This reading assignment is the longest in this course, so have patience. It is pp. 250-252, 280-295, 306-315, and 328-330.

In your study of demand-side economics, you will examine each of the four major sectors of the macroeconomy: consumption, investment, government purchases, and international trade. Of these four sectors, consumption is by far the largest and is the driving force in the U.S. economy. It accounts for about two-thirds of the GDP. Our starting point is an analysis of the consumption sector by itself. We will then add the other sectors one at a time.

Consumption is defined as household purchases of goods and services. Included in this category are durables, nondurables, and services. Consumer durable goods are built to last three years or more and include items such as cars, boats, appliances, and furniture. Examples of nondurable goods are food and clothing. Services is a wide-ranging category that includes items such as haircuts, airline tickets, and medical care.

The amount of consumption spending depends heavily on the level of disposable income. From your math courses you know that the term function suggests two variables, one independent and one dependent. In this case, disposable income is the independent variable and consumption spending is the dependent variable. The amount of consumption spending is a function of (i.e., depends upon) the amount of disposable income. This is a direct relationship: higher disposable income leads to more consumption spending and lower disposable income results in less consumption spending.

In macroeconomics, this relationship between income and spending is emphasized heavily, but there are other factors that influence the amount of household consumption spending, such as the number and ages of children, the occupation and past earning history of the head of the household, the consumption expenditures made by peers and friends, and whether a particular household has one, two, or more labor force participants. Still, the amount of disposable income is the single most important factor that determines the amount of consumption spending.

Four arithmetical concepts are used to analyze a given consumption function:

Keep in mind that the only choices a household has for its disposable income are consumption spending or saving. Household saving may be either positive or negative. Negative savings occurs when consumption spending exceeds disposable income. This can happen as a result of excessive usage of credit cards or other borrowing or by selling off assets.

We will now apply the definitions given in the above table to the following data:

As you fill in the rest of this table, keep in mind the following relationships:

This statement is true because the only choices for disposable income are consumption or saving. So if you know either the consumption or savings column, then you can use the complement method to balance the two so that when combined they equal disposable income. Your first entry in the savings column = -$2,000; your second entry = -$800. The rest of your entries should be positive: +$400, +$1,600, etc. Consumption and Savings, when combined, must equal disposable income.

Your first entry in the APC column = 22,000/20,000 = 1.10. Your second entry is 24,800/24,000 = 1.03. As you fill in the rest of this column, you’ll notice the APC results dropping below 1.00. When this happens, that indicates positive savings is occurring. Alternatively, when the APC number exceeds 1.00, that indicates negative savings. If APC = 1.00, then savings = 0.

The first calculation for the savings column is -$2,000/$20,000 = -.10 while the second calculation = -$800/$24,000 = -.03. The rest of the entries are positive. Since the only choices are consumption or savings, you can use the complement method once you know either the APC or the APS numbers. The two, when combined, must equal 100% or 1.00.

Since the only choices available for each extra $4,000 are consumption or savings, the MPC and MPS, when combined, must equal 100% or 1.00 of the additional $4,000 amount. If you know either the MPC or the MPS, then you can use the complement method to balance out to 1.00.

Try to fill in the rest of the table before reading any further. Remember, our special effort-detect software will make your computer lock up if it determines that you are peeking before working out the answer. After completing the table, scroll down a little to check your answers.

Note that the first entries in the MPC and MPS column are left empty since there is no previous disposable income level provided. Therefore, there is no change to be calculated. The first change is from DI = $20,000 to DI = $24,000.

At a glance, what is the APS if the APC = .89?

What is the APC if the APS = .02?

If you were not able to determine the answers easily, then go back and reread the above material. The answers are .11 and .98.

You will now learn how to graph a consumption function using the same data provided in the table above. This graph is easy to do provided you use the proper format. Use the data in the disposable income column (the left-hand column) as a guide to setting up a scale for the horizontal axis. Disposable income always goes on the horizontal axis. Now use the same exact scale for the vertical axis (the y-axis) that you used on the horizontal axis. Label the vertical axis "consumption spending." In a graph like this, consumption always goes on the y-axis. Now draw in a 45 degree reference line emanating from the origin (where both the x and y axis values = 0). Now you are ready to plot the points that constitute this consumption function. Connect all the points with a smooth line when you are done. Your first two points should lie above the 45-degree reference line. Then you will cross over the line and the rest of the points will lie below it.

