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Econ 100b

Created 4/30/1996
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Lecture Six

Division of GDP Between Consumption and Investment
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

January 31, 1996


Review
Aggregate Demand: Consumption
Government Purchases
Investment
Loanable Funds


Review

Last time we set up the simple supply side of our full-employment equilibrium model:


Output is determined by the available capital stock and labor supply, and by the technological efficiency at production--how good the technology is at turning labor and capital into output. The real wage is set, under perfect competition, and for the economy as a whole, by the requirement of labor market equilibrium: firms want to hire no more workers than the available labor force--but they do want to hire everyone in that available labor force. The real return to capital is set by the requirement of capital market equilibrium: capital is sufficiently expensive that firms don't want to hire any more than the economy's accumulated capital stock--but they do want to hire that accumulated capital stock.

Government Purchases

A first component of aggregate demand is government purchases: the purchase by federal, state, and local governments of goods and services. "G" does not include government transfers (remember, they show up later, in net taxes). The government's choices of spending on goods and services and of net taxea are together summarized as the governmetn's fiscal policy--and the difference between government purchases and net taxes, the deficit (DEF) is an often used measure of fiscal policy: actions to enlarge the deficit are seen as expansionary--or inflationary: expansionary if you like them, inflationary if you don't. Actions to shrink the deficit or run a surplus are contractionary (or, if you like them, prudent).

Aggregate Demand: Consumption

Consumption is the largest component of aggregate demand. Individuals receive income--wages and profits from the capital they own. Total income is total national product: Y.

Some of this income is taxed away. Some of this income is augmented by a government that writes entitlement checks to individuals: transfer payments. At the extremely broad aggregate level at which we are working, and modelling the economy, only the net flow from individuals to the government matters: T is net taxes, is the difference between taxes and transfer payments.

Disposable income is Y - T

What do people do with their disposable income? They save some of it (recall private saving, S-sub-p). They spend the rest on consumption goods--services, non-durable commodities, and consumer durables. Note that the line between consumption and saving is somewhat arbitrary: why is the purchase of a car consumption and not saving? Why is the purchase of a house saving and not consumption.

At the level of the aggregate economy, there is a pretty constant and pretty stable relationship between consumers' disposable incomes and how much the spend on consumption. We call this the "consumption function". And we call the rate at which consumption increases as income increases the MPC, the marginal propensity to consume.



We have a very strong belief that the MPC is going to be between zero and one--that people will spend some of any extra addition to their income on consumption (that is, they will not save all of it), but that they will not spend all of the extra addition to their income on consumption (that is, they will save some of it).

MPC varies depending on whether the increase in income is seen as permanent or as transitory. Kennedy-Johnson tax cut back in 1964 (or Reagan tax cut back in 1981) as opposed to the--explicitly temporary--Vietnam War tax surcharges of 1968-1969.

Remember George Bush's "withholding" change proposal? [Digression]

Investment

The single most important determinant of investment is "the" interest rate--or perhaps I should say, "the" interest rate combined with the marginal product of capital, the MPK, the R* above.

Investment depends upon the interest rate because investment decisions are long-term decisions, made with both eyes firmly on the future. You build a new factory, you live with that factory for thirty yeasr.

Businesses face a number of different investment opportunities, all of them with uncertain and different returns. Businesses try to guess which projects are worthwhile--and a key element in that assessment is the cost of the financing to make the investments, either in terms of the dividends, coupons, or bank interest that will have to be paid once the money is obtained; or in terms of the money lost if you take the cash you were going to use for investment and instead did something else with it--threw it back into the financial markets, and clipped coupons yourself.

Thus we write I=I(r), where r denotes the real interest rate--and I is a decreasing function of r.



The interest rates quoted in the newspapers are all nominal interest rates. We are going to use little-i for nominal interest rates. The interest rates that matter for businesses are real interest rates--with inflation, or at least expected inflation, taken out.

If it costs you ten percent per year to borrow, but if inflation is also ten percent per year, then the reali interest rate is zero: you have to pay back, when the loan comes due next year, no larger a bundle of real commodities than you got this year. Thus we want to talk about real interest rates, but--because future inflation rates have not happened yet, and are uncertain--real interest rates are uncertain and, in a sense, unobservable.

This cramps our style considerably.

Types of Interest Rates

There are lots of interest rates. They all move together--rise and fall together--so there is some justification for talking about "the" interest rate. Tax treatment, credit risk--the risk that the borrower will not repay--liquidity, term to maturity, are all reasons for interest rates to differ and fan out.

One--important--source of variation in real interest rates, noted above, is inflation.

Another important source of variation in interest rates is the term to maturity. Long-term rates and short-term rates. Term structure. Typical term structure. Relationship of stock market to bond market.

What is the price of a stock going to be?




Loanable Funds

What ensures that aggregate demand and aggregate supply match up? That the quantity of goods demanded by consumers, by firms for investment, and by the government adds up to the quantity produced by businesses?



Think back to last time's circular flow diagram:



Total production is equal to incomes...

A bunch of those incomes are spent immediately--private consumption and government. So subtract C and G from incomes and from output, and what do you get?

On the "incomes" side, you get private savings minus the government's deficit...

On the "output" side, you get investment...

So the circular flow balances--the economy is in full employment equilibrium--only if private savings is equal to the sum of investment and government deficit.

Are there any factors in our model to make this so?

Well, consider financial markets--the market for loanable funds. Suppose the real interest rate r is low, so that firms seek to


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Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/