Module 4 Flashcards
Consumption
The four building blocks of consumption are:
Are each positively or negatively related?
Current income - POSITIVE
Wealth - POSITIVE
Expected future income - POSITIVE
The interest rate on savings and borrowing - NEGATIVE
What is autonomous expenditure and what’s its effect on a graph?
Expenditure that is not affected by the current level of income in the economy.
After all, people need to consume food, water and pay utilities even if they have zero income. These basics are autonomous expenditures that do not vary with aggregate income
On a graph, the function will start above zero and not at the origin
Why is the savings function negative at x=0?
What is the space between the origin to the savings function called?
The savings function is negative at x=0 because of autonomous expenditures. People need to spend money, even if they haven’t earned any, so it chips into their savings.
The space is called DISSAVING
Induced expenditure
The rise in consumption from an increase in disposable income
Marginal Propensity to Consume (MPC)
How is it calculated?
MPC is the willingness of a person to consume, after a change in disposable income
MPC = ∆consumption ÷ ∆disposable income
Marginal Propensity to Save (MPS)
How is it calculated?
MPS is the willingness of a person to save, after a change in disposable income
MPS = ∆savings ÷ ∆disposable income
What is the relationship between MPS and MPC
Since disposable income can only be spent or saved, the relationship between MPS and MPC is: MPS + MPC = 1
What is Wealth? How does a change in wealth affect consumption
Wealth can be from savings accounts, checking accounts, holdings of stocks, bonds, mutual funds and the value of houses
Wealthier households tend to consume more, and lower wealth households tend to consume less
POSITIVELY RELATED
Is wealth a good predictor of Marginal Propensity to Consume (MPC)
No because research has shown us that both poor and wealthy households can have high MPC
Poor households have low income, so they spend whatever they earn
Wealthy households have money tied up in illiquid assets, so they often spend their paycheques
Effect of Expected future income on consumption
If you expect a higher future income, then you are more likely to dip into savings to fund current consumption
If you expect to have a lower future income to be lower, then you are likely to reduce current consumption in order to save more for later
POSITIVELY RELATED
Effect of Interest rate, or price of money, on consumption
A higher interest rate generally encourages saving, and heightens the cost of borrowing, which in turn decreases consumption
NEGATIVELY RELATED
Determinants of Investment: Expected future profitability
Innovations that open up new spheres for investment attract high amounts of investment in physical capital.
For example, the tech boom in the 1990s spiked a massive increase in investment in computer equipment and software
POSITIVELY RELATED
Determinants of Investment: Interest Rate
A significant way businesses invest is by borrowing financial capital. A primary determinant of investment then, is the interest rate (real interest rate) because it is the cost of borrowing capital
NEGATIVELY RELATED
Determinants of Investment: Business Taxes
Business taxes are essentially extra costs associated with investment (reducing profits), and when business taxes rise, it becomes more expensive to invest
NEGATIVELY RELATED
Is government spending affected by macroeconomic factors in the short term?
In the SHORT TERM, government spending is NOT AFFECTED by standard macroeconomic factors such as aggregate income, wealth and the interest rate
Direct transfers are not included in the calculation of government spending and only includes purchases of goods and services
Effect on Net Exports: Domestic Income
Domestic income is that income earned within a country, so when income in a country rises consumption rises with it
An increase in consumption also leads to an increase in imports (along with locally produced goods and services). Since imports decrease net exports, we conclude that domestic income and net exports are usually NEGATIVELY CORRELATED
Effect on Net Exports: Foreign Income
As income in foreign countries increases, so does consumption. Thus, higher consumption leads to more exports for the domestic country and higher net exports
POSITIVELY CORRELATED
What do exchange rates tell us about?
Represent the value of goods in one country expressed in terms of the same goods in another country
Effect on Net Exports: Exchange Rates
When real exchange rates increase, domestic goods become more expensive than foreign goods, which increases imports and decreases exports
NEGATIVELY CORRELATED
Effect on Net Exports: Tastes for Foreign Goods
When tastes for foreign goods increase, the level of imports also increases. Since high imports lead to lower net exports, tastes for foreign goods are negatively correlated with net exports
Effect on Net Exports: Trade policies
Changes in trade policies are reflected in exchange rates and other macroeconomic factors, rather than affecting net exports directly. Although, trade policies can be analyzed on a case-by-case basis for their direct effect on net exports
DEPENDENT ON SITUATION
John Maynard Keynes pointed out that firms don’t produce what they can at a given price…
They produce what they can sell
Planned Investment
The amount that firms actively choose to put into new capital resources and inventory accumulation
Actual Investment
Is the amount of new capital investment and ACTUAL inventory changes.
Changes in inventory are included in investment, so when firms draw down on existing inventories, their actual investment becomes NEGATIVE. On the flip side, when firms accumulate new inventories the actual investment is POSITIVE
If actual inventories exceeded planned inventories, then what would have happened? (Hint: demand levels)
There was a higher expected demand than what actually materialized
Planned Aggregate Expenditure (PAE) - What does it consist of and how is it calculated?
We can decompose PAE–the level of aggregate expenditure that consists of consumption, government spending, planned investment and net exports with the below equation
PAE = A + bY
A = a constant that represents the autonomous sources of spending (not directly affected by income) b = a positive coefficient that relates spending to national income Y = national income
Do national income, national production, planned aggregate expenditure and total output all represent the same thing?
Yes
What is the Keynesian Equilibrium?
Where planned aggregate expenditure is equal to actual aggregate expenditure. It represents the situation where firms don’t need to change their output levels in response to a gap in planned and actual inventories
We can find the Keynesian equilibrium by drawing an additional 45° line representing all the equilibrium points where planned and actual aggregate expenditure are equal (PAE = Y)
Non-income determinants effect on equillibrium aggregate expenditure
Will a PAE curve be higher or lower with higher/lower interest rates, business optimism and government spending?
A PAE curve will be higher than average in an economy with low interest rates, high business optimism and high government spending
A PAE curve will be lower than average in an economy with high interest rates, low business optimism and low government spending
This is due to the non-income determinants making autonomous expenditures higher or lower to begin with
Recessionary Output Gap
When equilibrium aggregate expenditure is below the level needed for full employment
Inflationary Output Gap
When equilibrium aggregate expenditure exceeds the level needed for full employment
Multiplier effect
Keynesian economics asserts that a change in autonomous expenditure can have a ripple effect on the rest of expenditure (when spending by one person in an economy causes increases in spending of other people that is greater than the initial increase in expenditure)
What is the end result of the multiplier effect on PAE
When the multiplier process comes to an end, the economy reaches a Keynesian equilibrium where unplanned aggregate expenditure is equal to zero, or alternatively when planned aggregate expenditures are equal to zero
How do you calculate the multiplier effect?
Final change in output for an increase in expenditure of $100 is equal to:
ΔY = $100 × (1/ 1− b)
For example, if b is equal to 0.8, then the final change in expenditure would be:
1/(1-0.8) = 5.
So the final change in aggregate expenditure would be five times higher than the initial change in aggregate expenditure
