Aggregate Spending and Consumption Function Quiz

Aggregate Spending

• Aggregate spending equals the sum of desired private consumption (C) and desired investment spending (I): AE = C + I
• Desired private consumption (C) is the largest component of aggregate spending

Consumption Function

• The consumption function relates total desired consumer spending to the variables that affect it
• In a basic framework, a household's spending is dependent on the amount of income available (disposable income): C = a + bYd
• Autonomous consumption (a) shows what consumption will be when household income is 0
• Induced consumption (bYd) is the change in consumption due to a change in disposable income
• Marginal propensity to consume (MPC) is the change in consumption divided by the change in disposable income: MPC = ∆C / ∆Yd
• Average propensity to consume (APC) is the proportion of consumption spending in total disposable income: APC = C / Yd

Equilibrium GDP

• At equilibrium, aggregate desired spending equals the total output: Y = AE
• In the hypothetical example, the equilibrium GDP is given as: Y = 350 + 0.8Y = 1750
• Graphically, equilibrium occurs where the aggregate spending curve intersects the 45° line

Changes in GDP

• Changes in GDP can occur due to:
  • Movement along the AE curve (increase in GDP/income)
  • Upward shift of the AE curve (increased desire to spend at each level of GDP)
• The aggregate demand curve shifts with:
  • Changes in consumption (households' desire to spend)
  • Changes in investment (firms' confidence in the economy)

Investment Spending

• Three major forms of investment spending are:
  • Investment in inventories
  • Investment in residential housing construction
  • Investment in business fixed capital
• In this basic model, investment spending is treated as exogenously determined (fixed)
• In reality, investment spending depends on variables such as the interest rate and is usually the most volatile component of GDP

Hypothetical Example

• The economy has a desired investment spending of N250 million, autonomous consumption of N100 million, and a marginal propensity to consume of 0.8
• The aggregate spending function is given as: AE = 350 + 0.8Y
• The marginal propensity to spend is the fraction of increment to GDP that will be spent on purchasing domestic output: c = ∆AE / ∆Y
• The marginal propensity not to spend is the fraction of any increment to GDP that does not add to desired aggregate spending: (1 - c)