Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

Student Price: Contact us to learn more

Principles of Economics will allow you to learn a new set of tools to use in personal, professional, business, and political decision making.

This content has been used by 3,587 students

What is a Top Hat Textbook?

Top Hat has reimagined the textbook – one that is designed to improve student readership through interactivity, is updated by a community of collaborating professors with the newest information, and accessed online from anywhere, at anytime.


  • Top Hat Textbooks are built full of embedded videos, interactive timelines, charts, graphs, and video lessons from the authors themselves
  • High-quality and affordable, at a significant fraction in cost vs traditional publisher textbooks
 

Key features in this textbook

Our Principles of Economics Textbooks extend beyond the page with interactive graphing tools, real-world news clips and articles that relate to current events and examples that are relevant to millennial audiences.
Our Principles of Micro and Principles of Macro textbooks can be adopted together or separately, giving you the flexibility to customize your course.
Question bank is available with every chapter for easy quiz and test creation.

Comparison of Principles of Economics Textbooks

Consider adding Top Hat’s Principles of Economics textbook to your upcoming course. We’ve put together a textbook comparison to make it easy for you in your upcoming evaluation.

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Pricing

Average price of textbook across most common format

Up to 40-60% more affordable

Lifetime access on any device

$130

Hardcover print text only

$175

Hardcover print text only

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Content meets standard for Introduction to Anatomy & Physiology course, and is updated with the latest content

In-Book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

Read the fully unlocked textbook below, and if you’re interested in learning more, get in touch to see how you can use this textbook in your course today.

Chapter 21: Spending

Figure 21.1: President Obama with workers and management, talking about spending and growth.​ [1]

A typical monthly news announcement of latest GDP figures:

The U.S. economy grew far less (1.2%) than expected in the second quarter of 2016 as inventories fell for the first time since 2011. A decline in inventories, however, sets up the economy for growth in the future. Additionally, a surge in consumer spending of greater than 4% points to underlying strength. A decline in business investment, however, continues to hamper future growth.

21.1 Objectives for Chapter 21

After completing this chapter, you will be able to:

  • Describe the major components of GDP.
  • Forecast the effects of changes in those components on spending and output.
  • Use the income-spending model to explain how the economy will approach an equilibrium between spending and output.
  • Understand the concept of the spending multiplier and use it to explain the effects of changes in spending.

21.2 Gross Domestic Product

Gross Domestic Product is the value of all the final goods and services produced in a country within a specific time period. GDP is calculated and reported quarterly, and it is usually expressed on an annual basis. We have already seen that the total amount produced – the total output or real GDP – is equal to the total amount of spending individuals and institutions want to do in a year plus the accumulation of inventories. One more relationship is crucial to understand if we are to build a model of the entire economy: total output is equal to total income for the economy.

Every dollar of output of goods and services becomes income to someone. Income includes wages paid to workers, rent paid to building owners, profits earned by business owners, and taxes sent to the government. Even money spent on raw materials and machines eventually goes to the workers, landlords, and owners at those companies. So, while one side of GDP is output, the other is income: wages, profits, rents, interest, and taxes.

It may be helpful to envision a circular flow diagram, as shown in Figure 21.2 and the below video, with arrows on top indicating consumption spending by individuals in exchange for goods and services provided by businesses. Then, on the bottom we see an arrow flowing from businesses to individuals indicating spending on wages in exchange for labor.

Figure 21.2: A Circular Flow​

Figure 21.2 is a vast simplification, as consumers do not spend all of their incomes; they save a portion. In addition, businesses do not use all of their income to pay wages. They also engage in investment spending to buy machines and new factories from other businesses. Also, some of the production is sent abroad, and consumers buy some of their goods and services from abroad. In addition, governments tax income and use the receipts to provide defense and other services as well as provide people income through social security, unemployment compensation, and welfare.

So, what happens if all of the millions of independent decisions about how much and on what to spend do not add up to exactly what businesses produce? There certainly are no guarantees that planned spending will be equal to planned output. To understand the answer fully, we will begin by developing a model of the entire economy.

21.3 Components of GDP

Remember our formula from Chapter 6: GDP = C + I + G + (X – IM); gross domestic product equals consumption spending plus investment spending plus government spending on goods and services plus export spending minus import spending. Let’s look at each component, in turn, to see what determines the amount of total spending.

ECN22_Figure21.3_updated.jpg
Figure 21.3: Components of GDP - 2019 (in billions of dollars).

We add up all of the consumer spending on goods and services in a year. That is what you and I spend on such things as clothes, rent, food, movies, and boats.

Businesses also spend on machines, tools, and factories in order to help themselves expand production and lower costs. When these “capital” goods are newly produced, we count them as part of GDP. If they were produced in a previous year, they are not counted as part of this year’s production. They were already counted in the year when they were produced. We call this type of spending investment, which is spending used to produce machines, tools, and buildings that are used to produce other goods and services. It is important to consider that spending by consumers is considered consumption, while spending by businesses is considered investment even if the same item (e.g., a computer) is purchased by a consumer and a business.

Governments spend on goods and services, too – police and fire protection, education, and national defense. Remember that social security and other transfer payments are not included in GDP because no good or service is produced.

In addition to all of this spending, individuals, businesses, and governments in other countries buy goods and services produced in the U.S. This spending is included in the accounts as exports. We produce goods, such as corn, wheat, movies, and automobiles, as well as a variety of services (e.g., consulting and financial services) and send them abroad where individuals and businesses abroad buy them. Individuals and businesses in the U.S. also spend on goods and services that are produced by other countries. These transactions, which are called imports, are then subtracted out when calculating GDP.

The accounts are often presented with exports and imports combined into net exports.

21.3.1 Consumption

Consumption is the total spending by individuals on goods and services in a year. It is approximately 70 percent of gross domestic product. Think about what causes you to change the amount of consumption spending you do over time. Why does total spending on consumption in our economy change?

