Question

Explain actual events or dynamics could have led to changes in each component in the economy.

Answer 1

• Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.

• Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.

• Investment can change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment can also change when interest rates rise or fall.

• Government spending and taxes are determined by political considerations.

• Exports and imports change according to relative growth rates and prices between two economies.

• Disposable income is income after taxes.

• An inflationary gap exists when equilibrium is at a level of output above potential GDP.

• A recessionary gap exists when equilibrium is at a level of output below potential GDP.

Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are things that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Services are intangible things consumers buy, like healthcare or entertainment.

• Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay. This left-over income is also also known as disposable income, which is income after taxes.

• Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.

Spending on new capital goods is called investment expenditure. Investment falls into four categories: producer’s durable equipment and software, new nonresidential structures, changes in inventories, and residential structures. The first three types of investment are conducted by businesses, while the last is conducted by households.

Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions.

When a business decides to make an investment in physical assets—like plants or equipment—or in intangible assets—like skills or a research and development project—that firm considers both the expected benefits of the investment, like future profits, and the costs of the investment, such as interest rates