MACROECONOMIC 2

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Week4StudentSlidesTopic4The4SectorsoftheEconomy-HouseholdandBusinessMelb5.pptx

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The 4 Sectors of the Economy- Household and Business Sectors

Topic 4 (Part 1)

Four Sectors of the Economy

Net Export Expenditure

Financial

Markets

Resource

Market

Income

Consumption Expenditure

Investment Expenditure

Production

Govt. Expenditure

Firm

Government

Product

Market

External

Household

Borrowing & Lending

Private and Public

Value of Production = Value of Resources = Value of Income Generated = Expenditure Undertaken

Review

AD1

AD2

Recall the Keynesian AD/AS framework

AD determines the level of economic activity

Production, Income, Aggregate Expenditure

RGDP = Y = AE = C + I + G + NX

Components of GDP

Consumption: Spending by households on goods and services, not including spending on new houses.

Investment: Spending by firms on new factories, office buildings, machinery (planned), and inventories (unplanned), and spending by households on new houses.

Government purchases: Spending by federal, state, and local governments on goods and services.

Net exports: The value of exports minus the value of imports.

Expenditure as a Percentage of GDP

(June 2017)

Consumption and Saving

Both consumption and savings levels are determined by household disposable income.

Consumption is the portion of their disposable income that households spend on goods and services.

Disposable income that is not consumed is called Savings

Keynes General Theory

What affects Consumption?

Disposable Income

Y = C + S + T

Y - T = C + S

since Y - T = disposable income (YD)

YD = C + S

As YD↑; C ↑ and S ↑

Keynes General Theory

Non-current Income Determinants

Wealth - total net value of household assets (minus any debt), incl. market value of housing, cars, and financial assets

Price Level

Level of Consumer Debt

Expectations

Availability and Cost of Credit - Interest Rates (r): When r↓ → cost of borrowing falls → C↑

Demographics

Consumption

The consumption function is the relationship that describes the determinants of consumption spending.

= Autonomous consumption – captures the effect of the non-income factors

= marginal propensity to consume (MPC): 0 < MPC < 1 extra consumption associated with an extra dollar of disposable income:

= induced consumption

Consumption Function/Schedule

Shifts vs Movements vs Pivots

A change in current Y causes a movement along a given function.

A change in one of the non-income factors affecting consumption changes (the vertical intercept), and therefore shifts the functions vertically.

An increase in the MPC will increase the slope of the function, and hence causes it to pivot upwards.

45o Degree Line

Check Your Knowledge

What effect will the following have on the consumption function:

the economy begins to recover from recession

people anticipate that the rate of inflation is about to rise

$40 savings

$40 dissaving

Savings Function

We know Therefore:

MPS: extra saving associated with an extra dollar of disposable income =

MPC + MPS = 1

Check Your Knowledge

The consumption function for a particular economy is C=120+0.6Y

What is the slope of the consumption function?

What is the value of the MPC?

What is the value of the MPS?

Relationship Between Income, Consumption and Savings

Savings to Income (S/YD) Ratio increases with YD.

If income is less than YD0, savings is negative;

If income is more than YD0, savings is positive

According to Keynes, as income rises, a larger share of YD is saved.

Check Your Knowledge

S = –20 + 0.2YD

What is the marginal propensity to consume?

If income after tax is $200, what is the value to total savings; what is the value of total consumption?

Alternate Theories of Consumer Behaviour

According to Keynes, the current level of income is the determines consumption.

The modern theory of consumption was developed independently in the 1950s by Milton Friedman (Permanent Income Hypothesis) and by Franco Modigliani (Live-Cycle Hypothesis).

These modern theories of consumption take into account that we, as consumers prefer stable patterns of consumption.

The Permanent Income Hypothesis

The Permanent Income Hypothesis (PIH) holds that consumption spending depends on the long-run average (or permanent) income that people expect to receive, not transitory ones.

Permanent Income (YP) is the annual average income that people expect to receive over a period of years in the future. Milton Friedman proposed that individuals consume a constant fraction of their expected income (YP)

People revise their estimates of permanent income based on events that occur – adaptive expectations.

The Permanent Income Hypothesis

Consumption can also be affected by Transitory Income (Yt), but in the long-run Yt will be zero because over time, transitory gains will be offset by transitory losses.

Therefore, consumption depends on long-run average income (permanent income) that people expect to receive

The Life-Cycle Hypothesis

The Live-Cycle Hypothesis (LCH) implies that households base their current consumption on their expected total lifetime incomes and their wealth. People would try to stabilise their consumption over their entire lifetime.

C0 = lifetime consumption per year

L = lifespan (in years)

Y0 = income per year

R = number of years of employment

With an endowment/inheritance of assets equal to A1:

Current consumption is based on expected total lifetime income and wealth holdings

Investment

Investment the purchase of capital goods - plant and equipment, residential structures, and changes in inventory - that can be used in the production of other goods and services.

Inventory Investment is the change in the stock of raw materials, parts and finished products held by businesses.

Any goods that are unsold automatically are counted as part of unplanned inventory investment.

Check Your Knowledge

Which of the following commercial transactions would be considered by economists to be investment expenditure?

You purchase a house at auction.

You invest $5,000 in the share market.

Your employer buys Office 2016 for office staff.

At an auction you lose control and end up as the proud owner of Picasso’s Weeping Woman.

Your family friend, a builder, decides to update his electric drill.