Indicate in the box below what you think are the most important factors in determining the amount of consumption spending. Can you explain why consumption is influenced in each case?

Question 21.01

Question 21.01

What determines consumption spending?

Hover here to see the hint for Question 21.01. 
Click here to see the answer to Question 21.01.

21.3.1.1 Income

Consumption spending, not surprisingly, depends primarily on income. As income rises, consumption spending rises. As total income in the economy (GDP) has increased over time, so too has the amount of consumption. However, income is not the only important factor. When you earn income, some of that income is withheld for social security and income taxes. Another determinant of consumption, then, is the amount one must pay in taxes. Business reporters and economists often use the term “disposable income” for the income left over after taxes are paid.

Disposable income is one’s income after taxes are paid. We can think of consumption spending as having two parts. One portion is related to the amount of disposable income. This is the portion that increases as disposable income increases. In Figure 21.4, we can see the strong relationship between total income (GDP) and consumption spending.

There is also an autonomous portion, that is, a portion that is independent of disposable income. Think of this as the level of your consumption if you had no income. For example, you would still have to eat. You may have past savings upon which to rely.

Where “C” is consumption; “a” is the autonomous portion; and “b times (disposable income)” is the portion dependent upon the level of disposable income. What do you expect the value of “b” to be?

It should be less than one. If disposable income changes and nothing else does, many of us will most likely increase our consumption spending and increase our saving. The fraction “b,” now about 95 percent, says that as disposable income increases, individuals will increase their consumption spending by 95 percent of that amount. So “b” should be a positive number, but less than one. The fraction “b” is what is called the marginal propensity to consume (MPC), or the percent of an increase in income that is consumed. A parallel concept is the marginal propensity to save, the percent of an increase in income that is saved.

But consumption also depends on future income, wealth, interest rates, and expectations of future conditions. Changes in any of these will change the autonomous portion of consumption.

ECN22_Figure21.4_updated.jpg
Figure 21.4: Annual consumption and disposable personal income in the U.S.

21.3.1.2 Future Income

One new graduate, an economics major, recently took a two-month trip around the world – to Greece to Nepal to Thailand, Vietnam, China, and home. Obviously, that trip involves a large amount of spending. How was she able to do that?

She has a very good job starting in the fall. Knowing she has a healthy future income influenced her decision to spend money now. If she had no job in the fall or had been continuing in school, she would have been less likely to take that trip. This is one example of why we include current income and future income in thinking about the levels of consumption spending. Peoples’ expectations of their future incomes influence their consumption spending now.

Expectations of related economic conditions play an important role. If people expect economic conditions to worsen, they tend to spend less and save more. If expectations are that conditions will improve, people tend to spend more. If you expect to lose your job next month, you will probably be a little more conservative this month. If you expect to get a raise next month, you may spend a little more this month.

21.3.1.3 Wealth 

If wealth increases, we would expect consumption to increase. Wealthy individuals consume more than less wealthy individuals. However, changes in wealth have rather small effects on actual consumption. It seems as though that for each increase in wealth of $1,000, consumption spending increases by about $50.

21.3.1.4 Interest Rates

If interest rates increase, we would expect those individuals who borrow to reduce their borrowing. Whether they are borrowing to buy automobiles or refrigerators or using their credit cards for other purchases, borrowing to buy those items becomes more expensive when interest rates increase. Changes in interest rates, however, appear to have only a small effect on consumption.

21.3.1.5 Transfer Payments

Government transfer payments, such as social security and Medicare, will affect total income, which in turn affects disposable income, thereby changing consumption spending.

Figure 21.5 shows a graph of a consumption function for an economy. The consumption function has a vertical axis intercept because even at zero income, people will buy necessities like food, either by borrowing or by using savings. In the graph, the autonomous consumption is $ 1 trillion. This is also the effect of all those variables other than income and income taxes. The intercept is “a” in our formula for the consumption function.

Figure 21.5: Consumption Function

The consumption function’s slope is equal to the marginal propensity to consume. Each increase in income goes towards taxes, savings, and consumption. If taxes are on average 25 percent of any increase in income and individuals save 5 percent of an increase, then the remaining 70 percent of the change will go to consumption spending. The consumption function would have a slope (and a marginal propensity to consume) of .7.

In Figure 21.6, spending is about $4.0 trillion with an income of $5 trillion. Spending is about $5.4 trillion when income increases to $7 trillion. The slope, then, is equal to the change in consumption spending divided by the change in income. [($5.4 trillion - $4 trillion) / ($7 trillion - $5 trillion) = $1.4 trillion / $2 trillion = .7] The slope (0.7) represents the percentage of each additional dollar of income that is spent on consumption.

Figure 21.6: Consumption Function​

Graphing Question 21.01a

Graphing Question 21.01b


Question 21.02

How does an increase in income in the U.S. affect the level of U.S. exports?

A

Increase

B

Decrease

C

No change

D

Cannot tell

Question 21.03

How does an increase in income in the U.S. affect the level of U.S. imports?

A

Increase

B

Decrease

C

No change

D

Cannot tell

Question 21.04

If average income goes from $30,000 to $33,000 and consumption increases from $29,000 to $31,000, the marginal propensity to consume is ______________.

A

.67

B

1.5

C

1.06

D

0.96

Question 21.05

If at an average salary of $ 33,000, consumption increases to $ 32,000 due to an increase in wealth, what has happened to the marginal propensity to consume?

A

Increase

B

Decrease

C

No change

Question 21.06

Compare the effects on this year’s consumption spending of: (1) A permanent ten percent cut in income taxes versus (2) A ten percent cut that will last only for one year.

A

(1) would cause the same increase in consumption as (2).

