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  The Stock Market and building blocks of the Flexible-Price Model

The Stock Market:

A substitute way of looking at investment—one that would make difficult our models too much for us to use it here—sees the level of investment spending as a function of the level of the stock market. Think about what figure out stock market values. the majority of investors in the stock market face a choice between holding stocks--shares of ownership of a corporation that as well give you ownership of that corporation's profits or earnings--or holding bonds- a piece of paper that represents a that pays interest. If you invest your funds in bonds, you make the real interest rate r. If you spend in shares of stock your return is equivalent to your share of the profits of the companies in which you have invested.

When probable future profits are high, investors will find stocks more striking than bonds and will bid up stock prices. The stock market will increase. When the real interest rate drops, investors will find stocks more attractive than bonds as well as will bid up stock prices as well. In moreover case the stock market will rise.

Nevertheless, when likely future profits are high, businesses will invest more. When the real interest rate drops businesses will find investment projects cheaper as well as will invest more. The similar things that determine the value of the stock market as well determine the level of investment spending. The stock market as well as investment move together: what increase or lowers one raise or lowers the other.

The only important difference is that causes of fluctuations in investment affect the stock market first as well as investment spending second. The stock market is therefore a very useful leading indicator of investment spending. Therefore keeps a close watch on the stock market if you want to forecast the level of investment spending.

Notice the pattern utilized for parameters so far: C0, Cy, I0, Ir. This must make the symbols used in algebraic equations clearer as well as easier to remember. The capital letter in the name of every parameter tells you what variable is on the left-hand-side of the equation in which the parameter appears. A “C” signifies that this parameter is part of an equation determining the level of consumption spending C; an “I” signifies that this parameter is part of an equation determining the level of investment spending; and so on. The subscript tells you by which changeable the parameter is multiplied in that equation. For instance Ir is the amount by which venture spending I changes in response to a change in the real interest rate r.

Similar to the consumption function the investment function is a huge simplification of real-world investment patterns.

Government Purchases:

The federal government purchases the labor of government employees--judges, customs inspectors, air traffic controllers, FBI agents, National Oceanic and Atmospheric Administration researchers and others—as well as military hardware, sections of the interstate highway system and other goods and services. All these spending make up the government purchases component of GDP. Such government buys of goods and services add up to about 25 percent of GDP, state, counting together the purchases of local, and the federal government.

Reminder that government spending is larger than government purchases. The government as well spends by transferring money to citizens through Social Security and other payments, food stamps, disability benefits and other transfer payments. For the reason that these transfer payments aren’t themselves demand for final goods and services they don’t show up directly as a piece of GDP in the government purchases total G. Somewhat transfer payments show up in the NIPA as negative taxes. The changeable T--taxes--represents net taxes and taxes less transfer payments. It is a net amount by which the government’s tax as well as transfer system reduces disposable income.

Recap: Domestic Components of Aggregate Demand

Consumption expenditure depends on four factors: (1) the baseline level of consumption C0, (2) the marginal propensity to consume [MPC] Cy, (b) the tax rate t and (4) the level of real GDP Y.

C = C0 + Cy x (1-t) Y

Investment expenditure depends on three things (1) the baseline level of investment I0, (2) the interest sensitivity of investment Ir and (3) the real interest rate r.

I = I0 - Ir x r

We leave the determinants of government expenditure to the political scientists.

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