Macroeconomics

2.0 Aggregate Expenditure

2.0 Aggregate Expenditure in a Closed Economy

Aggregate Expenditure (AE) is a one of two macroeconomic demand functions introduced by Keynes.  The other is Aggregate Demand (AD).   In symbolic terms, assuming a closed economy:

AE = C + I + G and

AD = C + I + G

where

Y = National Income (GDI) and/or Output (GDP)

C = Consumption by households;

I = Investment by firms in new plant, equipment and inventories;

G = Government spending derived from taxes on household or borrowing;

GDI = gross domestic income earned by all domestic factors of production including capital, labour and natural resources; and,

GDP = gross domestic product of all final goods and services produced by a national economy.

The difference between AE and AD is the aggregate price level (P).  For AE, P is assumed fixed.  For AD, P is assumed variable.  This has significant policy implications

Both AE and AD = Y (GDP) in equilibrium.  As a symbolic production function, assuming only three factors of production or inputs:

Y = f (K, L, N)

where:

K = Capital as plant, equipment & inventories;

L = Labour as productive, managerial and entrepreneurial workers;

N = Natural Resources; and,

f = Technology as in ‘know-how’.

Y as Output is measured as actual and potential GDP, i.e., what is the actual level of 'real' output (rather than 'nominal' or 'monetary' output which assumes a change in P) relative to potential if all factors of production were fully employed.  Y as output is also called Aggregate Supply (AS) measured in the short-run as an upward sloping SAS curve (its elasticity has significant policy implications) and in the long-run as a vertical or perfectly inelastic LAS curve which corresponds to potential output of a national economy assuming full employment of all factors of production.

Y as Income is earned by households thru the sale of factors of production (K, L, N) to firms.  Capital earns interest (r); Labour earns wages (w); and, Natural Resources earn rent (R).  In a closed economy you can only spend what you earn on what you produce and accordingly:

Y = (r + w + R) = AE or AD in equilibrium.

In this section we will examine the components of AE with respect to the Objective Function (maximizing subject to constraint) of each macroeconomic agent: consumers, investors and government.  We begin with a closed, mixed economy in which  P is fixed and equilibrium exists where AE = Y.  Graphically this is represented as a locus of points forming a 45 degree line drawn from the origin of a 2 dimensional graph with Y represented as the X-axis and AE by the Y-axis.   As we will see, as with AD, AE concerns planned spending, that is we live in the future but act in the present.

2.1 Consumption & Savings - Induced Expenditures

    Consumption, in economic theory, means the final use of goods and services to satisfy human wants, needs and desires.  In a sense, consumption is 'negative production' in that 'normal' goods and services are destroyed in the act of consumption.  Savings is the difference between disposable income and consumption.

    The primary factor affecting consumption and savings is disposable income which equals income earned less taxes plus transfers.  Consumption involves the purchase of goods and services by households.  Savings equals disposable income less consumption.  Households can thus do two things with its disposable income.  They can spend or save.  
    All things being equal, as disposal income increases, consumption and savings increase, that is, C & S are induced by changes in Y.

a) Consumption Function

    The relationship between disposable income and consumer expenditure is called 'the consumption function'.  If we plot disposable income on the x-axis with consumption  on the y-axis then a 45 degree line shows where consumption equals disposable income (MBB 10th Ed Fig. 7.2; MBB 11th Ed Fig. 6.2; PB Fig. 25.1, p. 545). 

The y-intercept for consumption is positive reflecting 'dis-savings' or the sale of assets if there is no disposable income.  This positive amount of consumption without any disposable income is called ‘autonomous consumption’.   When the consumption curve is above the 45 degree line there is, therefore, dis-savings; when below the line there is savings. Thus as disposable income increases so does savings.  Symbolically:

 C = a + bYd

where:

a = some minimum, non-discretionary survival level of consumption even when income is zero;

b =  the marginal propensity to consume (b); and

Yd = disposable income, i.e., gross income less net taxes.

b) Marginal Propensity to Consume

   The marginal propensity to consume (MPC) is the ratio between the increase in consumption and the increase in disposable income and is reflected in the slope of the consumption curve. On the 45 degree line, MPC = 1 (MBB 10th Ed Fig. 7.3; MBB 11th Ed Fig. 6.3; PB Fig. 25.2). 

c) Consumption as a Function of Real GDP
    Consumption is a function of real GDP because disposable income increases and decreases along with real GDP (MBB 10th Ed Fig. 7.4; MBB 11th Ed Fig. 6.4; PB Fig.  25.3).   The consumption function varies between countries. (MBB not displayed; PB Fig. 25.4)

    As noted above, disposable income equals real GDP (calculated as all income earned by factors of production assumed to belong to households) less net taxes.  Net taxes equal taxes minus transfers to households by government.  Net taxes tend to increase as real GDP or income increases, e.g. income tax.  The proportion of each additional dollar of real GDP that is taken by government as taxes is called the marginal tax rate (MTR).  The marginal tax rate (MTR) equals the ratio of increased taxes and increase in real GDP.  Put another way, MTR equals the ratio between increased taxes and increases in real GDP  Therefore, marginal propensity to consume out of real GDP equals MPC x (1-MTR).  Thus changes in MTR will shift the slope of consumption curve. 

d) Savings Function

The relationship between disposable income and saving is called the savings function.  If we plot disposable income on the x-axis and savings on the y-axis, the lower right quadrant shows dis-savings; at the x-axis intercept, savings equals zero; above the x-axis, savings are positive (MBB 10th Ed Fig. 7.3; MBB 11th Ed Fig. 6.3; PB Fig. 25.2).

e) Marginal Propensity to Save

The marginal propensity to save (MPS) is the ratio between increase in savings and increases in disposable income (MBB 10th Ed Fig. 7.3; MBB 11th Ed Fig. 6.3; PB Fig. 25.2).  When MPS = 0 this corresponds to  the point where consumption function is on the 45 degree line. Other influences on savings include changes in: interest rates; the value of net assets, i.e. changes in the price level.; and, expected future income.  Such changes can shift the consumption and savings functions.