B

The increase in consumption from (1) would be less than the increase from (2).

C

The increase in consumption from (1) would be more than the increase from (2).

D

(1) would cause an increase in consumption; (2) would cause no change in consumption.

Question 21.07

Suppose that in 2015 national income is equal to $5 trillion and consumption is $4 trillion. In 2016, with income of $5.1 trillion, consumption increased to $4.1 trillion. Calculate the marginal propensity to consume.

A

.02

B

.025

C

.25

D

.95

E

1.00

Question 21.08

An increase in wealth ______________ autonomous consumption. A tax rate increase ______________ autonomous consumption.

A

Increases; increases

B

Increases; does not change

C

Does not change; decreases

D

Decreases; decreases

21.3.2 Investment

Investment accounts for approximately 15 to 20 percent of our total annual economic activity. Investment spending represents an increase in capacity to produce future output. Investment is spending by businesses on new buildings, machines, tools, robots, and software. You as an individual might count spending on education as an investment. And you would be correct. However, our GDP accounting standards count spending on education by individuals as consumption. We count spending on education by governments as part of government spending.

Investment also includes changes in inventories and new residential construction. About 70 percent of investment spending consists of business investment in structures and equipment. Investment spending, while much smaller than consumption spending, is much more volatile. That is, it changes from year to year by large amounts and becomes a potential source of fluctuations in total spending.

Buying stocks and bonds is not counted as investment in calculating GDP, because when you buy a stock, most of the time you are buying it from an individual. That individual has your money; you have that individual’s share of stock. Even when you buy a new share, the money goes to the company, which may use it to pay off debt, buy another existing company, or build a new factory. Among these options, only when the money is used to build a new factory does it then become investment spending for GDP purposes. Investment as a part of GDP means additions to the capital stock – machines, factories, and inventories. It means that we are adding to our potential output. The immediate effect is to increase spending in the economy. The longer-run effect is to increase potential output.

Think of starting a business soon after you graduate. What will determine the amount you invest? For example, how much equipment will you buy? How big of an office building will you build? How many stores will you start? Make a list of the determinants of how much you will spend on capital goods.

Question 21.09

Question 21.09

What determines investment spending?

Hover here to see the hint for Question 21.09.
Click here to see the answer to Question 21.09.

Businesses invest because they expect to earn profits. The benefits of an investment include the increase in revenues or the reduction in costs of producing. The costs of an investment include the cost of the capital and, what we can easily miss, the interest we pay or give up in order to purchase the capital. Economic conditions, obviously, can become very important in influencing potential revenues.

21.3.2.1 Revenues

When spending on a particular industry’s goods or services is rising, businesses in that industry will often seek to expand capacity. As output rises, businesses will increase investment. So, we should expect that when real GDP is increasing, investment spending will also increase.

21.3.2.2 Costs

To make an investment, businesses must either borrow funds or use their own funds. In either case, the cost is either the interest they pay or the interest they give up, the opportunity cost. 

Increases in taxes on corporate profits will reduce after-tax profit. A tax credit, in contrast, will reduce taxes owed. 

21.3.2.3 Expectations

Business expectations about revenues and costs will affect the decision-making process. Because investment spending is undertaken to expand future output, expected future conditions are actually more important than current conditions.

Table 21.1: Profit Potential Per Investment​

Table 21.1 is a list of possible investment projects for a business next year.



Question 21.10

Question 21.10

Consider the relationship between interest rates and investment shown in Table 21.1. How much will the company invest if the interest rate is 11%? 9%? 6%? 4%?

Hover here to see the hint for Question 21.10.
Click here to see the answer to Question 21.10.

Graphing Question 21.02

Graphing Question 21.03

21.3.3 Net Exports

Think about using demand and supply diagrams for export and import markets.

Exports are goods and services that we sell to individuals and companies abroad – recently making up 12 percent of GDP. Imports are goods and services we buy from abroad – recently totaling 15 percent of GDP.

Net exports are very close to what is normally described as the trade deficit – our exports minus our imports. What determines the levels of exports? What determines the levels of imports? Think about who is buying and what might change demand, first for exports, then for imports.

Question 21.11

Question 21.11

What determines spending on exports?

Hover here to see the hint for Question 21.11.
Click here to see the answer to Question 21.11.

Question 21.12

Question 21.12

What determines spending on imports?

Hover here to see the hint for Question 21.12.
Click here to see the answer to Question 21.12.

Let’s go back to supply and demand analysis. Figure 21.7 shows a market for our exports. The prices are the U.S. prices, and the quantities are the actual quantities of our exports (measured in dollars) that will be supplied and demanded. The supply and demand curves should look like the normal supply and demand curves that we have discussed.

Figure 21.7: Market for U.S. Exports​

An increase in income of other countries, an increase in international preferences for U.S. goods, an increase in prices of substitute goods in foreign countries, or a decline in import taxes (tariffs) in other countries will increase demand for U.S. exports and cause the equilibrium quantity to increase. Changes in exchange rates will also affect the relative prices of our exports, but we are going to put off that discussion until later in our studies.

Figure 21.8: Market for U.S. Imports​

The supply and demand model for our imports (Figure 21.8) will have foreign prices on the vertical axis and the quantities (again measured in constant dollars) of imports on the horizontal axis. Again, normal supply and demand curves are appropriate, and we will ignore exchange rates for the moment. If our incomes, our tastes for goods from other countries, or our prices of substitute goods for the imports decrease, then the demand for imports into the U.S. will decrease. Also, if our taxes on imports (tariffs) increase, then our demand for imports in the U.S. will decrease. The demand, in this case, is our demand for goods produced in other countries. The supply is the production by businesses in other countries.

You should be able to model the opposite changes and explain why they happen.

