Fundamental Questions

1. How are consumption and saving related?

2. What are the determinants of consumption?

3. What are the determinants of investment?

4. What are the determinants of government spending?

5. What are the determinants of net exports?

6. What is the aggregate expenditures function?

Teaching Objectives

The primary purpose of this chapter is to begin the analysis of real GDP by studying the components of national spending: consumption (C), investment (I), government spending (G), and net exports (X).

The unique feature of this chapter is the explanation of the aggregate expenditure function.

The chapter develops the consumption and saving functions and demonstrates that one is the mirror image of the other. The marginal propensity to consume (MPC) is the change in consumption that results from a change in income. The MPC determines the slope of the consumption function. The chapter also discusses how the domestic economy is linked to the international economy through the net export function. The slope of the net export function is due to the marginal propensity to import (MPI). When these functions are combined with autonomous investment and autonomous government spending, the aggregate expenditures function is found. An appendix at the end of this chapter shows how this aggregate expenditure function and its components can be portrayed algebraically. The appendix also illustrates the important role income plays in determining aggregate expenditures.

Be careful to develop this material fully. Much of modern macroeconomic theory depends on the aggregate expenditures function. Pay special attention to how the net export function is constructed from the autonomous export and import functions.

Key Term Review

consumption function
saving function
dissaving
autonomous consumption
marginal propensity to consume (MPC)
marginal propensity to save (MPS)
average propensity to consume (APC)
average propensity to save (APS)
wealth
marginal propensity to import (MPI)

Lecture Outline and Teaching Strategies

1. Consumption and Saving

Households can consume, save, or pay taxes with their income.

1.a. Saving and savings: Saving is the flow of income that is not consumed over a period of time. Savings are the accumulation of saving over time and are a stock concept.

Teaching Strategy: Ask your students to think of savings as a bathtub that accumulates the saving in each period over time. Saving adds to the level of savings in the tub and dissaving reduces the level in the tub.

1.b. The consumption and saving functions: The primary determinant of consumption is the level of disposable income. The consumption function shows the relationship between consumption and disposable income. The level of consumption that is unrelated to income is autonomous consumption.

Explain to your students that autonomous consumption is a proxy for all of the non income factors that affect consumption. Ask the students to think about what a list of these factors should include.

1.c. Marginal propensity to consume and save: The ratio of the change in consumption to the change in disposable income is the marginal propensity to consume. The ratio of the change in saving to the change in disposable income is the marginal propensity to save. Because in an economy without taxes people must either consume or save their income, the MPC plus the MPS equals 1.

1.d. Average propensity to consume and save: The proportion of disposable income spent for consumption is the average propensity to consume; the proportion of disposable income that is saved is the average propensity to save.

Teaching Strategy: Be sure to calculate the APC at different levels of income to show how it declines as level of income rises.

1.e. Determinants of consumption: Beyond income there are several other determinants of consumption that affect autonomous consumption and the slope of the consumption function.

Point out to your students that there is now evidence that people are saving more and earlier. Discuss how this should affect the consumption function.

1.e.1. Disposable income: Changes in disposable income that are due to tax changes shift the consumption function. Changes that are due to changes in current income cause movements along the consumption function.

1.e.2. Wealth: As household wealth increases, consumption increases at every level of income.

Teaching Strategy: Mention that changes in consumption that are due to wealth changes are much smaller than changes that are accounted for by income. As an example compare fluctuations in the stock market over the past ten years to fluctuations in consumption.

1.e.3. Expectations: When consumers expect a recession, they tend to spend less and save more; when they are optimistic, consumption increases.

1.e.4. Demographics: The size of the population affects the position of the consumption function, whereas the age distribution of the population affects the slope.

2. Investment

2.a. Autonomous investment: Investment expenditures are assumed to be autonomous with respect to income.

2.b. Determinants of investment: The determinants of investment fix the position of the investment function.

2.b.1. The interest rate: This is the key factor in determining the rate of return on a firm's investment projects.

2.b.2. Profit expectations: The expected rate of return determines firms' level of investment.

2.b.3. Other determinants of investment: Three determinants-technological change, cost of capital goods, and capacity utilization-are particularly important.

Teaching Strategy: Point out that business firms will invest in new capital and production processes that incorporate new technologies in order to remain competitive. One reason that recessions can be prolonged is that a good deal of excess capacity is available during recessions. Investment spending does not support the early part of an expansion.

2.c. Volatility: Several determinants of investment have a significant impact on volatility-interest rates, expectations, technological change, tax policy changes, and capacity utilization.

Teaching Strategy: Explain that because an investment involves a decision that will be validated only in the future, firms will revise their investment decisions almost continuously. This makes investment a volatile component of aggregate expenditures.

3. Government Spending

Government spending on goods and services is the second largest component of aggregate spending.

Teaching Strategy: Point out that government spending is not autonomous in the real world. This is a good time to mention the concept of automatic stabilizers.

4. Net Exports

Net exports represent the difference between a country's exports and imports of merchandise and services.

Point out that when net exports are negative, that this means savings is less than investment and domestic expenditures are greater than domestic output.

4.a. Exports: Exports are positively related to the level of foreign income and the tastes of foreign buyers for domestic goods and are negatively related to the imposition by foreign governments of import restrictions and the value of the domestic currency in the foreign exchange market.

4.b. Imports: In addition to the factors that determine exports, domestic income influences imports of merchandise and services; imports increase as income increases.

4.c. The net export function: Net exports are inversely related to income because of the marginal propensity to import.

5. The Aggregate Expenditures Function

Teaching Strategy: It will pay off in the future if you change the values of the MPC and MPI and show how the aggregate expenditures function changes in response.

Teaching Strategy: Whenever a component of the aggregate expenditures function is added, explain and graphically demonstrate the addition. This will illustrate where the component fits in the model and will help the students become comfortable with the graphs.

5.a. Aggregate expenditures table and function

Teaching Strategy: Note that as long as G, I, and X are autonomous, the slope of the aggregate expenditures function is the MPC. When the MPI is added, the slope of the aggregate expenditures function becomes flatter.

5.b. The next step: The aggregate expenditures line has the opposite shape from the downward-sloping aggregate curve.