Principles of Macroeconomics|Legit essays

ECO 2302, Principles of Macroeconomics 1

Course Learning Outcomes for Unit V Upon completion of this unit, students should be able to:

5. Differentiate the aggregate expenditure and demand model of the macro economy from the supply and demand model at the micro level. 5.1 Describe how consumption and investment relate to the aggregate demand curve. 5.2 Explain factors that affect the consumption function. 5.3 Explain market forces that push the economy toward its potential output in the long run.

Course/Unit Learning Outcomes

Learning Activity

5.1

Unit Lesson Chapter 9 Article: “What Is Aggregate Demand?” Unit V Assessment

5.2

Unit Lesson Chapter 9 Article: “The U.S. Economy to 2024” Unit V Assessment

5.3

Unit Lesson Chapter 10 Article: “GDP and the Digital Economy: Keeping Up With the Changes” Unit V Assessment

Required Unit Resources Chapter 9: Aggregate Demand Chapter 10: Aggregate Supply In order to access the following resources, click the links below. Board of Governors of the Federal Reserve System. (2017, July 31). What is aggregate demand?

https://www.federalreserve.gov/faqs/what-is-aggregate-demand.htm Byun, K. J., & Nicholson, B. (2015, December). The U.S. economy to 2024. U.S. Bureau of Labor Statistics.

https://www.bls.gov/opub/mlr/2015/article/the-us-economy-to-2024.htm Moulton, B. R. (n.d.). GDP and the digital economy: Keeping up with the changes. Bureau of Economic

Analysis. https://www.bea.gov/sites/default/files/2018-05/gdp-and-the-digital-economy.pdf

Unit Lesson Before beginning Unit V, reflect back on how far you have come as an economics student. You are now half- way through this course. Your economics vocabulary has, most likely, dramatically increased. You may be finding yourself applying economic concepts in your daily life. This means that you are starting to become an economist. Don’t worry—you do not have to start wearing polyester clothes and a bow-tie. Joking aside, you should be proud of the knowledge you have gained so far in this course.

UNIT V STUDY GUIDE

Aggregate Demand and Supply

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In Unit V, you are going to be studying the components of aggregate spending and how it relates to the aggregate demand curve along with examining potential output. These concepts are addressed in Chapters 9 and 10 of the textbook and are discussed below.

The Aggregate Demand Curve The aggregate demand curve is influenced by consumption, investment, government spending, and net exports. This means that a thorough understanding of the aggregate demand curve requires that each of these elements be examined.

Consumption Each and every one of us consumes goods and services. From food and computers to cab rides and doctor visits, we are consuming goods and services. It is well understood that consuming goods requires money, and this money is acquired by income.

Economic theory presented in Unit II of this class showed us that changes in income can result in the demand curve shifting one way or another. Specifically, we saw that an increase in income results in the demand curve shifting to the right, as illustrated below.

In the figure above, increases in income have caused the demand curve to shift from D1 to D2. Additional increases in income cause the demand curve to shift from D2 to D3.

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Drawing even more on the information provided in Unit II, we learned that as the demand curve shifts to the right, holding price constant, quantity demanded will increase. In the figure below, price is held constant at “P.”

The price line (red line) intersects the initial demand curve (D1) at a quantity of Q1. When an increase in income shifted the demand curve to D2, the red price line intersected D2 at a quantity of Q2. Further increases in income caused the demand to shift to D3. The quantity level here is Q3. Notice that the price level is not changing at all. The only factor that has been changed is income. What the above graphic is suggesting is that there is a positive relationship between the amount consumed and income levels. This concept is not earth-shattering as you have probably witnessed this behavior in yourself and others. If you receive a bonus at work, your demand curve shifts to the right. You might be willing—and now able—to go eat a meal at a restaurant that might not normally be in your budget. You might be willing to purchase that new laptop computer. The list goes on and on regarding how the demand curve can shift to the right as income increases. Now that you know the basis behind the positive relationship between income and consumption, it is time to introduce a new curve to the learning—the consumption function. The consumption function shows the relationship between consumption and income (McEachern, 2019). More specifically, the consumption function shows the relationship between consumer spending and disposable income at the aggregate level.

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The above graphic utilizes data concerning consumer spending and disposable income for the United States from the first quarter of 2017 through the third quarter of 2019 (Bureau of Economic Analysis [BEA], 2019). This data is also presented in the table below.