Imports are subtracted from GDP because they are included in our consumption, investment and government spending and we are trying to measure GDP, that is, what is produced here. Since the good is produced overseas, we need to subtract it out to neutralize the effect, since it was already counted as consumption.

Graphing Question 21.04

Graphing Question 21.05

Graphing Question 21.06

21.3.4 Government

Government spending included in GDP is the total spending on goods and services by all levels of government in a specific time period – in 2019, about 17 percent of GDP. Government spending includes federal, state, and local government spending. Governments spend money on a variety of programs, such as defense, education, public works projects, police and fire departments, and many more. Government spending is on labor and capital. Government spending does not include expenditures normally described as transfer payments (e.g., social security, unemployment insurance, and Medicare expenditures) as this spending is a transfer from one segment of the population to another group. Government spending tends to be influenced foremost by political concerns and only influenced indirectly by the economic system. As such, in our initial model, we are going to treat government spending as independent of income even though in the long run, government spending surely rises as income rises.

Question 21.13

Question 21.13

Suppose you receive a one-time bonus of $10,000. Alternatively, you receive a $10,000 increase in your annual salary that will continue for the foreseeable future. Compare the marginal propensities to consume in each case and explain why they are the same or different.

Hover here to see the hint for Question 21.13.
Click here to see the answer to Question 21.13.

Question 21.14

Question 21.14

A giant asteroid is heading toward Earth and is expected to come within 50,000 miles of Earth's center in January of 2030. It's a mile wide and will be traveling at speeds of up to 90,000 miles an hour. If the asteroid hits the planet, it could severely damage the oxygen level available.

What are the likely effects on consumption spending prior to the asteroid’s arrival?

Hover here to see the hint for Question 21.14.
Click here to see the answer to Question 21.14.

Question 21.15

Question 21.15

What if we expect to survive the asteroid, but find that our taxes significantly rise to help pay for the damage? What are the likely effects on the composition of GDP?

Hover here to see the hint for Question 21.15.
Click here to see the answer to Question 21.15.

Question 21.16

Question 21.16

“The marginal propensity to consume for the nation as a whole is approximately 90 percent.” What does this statement mean?

Hover here to see the hint for Question 21.16.
Click here to see the answer to Question 21.16.

Question 21.17

Which of the following is correct?

A

An increase in interest rates may cause investment spending to increase because people will put more money into bank accounts.

B

An increase in GDP may cause investment spending to decrease because there will be fewer resources left for investment. A decrease in interest rates may cause investment to decrease as investments generate lower returns.

C

An increase in the tax on corporate profits may cause investment to decrease.

Question 21.18

Question 21.18

A business can borrow money or use its own money to increase its investment spending. Explain why the level of interest rates will affect the decision to invest in both cases.

Hover here to see the hint for Question 21.18.
Click here to see the answer to Question 21.18.

Question 21.19

An increase in prices abroad while prices are stable here will cause our net exports to _______. In turn, this change in net exports will cause our real GDP to _______.

A

Increase; increase

B

Increase; decrease

C

Decrease; decrease

D

Decrease; increase

Question 21.20

U.S. prices are rising. If European prices are rising more rapidly than U.S. prices, we would expect U.S. net exports to change as follows:

A

Exports up; imports up

B

Exports up; imports down

C

Exports down; imports up

D

Exports down; imports down

Question 21.21

Which of the following is included in investment spending?

A

Stocks and bonds

B

Inventories

C

Education

D

Mutual funds

Question 21.22

In which of the following situations would spending on investment be encouraged?

A

The opportunity cost of investing is high.

B

Real GDP is rising.

C

Interest rates are increasing.

D

Expected after-tax profits are falling.

Question 21.23

Suppose U.S. prices increase more than foreign prices. U.S. exports would ______________. GDP would ______________.

A

Increase; increase

B

Decrease; increase

C

Increase; decrease

D

Decrease; decrease

Question 21.24

Suppose that incomes in the U.S. rise and foreign incomes fall. U.S. exports will ______________. U.S. imports will ______________.

A

Increase; increase

B

Decrease; increase

C

Increase; decrease

D

Decrease; decrease

Question 21.25

An increase in government spending will have which of the following effects on real GDP?

A

Not affect GDP because taxes will increase and consumption will fall by an equal amount.

B

Government spending and taxes will always move in opposite directions.

C

Government spending and taxes will always move in same directions.

D

GDP will increase if nothing else changes.

21.4 Income-Spending Model 

We will build a simplified version of our economy using the results of our discussion about each of the GDP components. We will make a series of assumptions, each of which we will eventually reconsider.

  • We will assume that there will be no price changes. 
  • Producers can produce whatever is demanded; that is, there is no constraint on supply. 
  • Government, investment, exports, and imports are all autonomous, that is, independent of anything else in the model. We know that as income increases, investment is likely to increase and imports are likely to increase. But here we are going to assume that neither happens. It makes our initial model a little easier to understand.

In the graphical form of our model, real levels of spending will be on the vertical axis. How much individuals, businesses, foreigners, and governments want to spend at each level of income will eventually be indicated there. It is real spending because we are not allowing prices to change. On the horizontal axis, we will put income and output – real levels of income and output, because prices are not changing. (Remember that every dollar’s worth of output is income to someone.) Real output is real GDP, which is also equal to real income.

We will start by drawing only the consumption function. Figure 21.9 shows the line (the consumption function) that indicates the level of consumption spending at each level of income (also output and real GDP).

Figure 21.9: Consumption Function​

In the next step, Figure 21.10, we will add investment spending of $1.2 trillion at each level of income. The resulting line (C + I) indicates the amount of spending on consumption and investment that will be done at each level of income. The “C + I” line has shifted up by $1.2 trillion at each level of output.

Figure 21.10: Consumption Plus Investment​

Next, government is added in Figure 21.11. Government spending of $1 trillion on goods and services (not including transfer payments) makes the function represent the total consumption, investment, and government spending at each level of income. Again, the spending line shifts upward, this time by the additional $1 trillion of government spending.

