Keynesian Income and Expenditure Model 5

Investment Spending Factors

• Investment spending, though smaller than consumer spending, drives booms and busts in the business cycle.
• The equation is: Y = C + I + G + (X – IM).

Planned Investment Spending

• Businesses plan their investment spending for a given period.
• Planned investment depends on:
  • Interest rates
  • Expected future real GDP
  • Current production capacity levels

Interest Rates Impact

• Interest rates affect household spending on new homes and firm spending on business projects.
• Builders construct houses if they anticipate sales; lower interest rates increase affordability and sales.
• Firms proceed with projects if the expected return exceeds the project's cost.
• Higher interest rates lead to less profitable projects resulting in decreased planned investment.
• Lower interest rates lead to more profitable projects, resulting in increased planned investments.
• Firms using retained earnings for investment face the same trade-off due to opportunity cost.

Future Sales and Production Capacity

• Future sales and production capacity determine a firm's planned investment.
• Firms invest more when they anticipate sales growth provided that all other economic factors are held equal.
• Higher current production capacity leads to lower planned investment, if all other economic factors are held equal.

Accelerator Principle

• High expected real GDP growth indicates high future sales.
• Higher expected real GDP growth results in increased planned investments.
• Lower expected real GDP growth results in decreased planned investments.
• The accelerator principle remains valid even with excess production capacity if firms expect to use it soon.

Inventories and Investment

• Most firms hold inventories of goods to meet future sales demand.
• Increasing inventories counts as a form of investment.
• Inventory investment is the value change in total inventories held in the economy during a period.

Unplanned Investment Defined

• Sales fluctuations and inaccurate sales predictions lead to unplanned investment.
• Unplanned inventory investment is the unintended change in inventories due to unforeseen sales changes.

Actual Investment

• Actual investment spending is the addition of planned investment and unplanned investment.
• The formula is: I = I(planned) + I(unplanned)

Economic Indicators

• Macroeconomists analyze inventory investment changes to forecast the economy's path.
• Rising inventories typically indicate unplanned investment increases, leading to production cuts and a slowing economy.
• Falling inventories typically indicate unplanned investment decreases, leading to increased production and a growing economy.

Income-Expenditure Model

• Changes in spending are multiplied throughout the economy.
• The goal is to understand that the multiple rounds of changes in real GDP are accomplished through changes in the amount of output produced by firms, resulting in changes in inventories.

Multiplier Process Assumptions

• Producers are willing to supply additional output at a fixed price, meaning changes in aggregate spending translate to aggregate output changes.
• The interest rate is fixed.
• Taxes, government transfers, and government purchases are all zero.
• Exports and imports are both zero.

Planned Aggregate Spending and GDP

• With the assumptions that taxes and government spending are zero and exports and imports are zero: Y = C + I.
• Disposable income is equivalent to total income with the equation Yd = Y.
• Aggregate consumption function formula: C = A + MPC × Yd
• Planned aggregate expenditure formula: AE(planned) = C + I(planned).

Equilibrium

• In equilibrium, unplanned inventory investment is zero (Iunplanned = 0).
• In equilibrium, real GDP equals planned aggregate spending (AEplanned).
• The economy is in income-expenditure equilibrium when aggregate output equals planned aggregate expenditure.
• Income-expenditure equilibrium GDP (Y*) is the real GDP level where real GDP equals planned aggregate expenditure.
• AE(planned) ≠ Real GDP only if I(unplanned) ≠ 0
• If firms overestimate sales, I(unplanned) > 0.
• If firms underestimate sales, I(unplanned) < 0.

Mathematical Representation and Adjustments

• Real GDP = C + I = C + I(planned) + I(unplanned) = AE(planned) + I(unplanned)
• When real GDP > AE(planned), I(unplanned) > 0.
• When real GDP < AE(planned), I(unplanned) < 0.
• Firms adjust to correct mistakes, assuming prices are fixed, but output can change.
• These changes eventually eliminate unanticipated changes in inventories and establish equilibrium.

Graphical Representation

• Income-expenditure equilibrium occurs where AE(planned) crosses the 45-degree line on a graph.
• This type of diagram is called the Keynesian cross.

Shifts in Aggregate Expenditure

• Shifts in the AE(planned) line derive from changes in planned investment or shifts in the aggregate consumption function.
• Changes in planned investment can be due to interest rate changes.
• Shifts in the aggregate consumption function arise from changes in its intercept, caused by shifts in aggregate wealth, such as changes in house prices.

Multiplier Effect

• The multiplier measures the change in equilibrium in real GDP due to a change in planned aggregate spending
• The equation for calculating the change in equilibrium output: ΔY* = [1/(1-MPC)] x Δ(A + Iplanned)
• The autonomous spending multiplier is 1/(1-MPC)
• Where: ΔAAEplanned: is the autonomous change in AEplanned
• Where: ΔY* = Y2* - Y₁*: is the change in income-expenditure equilibrium real GDP
• An MPC less than 1 means that each increase in Yd and each resulting increase in consumption is smaller than in the previous round.
• This is because some of the increase in Yd goes into savings.

Inventory Significance

• Planned spending is not equal to aggregate output, this is shown in changes in inventories
• Firms respond to inventory changes and move real GDP to balance real GDP with planned aggregate spending.
• Changes in inventories are a leading indicator of future economic activity.

Paradox of Thrift

• Individual actions can lead to a result different and worse than the sum of those actions.
• A fall in investment spending causes a more significant drop in equilibrium GDP.
• Consumers and producers are worse off if they reduce their spending.

Exports and Imports

• Countries trade internationally. How does this affect our model?
• Earnings from exports contribute to domestic production.
• The multiplier effect is weaker due to foreign trade.
• Increased consumer spending increases imports and does not affect domestic income.
• International trade creates economic interdependence. A country's exports are another's imports.
• Trade links may cause international business cycles, leading to simultaneous recessions and recoveries across countries.