SESSION 2: COMPONENTS OF AGGREGATE PLANNED EXPENDITURE
We introduced national income and equilibrium national income in the previous session. This session will examine the components of aggregate planned expenditure as a component of national income, the factors that influence the various components of aggregate planned expenditure, and the government’s role in stimulating aggregate demand.
Objectives Following completion of this material, you will be able to:
- comprehend the constituents of total anticipated expenditure
- Recognize the influences on consumer expenditure (consumption) and savings levels
- Determine the variables that affect investment expenditure.
- Learn the roles of government spending and monetary flows from exports and imports in determining national income equilibrium.
Now read on …
2.1 Consumer Expenditure and Savings
In all economies, domestic consumer spending dominates aggregate demand, dwarfing all other expenditures.
For example, consumers account for approximately two-thirds of total domestic expenditures in developed nations.
This figure tends to be even higher in poorer economies, reflecting particularly low levels of investment expenditure.
Thus, any changes in consumers’ spending intentions are likely to have a substantial effect on an economy’s level of economic activity.
The converse is also true.
Since consumers can choose to spend or save their after-tax income, an increase in consumer expenditure tends to reduce the percentage of planned savings, and vice versa. Several additional factors may influence consumption.
- consumer confidence and the wealth of consumers,
- the cost and availability of credit,
- government taxation and subsidies,
- advertising goods and services and so on
Even though the aforementioned variables may impact consumer spending, economists typically identify disposable income as the most significant factor.
After paying direct taxes to the government and receiving direct state subsidies, consumers’ disposable income (Yd) is the amount of money left over.
Therefore, an individual’s total planned consumption is dependent on disposable income.
This is written as; C = f (Yd) It also follows that as disposable income can be spent or saved, planned savings (S) are also a function of disposable income. That is; S= f (Yd)
2.2 Propensities to Spend and Save
From the relationships between consumer expenditure, savings, and disposable income, we can derive crucial concepts for determining economic activity.
- the average propensity to consume (apc);
- the average propensity to save (aps);
- the marginal propensity to consume (mpc);
- the marginal propensity to save (mps).
2.2.1 Average propensity to consume (apc) is the proportion of disposable income that goes towards consumer spending.
Apc = Total Savings = c
Total dispensable income yd
2.2.3 Average propensity to save is the proportion of disposable income saved. Aps = = The numerical values of the average propensities to consume and save must sum to 1.
That is, apc + aps = 1.
It must also be noted that total consumer spending and savings increase as total disposable income rises in an economy and the reverse is true.
2.2.4 Marginal propensity to consume and save
The proportion of any change in disposable income that is spent on consumer goods and services is referred to as the marginal propensity to consume (mpc), whereas the proportion of any change that is consumed by additional savings is known as the marginal propensity to save (mps).
More formally: mpc = = mps = = Once again, since any change in household disposable income can only be used for consumption or savings, it follows that the numerical values of the marginal propensities to consume and save must sum to 1, That is, mpc + mps = 1 Let us use the following example to clarify the meaning of the terms apc, aps, mpc and mps.
Illustration 1 Suppose that an individual household plans to spend 72 per cent of its weekly disposable income of GHC500 on consumer goods and save the rest. Compute the apc and aps.
Solution: apc = GHC360/GHC500 = 0.72
aps = GHC140/GHC500 = 0.28
Illustration 2 If the household’s disposable income now rises to GHC600, and the individual decides to spend GHC60 of the extra GHC100, saving the remainder of the additional disposable income, what will be the mpc and mps.
Now the apc = GHC (360+60)/GHC (500+100) = 0.7 and the aps = GHC (140+40)/GHC(500+100) = 0.3 The mpc and mps can also be calculated as follows mpc = GHC60/GHC100 = 0.6
mps = GHC40/GHC100 = 0.4
This graph depicts a trend in which, as disposable incomes rise, individuals tend to save a greater proportion of any income increase. In other words, the mpc and, consequently, the apc tend to decrease. At any particular time, different income groups in society can be expected to have varying propensities for consumption and savings.
Richer social groups are likely to save a larger proportion of any increase in disposable income than impoverished social groups.
The following diagrams illustrate both the consumption and savings functions.
