Aggregate Spending Model: Keynesian Approach relating Total Spending to Income

What does the model try to explain?

Spending model: elements of expenditure

How Consumption depends on income

Then Add Investment, Govt, net exports

In Classical View

Say’s law: General assumption that production creates its own demand

To be in equilibrium

total supply and total demand must be equal.

Production must equal purchases

BUT: what forces operate to achieve this?

Market forces will determine a price level

but this changing price level may not direct the economy to reach its goals.

Potential Problems with Macroequilibrium

Undesirable: The equilibrium may be more or less than our full employment capacity.

Unstable: Aggregate Demand and Supply can be moving due to other factors, like external shocks or expectations.

Macro- equilibrium and the price mechanism: Does it work?

Why not?

Total Demand and Supply depend somewhat on the price level.

BUT not in the simple way as SAY’s law suggests.

The production of a good does result in an equal amount of income

BUT it does not necessarily result in an equal amount of spending.

Demand Side approaches to policy

Fiscal : Change taxes and spending - to affect total demand. Most directly Keynesian

Monetary : focus on the money supply and interest rates to affect demand.

 

Keynes View

Falling prices and wages do not restore the economy.

Fall in income à fall in consumption

à further fall in production

Equilibrium may be restored at lower levels of output.

So– the economy can get caught at low level of production

Aggregate Spending Model

So– important to study the relationship of Spending and Income.

Keynesian model of spending

Will the different parts of spending add up to

A level of total demand equal to the amount produced?

Will this be at full employment

Components of Total Spending:Keynes’ concerns

 

Consumption depends on income, but people do not spend all of their income.

Investment:  Depends on expectations more than income from production.

Government : up to us

Exports - Imports (depends on global effects: later)

Why production does not necessarily => spending

Main Issue:

the amount people save will reduce the amount of spending on consumption

If all of savings became investment (purchases of capital goods) , this would even out

But savings and investment are not coordinated, so this may not happen

Other issues:

Exports may not = Imports (later)

Government : up to us

 

Why production does not necessarily => spending

Flow: Production -> income ->spending -> production

But we will have

Leakages : amount of income that are not spent

Injections : spending that is does not determined by income

Total spending = C +I+G+Xn

Issues in the Keynesian Model

Disequilibrium: Total Spending and Output may not be equal if Leakages not equal to Injections.

Equilibrium can be at less than potential output.

Fiscal Policy: Gov’t spending and taxation can be used to affect Spending

GETTING THE TERMS STRAIGHT

Aggregate = Total

Expenditure = Spending

Output = real GDP

Income (expressed as Y)

Identities and Conditions

Always the case

Total Spending = C + I(actual)+ G + Xn

Output (=GDP) = Income

Only true in Expenditure Equilibrium

Total Spending = Output

EQUILLIBRIUM

By definition

OUTPUT must = INCOME

But, must

OUTPUT = Spending ???

Preview of DISEQUILIBRIUM

How can output be different from Spending?

Building the Model
All parts of Expenditure are included

Consumption (C)

Investment (I)

Government spending (G)

Net exports (X - IM)

CONSUMPTION
Purchases by households

Depends on

Income

Wealth

Expectations

Cost of Credit (interest rate)

Taxes

Consumption Function

Income ß key connection

Why is it so important in our model?

Strongest determinant of consumption

Linked to output (since we get our incomes from production)

Can use to predict how changes in income affect consumer spending.

Consumption Function

Consumption has two components:

Consumption Function

Autonomous : a

Depending on income:

MPC x Y

MPC = marginal propensity to consume

Y = Income (disposable)

Calculating Consumption

If GDP is $2,000 billion; the MPC is .75 and the autonomous consumption is $100bil., what is consumption?

Y= _________ a= _________

C = _______ + _______________

Consumption function

To find consumption for each level of income (or output, since output = income) we can use the equation:

C = A + (MPC) x Y disposable

In this situation :

C = $100 billion + (.75) x Y

Graphing consumption

Draw a graph of the level of consumption at different levels of income.

Shows how consumption increases as income increases

At the rate of consumers’ MPC  =  Slope of the Consumption Function

                    Change in C caused by change in Income

Note that the consumption function is already written in the form of an equation for a line.

Change in Consumption due to other factors not related to income

Several factors affect consumption even if income stays the same:

Consumer expectations (confidence)

Wealth

Credit conditions

Taxes

Price level

Consumer Expectations

People who anticipate a pay raise often increase spending before extra income is received.

People who expect to be laid off tend to save more and spend less.

Measure of "consumer confidence" used as a leading indicator

Changes in Wealth

Changes in the values of important assets – stocks, houses

Changes in total savings or debt

Can change the amount consumers spend

Wealth effect

The stock market boom of 1996-1999 increased the value of household wealth AND increased expectations of future income.

Effect added 1 point to the percentage consumed out of income in 1997 and 1998.