Figure 21.11: Consumption Plus Investment plus Government​​​

Next, we add exports of $1 trillion and subtract imports of $1.1 trillion. The “C + I + G + EX” line in Figure 21.12 shows total spending at each level of income, including the exports incorporated in the line as the subtraction of $1.1 trillion in imports, which are the part of consumption, investment, and government spending that is actually done outside of this country.

Figure 21.12: Consumption Plus Investment Plus Government Plus Net Exports​

21.4.1 An Equilibrium Spending = Output = Income 

Now to the important and difficult part. Where along the total spending line (C+I+G+EX-IM) will the economy actually end up? The result depends on the level of spending versus output as shown in Table 21.2.

If spending is greater than output, inventories will fall. That is the only way businesses can sell more than they produce. Businesses see that they are selling more than they are producing and will likely to begin to expand. Output and income will increase, and the economy will move out along the spending line.

Table 21.2: How Spending Versus Output Affects Future Output​

If total spending is less than output, inventories will rise, and businesses will begin to cut back as they see that they are producing more than they can sell. In this instance, output and income will begin to decrease, and the economy will move downward along the total spending line.

Another way of thinking about the problem is to refine the graph we have derived. But first, we need to add one more tool. In Figure 21.13, we draw a new line, one that represents the series of points on the graph where spending equals output. It is drawn at 45 degrees and shows the only points on the graph where the two are equal. We have labeled the line the “spending = output” line. There is really no economic analysis included in this graph. It is only a technique to help find those points where the two are equal.

Figure 21.13: Spending Equals Output

Question 21.26

Question 21.26

Compare the levels of spending and output at points A, B, C, and D. Can you make a generalization about points on the “spending = output” line, points below the line, and points above the line?

Hover here to see the hint for Question 21.26.
Click here to see the answer to Question 21.26.

In Figure 21.14, we combine our total spending line with the 45-degree line. Where the total spending line crosses the “spending = output” line, output is equal to $8 trillion, and spending is equal to $8 trillion. At every other point along the total spending line, spending is either greater than or less than the amount of output. For example, at $14 trillion, spending will be about $12 trillion. At any level of output greater than the equilibrium level, output will be greater than spending. At an output of $3 trillion, spending is about $4.5 trillion. At any output level less than the equilibrium level of output, spending will be greater than output.


Figure 21.14: Income-Spending Model​

Only at $8 trillion is the economy in equilibrium. In the case where current spending is less than output, buyers are not buying all that businesses are producing and inventories start to rise. Businesses will start to decrease production and output will begin to fall. As output decreases, income decreases. Therefore, consumption decreases, but by less than the decrease in income. This causes further cutbacks in production. Total spending will continue to decrease, but by smaller amounts than the decreases in output. The process continues until spending and output are equal, in this case at about $8 trillion of spending and $8 trillion of output.

Question 21.27

Question 21.27

You should be able to explain the process of adjustment in the figure below. We start in exactly the opposite situation. Spending is greater than output. What is that explanation?

Hover here to see the hint for Question 21.27.
Click here to see the answer to Question 21.27.

Figure 21.15: Decrease in Net Exports​

Graphing Question 21.07

Question 21.28

Question 21.28

If current real national output and income are larger than the total sum of consumption, desired investment, government, and net export spending, what will happen in the economy? Why?

Hover here to see the hint for Question 21.28.
Click here to see the answer to Question 21.28.

Rising Inventories Pose a Threat to Businesses and the Economy [1]

“Inventories are rising—and that’s scary. After a very long-run trend of leaner inventories, companies are now holding significantly more than they did just four years ago. Excess inventories are an easy way to go bankrupt, so this movement deserves attention.

At the end of 2011, companies held $1.26 worth of inventory for every dollar’s worth of monthly sales. Their holdings now amount to $1.38. (Inventory data.)"

                                                                                             -Forbes, 21 December 2015

Question 21.29

Question 21.29

What do rising inventory levels suggest for the immediate future of the economy?

Hover here to see the hint for Question 21.29.
Click here to see the answer to Question 21.29.

21.5 The Spending Multiplier

In this brief video, the instructor succinctly defines the marginal propensity to consume and save. He then explains how this translates into the spending multiplier, or the amount that an increase in autonomous spending ripples through the economy.

When leaders in the city government of Los Angeles and the state government of California proposed bringing the St. Louis Rams to Los Angeles, they argued that the effect on the economy of Los Angeles and California would be much larger than the amount of money spent on the stadium and the purchase of tickets, food, and parking. The estimates provided by the state were that thousands of new, full-time jobs would be created by the Rams’ arrival, when only a few hundred would be directly employed by the team. Why would they make that argument?

Similarly, cities around the world spend large amounts of resources in attempts to attract the Olympics. It is often simple civic pride that motivates. But included in almost every justification is the economic benefit of the spending that will occur as a result. That spending is always larger than the amount actually spent by those attending the events.

A very similar concept applies to total spending in our economy.

Figure ​21.16: Increased Wealth

Question 21.30

Question 21.30

In the top figure, it looks like the initial decline in spending from falling exports was about one-half of a trillion dollars. How do we find that? (Look on the vertical axis. The spending line shifted down by what looks like about one-half trillion dollars.) But yet the equilibrium level of output decreased by about $2 trillion. Why? In the figure on the bottom, consumption rose about $1 trillion, and equilibrium output went up by almost $4 trillion. Why?

Hover here to see the hint for Question 21.30.
Click here to see the answer to Question 21.30.

