Chapter 11: Income and Expenditure
1. Overview. We are now going to build the basic model of the economy. The goal of this section
is to explain the business cycle; to explain fluctuations in GDP. The key to explaining why
businesses produce a lot of goods and services or not very many goods and services is to focus
on the demand side of the economy. We will call the total demand for goods and services
aggregate expenditures, or AE. The model consists of the following equations:
AE = C + I + G + (X – IM)
C=
I=
G=
X=
IM =
Y = AE (Equilibrium Condition)
The first equation is simply the definition of AE. AE equals the sum of spending from consumption,
investment, government purchases, and net exports. The middle five equations look at these spending
terms in more detail. Finally, the last equation is called the equilibrium condition. It simply says that the
actual amount of GDP that businesses produce is a function of demand. If demand is high, businesses
produce a lot of stuff. If demand is low, businesses do not produce much stuff. We will first look at the
spending components individually, before coming back and putting everything together.
2. Consumption C. What is the most important factor that influences your total spending during
the month? Answer: Income. Income is far and away the most important factor that influences
consumer spending. If income increases, consumer spending increases. The relationship
between a change in income and a change in consumer spending is very important in
understanding the business cycle (since the key to explaining the business cycle is spending, the
largest spending component is consumption, and the most important determinant of
consumption is income). A number of Nobel Prizes have been awarded for studying this
relationship between a change in income and a change in consumer spending.
Suppose that income rises by $1,000. How much does your consumer spending increase? Clearly, this is
an individual decision. Some consumers will spend most, if not all, of the increase. Other consumers
will spend very little. For the economy as a whole, let us suppose that consumption increases by $800.
This means that the remaining $200 was saved. You either consume or spend a change in your income.
(We are leaving taxes out of the picture for the time being.) The variable that measures the relationship
between a change in income and a change in consumption is called the marginal propensity to consume,
or MPC.
MPC = (Change in Consumption) Divided by (Change in Income)
In our example, the MPC is $800/$1,000 = .8. The dollars cancel. The MPC will always be between 0 and
1. It is the fraction of any change in income that you will spend. If you get $1, you will spend 80 cents.
This also works for decreases in income. If your income falls by $1,000, you will cut your spending but
probably not by the entire amount. If you cut your spending by $800, pulling some money out of your
savings, the MPC is again .8.
I drew the graph for consumption in class, with consumption (and aggregate expenditures) on the
vertical axis and income (using our Y symbol) on the horizontal axis. Consumption is upward sloping
because, as income increases, consumer spending increases. It is drawn with an intercept. We label the
intercept as C with a bar over it, or Cbar. The slope is the change in consumption divided by the change
in income, which is also the definition of the MPC. Thus, the MPC is the slope of the consumption
function. So, the equation for consumption can be written as C = Cbar + MPC x Y. We are using Y to
stand for income. The equation just says that as income increases, this causes consumption to increase.
Other Factors that influence consumer spending:
a. Wealth. Wealth is different than income. Income is how much you make each year. Wealth is
in a sense, an accumulation of your savings—your net worth—how much you have in assets,
such as the stock market, your house, your bank account, minus your liabilities, such as what
you owe on your house, your car, your credit card, your student loan. If you make money in the
stock market, that represents an increase in your wealth. Even if your current job situation has
not changed, you might go out and buy something from your gain in the stock market. This is
known as the wealth effect and is the main way in which economists believe that the stock
market influences the real economy. If stocks go up in price, wealth increases, which may lead
to increased consumption, which can help out businesses. On the other hand, if stock prices
plummet, this represents a drop in wealth and if this leads to a drop in consumer spending, this
in turn can hurt businesses.
b. Consumer Debt—the opposite of wealth. Given higher consumer debt, we will get less
consumer spending because consumers must first pay their credit card bill (or house bill or
student loan bill). Consumers, like business and the government, have run up a lot of debt.
(Student loan debt just passed credit card debt.)
c. Taxes. Most federal taxes are the personal income tax. When taxes are changed, this primarily
influences consumer spending, although it depends somewhat on what taxes are changed. The
tax impact on consumer spending in the first of three primary tools that the government has for
influencing aggregate expenditures and the overall economy. A decrease in taxes would help to
encourage more consumption, for example.
d. Consumer Confidence. If consumers are optimistic about the future they might consume more,
which helps businesses and helps the economy. This can be somewhat self-fulfilling. On the
other hand, if consumers are pessimistic about the future and cut their spending, this can hurt
businesses, leading to cuts in production and layoffs—again somewhat self-fulfilling. There is a
monthly measure of consumer spending from the University of Michigan. However, even
though consumer confidence can be an important influence over economic activity, it is very
difficult to measure accurately and to then build into an economic model.
