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These factors were summarized in the earlier discussion of consumption. When the consumption function moves, it can shift in two ways: either the entire consumption function can move up or down in a parallel manner, or the slope of the consumption function can shift so that it becomes steeper or flatter. For example, if a tax cut leads consumers to spend more, but does not affect their marginal propensity to consume, it would cause an upward shift to a new consumption function that is parallel to the original one.
However, a change in household preferences for saving that reduced the marginal propensity to save would cause the slope of the consumption function to become steeper: that is, if the savings rate is lower, then every increase in income leads to a larger rise in consumption. So how does this relate to the national economy?
Let us return to our equations from chapter 8. For simplicity, we will rewrite taxes minus transfer payments as net taxes. If this value is positive, that means that the average consumer receives more transfer payments from the government than they pay in taxes and vice versa.
If we assume that net taxes will be constant based on a given income level in reality, they are not, but let us keep this simple , then we see that any increase in national income will lead to an increase in consumption. The same holds for disposable income as seen earlier. Investment does not yield immediate profit. Instead, investment requires a large upfront expenditure with the hope of earning future profits. But investment also requires a risk. Therefore, as firms expect greater future profitability, their appetite for investment risk will increase.
Therefore, an increase in expected future profit will lead to more investment while a decrease in expected future profit, such as during times of economic slowdown, will lead to a reduction in investment. This is evident in Figure 9. For the same rationale as we saw with consumption, the real interest rate will dictate the cost of investment spending. Because investment can be costly, firms often must finance these investment activities.
Again, the real interest rate gives the cost of borrowing. So, as the real interest rate increases, the cost of borrowing increases which reduces investment spending. On the other hand, as the real interest rate decreases, the cost of borrowing decreases which increases investment spending. When considering consumption spending, we investigated income versus disposable income.
While we will not explicitly make the differentiation here, we must still make the consideration. If taxes increase, companies must spend more money on their tax payments and will therefore have less to spend on investment projects. But, if taxes fall, companies now have more money, all else equal, to spend on investment projects. While some companies finance their investment projects, others use cash-on-hand to finance these projects.
Therefore, the greater the cash flow for a company, the greater the ability to engage in these investment projects. We assume that planned investment will determined ahead of time and will therefore not change based on current real GDP.
The graph is therefore horizontal. This is shown below in Figure 9. Government spending appears as a horizontal line, as in Figure 9. As in the case of investment spending, this horizontal line does not mean that government spending is unchanging. It means only that government spending changes when Congress decides on a change in the budget, rather than shifting in a predictable way with the current size of the real GDP shown on the horizontal axis.
Again, taxes can complicate the situation but for simplicity, we will assume that they are constant and incorporated into the consumption portion of our graph. When economists refer to potential GDP , they are referring to that level of output that can be achieved when all resources land, labor, capital, and entrepreneurial ability are fully employed.
While the measured unemployment rate in labor markets will never be zero, full employment in the labor market occurs when there is no cyclical unemployment. There will still be some frictional or structural unemployment, but when the economy is operating with zero cyclical unemployment, the economy is said to be at the natural rate of unemployment, or at full employment.
Figure 9. Department of Commerce. What should be clear is that while actual GDP is sometimes above and sometimes below potential, over the long term it tracks potential quite well. For example from to , the U. At other times, like in the late s or late , the economy ran at potential GDP—or even slightly ahead. Clearly, short-run fluctuations around potential GDP do exist, but over the long run, the upward trend of potential GDP determines the size of the economy.
The unemployment rate has fluctuated from as low as 3. Even as the U. When the Congressional Budget Office carried out its long-range economic forecasts in , it assumed that from to , after the recession has passed, the unemployment rate would be 5. From a long-run perspective, the economy seems to keep adjusting back to this rate of unemployment, which we described above as the natural rate. Growth in GDP can be explained by investment in physical capital and human capital per person, as well as advances in technology.
Physical capital per person refers to the amount and kind of machinery and equipment available to help people get work done. Compare, for example, your productivity in typing a term paper on a typewriter to working on your laptop with word processing software.
Clearly, you will be able to be more productive using word processing software. The technology and level of capital of your laptop and software has increased your productivity. More broadly, the development of GPS technology and Universal Product Codes those barcodes on every product we buy has made it much easier for firms to track shipments, tabulate inventories, and sell and distribute products.
Likewise, increasing human capital involves increasing levels of knowledge, education, and skill sets per person through vocational or higher education. Physical and human capital improvements with technological advances will increase overall productivity and, thus, GDP. The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy are equal to the amount of output produced.
