No Such Thing as a Free Lunch: Principles of Economics (Part 109)

We're living in a Dark Age of macroeconomics.

Remember, what defined the Dark Ages wasn’t the fact that they were primitive — the Bronze Age was primitive, too. What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed.

— Paul Krugman

Aggregate Expenditure and Equilibrium Output

(Part C)

by

Charles Lamson

Planned Investment (I)

Consumption, as we have seen, is the spending by households on goods and services, but what kind of spending do firms engage in? The answer is investment.

What is Investment? Let us begin with a brief review of terms and concepts. In everyday language, we use investment to refer to what we do with our savings: "I invested in a mutual fund and some Amazon stock." In the language of economics, however, investment always refers to the creation of capital stock. To an economist, an investment is something produced that is used to create value in the future.

You must not confuse the two uses of the term. When a firm builds a new plant or ads new machinery to its current stock, it is investing. A restaurant owner who buys tables, chairs, cooking equipment, and silverware is investing. When a college builds a new sports center, it is investing. From now on, we use investment only to refer to purchases by firms of new buildings and equipment and inventories, all of which add to firms' capital stocks.

Inventories are part of the capital stock. When firms add to their inventories, they are investing---they are buying something that creates value in the future. Most of the capital stock of a clothing store consists of its inventories of unsold clothes in its warehouses and on its racks and display shelves. The service provided by a grocery or department store is the convenience of having a large variety of commodities in inventory available for purchase at a single location.

Manufacturing firms generally have two kinds of inventories: inputs and final products. General Motors (GM) has stocks of tires, rolled steel, engine blocks, valve covers, and thousands of other things in inventory, all waiting to be used in producing new cars. In addition, GM has an inventory of finished automobiles awaiting shipment.

Investment is a flow variable---it represents additions to capital stock in a specific period. A firm's decision on how much to invest each period is determined by many factors. For now, we will focus simply on the effects that given investment levels have on the rest of the economy.

Actual versus Planned Investment One of the most important insights of macroeconomics is deceptively simple: a firm may not always end up investing the exact amount that it planned to. The reason is that a firm does not have complete control over its investment decision; some parts of that decision are made by other actors in the economy. (This is not true of consumption, however. Because we assume households have complete control over their consumption, planned consumption is always equal to actual consumption.)

Generally, firms can choose how much new plant and equipment they wish to purchase in any given period. If GM wants to buy a new robot to stamp fenders or McDonald's decides to buy an extra french fry machine, it can usually do so without difficulty. There is, however, another component of investment over which firms have less control---inventory investment.

Suppose GM expects to sell 1 million cars this quarter and has inventories at a level it considers proper. If the company produces and sells 1 million cars, it will keep its inventories just where they are now (at the desired level). Now suppose GM produces 1 million cars, but due to a sudden shift of consumer interest it sells only 900,000 cars. By definition, GM's inventories of cars must go up by 100,000 cars. The firm's change in inventory is equal to production minus sales. The point here is:

Because involuntary inventory adjustments are neither desired nor planned, we need to distinguish between actual investment and desired, or planned, investment. We will use I to refer to desired or planned investment only. In other words, I will refer to planned purchases of plant and equipment and planned inventory changes. Actual investment, in contrast, is the actual amount of investment that takes place. If actual inventory investment turns out to be higher than firms planned, then actual investment is greater than I, planned investment.

For the purposes of the next few posts, we will take the amount of investment that firms together plan to make each period (I) as fixed at some given level. We assume this level does not vary with income. In the example that follows, we will assume that I = $25 billion, regardless of income. As Figure 7 shows, this means the planned investment function is a horizontal line.

Planned Aggregate Expenditure (AE) 

We define total planned aggregate expenditure (AE) in the economy to be consumption (C) plus planned investment (I). 

planned aggregate expenditure ≡ consumption + planned investment

AE ≡ C + I

Recall that the triple equal sign means that this is an identity, or something that is always true.

AE is the total amount that the economy plans to spend in a given period. In the next post we will use the concept of planned aggregate expenditure to discuss the economy's equilibrium level of output. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 437-440*

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