Other Determinants of Consumption - Shifters

Changes in disposable personal income cause movements along this curve; they do not shift the curve. The curve shifts when other determinants of consumption change. Examples of shifters are changes in real wealth and changes in expectations. Figure Shifts in the Consumption Function illustrates how these changes can cause shifts in the curve.

Figure Shifts in the Consumption Function

Changes in Real Wealth

An increase in stock and bond prices, for example, would make holders of these assets wealthier, and they would be likely to increase their consumption. An increase in real wealth shifts the consumption function upward, as illustrated in Panel (a) of Figure Shifts in the Consumption Function. A reduction in real wealth shifts it downward, as shown in Panel (b).

Changes in Expectations

Consumers are likely to be more willing to spend money when they are optimistic about the future. An increase in consumer optimism tends to shift the consumption function upward as in Panel (a); an increase in pessimism tends to shift it downward as in Panel (b). The sharp reduction in consumer confidence in 2008 and early in 2009 contributed to a downward shift in the consumption function and thus to the severity of the recession.

Unit 8.2 The Aggregate Expenditures Model

Learning objectives

1. Explain and illustrate the aggregate expenditures model and the concept of equilibrium real GDP.

2. Distinguish between autonomous and induced aggregate expenditures and explain why a change in autonomous expenditures leads to a multiplied change in equilibrium real GDP.

3. Discuss how adding taxes, government purchases, and net exports to a simplified aggregate expenditures model affects the multiplier and hence the impact on real GDP that arises from an initial change in autonomous expenditures.

The consumption function relates the level of consumption in a period to the level of disposable personal income in that period. In this section, we incorporate other components of aggregate demand: investment, government purchases, and net exports. In doing so, we shall develop a new model of the determination of equilibrium real GDP, the aggregate expenditures (AE) model. This model relates aggregate expenditures, which equal the sum of planned levels of consumption, investment, government purchases, and net exports at a given price level, to the level of real GDP. We shall see that people, firms, and government agencies may not always spend what they had planned to spend. If so, then actual real GDP will not be the same as aggregate expenditures, and the economy will not be at the equilibrium level of real GDP.

The AE Model: A Simplified View

To develop a simple model, we assume that there are only two components of aggregate expenditures: consumption and investment. In the chapter on measuring total output and income, we learned that real GDP and real GDI are the same thing. With no government or foreign sector, GDI in this economy and disposable personal income would be nearly the same. To simplify further, we will assume that depreciation and undistributed corporate profits (retained earnings) are zero. Thus, for this example, we assume that disposable personal income and real GDP are identical.

Finally, we shall also assume that the only component of aggregate expenditures that may not be at the planned level is investment. Firms determine a level of investment they intend to make in each period. The level of investment firms intend to make in a period is called planned investment. Some investment is unplanned. Suppose, for example, that firms produce and expect to sell more goods during a period than they actually sell. The unsold goods will be added to the firms’ inventories, and they will thus be counted as part of investment. Unplanned investment is investment during a period that firms did not intend to make. It is also possible that firms may sell more than they had expected. In this case, inventories will fall below what firms expected, in which case, unplanned investment would be negative. Investment during a period equals the sum of planned investment (I _P) and unplanned investment (I _U).

I = I _P + I _U

We shall find that planned and unplanned investment play key roles in the AE model.