The axes of the Keynesian cross diagram presented in Figure 9. While we have not yet discussed potential GDP, we will discuss it in the next chapter. For now, consider it to be the level of output that an economy can comfortably produce at given its factors of production. The gap between the current level of expenditure and the potential GDP will dictate whether an economy is in a state of expansion or contraction. All the components of aggregate expenditure for a closed economy —consumption, investment, and government spending—are now in place to build the Keynesian cross diagram.
Ignore the NX function. A new image will be inserted in the next draft. One spot of confusion may be as to why the investment and government lines seem to be upward-sloping. They are not. The aggregate expenditure function is formed by stacking on top of each other the consumption function after taxes , the investment function, the government spending function, the export function, and the import function.
The point at which the aggregate expenditure function intersects the vertical axis will be determined by the levels of investment and government purchases—which do not vary with national income. The upward slope of the aggregate expenditure function will be determined by the marginal propensity to save and the tax rate.
A higher marginal propensity to save and a higher tax rate will all make the slope of the aggregate expenditure function flatter—because out of any extra income, more is going to savings or taxes or imports and less to spending on domestic goods and services. With the aggregate expenditure line in place, the next step is to relate it to the two other elements of the Keynesian cross diagram.
Thus, the first subsection interprets the intersection of the aggregate expenditure function and the degree line, while the next subsection relates this point of intersection to the potential GDP line. It is the only point on the aggregate expenditure line where the total amount being spent on aggregate demand equals the total level of production.
To understand why the point of intersection between the aggregate expenditure function and the degree line is a macroeconomic equilibrium, consider what would happen if an economy found itself to the right of the equilibrium point E, say point H in Figure 9. At point H, the level of aggregate expenditure is below the degree line, so that the level of aggregate expenditure in the economy is less than the level of output.
As a result, at point H, output is piling up unsold—not a sustainable state of affairs. Conversely, consider the situation where the level of output is at point L—where real output is lower than the equilibrium. In that case, the level of aggregate demand in the economy is above the degree line, indicating that the level of aggregate expenditure in the economy is greater than the level of output.
When the level of aggregate demand has emptied the store shelves, it cannot be sustained, either. Firms will respond by increasing their level of production. Thus, the equilibrium must be the point where the amount produced and the amount spent are in balance, at the intersection of the aggregate expenditure function and the degree line. Suppose that the macro equilibrium in an economy occurs at the potential GDP, so the economy is operating at full employment.
Keynes pointed out that even though the economy starts at potential GDP, because aggregate demand tends to bounce around, it is unlikely that the economy will stay at potential. In , U. As a result, the U. But how much did GDP fall? If so, you would be wrong. Or to say it differently, the change in GDP is a multiple of say 3 times the change in expenditure.
This is the idea behind the multiplier. The reason is that a change in aggregate expenditures circles through the economy: households buy from firms, firms pay workers and suppliers, workers and suppliers buy goods from other firms, those firms pay their workers and suppliers, and so on. In this way, the original change in aggregate expenditures is actually spent more than once. This is called the expenditure multiplier effect : an initial increase in spending, cycles repeatedly through the economy and has a larger impact than the initial dollar amount spent.
To understand how this works, we need to introduce two new terms: autonomous spending versus induced spending:. Autonomous consumption also exogenous consumption is the consumption expenditure that occurs when income levels are zero. Such consumption is considered autonomous of income only when expenditure on these consumables does not vary with changes in income; generally, it may be required to fund necessities and debt obligations. If income levels are actually zero, this consumption counts as dissaving , because it is financed by borrowing or using up savings.
Autonomous consumption contrasts with induced consumption , in that it does not systematically fluctuate with income, whereas induced consumption does. So far, we have explored consumption, planned investment, and government spending. Both planned investment and government spending are autonomous which means these values are given and not based on real GDP. Recall that when we created the aggregate expenditure model, adding planned investment and government spending shifted the AE curve vertically causing the movements to be parallel.
Also recall that the graph for each was horizontal. This indicates that these will not change with real GDP unless we force it to change due to some external circumstance. On the on the other hand, the consumption function has both an autonomous and induced component. Recall that we said that a certain level of consumption will occur regardless of income as people need to consume the bare necessities even if they do not have income.
This is autonomous. On the other hand, we also said that people will consume more as their income increases. This consumption is induced since it is caused, or induced, by additional income. So, what happens if there is an increase in planned investment? We can see on Figure 9. Changed in autonomous variables cause the AE curve to shift vertically upward or downward. In this case, there is an increase in planned investment. But we see there is a new equilibrium on the new AE curve where AE 1 intersects with the degree line.
Even more important, the increase in real GDP is greater than the increase in planned investment. Let us explore why. Let us consider government spending, which is also a type of autonomous spending. The producers of those goods and services see an increase in income by that amount. They use that income to pay their bills, paying wages and salaries to their workers, rent to their landlords, payments for the raw materials they use. Any income left over is profit, which becomes income to their stockholders.
