Movement along the consumption function occurs whenever the national income changes- if it increases, then we move up and to the right along the consumption function. If the national income decreases, we move left and downwards along the consumption function. The graph itself, however, doesn't move in response to changes in national income.
Changes in the ceteris paribus variables (wealth, expectations, and interest rates), however CAN shift the consumption function up and down. This constitutes a SHIFT in consumption!
When consumption increases, the graph shifts up. When consumption decreases, the graft shifts down.
WEALTH causes direct shifts: an increase in wealth causes an upward shift of consumption
EXPECTATIONS cause direct shifts: optimism causes upward consumption shifts, while pessimism causes downward consumption shifts
INTEREST RATES cause inverse shifts: as interest rates rise, consumption decreases and vice versa.
Most of these variables tend to remain stable in the short run, however, so economists suspect that changes in consumption are not the root cause of the fluctuations we witness in business cycles.
There are other theories about consumption other than the one we have just learned about!
Modigliani and Friedman both came up with similar theories that suggest that consumption is a function of someone's average lifelong income, rather than current disposable income. This accounts for consumption which continues to remain high after retirement- current disposable income is very low for retirees, but they are able to live off of some stockpiled income from their income throughout the rest of their lives.
Okay.. time to factor in INVESTMENT!
Remember, investment involves Plant and Equipment, Inventories, and Residential Construction. Of all of these subfactors of investment, inventories tend to fluctuate the most.
There at 3 BIG factors which affect investment, so you could think of all of these at the ceteris paribus variables for investment
-The Real Interest Rate
-Changes in Sales
-Business Confidence
(Technology improvements, a decline in the price of new capital goods, and higher relative output prices may also affect investment, but we don't have to worry about that right now)
Interest Rates have a reverse relation to investment: the higher the interest rates, the higher the opportunity cost of borrowing money for investment, so overall investment decreases as interest rates rise
Sales have a direct relationship with investment. As sales increase, businesses need to have a larger inventory to buffer possible stock depletion, and also sales requires greater production, which facilitates investment in more plant an equipment.
Business Confidence has a direct relationship with investment. If business are confident that their economic futures are promising, then they will invest in more plants, equipment, buildings, and inventories. If the prospects appear grim, however, and businesses are uncertain if they will make profits in the near future, they are far less likely to invest.
SOOO: Investment is related and affected by these three factors... BUUUUUUUUUTTTTTTTTTTTTT
INVESTMENT IS NOT RELATED TO NATIONAL INCOME! IT IS AUTONOMOUS
In other words, if we were to graph investment as a function of national income, it would be a constant, flat-line graph!
Investment stays the same even as national income change, as long as the ceteris paribus variables remain constant.
Changes in the ceteris paribus variables can shift investment up or down, however!
OKAY: That's all we need to know about investment. Now, we just have to put the two together: This is called aggregate expenditure, and we graph it as a function of national income, so AE = f(Y)
In a frugal economy (with only a bank added to the economic flow system), desired Aggregate Expenditure = Consumption + Investment
SO, AE = C + I = f(Y)
AE = autonomous consumption + mpc(national income) + Investment
AE = a +b(Y) + I
This is the aggregate expenditure function! The slope of the aggregate expenditure function is called the Marginal Propensity to Spend (The change in expenditure divided by the change in national income)
***Important: You do not want to consume MPSpend with MPS, as MPS is the marginal propensity to save (which is how much money is saved per dollar of income, or the slope of the savings function)
So, now we know what the aggregated expenditure function looks like. Now, the only thing left to do is to figure out where equilibrium is.
SO, where is equilibrium?
It's any point where Income stays constant over time!
Well, there are two ways of thinking about equilibrium in macroeconomics:
-The Garden Hose Theory suggests that equilibrium is when Income is equal to expenditures. If you think about this in terms of the circular flow diagram, this means that the incomes that household receive from firms are equal to the expenditures that firms receive from households. Here, the condition for equilibrium is that the national income must equal expenditures!
-The Bathtub theory suggests that equilibrium is when the amount of monetary injections into an economy are equal to the amount of monetary withdrawal from an economy. Think of it like a bathtub with the tap adding water to the tub, while the drain removes water from the tub. If the tap adds water to the tub at the same rate that the drain removes water from the tub, then the water level in the tub remains the same, so we could say that the tub is in equilibrium! Using our current frugal economic model, equilibrium is when savings (withdrawals) are equal to investment (injections).
You will find that the point where Y = AE and where J (Injections) = W (Withdrawals) is the same!
This is also a stable equilibrium! There are pressures which return both expenditure and investments to equilibrium levels in the event of disequilibrium!
Let's say that desired expenditure is lower than GDP: This means that people want to consume more than an economy is effectively producing. In response to this increase in demand, producers will increase their level of production to make more products to satisfy that demand. That increase in production causes gross domestic product to raise, and eventually align with expenditure!
On the other hand, if GDP is greater than expenditure, this means that more products are being produced by an economy than are being consumed by households. Businesses will notice the drop in sales, and respond by producing fewer products. This reduction in output causes the GDP to fall until it aligns with expenditure.
The savings function works similarly, BECAUSE IT IS DERIVED FROM THE CONSUMPTION FUNCTION!
We can then shift around all of these different graphs by changing ceteris paribus variables, and then try and predict where new equilibriums will be! Expect this sort of thing on your typical, Gateman-style examination! Practice this sort of activity in your precious spare time, and you'll be a macroeconomic whiz-kid!
I bet you're EXCITED!
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