for firms to borrow funds that can be used to build new plants or purchase new capital equipment. Similarly, firms with cash on hand can earn high returns on interest-earning assets, again making investment in new capital a less attractive alternative. Thus, high real interest rates lead to a reduction in desired investment in capital equipment, whereas low real interest rates increase desired investment.

Question 52

What does the real interest rate reflect in association with investment?

Answer 52

The real interest rate reflects the opportunity cost associated with investment, whether in inventories, residential construction, or new plant and equipment. The higher the real interest rate, the higher the opportunity cost and thus the lower the amount of desired investment.

Question 53

What is the size of and change in inventories related to?

Answer 53

Because the size of inventories is related to the level of sales, the change in inventories (which is part of current investment) is related to the change in the level of sales.

The higher the average level of sales, the larger the desired stock of inventories. Changes in the average rate of sales therefore cause temporary bouts of investment (or disinvestment) in inventories.

Question 54

How does future expectations about the state of the economy effect investment?

Answer 54

Investment depends on firms’ expectations about the future state of the economy. Optimism about the future leads to more desired investment; pessimism leads to less desired investment.

Question 55

Why is GDP not included in the determinants of current desired investment?

Answer 55

Since most investment takes time to complete and is long-lasting, the current level of real GDP is not an important determinant of current desired investment.

Question 56

What is the Aggregate expenditure function? (AE)

Answer 56

Aggregate expenditure (AE) function

      The function that relates desired aggregate expenditure to actual national income.

The AE function is constructed by vertically summing the C function and the I function, thus showing desired total spending at each level of actual national income.

Question 57

What two things does the aggregate expenditure function relate together?

Answer 57

The aggregate expenditure function relates desired aggregate expenditure to actual national income.

Question 58

What is “Marginal propensity to spend”?

Answer 58

Marginal propensity to spend

      The change in desired aggregate expenditure on domestic output divided by the change in national income that brought it about.
				
				he marginal propensity to spend is measured by the change in desired aggregate expenditure divided by the change in national income that brings it about.

Question 59

What is the difference between the marginal propensity to spend and the marginal propensity to consume?

Answer 59

The marginal propensity to spend is the amount of extra total expenditure induced when national income rises by $1, whereas the marginal propensity to consume is the amount of extra consumption induced when households’ disposable income rises by $1.

Question 60

What is the equation for the simple consumption function? What does each variable represent?

Answer 60

Question 61

What does each variable in the consumption function represent (with chart)

Answer 61

Question 62

How do you determine the slope of the savings function given the MPC?

Answer 62

Question 63

What is the aggregate expenditure function written as? How is it graphed?

Answer 63

Question 64

In simple models, why does MPS = MPC?

Answer 64

Question 65

Difference between how we write the equations for actual and desired national income from the expenditure side

Answer 65

Question 66

What does the graph of an AE function look like?

Answer 66

Question 67

What is the connection between the intercept of the savings function and the consumption function?

Answer 67

The are the inverces of each other. -200 on the savings functioon would be 200 on the consumption function.