Each of these economic agents takes their new income and spend some of it. Those purchases then become new income to the sellers, who then turn around and spend a portion of it. The process continues, though because economic agents spend only part of their income, the numbers get smaller in each round. When the dust settles the amount of new income generated is multiple times the initial increase in spending—hence, the name the spending multiplier.
The table below gives an example of how this could work with an increase in government spending. Note that the multiplier works the same way in reverse with a decrease in spending. Net exports may be negative.
Subsidies are transfer payments to assist industries that benefit the public, but might not survive or remain stable if operated for profit without subsidies. Farm products and rail transportation are subsidized in most modern economies.
Spending by consumers, which economists call consumption or consumption expenditure, is by far the largest part of the U. Also, consumption roughly equals household income, because people spend what they earn as income. True, they also save some of it and they borrow to spend, but let's leave that aside for now.
Business investment is the total amount of spending by businesses on plant and equipment, and it accounts for a little over 15 percent of total GDP. This might seem to be a relatively small portion of GDP for business, but it's an extremely important one. Businesses invest in productive equipment and that equipment typically creates jobs as well as goods and services.
The wages and salaries that businesses pay to workers are not counted as businesses investment? That money is already counted in consumption? Government spending on goods and services averages about 20 percent, or one fifth, of total GDP. The government takes in an amount equal to more than one fifth of GDP in taxes, but a portion of that money, equal to about 10 percent of GDP, goes to transfer payments rather than expenditures on goods and services.
Transfer payments include Social Security, Medicare, unemployment insurance, welfare programs, and subsidies. These are not included in GDP because they are not payments for goods or services, but rather means of allocating money to achieve social ends. Net exports for the United States are close to zero or, oftentimes, a bit negative. Yes, the United States exports a tremendous amount of goods, but it imports even more.
Each component of GDP is important.
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Actual investment spending includes spending by consumers on binary options trading strategies videoMacroeconomics - Chapter 23: Aggregate Expenditure and Output in the Short Run
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If we remove that outlier, the impact has been only slightly negative. In summary, it is possible to have a recession without a large, or even any, decline in consumer spending. It all depends on what caused the recession, how long and how bad consumers expect the recession to be, how concerned they are about personal income and job losses, and how they react to it with their wallets. As you can see in Figure 5. However, consumer spending has not always declined during a recession. The cause of a recession determines how consumers will react to a decline in GDP, and consumers can sometimes be the cause of a recession as they pull back spending in anticipation of falling personal incomes or job losses.
It is clear that personal consumption expenditures declined noticeably during the Great Recession of and during the pandemic-induced recession of , which was a massive and rapid shift left in the aggregate demand curve due to government-imposed lockdowns across the entire economy.
Consumer spending and GDP then both rebounded in as the lockdowns were lifted and the economy opened back up. Figure 5. In the chart below Figure 6 , you can see that not only is consumer spending the largest component of GDP in the United States, but its share of GDP has been increasing over time. Some factors leading to a higher share of GDP include the advent of the internet, more online shopping, and globalization, which has, until recently, kept consumer goods prices low and thereby more affordable.
Figure 6. The Great Depression was caused by a massive decline in investment spending in In contrast, the decline in consumer spending was a lot smaller on a percentage basis. In , investment spending plunged further, while consumer spending only fell by a small percentage. Throughout the entire Depression from , the bigger dollar decline came from consumer spending because consumer spending is a much larger share of the economy , while the bigger percentage decline came from investment spending.
Alternatively, consumer spending can be calculated by adding the three categories of consumer spending:. It must be noted that using this method will not result in the same value as using the first method. Unemployment affects consumer spending negatively.
Consumer spending generally declines when unemployment increases, and rises when unemployment falls. However, if the government provides enough welfare payments or unemployment benefits, consumer spending may hold steady or even increase despite high unemployment.
The relationship between income and consumer spending is known as the consumption function:. Select your language. Suggested languages for you:. Deutsch US. Americas English US. StudySmarter - The all-in-one study app. Rate Get App Share. Economics Macroeconomics Consumer Spending.
Sign up to use all features for free. Sign up now. Consumer Spending Table of contents :. Consumer spending definition Have you ever heard on TV or read in your news feed that "consumer spending is up", that "the consumer is feeling good", or that "consumers are opening up their wallets"? Consumer spending and GDP In the United States, consumer spending is the largest component of the economy, otherwise referred to as Gross Domestic Product GDP , which is the sum of all final goods and services produced in the country, given by the following equation:.
