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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. Thus
there are also two supply curves in the Keynesian model. Y as
output is 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 (P&B 4th Ed
Fig. 25.1;
7th Ed. Fig. 27.1).
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 (P&B 4th Ed Fig. 25.2;
7th Ed Fig. 27.2).
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 (P&B 4th Ed Fig.
25.3;
7th Ed not displayed). The consumption function varies between
countries. (P&B 4th Ed Fig.
25.4; 7th Ed. p. 653)
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 (P&B 4th Ed Fig. 25.2;
7th Ed Fig. 27.2).
e)
Marginal Propensity to Save
The marginal propensity to save (MPS) is the ratio between
increase in savings and increases in disposable income (P&B 4th Ed Fig. 25.2;
7th Ed Fig. 27.2). 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
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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. 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
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 (P&B 4th Ed
Fig. 25.5;
7th Ed Fig. 27.3).
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.
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