Chapter 8

1. Chapter 8 Aggregate Demand and the Powerful Consumer Men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. JOHN MAYNARD KEYNES

2. Outline Chapter 7 covered economic growth determinants of potential GDP Now we turn to actual GDP determined by AD and AS In short-run  by AD (Chp.8 and 9) In long-run by AS (Chp.10)

3. Aggregate Demand • Aggregate demand • Total amount • All consumers, business firms, & government agencies • Spend on final goods and services • Components of aggregate demand • Consumer expenditure (C, consumption) • Investment spending (I) • Government purchases (G) • Net exports (X-IM)

4. Aggregate Demand • C - Consumer expenditure / consumption • Total amount • Spent by consumers • Newly produced goods & services • Exclude: purchases of new homes • Investment goods • 2/3 of total spending

5. Aggregate Demand • I - Investment spending • Sum of expenditures • Business firms - new plant & equipment • Households - new homes • Not included • Financial “investments” (Why?) • Re-sales of existing physical assets

6. Aggregate Demand • G - Government purchases • Goods & services • Purchased by – all levels of government • X-IM - Net exports • X – exports • Sell to foreigners, foreign demand on US domestic product  count in AD of US • IM – imports • Buy from foreigners, US demand on foreign produced goods  not count in AD

7. Aggregate Demand AD=C+I+G+(X-IM)

8. National Income • National income • Total income - all individuals in economy • Wages, interest, rents, profits • Excludes • Government transfer payments • Before taxes / deductions

9. National Income • Disposable income (DI) • Total income - all individuals in economy • After taxes – deducted • After transfer payments - added • Spend and save • Transfer payments • Sums of money • Form government – to certain individuals • Outright grants

10. Circular Flow: Spending, Production, Income • Disposable income, DI = C+S • Consumption (C) • Savings (S) • “Leakages” • S, IM, Taxes • “Injections” • I, G, X, Transfers

11. Figure 1 The circular flow of expenditures and income

12. Circular Flow: Spending, Production, Income • Aggregate demand = C+I+G+(X-IM) = Gross national income (NI) • National income = Gross Domestic Product (GDP) • DI=GDP - Taxes + Transfer Payments =GDP - (Taxes - Transfers) =Y - T

13. Consumer Spending and Income • Consumer spending - responds • Change in income taxes • If DI increases • C – increases • If DI decreases • C – falls

14. Figure 2 Consumer spending and disposable income

15. Consumer Spending and Income • Scatter diagram – graph • Relationship between two variables • Each year – a point in diagram • Coordinates of each year’s point • Values of two variables - year

16. Figure 3 Scatter diagram: consumer spending &disposable income

17. Figure 4 Scatter diagram of consumer spending and disposable income, 1947–1963

18. Consumption Function & MPC • Consumption function • Relationship • Total consumer expenditures • Total disposable income • All other determinants constant • Marginal propensity to consume (MPC) • Ratio of changes in consumption • To changes in disposable income • Slope of consumption function

19. Consumption Function & MPC • Estimate initial effect of tax cut - on C • Estimate MPC = Amount of tax cut ˣ MPC

20. Table 1 Consumption and income in a hypothetical economy

21. Figure 5 A consumption function C $4,200 3,900 3,600 Real Consumer Spending, C 3,300 3,000 2,700 0 3,200 3,600 4,000 4,400 4,800 5,200 Real Disposable Income, DI

22. Factors that Shift the Consumption Function • Change: disposable income • Movement along - consumption function • Change: other determinants of C • Shift - consumption function

23. Figure 6 Shifts of the consumption function Movements along consumption function C0 C2 C1 Real Consumer Spending A Shifts of consumption function Real Disposable Income

24. Factors that Shift the Consumption Function • Other determinants of C • Wealth • Stock market boom: upward shift • Price level • CPI  inflation  real purchasing power  real wealth  downward shifts • Real interest rate • r  encourage I, discourage C  C • Future income expectations • Permanent cuts in income taxes • Greater increase in C than temporary cuts

25. Table 2 Incomes of three consumers Which consumer has highest consumption in 1974? Will “temporary” consumer spend $20 more than “constant” one in 1974? Policy implication: temporary tax cut would not work!

26. Extreme Variability Of Investment • Investment spending (I) • the most volatile component of aggregate demand • Interest rates • Tax provisions • Technical change • Strength of economy • State of business confidence • Expectations about future

27. Determinants of Net Exports • Income levels • GDP rises • Imports – rise • GDP falls • Imports – fall • Exports - relatively insensitive to GDP

28. Determinants of Net Exports • Relative prices & Exchange rates • Prices increase • Net exports – decrease • Prices decline • Net exports – increase • Foreign prices – increase • Net exports – increase • Foreign prices – decrease • Net exports – decrease

29. How Predictable is Aggregate Demand? • Aggregate demand – difficult to predict • Consumption • Wealth, stock market • Future prices, income tax law • Investment • Business confidence, expectations • Government purchases • Politics, military and national security events • Net exports • Development abroad

30. Summary AD = C + I +G +(X-IM) AD = NI = GDP DI = GDP – T C is a fn of DI, and slope of C fn is MPC (MPC=C/DI ) Shift of C fn vs. Movement along C fn I is very volatile The Determinant of Net Exports

31. National income accounting • National income accounting • System of measurement • Collect & express macroeconomic data • Gross domestic product (GDP) • Sum of money values • All final goods & services • Produced - specified period of time • Usually one year

32. GDP – exceptions to the rule • Government output • Valued at cost of inputs • Inventories • Counted in GDP • Investment goods • Intermediate goods • Included in GDP

33. GDP: sum of final goods and services • Y = C + I + G + (X – IM) • I = Gross private domestic investment • Business investment • Plant, Equipment, Software • Residential construction • Inventory investment • Includes only • Newly produced capital goods • Doesn’t include • Exchanges of existing assets

34. GDP: sum of final goods and services • Y = C + I + G + (X – IM) • G = Government purchases • Current goods & services • Purchased: all levels of government • Don’t include transfer payments

35. GDP: sum of final goods and services • Nation’s total output Y=C+I+G+(X-IM) • Shares of GDP - used up by • Consumers (C) • Investors (I) • Government (G) • Foreigners (X-IM)

36. Table 3 Gross Domestic Product, 2007: sum of final demands

37. GDP: sum of all factor payments • GDP = National income • Add up - All income in economy • GDP = Wages + Interest + Rents + Profits • Includes: indirect business taxes • Excludes: transfer payments • No deduction for income taxes

38. Table 4 Gross Domestic Product in 2007: sum of incomes

39. GDP: sum of all factor payments • Net national product (NNP) • Gross national product (GNP) • Depreciation • Portion of capital equipment - Used up

40. GDP: sum of value added • Value added firm • Revenue from selling a product • Minus amount paid • Goods & services purchased from other firms • GDP = sum of values added by all firms • Value added = Wages + Interest + Rents + Profits

41. Table 5 An illustration of final and intermediate goods

42. Table 6 An illustration of value added