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We will now consider a second sector, investment, as we pursue the study of demand-side economics. Investment is generally defined as the production and installation of capital goods. The predominant type is business investment (also known as nonresidential investment) and this includes expenditures by business firms on tools, equipment, machinery, and factories. The other type is residential investment and includes all new residential construction. Single and multi-family dwelling units are part of this calculation.

A number of factors determine the level of investment. Interest rates are one such factor. When rates are low, house payments are more affordable and the amount of new residential construction increases. Business investment projects such as purchasing new mainframe computers or a new fleet of trucks also become more affordable. The rate of return on such projects is more likely to be higher than the interest rate, making the investment projects economically viable.

When interest rates are high, just the opposite is true. House payments become less affordable and so do the possible business investment projects. For business firms, it is now more likely that the projected rate of return from a particular project will be less than the interest rate charged by a lender to finance it. The total amount of investment will fall.

Another factor that determines the amount of investment is improvements in technology. Suppose you’re running a pizza restaurant and attend a trade show. A brand-new, high-powered oven is shown to the market for the first time. This oven will cook pizza in two minutes instead of fifteen, effectively converting pizza into fast food. The availability of such an oven may induce you and other entrepreneurs to buy it, thereby increasing the level of investment in the economy.

Government tax and regulatory policies are also relevant in determining the amount of investment in the macroeconomy. You learned about this in the previous section on supply-side economics. If the tax code allows for faster write-offs of machinery and equipment, that may provide an incentive for business firms to more quickly replace their equipment, thereby boosting the level of investment.

Business firms’ expectations regarding future sales and profits are a major determinant of investment expenditures. Of course, this is subject to ongoing reevaluation and change by managers and executives. Note the word future. The key is what firms believe will happen to their sales and profits six months, nine months, or one year from now as opposed to their current sales and profits position. It depends on how confident businesses are about the future.

Fill in the aggregate demand column. To do this, combine C + I. After completing this column, fill in the right-hand column by subtracting GDP from each level of aggregate demand. You should be able to determine the equilibrium GDP based on the conditions stated above: Aggregate Demand = GDP and S = I in the equilibrium position for a two-sector economy.

Your completed table should look like this:

You correctly figured equilibrium GDP = 1100 because aggregate demand = GDP and S = I at a GDP of specifically 1100. Note that in the right-hand column the first three entries show aggregate demand as greater than GDP, thereby putting upward pressure on the level of equilibrium GDP. The last three entries indicate that aggregate demand is less than GDP, which means that some goods and services are not being sold. This puts downward pressure on the GDP to correct for this imbalance between production and demand. It is only when GDP = 1100 that the economy is in balance. Note that just because the economy is in balance or equilibrium does not necessarily mean that the economy is performing well in terms of a low unemployment rate and a low inflation rate. The unemployment rate could be low or high and the economy could still be in equilibrium. The same is true for the inflation rate.

You can see that the new equilibrium GDP is 1200 instead of the old 1100. This is true even though investment spending only increased by 40. The reason for this is known as the multiplier effect. The multiplier concept is that an initial change in one of the sectors of the economy, such as investment, leads to a multiplied change in the GDP. When business firms decide to increase investment spending by 40, this translates into more production of machinery and equipment, more jobs for the work force, more income for households, and more spending. In turn, this extra spending induces businesses to produce more goods and services, resulting in more jobs.

There is a shortcut method available to determine the effect of such an initial change (+40) on the equilibrium GDP. The formula is:

We know the initial change in this example = +40. To determine the multiplier, we first have to know the MPC. Can you calculate the MPC based on the information in the above table? Use DI = GDI for a two-sector economy only. Then apply the formula you learned while studying the consumption function and you’ll have the MPC:

If you figured correctly, the MPC = .60 (and the MPS = .40). Now we can use the multiplier formula:

Substituting into this formula, the multiplier = 2.5. Now take the initial change of 40 and multiply by 2.5 and you have +100, the difference between the original equilibrium of 1100 and the new equilibrium of 1200.