Gross vs Net Investment

Net investment = Gross investment - depreciation

Depreciation is an allowance for the capital goods that have been used up in the process of producing this year’s GDP.

Gross investment is the amount spent on replacing the depreciated capital and on net additions to the capital stock.

Net private investment is the net addition to the economy’s capital stock.

The economy’s ability to produce goods and services depends significantly on its stock of capital goods.

When gross investment exceeds depreciation, net investment is positive, and the economy is expanding.

If gross investment is less than depreciation, net investment is negative, and the economy would be contracting.

Determinants of Investment

There are 2 main determinants of investment:

Real Interest rates: The cost of borrowing funds for the purchase of real capital.

It is the real rate of interest, rather than the nominal rate, that is crucial in making investment decisions.

The real interest rate is the nominal rate less the rate of inflation.

The expected net rate of profit that businesses hope to realise from investment spending.

Interest Rates

For savers, interest rates are a reward/incentive for deferring spending.

For borrowers, interest rates are a cost of borrowing for spending.

Autonomous consumption and investment will be affected by interest rates.

General Decision Rule

The business sector buys capital goods only when it expects such purchases to be profitable.

If expected rate of net profit ≥ real interest rate, it is profitable to invest. since revenue earned > interest and principle repaid.

If expected rate of net profit < real interest rate, it will not be profitable to invest. since revenue earned < interest and principal repaid.

Investment Spending

Anything that changes the expected net rate of profit changes investment spending

Interest rates

Expectations

Acquisition, Operating and Maintenance Costs

Business Taxes

Technological Change/Innovation

Existing Capital Stock

Investment Demand Curve

Investment Demand

Shifts of Investment Demand:

Expectations

Acquisition, operating and maintenance costs

Business Taxes

Technological change/innovation

Capital stock

Planned Investment Expenditure

We assume that investment is independent of current income, ie autonomous.

If one or more determinants of investment change, it will cause the investment schedule to shift.

This assumption is a simplification. There are reasons why investment may vary directly with income.

Aggregate Expenditures-Output Approach

Aggregate Expenditure

Output

AE = C + I

Investment Expenditure

Equilibrium Levels of Output and Income

Equilibrium income means the only income that the economy will be able to sustain. It does not necessarily mean full employment income.

At an equilibrium level of output, the value of the economy’s total expenditure on output (C + I) is just equal to the value of total output that the firms in the economy produce (RGDP).

In Equilibrium, Y = C + I

Planned and Unplanned

Of all the components of AE, only investment can be either planned (Ip) or unplanned (Iu)

Business firms will adjust their production until unplanned investment is eliminated.

If unplanned investment is positive (Iu>0), output will be reduced.

If unplanned investment is negative (Iu<0), output will be increased.

Autonomous and Induced Spending

Aggregate Output-Expenditures Approach

45o (where E=Y)

Ep = C + I

At equilibrium Y = C + I (i.e. no unplanned investment)

Check Your Knowledge

In a simple two sector economy, what is meant by equilibrium output? How does it differ from total output?

Equilibrium RGDP

Changes to Equilibrium GDP

45° line

ΔI/ ΔCa

ΔY

Note: D Y > D I

Effect on AE? Shift up by amount = Δ I or Ca

Multipliers

Changes in aggregate expenditure give rise to even larger changes in total income and output.

This reflects the “multiplier effect”.

If multiplier = 3

For every $1 increase in expenditure, income and output will increase by $3.

D in equilibrium real GDP

D in Autonomous Spending

Autonomous Expenditure Multiplier =

Expenditure Multiplier

The expenditure multiplier (k):

= or =

Δ Y = k x Δ A

The larger is MPC, the smaller is MPS, the steeper the AE curve, then the larger will be the multiplier.

1-MPC

MPS

Implications

Business Cycle:

Small changes in spending may be greatly magnified in resulting income and employment outcomes resulting in the fluctuations of the business cycle.

Policy:

Small increases in G could stimulate output enabling the government to push the economy out of recession more easily?

BUT

It takes time for k to work

Future-oriented theories of consumption

Are idle resources available?

Recessionary Gap

45° line

YACTUAL

Recessionary Gap

Output/

GDP Gap

Inflationary Gap

RGDP

45° line

Inflationary Gap

Relation of Investment and Saving

Personal Saving (S) is that part of personal income that is not consumed or paid out in taxes

Also referred to as Private Saving

Algebraically: S = (Y-T) - C (where T = Net Taxes)

Funds from savings are channeled to firms in two basis ways:

Households buy bonds and stocks issued by firms

Households deposit savings in banks and other financial institutions that in turn lend money to firms

Firms use the money channeled from savings to buy investment goods

Leakages-Injections Approach

Savings is a leakage from the income-expenditure stream.

Investment can be viewed as an injection of expenditure that can offset this leakage.

At equilibrium C + S = C + I, or S = I

Marginal leakage rate: fraction of income that is taxed or saved (or used for imports) rather than being spent on domestic expenditure.

Marginal leakage rate = s

2-Sector Equation Summary

C = Cα + cY

S =– Cα + (1 – c)Y

At equilibrium, EP=C+Ip

 Ye = Cα + cY + Ip

 Ye = (Cα + Ip)

Marginal leakage rate: fraction of income that is taxed or saved (or used for imports) rather than being spent on domestic expenditure.

 Marginal leakage rate = s

 Ye =

S = I

ofit

Cost

100