If you suggested that a change in spending creates a change in income, which in turn means a change in consumption spending, you are thinking correctly. For example, in Figure 21.16, spending is greater than output by $1 trillion once consumption spending has increased. (At an output of $8 trillion, the new total spending would be equal to $9 trillion.) Inventories start to fall. Businesses start to increase production, and output begins to rise. What happens to total spending as output begins to rise?

As output increases, income increases, and therefore consumption increases even further. This is in addition to the original increase in consumption spending. So, total spending will increase by even more than the initial increase because of the additional induced consumption spending. The effect of the initial increase in spending will be multiplied by this phenomenon.

The size of this increase is determined by how sensitive consumption spending is to changes in income – the marginal propensity to consume (change in C/change in Y), which is the slope of the consumption function, as stated earlier. 

A mathematical model would show the following:

where “a” is autonomous consumption and “b” is the marginal propensity to consume (MPC), and

If we substitute our consumption function (the first equation) into the definition of GDP (equation 2), we get the following:A little algebra gives us:

A little algebra gives us:


and 

Any change in “a” (autonomous consumption), I, G, or NX will have an effect on GDP that is multiplied by 1/(1 - b).

Remember that b is our marginal propensity to consume. In our example, 25 percent of income was taken out in taxes, and 5 percent was saved. Thus, the marginal propensity to consume is .7. The spending multiplier is equal to 1 / (1 - .7) or 3.33. Each one-dollar change in spending will eventually cause total spending to change by $3.33. It works because the initial change in spending changes output, which in turn affects income and then consumption spending. The reason is that for every additional dollar spent, there is an additional dollar of goods produced. Employment or hours worked needs to increase in order to produce more. As employment or hours worked increase, so too does compensation, which will result in increased consumption.

Let’s look at an example. With a decrease in spending of $100 billion dollars, income falls by $100 billion. The decrease in income causes consumption spending to fall by a portion of that decrease. If the marginal propensity to consume is .7, then consumption spending falls by .7 times $100 billion, or $70 billion. This decrease in consumption spending, in turn, decreases income by $70 billion. Consumption spending will fall by an additional .7 times $70 billion, or $49 billion. Income falls again; consumption falls again, this time by $34.3 billion (.7 times $49 billion = $34.3 billion). The additional decreases in spending become smaller and smaller. If we add all of the decreases together, they will equal approximately $333 billion, or 3.33 times the original change in spending.

This is actually a simplified version of the multiplier. Remember what happens to investment and net exports as income changes. A more sophisticated and realistic version would also include these effects with investment reinforcing the first change and new exports countering the change. We will see later that price changes also affect the size of the spending multiplier. Still, the concept works – primarily because of the role of consumption spending.

Spending on the the Los Angeles Rams increased income for some, and those individuals increased their consumption spending. The increased spending, if it is new spending in the Los Angeles economy, had a multiplied effect. If, however, the spending simply replaced spending on other goods, the net effect is zero.

21.5.1 The Tax Multiplier 

Can you determine the effects on the spending multiplier of a change in income taxes? Does the spending multiplier increase, decrease, or not change? Why?

Question 21.31

Question 21.31

Does the spending multiplier change? Why or why not?

Hover here to see the hint for Question 21.31.
Click here to see the answer to Question 21.31.

21.6 Important Skills 

After reading the chapter, answering the questions, and working the problems, students should be able to explain how and why changes in income, taxes, saving rates, future income, wealth, and transfer payments may cause changes in consumption spending. You should also be able to explain why interest rates and expectations of costs and revenues affect investment spending. And finally, you should be able to explain how and why prices here and abroad, incomes here and abroad, and tastes here and abroad change exports and imports.

Each of those changes plus changes in government spending on goods and services will in turn cause changes in total spending. The final change in total spending will likely be larger than the original change in consumption, investment, net exports, or government spending because initial increases in spending create increases in income, which cause consumption spending to rise as a result. The amount of the subsequent increase in total spending depends upon how much people save out of increases in income and income tax rates. Those factors determine the size of the spending multiplier.

Most important is an understanding of the adjustment process from one equilibrium level of spending and output to another. The process begins with a comparison of the levels of spending and output. A difference in the two creates changes in inventories. Those changes in inventories create incentives for businesses to increase or decrease production. Income thus increases or decreases. Additional changes in consumption spending occur as a result. This process, with smaller and smaller additions to total spending, continues until output and spending are equal at a new equilibrium level of real GDP.

21.7 Summary

  • Gross domestic product is the production of all final goods and services in a country in a specific time period.
  • Gross domestic product includes spending on consumption goods and services; investment spending on plants, equipment, inventories, and new housing; government spending on goods and services; and foreign spending on U.S. exports minus U.S. spending on imported consumption, investment, government, and export goods and services.
  • The level of consumption spending depends on income, wealth, taxes, the amount of desired saving, and expectations.
  • The level of investment spending depends upon expectations of revenues, costs, and interest rates.
  • The level of government spending depends on political decisions about how much to spend on goods and services.
  • Foreign spending on our exports depends on foreign tastes, relative prices, exchange rates, and foreign income.
  • Our spending on imports into the U.S. depends upon our tastes, relative prices, exchange rates, and U.S. income. 
  • A change in any component of spending will have a multiplied effect on total spending and output. 
  • Because a change in spending causes an increase in income, it, in turn, creates a further, yet smaller, increase in consumption spending. That increase in spending causes another increase in income and a further, smaller change in consumption spending. The process continues until the economy reaches a new higher equilibrium level of income, output, and spending.
  • Spending will equal output at the equilibrium levels of spending and output.
Question 21.32

Given the following information, which level of output is the equilibrium level (in billions)?

question description
A

$8600

B

$8800

C

$9000

D

$9200

E

$9400

Question 21.33

If import spending decreases by $200 billion at each level of output (and consumption spending does not change with the change in import spending), what will the new equilibrium output and income be? Exclude the dollar sign.