Year Quarter Personal Income

(Billions of $)

Consumer Spending (Billions of $)

2017

Q1 16,604.1 13,104.4

Q2 16,749.6 13,212.5

Q3 16,930.4 13,345.1

Q4 17,231.2 13,586.3

2018

Q1 17,540.3 13,728.4

Q2 17,725.0 13,939.8

Q3 17,928.5 14,114.6

Q4 18,082.8 14,211.9

2019

Q1 18,355.4 14,266.3

Q2 18,555.9 14,511.2

Q3 18,676.9 14,678.2

Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d. (https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ ories=survey). In the public domain.

Marginal analysis was introduced in Chapter 1. As a refresher, anytime you see the term marginal in economics, think change. Here, marginal analysis is used to determine how much consumption changes if income changes. This type of marginal analysis is referred to as the marginal propensity to consume (MPC). The MPC is determined by dividing the change in consumption by the change in income (McEachern, 2019).

Calculating Marginal Propensity to Consume An example of how the MPC is calculated is shown below using disposable income and consumer spending information from the table above.

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Step 1: Calculate the difference in consumption. In the example below, the difference in consumer spending between the first quarter of 2017 and the first quarter of 2019 is calculated.

Year Quarter Consumer Spending

(Billions of $)

Difference in Consumer Spending (Billions of $)

2019 Q1 14,266.3

14,266.3 – 13,104.4 = 1,161.9

2017 Q1 13,104.4

Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d. (https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ ories=survey). In the public domain.

Step 2: Calculate the difference in disposable income using the same two time periods used in Step 1. For example, the table below uses the difference in personal income between the first quarter of 2017 and the first quarter of 2019.

Year Quarter Disposable

Income (Billions of $)

Difference in Disposable Income (Billions of $)

2019 Q1 18,355.4

18,355.4 – 16,604.1 = 1,751.3

2017 Q1 16,604.1

Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d. (https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ ories=survey). In the public domain

Step 3: Dividing the answer in Step 1 by the answer in Step 2 will yield the marginal propensity to consume (MPC).

Step 1 Answer Step 2 Answer Step 1 ÷ Step 2

Difference in Consumer Spending (Billions of $)

Difference in Personal Income

(Billions of $) MPC

1,161.9 1,751.3 0.66

The result of 0.66 in the table above suggests that a $1 billion increase in income will cause consumption to increase by $0.66 billion. When you sit back and think about MPC, it is a very powerful calculation. For instance, policy makers may be trying to determine if a reduction in income taxes would help increase spending in the economy. By using the MPC, these policy makers can get an estimate of just how much consumption will change as income changes. As you might have already noticed as well, the MPC is also the slope of the consumption function illustrated earlier in this lesson.

Saving Notice that disposable income is greater than the consumer spending in the first table above for every quarter. For instance, in Quarter 1 of 2017, personal income equals $16,604.1 billion, and consumer spending totals $13,104.4 billion. One would wonder why consumer spending does not equal income. The answer is savings. If income is not spent, it is assumed that income is saved. Regardless of whether income above expenses is deposited into a savings account at a bank or extra cash is lost between the cushions of a sofa, any income over and above expenses is considered to be saved. That means an additional column can be added to the table above. This additional column would be savings and is determined by subtracting consumer spending from disposable income.

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Year Quarter Personal Income

(Billions of $)

Consumer Spending

(Billions of $)

Savings

(Billions of $)

2017

Q1 16,604.1 13,104.4 3,499.7

Q2 16,749.6 13,212.5 3,537.1

Q3 16,930.4 13,345.1 3,585.3

Q4 17,231.2 13,586.3 3,644.9

2018

Q1 17,540.3 13,728.4 3,811.9

Q2 17,725.0 13,939.8 3,785.2

Q3 17,928.5 14,114.6 3,813.9

Q4 18,082.8 14,211.9 3,870.9

2019

Q1 18,355.4 14,266.3 4,089.1

Q2 18,555.9 14,511.2 4,044.7

Q3 18,676.9 14,678.2 3,998.7

Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d. (https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ ories=survey). In the public domain.

Marginal analysis can also be used to determine how much a change in income will impact savings. To perform this marginal analysis, the change in savings would need to be divided by the change in income. The result of this calculation is called the marginal propensity to save (MPS).

Calculating Marginal Propensity to Save An example of how the MPS is calculated is shown below using the disposable income and saving information in the table above. Step 1: Calculate the difference in saving. In the example below, the difference in saving between the first quarter of 2017 and the first quarter of 2019 is calculated.

Year Quarter Saving

(Billions of $)

Difference in Saving (Q12019 – Q12017)

(Billions of $)

2019 Q1 4,089.1

4,089.1 – 3,499.7 = 589.4

2017 Q1 3,499.7

Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d. (https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ ories=survey). In the public domain.