3. Investment I. Within our model, we will just set investment to a particular level, such as $2.1
trillion. In graphing investment, we would just have a flat line at this fixed amount. However,
clearly investment spending is not fixed. It is often business spending and the housing market
that lead us into and out of recessions. What we want to do is to look at the behavior of the
market system with a fixed level of investment and then allow investment to change to see the
impact.
Factors that influence investment spending:
a. Interest Rates. Most people who buy a house borrow the money over a 30 year period of
time. Therefore, the interest rate that you are borrowing at makes a big different in your
monthly mortgage payment. This is the second key tool that the government uses to
influence the economy. The Federal Reserve has lowered interest rates to near record
levels—around 3.5% to borrow on a 30-year mortgage. They are doing this to help turn
around the housing market, trying to increase the level of housing investment. The housing
market has gone from massive decreases in housing investment in 2008 to significant
increases in 2012-13. Interest rates also influence business investment. Lower interest
rates makes business borrowing for investment projects more profitable. Business
investment has also changed dramatically over the last 4-5 years, moving from large
decreases to significant increases.
b. State of Economy or Sales, as measured by GDP. If you are running a business, when are
you going to expand—to build another factory and buy more capital equipment? You are
probably more likely to do this when your business is doing well—when your sales are high
and rising. If this is happening for businesses in general, we can use GDP as the measure. If
GDP is rising, representing increased sales, businesses may invest more. But if businesses
are investing more—spending more on factories and machines—that will help other
businesses and lead to an increasing economy. On the other hand, if GDP is dropping,
businesses may cut back on their spending, which hurts other businesses and makes the
recession even worse. It is for this reason that this model is called the Accelerator Model of
investment. Movements in the economy are accelerated. If we start on a downswing (and
the government does not step in) we might accelerate downward as businesses cut their
spending. This leads to a more unstable market economy. This is more of the Keynesian
view of the market system—that government staying out of the economy can lead to quite
an unstable situation. Thus, Keynesian models tend to include the Accelerator Model and
Classical models tend to leave it out. Who is right? Unfortunately, it is not so easy to test
exact relationships in economics (as it is in chemistry). It is hard to run a controlled
experiment. In general, we look at numbers from the past to find relationships between
variables. However, the experiment is never controlled and there is often room for
argument that the relationship between two variables is really due to other variables
changing.
c. Business Taxes. A cut in business taxes might lead to higher profits, which could lead to
greater business investment. A business tax cut could take the form of a decrease in the
corporate income tax rate, an increase in the depreciation allowance, an investment tax
credit, or possibly a decrease in the personal income tax which affects smaller businesses.
d. Corporate Debt. Given higher debt, corporations are less likely to expand. In fact,
sometimes the result of big corporate takeovers is less investment. This is because
takeovers are often financed by borrowing heavily. The resulting company can be saddled
with high debt. There have been many instances where the takeover results in
“downsizing” the company just to meet debt obligations. Like consumers and the
government, corporations have piled up a lot of debt, which can lead to less business
investment over the long run.
e. Stock and Bond Prices. One way for corporations to finance expansion is through the stock
or bond markets. (Stock represents ownership. Bonds represent borrowing.) If stock prices
and/or bond prices are rising, corporations might be more likely to issue new stock or bonds
to finance investment spending. When the stock market was rising in the 1990s, there were
f.
lots of new issues. When the stock market collapsed in 2000, new issues dried up. We are
starting to see more new issues as stock prices have more than doubled over the last 5
years.
Business Confidence. Similar to consumer confidence, business confidence can influence
spending. If business leaders are optimistic about the future, they might be more likely to
invest. This in turn helps other businesses, which can help to produce a booming economy.
If business leaders are pessimistic, on the other hand, this can lead to less investment, which
can lead to a slowdown in the economy. So, this can also be somewhat self-fulfilling, but is
also very difficult to mathematize to put into an economic model. Who knows why business
leaders are optimistic one day and pessimistic the next? Keynes referred to this as “animal
spirits” influencing business leaders—not something that can be easily translated into a
mathematical equation.
4. Government Purchases G. We fix government purchases at a particular level, such as $3 trillion.
However, we know that government purchases are not fixed. This is an important control
variable that the government has for influencing the economy (and is our third key tool). We
will first look at how the market system functions with a fixed level of government spending. In
the next chapter on fiscal policy, we will return to government purchases to see how changes in
spending influence the economy.
5. Net Exports (X – IM). This is also fixed within the model, such as fixing net exports at -$.7
trillion. (Negative for a trade deficit and positive for a trade surplus.)
Factors that influence net exports:
a. Government Restrictions, including tariffs (tax on imports), quotas, and bans. Economists
tend to argue against government restrictions such as tariffs as this tends to reduce
international trade and increase prices for consumers. In addition, the U.S. tends to have
the lowest amount of trade restrictions and can benefit more internationally by arguing for
decreased government restrictions.
b. U.S. Income. If U.S. income rises, this leads to more spending by consumers. Not all of this
spending is on domestic production. Some of it goes to foreign products. Thus, imports
rise. Note that this can lead to a trade deficit, even though it is reflecting something good in
the United States. Thus, a trade deficit by itself is neither bad nor good, it depends on what
causes it. There are other influences over our trade deficit that are not so good.
