William A. McEachern: Chapters Discussion, Essay Example
Consumption is the largest component of aggregate expenditure in the U.S., accounting for 70 percent of the national GDP. Consumption has a positive relationship with the income factor which means higher income leads to higher consumption levels and vice versa. The difference between disposable income and consumption is saving or in other words the part of the income not being spent. Another important economic concept related to disposable income and consumption is the marginal propensity to consume (MPC) which denotes the fraction of additional income spent on consumption. Similarly, marginal propensity to save (MPS) is the fraction of additional income not spent and the sum of MPC and MPS is 1. If one spends 80 percent of additional income on consumption, MPC will be 0.8 and MPS will naturally be 0.2 since the sum of both MPC and MPS should equal 1 (McEachern, 2012).
In additional to income, consumption levels are also influenced by other factors one of which is one’s net wealth and is calculated by subtracting one’s liabilities from one’s total assets. Consumption also has a positive relationship with net wealth and a decrease in net wealth causes the entire consumption function to move leftwards and vice versa. Other factor that causes consumption levels is price level which has negative relationship with consumption. As things become more expensive, one’s purchasing power declines and so does one’s consumption while saving levels increase. Interest rates also have negative relationship with consumption levels because higher interest rates increase the incentive to save. Future expectations has positive relationship with consumption level (McEachern, 2012).
Investment is another component of the aggregate expenditure and includes investments in physical capital, real estate, and inventories. Firms engage in investment activities only if they expect the returns to exceed the cost of capital. Investment has negative relationship with interest rate because it becomes more expensive to borrow and the risk of loss is higher when interest rates are higher. Optimistic expectations have positive relationship with investment. As opposed to income, investment activities are more sensitive to the state of the economy and, thus, account for bulk of the changes in real GDP. The expenditure function also includes government purchases as well as export-import activities. Besides income, net exports are also influenced by non-income factors such as local and international price levels, local and international interest rates, foreign income, and currency exchange rates. Governments usually desire currency depreciations because they give boosts to exports by making local products and services cheaper for foreign consumers (McEachern, 2012).
Aggregate Expenditure and Aggregate Demand
The aggregate expenditure is equal to the real GDP. A spending level greater than the real GDP also sparks an increase in the economic activities, resulting in higher production, employment, income, and spending levels while spending lower than the real GDP has the opposite effect and results in recession. On a chart, real GDP level is determined at the point where aggregate expenditure equals the aggregate output. Government spending is desired, especially during recessionary periods because an increase in aggregate expenditure usually leads to a greater increase in the real GDP, a phenomenon sometimes also known as the spending multiplier effect. The larger is the MPC, the greater is the spending multiplier (McEachern, Aggregate Expenditure and Aggregate Demand, 2012).
Inflation is also undesirable because it also leads to higher interest rates. The higher borrowing costs discourage investment and spending activities and the result is a decline in the real GDP. But when general price level is lower, the purchasing power rises and the result is an increase in consumption and investment activities which all help the economy grow. A change in price level results in movement along the aggregate demand curve while a change in spending shifts the entire aggregate demand curve. Another concept is marginal propensity to import (MPI) could be defined as the portion of additional money spent on imports and is smaller than the spending multiplier. When real GDP grows, MPI also grows since net exports has a negative relationship with real GDP (McEachern, Aggregate Expenditure and Aggregate Demand, 2012).
Aggregate supply could be defined as the relationship between the price level and the output levels firms are willing and able to supply. Labor usually accounts for the bulk of the production costs and labor size depends upon various factors such as adult population size and their work vs. leisure lifestyles. Labor enjoys positive relationship with wage levels though inflation may erode some of the attraction of higher wage due to lower purchasing power (McEachern, Aggregate Supply, 2012).
It is important to distinguish between nominal wage which is wage in current year terms and real wage which takes into account the effects of inflation. Expected price levels also affect wage negotiations because inflation erodes purchasing power. When employment is at full rate, the labor force produces natural rate of output. Full employment rate doesn’t necessarily mean every single person willing to work is employed since there may be frictional, structural, and seasonal unemployment. This is also referred to as natural rate of unemployment and is usually between 4 to 6 percent (McEachern, Aggregate Supply, 2012).
Movements in price level influence the production activity within the economy. Higher price levels increase profit potential and influence firms to hire more workers as well, resulting in unemployment rate falling below the natural unemployment rate and vice versa. Similarly, the actual overall economic output exceeds the potential output when actual price exceed expected price levels in the short run but in the long run, there are no surprises about price levels since factors of production can be adjusted (McEachern, Aggregate Supply, 2012).
When aggregate demand exceeds expected demand in the short run, there is an expansionary gap which is marked by higher output and employment rates as well as inflationary pressure. But in the long run, the expansionary gap disappears as expectations regarding wages and price are revised upwards and the result is cost-push inflation due to higher production costs. The recessionary gap results from aggregate demand being lower than expected demand which is accompanied by lower output, employment rate and downward pressure on prices. But the revised expectations help close recessionary gap in the long run and the result is greater output due to lower production costs (McEachern, Aggregate Supply, 2012).
These chapters have significantly improved my understanding of macroeconomic concepts and have also helped me better understand the actions taken by the U.S. Government and the Fed in the wake of the recent financial crisis. I now understand why the U.S. Government wants people and businesses to spend more (Shiller, 2012) and why Fed encourages it through lower interest rates (Board of Governors of the Federal Reserve System). I also have better understanding of why U.S. Government prefers weaker dollar (Laskoski, 2013) and why China is often accused of manipulating its currency for advantage in international trade. Similarly, I have also learnt that imports increase when economy is doing better which is why U.S. trading partners see lower exports when U.S. is struggling economically. These chapters have really helped me see the rationale behind economic news I come across in digital and print media on regular basis.
Board of Governors of the Federal Reserve System. (n.d.). Why are interest rates being kept at a low level? Retrieved August 2, 2013, from http://www.federalreserve.gov/faqs/money_12849.htm
Laskoski, G. (2013, February 27). Will the Declining U.S. ‘Petro-Dollar’ Induce Middle East Conflict? Retrieved August 2, 2013, from http://www.usnews.com/opinion/blogs/on-energy/2013/02/27/the-dollars-domination-could-be-ending
McEachern, W. A. (2012). Aggregate Expenditure. In ECON Macro (3rd ed.). Cengage Learning.
McEachern, W. A. (2012). Aggregate Expenditure and Aggregate Demand. In ECON Macro (3rd ed.). Cengage Learning.
McEachern, W. A. (2012). Aggregate Supply. In ECON Macro (3rd ed.). Cengage Learning.
Shiller, R. J. (2012, January 14). Spend, Spend, Spend. It’s the American Way. Retrieved August 2, 2013, from http://www.nytimes.com/2012/01/15/business/consumer-spending-as-an-american-virtue.html?pagewanted=all
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