2.3 Factors that influence the magnitude of the propensities to consume and save
- Changes in the distribution of income (the impact of taxes and subsidies)
- The cost and availability of credit
- Interest paid on savings 4. The age distribution of the population
- the young and the retired tend to spend a larger proportion of their incomes on consumption
- whereas middle-aged individuals tend to have a greater propensity to save.
2.4 Investment Expenditure
Investment expenditure is another significant element of total expenditure. Let’s examine investment as a component of national income in greater depth.
By ‘investment’, economists mean capital expenditure on the purchase of physical assets such as plants, apparatus, and equipment (referred to as fixed investment) and stocks (referred to as inventory investment).
Expenditures on physical investment generate new assets, thereby enhancing a nation’s capital stock and, consequently, its production capacity.
The relationship between investment spending and national income (real GDP) is more complex than that between consumption spending and national income.
In practice, firms’ investment and expenditure decisions are likely to be influenced by a variety of factors that we will examine later in this session.
2.5 Distinction between Autonomous and Induced Investment
There is a clear distinction between autonomous and induced investment.
2.5.1 Autonomous investment (exogenous investment)
refers to the level of investment expenditure that is not determined by the level of national income.
2.5.2 Induced investment (endogenous investment)
Are fluctuations in the level of national income a cause of variations in the level of investment? However, according to economists, anticipated investments are independent of national income levels. This is due to the fact that planned investments are founded on prior strategic decisions and require time to modify.
This indicates that the quantity of planned investment is determined by other factors that may influence investment. The following are:
- interest rates,
- return on capital,
- the state of technology, the growth in consumer demand, d. taxation and investment incentives,
- business confidence and expectations.
If we add the level of planned investment in the economy, I, to the consumption function, we can derive a C + I line as shown below;
2.6 Government Spending
The letter G stands for planned government spending, which is the third component of total scheduled expenditures. This reflects the current and capital expenditures (i.e., investments) incurred by central and local governments to provide social products and services.
It is difficult to predict a stable and reliable relationship between national income (real GDP) and planned government expenditure.
For instance, the number of schoolchildren is more likely to influence the intended introduction of a school-building program than national income. Given the unpredictability of the relationship between government spending and national income, we presume that government spending (G) is independent of national income.
This is depicted as a horizontal line in the diagram that follows:
If planned government expenditures increase or decrease for any reason unrelated to a change in real GDP, this will be reflected in the graph by a parallel shift upwards or downwards. downwards in the line, respectively. Moreover, adding G to C and I gives the line C + I + G as shown in the figure above.
2.7 Expenditure on Exports and Imports
Add the difference between intended export (X) and import (M) expenditures to complete our analysis of total planned expenditures.
When foreigners purchase our exports, take vacations in our country, or use our national airline, for instance, the amount becomes a part of the total demand for our products and services (injection).
Similarly, when we purchase foreign products, our economy suffers a loss (leakage). Similarly, any capital flows into the country for investment purposes, such as investments in stocks and shares, bank accounts, and other tangible investments, which raise demand by increasing consumption (C) and investment (I).
In contrast, when residents of our economy invest abroad, funds leave the country, increasing demand abroad but decreasing it at home.
Although this is a gross simplification, it is presumed for convenience that X and M, like I and G, are independent of national income.
Typically, planned expenditures on exports of products and services are proportionately more correlated with the level of income on export markets than with national income at home.
The difference between X and M can be positive or negative based on whether the value of planned exports exceeds or falls short of the value of planned imports.
Assuming the difference between X and M is positive, adding X-MM to C, I, and G results in the aggregate schedule, denoted AE in the table below.
The vertical distance between the lines C + I + G (as calculated above) and C + I + G + (X – M) in this figure represents the net value of exports and imports.
Therefore, if planned import expenditures were greater than planned export expenditures, the C + I + G + (X + M) line would be below the C line.
This session has allowed us to examine, in particular, the composition of aggregate expenditures and the impact of changes in aggregate planned expenditures on national income and, consequently, employment and inflation.
- Enumerate the factors that may affect consumption.
- Differentiate between the marginal and average propensities to save.
- Differentiate between;
- autonomous and induced investment
- autonomous and induced consumption
- What factors influence the magnitude of the propensities to consume and save?
- Using diagrams, explain the consumption and savings function.