Consumption Spending Proxy Since personal consumption expenditures data is only reported quarterly as a component of GDP, economists closely follow a subset of consumer spending, known as retail sales , not only because it is reported more frequently monthly but also because the retail sales report breaks down sales into different categories, which helps economists determine where there is strength or weakness in consumer spending.
Consumer Spending: Demand Grows Faster Than Supply If demand grows faster than supply - a rightward shift of the aggregate demand curve - prices will move higher, as you can see in Figure 1. Impact of recession on consumer spending between and There are three categories of consumer spending; durable goods cars, appliances, electronics , non-durable goods food, fuel, clothing , and services haircut, plumbing, TV repair.
The impact of a recession on consumer spending can vary. It depends on what caused the recession and how consumers react to it. Moreover, it is possible to have a recession with no decline in consumer spending at all. Consumer Spending What is consumer spending? How did consumer spending cause the Great Depression?
How do you calculate consumer spending? We can calculate consumer spending in a couple of ways. How does unemployment affect consumer spending? What is the relationship between income and consumer spending behavior? Show answer. Answer Consumer spending is the amount of money individuals and households spend on final goods and services for personal use. Show question. Question Consumer spending accounts for approximately how much of the U. Question Which of the following is not a category of consumer spending?
Answer Durable goods. Question Appliances are an example of durable goods. Answer True. Question Fuel is an example of. Question The purchase of a house is considered. Answer Consumer spending. Question Demand for consumer goods is a good predictor of economic growth. Question Economists follow which indicator as a proxy for consumer spending? Answer Home sales. Question If demand falls, prices generally.
Answer Decrease. Question Over the last few decades, consumer spending as a share of GDP has. Answer Increased. Question A decline in consumer spending is always the cause of a recession. Question Which of the following is not an example of consumer spending?
Answer Car. Question Prices generally rise when. Answer Demand falls. Question Which of the following might cause consumer spending to increase? Answer Higher unemployment rate. Will you pass the quiz? Start Quiz. More explanations about Macroeconomics. Aggregate Demand Learn. Aggregate Demand Curve Learn. Aggregate Supply Learn. Appreciation and Depreciation Learn.
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Indian Economy Learn. Inflation and Deflation Learn. Inflation Tax Learn. Investment Spending Learn. Japan Lost Decades Learn. In addition, machinery is generally indivisible which means it cannot be broken into small amounts and bought separately. Even small increases in demand can trigger the need to buy complete new machines or build entirely new factories and premises, even though the increase in demand may be relatively small.
The combined effect of these two principles creates what is called the accelerator effect. The initial impact of investment is on the AD curve , which shifts to the right as investment I is a component of AD, show shown below:. Finally, it is likely that production costs will fall as new technology increases efficiency and reduces average costs. This means that the SRAS curve shifts to the right. The combined effects are that the economy grows, both in terms of potential output and actual output, without inflationary pressure.
After over a decade of continuous growth, gross investment fell during and Investment grew again during , but fell back between and , indicating the continuing negative impact of the recession on the availability of capital, and on business confidence. By business investment had returned to its pre-recession levels. Despite the initial uncertainty surrounding the Brexit vote on June 23rd, , investment in the UK continued to grow throughout and However, in the first and second quarter of gross investment fell, reflecting increasing uncertainty over the nature of the Brexit deal.
Managing the economy. Investment spending Investment spending is an injection into the circular flow of income. Firms invest for two primary reasons: Firstly, investment may be required to replace worn out, or failing machinery, equipment, or buildings. This is referred to as capital consumption, and arises from the continuous depreciation of fixed capital assets. Secondly, investment may be undertaken to purchase new machinery, equipment, or buildings in order to increase productive capacity.
This will reduce long-term costs, increase competitiveness, and raise profits. The determinants of investment The level of investment in an economy tends to vary by a greater extent than other components of aggregate demand. The main determinants of investment are: The expected return on the investment Investment is a sacrifice, which involves taking risks.
Business confidence Similarly, changes in business confidence can have a considerable influence on investment decisions. Changes in national income Changes in national income create an accelerato r effect. Interest rates Investment is inversely related to interest rates, which are the cost of borrowing and the reward to lending. Firstly, if interest rates rise, the opportunity cost of investment rises. This means that a rise in interest rates increases the return on funds deposited in an interest-bearing account, or from making a loan, which reduces the attractiveness of investment relative to lending.
Hence, investment decisions may be postponed until interest rates return to lower levels. Secondly, if interest rates rise, firms may anticipate that consumers will reduce their spending, and the benefit of investing will be lost. Investing to expand requires that consumers at least maintain their current spending. Therefore, a predicted fall is likely to discourage firms from investing and force them to postpone their investment decisions.