Suppose instead of increasing investment by $40 billion, executives decided to decrease it by $40 billion. Would this the multiplier work in reverse? Yes, it would. There would be job losses, less income for households, less spending in the macroeconomy, and less production as a result. This process would continue in a negative direction. If investment was reduced to 120, the new equilibrium GDP would be ... ? You should be able to get this. If you can’t, then go back and review this material. You should have figured the new equilibrium GDP to be 1000, since aggregate demand would = 1000 (consumption = 880 and investment = 120) and S = I = 120.

We will now add a third sector to the analysis, government purchases (G). A government purchase requires the usage of current factors of production and includes paying the salaries of those who serve in the armed forces as well as buying of pencils and computers for bureaucrats who work in various government agencies. It also includes the purchase of aircraft carriers, submarines, and other military hardware. Government purchases should be distinguished from government transfer payments, which include social insurance payments (e.g., Social Security and Unemployment Compensation) and public assistance (e.g., Supplemental Security Income and Temporary Assistance to Needy Families). Transfer payments are part of total government spending, but they are not included in government purchases.

The determinants of government purchases are murky, but certainly military and security needs are one major factor. We would assume that these needs are independent of the economy’s position on the business cycle. It wouldn’t make sense to increase defense spending just because the economy is at a peak of activity. Nor would it be sensible to cut defense spending just because the economy is in a trough of the business cycle.

There are many other needs, such as roads and bridges that are in need of repair. School construction and maintenance is another need. As is true for defense spending, these needs are not dependent upon our current position in the business cycle.

Sometimes government purchases are analyzed by cost-benefit analysis, although the phrase sounds more precise than it really is. The cost of a particular government purchase, such as the building of a new school, should be ascertainable. This includes both the cost of initial construction as well as the ongoing operational cost. Benefits may be more difficult to quantify. If the school is an additional college campus, then benefits may include easier access to higher education services for some parts of a metro area. The enhanced access may result in a better-trained labor force and may be an attractor for a business firm seeking a new location. If the proposed government expenditure involves building a dam to stop a river from flooding, then the benefits may include property saved from destruction by flood. These property savings (benefits) should be measurable. The idea is that if the benefits of a proposed government expenditure exceed the costs, then the project should be undertaken. But if the costs exceed the benefits, then the money should not be spent.

Based upon the above ambiguous determinants of government purchases, the federal, state, and local governments decide how much they wish to spend. As noted above, the amount is not dependent upon the economy’s current position on the business cycle. Therefore, as in the case of investment, government puchases is treated as a constant. The number is given and is used for all of the various levels of GDP/GDI. Consider the following table:

What is the level of equilibrium GDP for this three-sector economy? As you can tell, the answer is 2600. The conditions for equilibrium in a three-sector economy are:

• Aggregate Demand = GDP = 2600
• S + T = 600 = I + G

In the table, why is it that the data in the DI column is less than the data in the GDP/GDI column? Because we now have government involved in the economy and taxes are taken out of the GDP/GDI.

What is meant by the term "net taxes"? This just means that government has paid out the transfer payments it is required to make and the money that remains (net taxes) is available for government purchases, plus a few other items such as interest payments on the accumulated deficit.

As you examine the above table, remember that C + S = DI. Can you determine the MPC and MPS from the above figures? Stop right now and work out the answers. You should be able to do this. If you’re not sure, go back and reread the discussion about the consumption function. The MPC and MPS concepts are presented there. In this table, the MPC = .75 and the MPS = .25. Make sure you understand why these are the correct answers.

In the table above you just combine C + I + G to obtain the aggregate demand. In the equilibrium position, the total leakages out of the economy (S + T) must equal the total injections back in (I + G). It is not necessary that S = I and T = G, although that happens to be true in this example. The requirement is for S + T = I + G, that is, total leakages out = total injections in.

You should be able to graph this three-sector economy using the same procedure you used in graphing a two-sector economy. Use the figures in the GDP/GDI column as the basis for your horizontal axis scale. Then set up the exact same scale on the vertical axis. Add a forty-five degree reference line and you’re ready to start plotting the points. Your crossover point (equilibrium) is 2600. For all GDPs less than 2600 your plotted points should be above the reference line. For all GDPs greater than 2600 your plotted points should be below the reference line.