Question 21.34

Using the data from Question 21.32 and 21.33, what is the marginal propensity to consume?

Question 21.35

If GDP decreased, what would be the most probable effect on the other components of GDP?

A

Consumption alone would decrease.

B

Consumption and investment alone would decrease.

C

Consumption, investment, and imports would decrease.

D

Consumption, investment, and net exports would decrease.

Question 21.36

An increase in income taxes will affect the marginal propensity to consume and the spending multiplier in which of the following ways? It will make the MPC ______________ and the spending multiplier ______________.

A

Larger; larger

B

Smaller; smaller

C

Larger; smaller

D

Smaller; larger

21.8 Key Concepts

Determinants of total spending
Consumption
Marginal propensity to consume
Current and future income
Wealth effect
Investment
Interest rates as a cost of investment
Government
Exports and Imports
Prices
Incomes
Tastes
Circular Flow – Output, income, and spending
Spending = Output (and Income)
Changes in inventories
Movement to equilibrium
Spending multiplier

21.9 Glossary

Autonomous consumption: The portion of consumption that is independent of changes in disposable income.

Capital: Factories, machines, inventories, and tools in an economy. (Education is sometimes referred to as human capital; factories, machines, inventories, and tools as physical capital.) Capital is used in producing other goods and services.

Consumption: Spending by households, including durable goods (washing machine, stereos, and cars), non-durable goods (food, clothing, and gasoline), and services (haircuts, medical care, education).

Disposable income: One’s income after taxes are paid.

Exports: Goods and services produced in the United States and sold abroad.

Government spending: The sum of federal government, state, and local government purchases of goods and services.

Imports: Goods produced abroad and purchased domestically.

Inflation: An increase in the overall level of prices of goods and services in the economy. Often expressed as an annual rate of increase.

Interest rate: Payments by a borrower to a lender for the right to borrow money. Usually expressed as an annual percentage.

Investment: Spending on new buildings, machines, tools, inventories, and new residential construction. Investment spending represents an increase in capacity to produce future output.

Marginal propensity to consume: The change in consumption spending divided by the change in total income.

Marginal propensity to save: The change in savings divided by the change in total income.

Net exports: Exports of goods and services minus imports of goods and services.

Opportunity cost: The true cost of making a choice is the value of what is given up as a result of that choice; it is the value of the next best alternative.

Physical capital: Factories, tools, machines, inventories, and houses that can be used to produce goods and services.

Potential output: The real GDP that can be produced when we are at full employment.

Real GDP: The real value of all final goods and services produced in an economy in a year. Real GDP is measured in dollars adjusted for changes in the overall price level.

Recession: A recession includes the following: a significant decline in production and employment; the decline is spread throughout the economy; and it lasts more than a few months.

Saving: The portion of one’s income that is not spent on consumption or taxes.

Spending multiplier: The change in total spending that will result from a change of a dollar of consumption, investment, government, or net export spending.

Total spending: Spending by consumers, investment spending, government spending on goods and services, plus spending on U.S. exports minus U.S. spending on imports.

Trade deficit: Exports minus imports. If the result is a negative number, it is a trade deficit. If the result is a positive number, it is a trade surplus.

Transfer payments: Government payments to individuals. Social security, unemployment compensation, and welfare payments are examples. Called transfer because in principle the payments are transferring income from taxpayers to recipients of the payments.

Wealth: The value of an individual’s assets minus liabilities.



Locked Content
This Content is Locked
Only a limited preview of this text is available. You'll need to sign up to Top Hat, and be a verified professor to have full access to view and teach with the content.


Answer Keys:

Answer to Question 21.01

You probably listed the amount of income first. You might have listed wealth. Here is a list of factors you might have included.

Income, income taxes, expectations of future income, wealth, amount people want to save, interest rates, and transfer payments. 

Click here to return to Question 21.01.






Answer to Question 21.09

Your answer should include what you expect to be the benefits compared with what you expect to be the costs.

Click here to return to Question 21.09.






Answer to Question 21.10

At each interest rate, the investment-making firm will decide which investments will earn a higher rate of return than the existing interest rate. Investing in projects that earn a lower rate of return than the interest rate has an opportunity cost higher than the benefit of the investment – the money could be put in a bank at the interest rate and earn a higher return. So, at an interest rate of 4%, a profit of 3% will not earn a commensurate return relative to the 4% that can be earned elsewhere. The firm will not make this investment but will make the other investments ($1 million + $500,000 + $200,000 + $2 million =) $3,700,000. At a higher interest rate of 6%, the $1 million investment earning 5% now has an opportunity cost outweighing its benefit. The firm will not make this investment at an interest rate of 6%. Investment at a 6% interest rate will be ($500,000 + $200,000 + $2 million =) $2,700,000. Using the same reasoning, we can see that at an interest rate of 9% investment will be $700,000, and at an interest rate of 11% investment will be $200,000. When graphed, the relationship should look like the figure below.

Explanation:


Click here to return to Question 21.10.






Answer to Question 21.11

Spending on exports is determined by exchange rates, prices in domestic markets relative to foreign markets, income of foreigners, preferences, and tariffs on U.S. goods. As such, if the U.S. dollar becomes more valuable, foreigners have to pay more for U.S. goods because they have to pay more for U.S. dollars to buy U.S. goods. As a result, exports will likely decline. Similarly, as U.S. prices increase due to inflation, foreigners have to pay more for U.S. goods, causing exports to decline. An increase in import taxes by foreign governments will also increase the price to foreigners of exports. Also, as income of foreigners decrease, they have less money to pay for U.S. goods. Finally, preferences for U.S. goods affect spending on exports.

Click here to return to Question 21.11.