Step 2: Calculate the difference in disposable income using the same two time periods as in Step 1. For example, the table below uses the difference in disposable income between the first quarter of 2017 and the first quarter of 2019 is calculated.

Year Quarter Personal Income

(Billions of $)

Difference in Disposable Income (Q12019 – Q12017)

(Billions of $)

2019 Q1 18,355.4

18,355.4 – 16,604.1 = 1,751.3

2017 Q1 16,604.1

Data from “Table 2.1. Personal income and its disposition,” by BEA, n.d. (https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&nipa_table_list=58&categ ories=survey). In the public domain.

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Step 3: Dividing the answer in Step 1 by the answer in Step 2 will yield the MPS.

Step 1 Answer Step 2 Answer Step 1 ÷ Step 2

Difference in Saving (Billions of $)

Difference in Disposable Income

(Billions of $) MPS

589.4 1,751.3 0.34

The result of 0.34 in the table above suggests that a $1 billion increase in income will cause savings to increase by $0.34 billion. The MPS is also equal to the slope of the marginal propensity to save function. Also, adding up the marginal propensity to consume and the marginal propensity to save will equal 1.0 (remember, income is either spent or it is saved).

Other Factors Affecting Consumption Remember the demand curve back in Unit II? The demand curve showed the relationship between price and quantity. If any other factor changed, the demand curve would shift. Here in Unit V, the consumption function shows a relationship between spending and disposable income, holding a host of other variables constant. Just like the demand curve, the consumption function can shift if one of the other factors changes. These factors are net wealth, price level, interest rates, and consumer expectations. These factors are discussed in detail below.

Net Wealth Net wealth is explained as the value of assets that are owned by households less liabilities or debts (McEachern, 2019). To put it in another way, net wealth is the difference between what you own and what you owe. The clothes you have on right now are part of your owned assets. The pen you use to take notes is as well. The same goes for your car, bank account, etc. What you owe would represent any debts you have. To calculate your own net wealth, add up the value of every asset you have and subtract the total debts you have. Changes to net wealth would cause the consumption function to shift to a new location. For instance, home values in California fell 6.6% between the last quarter of 2006 and the last quarter of 2007 (Kolko, 2008). With the net wealth of home owners being lower, home owners were less willing to spend money. That means the consumption function shifted to the left (decrease). On the other hand, stock prices increasing dramatically results in an increase in net wealth for many individuals. Increases in net wealth will cause the consumption function to shift to the right (increase).

Price Level As the price level in the economy changes, the purchasing power of consumers changes as well (McEachern, 2019). For instance, let’s say $100 in a checking account today can purchase 100 packs of gum (each pack of gum costs $1). If the price of a pack of gum increased by 10% (each pack now costs $1.10), that same $100 could now only purchase 90 packs (with $1 left over). In this case, your own personal consumption function has shifted to the left (decreased).

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The same holds true for a nation’s consumption function. If the average price level in an economy increases, the entire nation’s consumption function will shift left, and vice versa if the average price level in an economy decreases.

Interest Rate When money is deposited into a savings account, that money will earn interest (McEachern, 2019). Likewise, credit card companies charge interest on spending that is not paid off at the end of the month. These interest rates can cause the consumption function to shift. For instance, if the interest rate that would be paid for depositing money into a savings account is 0.25%, a $10,000 investment today would be worth $10,025 in 1 year. In this case, there is little incentive to invest the $10,000 in a savings account, and consumers are more willing to spend their additional money. However, if the interest rate were at 14%, that $10,000 investment would be worth $11,400 in 1 year. There would be much more incentive to save money when the interest rate is at 14% versus 0.25%. Since we already know that money is either saved or it is spent, higher interest rates would mean the consumption function would shift to the left (decrease due to reduced spending). Lower interest rates would cause the consumption function to shift to the right (increase due to increased spending).

Interest rates on credit cards work similarly. Higher interest rates on credit cards discourage spending, while lower interest rates on credit cards encourage spending.

Consumer Expectations Consumer expectations regarding future income, net wealth, price level, or interest rates can cause the current consumption function to shift (McEachern, 2019). Expectations for a big raise after completing your degree can result in the purchase of a new car, home, and so on, during the last semester of school. Expectations of higher price levels in the economy next year can result in increased consumption this year for larger items as well. The same goes for interest rates. Expectations that interest rates are going to increase next quarter may be the deciding factor for purchasing a new car now that will be financed. We can even find that the expectation regarding the need to save will impact the consumption function. Investing money monthly into a 401k is an example of expectations concerning the need for money in the future. The inv