The reverse occurred in 2001 when stock values fell

Change in wealth also changes the amount saved.

In 1998, Americans spent more money than they received in after-tax income.

Negative personal savings rate for the first time since 1959.

This left Americans with a large amount of debt –

Made the 2001 fall in consumption worse?

Credit Conditions

Interest rate

If interest rates fall, it is cheaper to borrow to buy now

Consumption will increase in the current period

Fall in interest rates for auto purchases in 2002

Availability of credit

If it is easier to get a loan or buy on credit, consumers will buy more

Taxes

If consumer income tax increases, disposable income decreases at the same level of output (national income)

Therefore, consumption decreases.

Taxes can change independent of income.

Price level

If the price level increases, there is no reason that real income changes

Aggregate demand model : increase prices have wealth, credit , trade effects.

In this model, we ignore the price effects. To see price effects, use AS/AD model

Autonomous part of consumption

These factors change the amount of consumption not related to income

This is the "autonomous" part of the consumption equation

Any change in the autonomous part will shift the consumption line up or down by the change in consumption

Shift Caused by a Change in ‘autonomous factors’

Shift in Consumption Function also shifts of Aggregate Demand

An upward shift of the consumption function

- > Means more spending at each price level

= a rightward shift of the aggregate demand curve.

Shifts of Aggregate Demand

Total Spending

Total spending = C + I + G + Xn

To find the total amount of spending, we must

Add Investment, Gov’t spending, and (exports – imports)

Investment Spending

Spending on (production of) new capital (plant, equipment, and structures)

Changes in inventories is not spending.

While much of savings is directed into investment,

Investment is not the same as savings

Investment is determined by factors other than income.

Investment Determined by.

Expected Rate of return

Future sales

Future sales price

Cost of investment

Interest rate

Changes in Technology

Difference between desired and optimal capital stock.

Access to funds.

Adding Investment to Consumption

Government Spending:

Taxes receipts change when output/income changes

State, local government spending are generally limited to taxes

Federal government can spend more or less than taxes

Net effect: spending not determined by income

Govt spending : business cycle

State/local: since taxes will decrease when income decreases

and spending is limited by taxes

State/local spending tends to be pro-cyclical

Ex. current state budget cuts may lower spending during growth recession

Federal Government spending related to business cycle

Federal govt can run a deficit

While taxes fall during a recession (raising disposable income)

certain federal govt expenditures increase during a recession

So – tends to be counter cyclical

Adding Government

Net Exports

Export sales depend primarily on

foreign income

Exchange rate

Imports

depend on exchange rate

may increase or decrease with income.

Conclusion: Net Exports (exports- imports) depend little if at all on income.

Net Exports usually negative

During most recent period

Exports have been less than imports

Net exports have been negative

=> Trade deficit

Aggregate Spending

Expenditure Equilibrium

Will Spending be at the correct level?

We want the macroeconomic equilibrium to be at full employment.

Spending must be at the right level for this to occur.

This is the critical question asked by the Keynesian model.

What if full employment output/income were $3,000?

Recessionary Gap

The level of spending is less than required if

the amount of desired spending

that would exist at the full employment level of output

is not enough to sustain the economy.

Measuring the Recessionary Gap

the amount by which total spending at full-employment

falls short of full-employment output.

Recessionary Gap

If economy has full employment output at $3,000?

At an output of $3,000 bil.

C+I+G+Xn = 2750

Not all output would be sold

Inventories would be increasing

producers may react to the spending short-fall by

cutting back on production

laying off workers.

Result: Macro Failure

The economy cannot sustain output at the full employment level

The economy moves to an Equilibrium at a lower level of output

à Unemployment equilibrium

Going back to the Aggregate
Supply and Demand model

This situation is the same as

Where the equilibrium in the AS/AD model is below full employment level

This difference is called the Real GDP Gap

Equilibrium below Full Employment

Relation to Business Cycle

Recessionary gaps are a primary cause of cyclical unemployment.

(the unemployment due to a lack of jobs)

In a boom, we may get to full employment,

But if aggregate expenditure falls,

the economy will move to a lower equilibrium output.

A Decline in some part of Total Expenditure:

Inflationary Gap

What if equilibrium is above full employment level?

an inflationary gap would exist.

total spending at full-employment is more than full-employment output.

Therefore, even if the economy could move to equilibrium, it would cause inflation.

Inflationary gap
if full employment Y is at 1250

Doomed to Macro Failure?

Keynes believed macro failure was likely in a market-driven economy.

Leakages (savings, imports, taxes) not tied to Injections (Investment, exports, govt spending)

Spending not simply related to prices,

No reason to expect that total spending would = total output at full employment.

Doomed to Macro Failure?

If Demanders want to spend less than full-employment output at current price levels à cyclical unemployment

If total spending exceeds the amount of output à demand-pull inflation