This link between what is happening in the United States (U.S Income) and imports is the
key link between economies around the world. If income in the United States is rising, this
can help to pull up income in other countries. We buy more from Japan, for example, which
helps exporters in Japan, who step up production and hire more people. It has been
estimated that a 1% rise in the U.S. economy helps to boost the Japanese economy by 1%
(compared to what they otherwise would have done). And the impact that the U.S. has is
significantly higher in many smaller countries. Some countries are very trade dependent
with the United States. If the U.S. economy is doing well, we buy lots of goods from other
countries, which helps to produce a booming country. On the other hand, when the U.S.
falls into a recession, we buy less stuff from other countries. This can literally cause a
recession in those countries.
c. Foreign Income. If foreign income falls, consumers in those countries buy less from the
United States—our exports fall. Note that this also contributes to a trade deficit, which is
not such a good thing. Although the United States, with the world’s largest economy, has
potentially an enormous influence over other economies, the reverse is not nearly so true,
although this has been increasing in importance. In the mid to late 90s, many countries,
particularly in Asia were experiencing slow economies. There was worry that this slowdown
would spill over into the United States. Although this did not happen, international trade
has been increasing in importance. Recessions in the United States are more often caused
from slowdowns in investment spending, rather than slowdowns in exports.
d. U.S. Prices. Rising U.S. prices can lead to lower quantities of exports (and higher quantities
of imports).
e. Foreign Prices. Falling foreign prices can lead to higher quantities of imports (and lower
quantities of exports).
f. Exchange Rate. In comparing prices between countries, a conversion must be made
between the price of a U.S. good in dollars and the price of a Japanese good in yen. The
exchange rate can also have a significant impact on trade. If I define the exchange rate as
the value of the dollar, then the exchange rate is equal to foreign currency per dollar—how
much foreign currency one gets per dollar or how much foreign currency must be paid to
get a dollar. (You can also look at the reciprocal, which would be the value of the foreign
currency—dollar per foreign currency.)
What happens when the value of the dollar rises, also called a strong dollar? Sounds like a
good thing, but it really depends on what group you are looking at. An increase in the value
of the dollar would certainly help U.S. consumers. If you are traveling to Europe, for
example, a strong dollar gets you more Euros per dollar, essentially lowering the prices of
foreign goods. We would buy more foreign goods. The downside to this is that since the
value of the foreign currency must be decreasing (by definition), foreign countries would be
less likely to buy our goods. Thus, a strong dollar can hurt U.S. exporters. Washington
State, in particular, being the most trade-dependent state in the country (with exporters
such as Boeing and Microsoft) would be hurt. Note also that a strong dollar leads to a trade
deficit since exports fall and imports rise.
What determines the exchange rate? Most countries allow exchange rates to be primarily
determined on the open market—simply the interaction of supply and demand. The supply
of dollars originally comes from the Federal Reserve since they are responsible for printing
dollars. However, now that dollars are out in circulation, anyone can be part of the supply.
If you are traveling to Europe next summer, you would supply dollars to get Euros.
Businesses involved in international transactions would be supplying dollars to convert into
foreign currencies. In fact, many countries that do not use the dollar directly, often use the
U.S. dollar for international transactions. If there is any world currency, the U.S. dollar
comes the closest.
On the demand side for the dollar, when you return from Europe you would be demanding
dollars (by supplying Euros). Similarly for international businesses. Central banks can also
buy and sell dollars. This interaction between demand and supply determines the price (or
value) of the dollar. The Federal Reserve has printed a lot of money over the last 5 years.
This increased supply is one of the factors that has decreased the value of the dollar. (Note
that this has been the general trend, although it does depend on which day or month or
country that you are looking at.)
Both President Bush and now President Obama have allowed (and even encouraged) the
decrease in the value of the dollar. This helps to lower our trade defict as exports increase
and imports decrease. One sticking spot is our trade with China. China is one of the few
countries that does not allow their exchange rate to be determined on the open market.
They tend to peg the value of their currency with the value of the U.S. currency. When the
value of the U.S. dollar decreases, China tends to lower their value so that there is little or
no change in the exchange rates between the two countries. They do this to keep up
exports with the United States.
One of the justifications for bringing China into the World Trade Organization is to put more
pressure on China to allow their currency to rise in value. And, China has allowed some
movement in their currency—as the U.S. dollar drops in value relative to most currencies,
China has allowed a bit more flexibility in letting the value of the Chinese currency to
increase somewhat. However, most economists believe that the Chinese currency is still
significantly undervalued.
6. Equilibrum
7. Spending Multiplier
The last two sections, where we put the main model of the economy together, will be covered in
class.