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Since we will devote a fair amount of coverage to the fourth sector, international trade, in Unit Four, only a few observations will be made at this time. When this fourth sector is added there is an additional leakage out of the economy: Imports. These are items we buy that are produced in other countries and sent here to be sold. There is also another injection: Exports. These goods are produced in the U.S. and sent to other countries to be sold. When the full four-sector economy is in an equilibrium position, the following conditions are met:

As shown above, at equilibrium, the total leakages out = the total injections in.

Fiscal policy involves the manipulation of taxes and government spending by government so as to assist the economy in achieving a full-employment GDP without overstimulating the economy and causing undesirable inflation.

Fiscal policy is thought of as counter-cyclical, that is, it is intended to offset the extremes of the business cycle and keep the economy in a more central position on the business cycle. It is supposed to eliminate the extreme peaks and valleys of the business cycle.

Fiscal policy may be expansionary or contractionary. An expansionary fiscal policy would be used to try to stimulate the economy out of a trough in the business cycle. The options for an expansionary fiscal policy are:

Note that the effect of these actions would be to increase the size of the government’s deficit (or reduce the size of the surplus). Under the traditional fiscal policy approach, this is not considered a problem because in other situations there are supposed to be surpluses to balance out the deficits.

A contractionary fiscal policy would be used when the economy is in danger of overheating with too much inflation. The above actions are reversed in pursuing a contractionary fiscal policy:

The effect of a contractionary fiscal policy action would be to push the government’s budget toward a smaller deficit or a larger surplus.

Some fiscal policy actions are automatic or built-in stabilizers while others are discretionary. Examples of automatic stabilizers include the following:

When the economy is in a trough, unemployment compensation payments increase. This provides some extra spending power for households eligible for these payments and pushes the economy up the business cycle. This effect may not be as strong for other transfer payments such as welfare (SSI, AFDC, etc.), but it still exists. When the economy performs poorly there is increased eligibility for public assistance. This gives some additional money for consumption spending to households receiving this assistance. Obviously, when the economy is at or near the peak of a business cycle, unemployment and public assistance payments are reduced. Jobs are more plentiful and so there is less need for these payments.

The federal income tax system nominally uses different tax rates, depending on the level of income and filing status. When the economy performs poorly, more households drop into lower brackets. The effect is to increase their disposable income compared to what it would have been had they remained in their original, higher bracket. This increases household disposable income and results in more consumption spending. Conversely, when the economy approaches a peak of activity more households have better jobs and higher income. They move into higher tax brackets. This reduces inflationary pressure on the macroeconomy.

Any fiscal policy action that is not automatic is considered discretionary fiscal policy. This just means that Congress and the Administration must agree on legislation that changes current law. If, in an effort to stimulate the economy out of recession, Congress passed and the President signed a bill providing for the construction of a new Interstate highway system for semi-trailer rigs only, then that would be an example of discretionary fiscal policy. If the bill involved a jobs program to pay people to pick up all litter from federal and state highways in an effort to reduce the unemployment rate, then that would be an example ofdiscretionary fiscal policy also.

It should be noted that the position of the economy on the business cycle has a huge impact on whether the government will run a surplus or deficit in any given year. When the economy performs well and is at or near the top of the business cycle, tax revenues are strong. Personal income tax as well as corporate profits tax collections are high. Some of the spending obligations of government for certain transfer payments may come down, although this effect is not as strong as what happens on the revenue side. When the economy tumbles down the business cycle, government revenues drop off substantially and the budget is pushed toward deficit. In addition, the government's spending obligations for transfer payments will increase, although this effect is not as strong as the reduction in revenue. The results also depend upon the expectations and assumptions of those who prepare the federal government’s budget and the performance of the economy subsequent to this preparation. If the economy performs better than expectations, the budget position is shifted away from deficit and toward a surplus. If the economy performs worse than expected, then the budget is pushed toward a deficit.

You are now ready to work on the Problems and Exercises for Unit Three, Assignment Three.