Answer to Question 21.12

Like with exports, spending on imports is determined by exchange rates, prices in foreign markets relative to domestic markets, preferences, income of U.S. households and businesses, and tariffs on foreign goods. As such, if the U.S. dollar becomes more valuable, foreign goods become cheaper because U.S. households and businesses will pay fewer U.S. dollars to buy foreign goods. As a result, imports are likely to increase. Similarly, as foreign prices decrease due to a decline in inflation, U.S. households and businesses have to pay less for foreign goods, causing imports to increase. A decrease in import taxes by the U.S. government will also decrease the price of imports to U.S. consumers. Also, as U.S. income decreases, demand for imports decreases. Finally, changes in preferences for foreign goods will affect spending on imports.

Click here to return to Question 21.12.






Answer to Question 21.13

The one-time bonus will raise current income. The permanent raise will increase current income by the same amount plus it will increase future income, presumably for each year one holds this job. Consumers tend to spend a smaller portion and save a larger portion of one-time or temporary changes in income. If the change is permanent, consumers tend to save less and spend more. Thus, the permanent raise causes current consumption to increase by a larger amount than the one-time bonus.

Click here to return to Question 21.13.






Answer to Question 21.14

There are several possible answers. One serious answer is that because of the upcoming end of the world, the need for saving is reduced. Thus, consumption spending should increase.

Click here to return to Question 21.14






Answer to Question 21.15

Government spending and investment are likely to increase to repair the infrastructure. As a result, taxes are likely to increase, causing disposable income will fall. The decrease in disposable income should cause a decrease in consumption spending.

Click here to return to Question 21.15.






Answer to Question 21.16

A change in disposable income will cause a change in consumption spending that is equal to 90 percent of the change in disposable income.

Click here to return to Question 21.16.






Answer to Question 21.18

One of the costs of making an investment is the interest paid to a financial institution that has lent the business money to make the investment. The interest payments must be made as a condition of the loan. If the business uses its own money, it will withdraw it from a bank account and lose the interest it was earning. The forgone interest income is a cost just like it is if the business were paying the interest to a bank. It is no longer earning that interest income.

Click here to return to Question 21.18.






Answer to Question 21.26

At point A, output is $6 trillion, and spending is equal to $6 trillion. Point B shows a combination where output and spending are both $14 trillion. At point C, output and spending are not equal; spending is equal to $6 trillion, and output is equal to $14 trillion. Point D shows output of $6 trillion, and spending of $14 trillion. Points below the “Spending = output” line represent output greater than spending. Points above the line represent combinations where spending is greater than output.

Click here to return to Question 21.26.






Answer to Question 21.27

Since spending is greater than output, buyers are buying more than businesses are producing. The only way that can happen is if inventories start to fall. Businesses will start to increase production and output will begin to rise. As output increases, income increases, and therefore consumption increases, but by less than the initial increase in output. This causes further increases in production. Total spending will continue to increase, but by smaller amounts than the increases in output. The process continues until spending and output are equal.

Click here to return to Question 21.27.






Answer to Question 21.28

If output is more than the level of total spending, inventories will be rising. Businesses begin to cut output, perhaps to the level of current spending. The decreased output will cause incomes to fall. As incomes fall, individuals will decrease their consumption spending by a portion of the decrease in income. Total spending decreases further, causing even less output and incomes and an additional smaller decrease in consumption spending. Each additional decrease in spending gets smaller and smaller as people continue to reduce their spending by only a portion of the decrease in incomes. The process continues until we reach a new equilibrium.

Click here to return to Question 21.28.






Answer to Question 21.29

If inventory levels are “too high,” it must mean that businesses will eventually begin to reduce production in order to cut back on inventories. It is analogous to current output being greater than the equilibrium level of output. We may enter into a period of slowing growth in output or a reduction in output.

Question about marginal propensity to consume on page 9-23. The marginal propensity to consume must be .75. If the multiplier is 4, the formula is 4 = 1 / (1 - MPC).

Click here to return to Question 21.29.






Answer to Question 21.30

The multiplier must be 4 for a decline of $.5 trillion in exports to result in a decline in income of $2 trillion. A spending multiplier of 4 implies a marginal propensity to consume of .75 since 1/(1-.75) = 4.

Click here to return to Question 21.30.






Answer to Question 21.31

The spending multiplier works because an increase in income caused a subsequent change in spending. The change in spending is smaller than the change in income because part of the change in income is saved. The greater the saving, the less the increase in consumption and the less the spending multiplier will ultimately be. Taxes function much like saving in this instance. The greater the tax rate, the less the subsequent change in spending will be. Thus, an increase in income taxes will reduce the size of the spending multiplier.

Click here to return to Question 21.31.






Image Credits:

[1] Image courtesy of Pete Souza under CC BY 3.0.



Think about the factors that affect how much you decide spend in any given year.
one’s income after taxes are paid
The portion of consumption that is independent of changes in disposable income
The change in consumption spending divided by the change in total income.
Remember, investment spending is influenced by the potential benefits and the costs of making the investment.
The company will invest to the point where the marginal benefit (profits) equals the marginal cost (interest rate).
Spending on exports is influenced by factors that influence demand for US goods and services.
Spending on imports is influenced by factors that affect demand for foreign goods.
Consumption is influenced by current and future income. As future income grows, so too does consumption.
Will future income changes affect current spending?
Taxes are a shift factor for consumption.
After taxes, income can be either consumed or saved.
Think about opportunity cost. An interest rate refers to the opportunity cost of funds. If one borrows, then they can use their own funds to invest elsewhere.
Consider points above the line to be where spending is greater than output, while points below the line is where spending is less than output.
If spending is greater than output in the current period, then future output should increase. The reverse is the case if spending is below output.
If production or output is greater than spending, inventories rise in the current period.
Rising inventories are a signal of future declines in output.
Change in spending gets multiplied through the economy via the spending multiplier.
Spending multipliers vary with sentiment levels and taxes.