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Rolston Burton

2/28/08
ECON 1100
Chapter 10 Summary

Aggregate Expenditures

In this chapter we examine, in detail, the demand side of the economy by examining

aggregate expenditures. To understand why real GDP, unemployment, and inflation rise and fall

over time, it is necessary to know what causes aggregate demand and aggregate supply curves to

shift. It is not possible to understand how recession and expansion of the economy functions

without understanding how both these curves shift. This chapter will examine the nonprice

determinants of spending and shifts of aggregate demand in greater detail assuming that the price

level is fixed.

Consumption and Saving

When households receive income they can do three things with it. They spend it for the

consumption of goods and services, save it, and pay taxes with it. Taxes must and will be paid.

Disposable income is what households actually have available after taxes. Whatever is not used

for consumption is saved.

In a household, saving generally means putting money aside. In a broader sense,

typically used in economizing, it can mean cutting costs. Saving occurs over a unit of time, it is

a flow concept. Saving can therefore be vital to increase the amount of fixed capital available,

which contributes to economic growth. Like saving, GDP and its components are also flow

concepts. Each of them occur over a period of time.

The primary determinant level of consumption is the level of disposable income. In other

words, the higher the disposable income a household has the more they will be willing and able

to spend. The relationship between disposable income and consumption is called the

consumption function. The consumption function calculates the amount of total consumption in
an economy. On the graph there is a 45 degree line splitting the graph into two equal pieces. This

line represents where consumption and income are equal. Saving occurs when level of disposable

income lies below the 45 degree line. At this point consumption is less than disposable income.

When the level of disposable income lies above the line, it means that the household is spending

more income than it earns. This usually happens at generally lower income levels. When this

happens the household must finance its spending by either borrowing or using savings. This is

called dissaving.

Both the consumption function and saving function have positive slopes because as

disposable income rise so do savings and consumption. The marginal propensity to consume is a

way to measure the change in consumption as a proportion to the change in disposable income.

The MPC tells us what fraction of change in income is used for consumption. The marginal

propensity to save is a way to measure the change in saving as a proportion to the change in

disposable income. Both the MPC and MPS are the save as the slope of the consumption and

saving functions.

Disposable income is not the only factor of that influences consumption. Changes in

wealth, expectation, demographics, and taxation are other determinants of consumption. Each

one of these determinants can have a positive or negative effect on disposable income. This is

represented by shifts in the consumption and savings graphs.

Investments

Investment or investing is a term with several closely-related meanings in business

management, related to saving or deferring consumption. Investment is business spending on

capital goods, inventories and the necessary items needed to produce their products. On a graph,

as a function of real GDP, autonomous investment is drawn as a horizontal line. We say

autonomous assuming that it remains constant as real GDP changes. As the determinants of
investments change the investment function shifts upward as investment increases and

downward as investment decreases. The primary determinants of investments are the interest

rate and profit. The interest rate is the cost of borrowed funds. Many businesses are financed by

borrowing. The higher the interest rate the lower the rate of investment. Profit expectations are

forecasted to determine the total costs of investments. Factors such as new business competition,

politics, laws, taxes, all have an effect on the forecasted profit expectations. Technological

change, the cost of capital goods, and then rate of capacity utilization have an impact on the two

main factors.

Government spending is the second largest component of aggregate expenditures in the

United States. Government purchases of goods and services intended to create future benefits,

such as infrastructure investment or research spending. Government spending is classed as

government investments.

Net Exports

The last component of aggregate expenditure is net exports. Net exports equal a

country’s exports minus its imports. When exports are positive there is a surplus, when negative

there is a deficit. Assuming that net exports are autonomous there are many determinants that

determine the actual value of exports. These are foreign income, tastes, government trade

restrictions, and exchange rates. They are all independent of real GDP.

Aggregate expenditures are the sum of planned consumption, planned investment,

planned government spending, and planned net exports at every level of real GDP.