2.2 Investment & Government Expenditure - Autonomous Expenditures

a) Investment

    Each firm has a list of investment projects that can be rank ordered by expected rate of return as profit (π) then compared with the opportunity cost of money, i.e., the interest rate (r).  This schedule was introduced by Keynes and is known as the 'marginal efficiency of capital schedule'.  While mainstream economists have assumed rationality in calculating the schedule, Keynes stressed limitations of long-run expectations due to true ignorance, i.e., lack of knowledge about the future.  (see: The General Theory of Employment, Interest and Money Chapter 12: The State of Long-Run Expectations.  These limitations combined with his contrast between 'enterprise' (investing for the long-run) and 'speculation' (playing the market) are directly applicable to the Crash of 2008. 

Further, as one noted economist wrote about Chapter 12:

Keynes’s whole theory of unemployment is ultimately the simple statement that rational expectation being unattainable, we substitute for it first one and then another kind of irrational expectation: and the shift from one arbitrary basis to another gives us from time to time a moment of truth, when our artificial confidence is for the time being dissolved, and we, as business men are afraid to invest, and so fail to provide enough demand to match our society’s desire to produce.  Keynes in the General Theory attempted a rational theory of a field of conduct which by the nature of its terms could be only semi-rational.  But sober economists gravely upholding a faith in the calculability of human affairs could not bring themselves to acknowledge that this could be his purpose.  

Shackle, G.L.S., The Years of High Theory: Invention and Tradition in Economic Thought 1926-1939,

Chapter 11 - To the 'QJE' from Chapter 12 of the "General Theory': Keynes's Ultimate Meaning,

Cambridge at the University Press, 1967

 .

Investment, in economic theory, means the acquisition of the means of production (including goods for selling) with money capital.  The decision to invest (or level of investment) depends on expected real profit rate and the real interest rate.  

Expected real profit rate equals the monetary profit rate minus the inflation rate.   All things being equal, the higher the real profit rate the higher the level of investment.

    Real interest rate equals the monetary interest rate minus the inflation rate.   All thing being equal, the higher real interest rate the lower investment.   The interest rate is, in effect, the price of money.  Because investment involves the acquisition of the means of production using money capital, if the real interest goes up, the opportunity cost of investment goes up, that is the purchase of interest earning assets rather than means of production becomes more attractive.

    Changes in expected real profits and real interest rates will affect the level of investment.  Changes in real GDP will not.  In this sense, investment is autonomous of real GDP.  (MBB 10th Ed Figs 7.5, 7.6., 7.7 & 7.8; MBB 11th Ed. Figs. 6.5, 6.6, 7.1, 6.7; PB not displayed)  Its formula is: I = (π, r), i.e., some function of the expected rate of return or profit (π) and the interest rate (r). 

b) Government Expenditure

    Government spending is funded out of taxes on the income earned by households and/or borrowing on financial markets.  It is determined politically, that is government spending influences real GDP but real GDP does not necessarily influence government spending.  In this sense, government expenditure is autonomous of real GDP. Its formula is G = (politics), i.e., government spending is a political not a strictly economic decision.

2.3. An Open Economy: Exports & Imports

a) Exports

    In economic theory, exports are goods and services sold to citizens of another country plus services involved in the shipping, financing and otherwise facilitating such exports.  Exports are determined by international prices (determined by the exchange rate), trade agreements and, most importantly, the real GDP of foreign countries.  All things being equal: the higher foreign prices, the more liberal trading agreements and the higher the real GDP of foreign countries the higher will be exports.  Exports are autonomous of domestic real GDP.

b) Imports

    In economic theory, imports are goods and services bought from citizens of another country plus services involved in the shipping, financing and otherwise facilitating such imports.  Imports are determined by international prices, trade agreements and, most importantly, the real domestic GDP.  All things being equal: the lower foreign prices (determined by exchange rates), the more liberal trading agreements and the higher domestic real GDP, the higher will be imports.  

    The import function is the relationship between real domestic  GDP and imports assuming all other factors are held constant.  The slope of the Import Function is the marginal propensity to import, that is, the ratio of increase in imports to increase in real domestic GDP (MBB 10th Ed not displayed; MBB 11th Ed Fig. 7.4; PB Fig. 25.5, p.550).  

c) Tangibles, Intangibles & Intra-Corporate Transfer Pricing

Some things, generally tangible things, are easy to count, e.g., wheat, coal, cars, etc.  These constitute tangible imports or exports.  Other things, generally intangible things, are more difficult to count, e.g., intellectual property royalties, management fees, etc.  This puts a bias into the final count.  Furthermore, with multi- or trans-national corporations there is the problem of intra-corporate transfer pricing which involves, among other things, maximum avoidance of tax given the different jurisdictions in which they operate.