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

Outline

• Chapter 7 covered economic growth– determinants of potentialpotential GDP

• Now we turn to actualactual GDP– determined by AD and AS

– In short-run by AD (Chp.8 and 9)

– In long-run by AS (Chp.10)

Aggregate Demand

• Aggregate demand– Total amount– All consumers, business firms, &

government agencies– Spend on final goods and services

• Components of aggregate demand– Consumer expenditure (CC, consumption)– Investment spending (II)– Government purchases (GG)– Net exports (X-IMX-IM) 3

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

4

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

5

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 AD6

Aggregate Demand

AD=C+I+G+(X-IM)

National Income

• National income– Total income - all individuals in economy

• Wages, interest, rents, profits

– Excludes• Government transfer payments

– BeforeBefore taxes / deductions

8

National Income

• Disposable income (DI)– Total income - all individuals in economy

– AfterAfter taxes – deducted

– After transfer payments - added

– Spend and save

• Transfer payments– Sums of money

– Form government – to certain individuals

– Outright grants9

Circular Flow: Spending, Production, Income

• Disposable income, DI = C+S– Consumption (C)

– Savings (S)

• “Leakages”– S, IM, Taxes

• “Injections”– I, G, X, Transfers

10

The circular flow of expenditures and income

Figure 1

11

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

12

Consumer Spending and Income

• Consumer spending - responds– Change in income taxes

• If DI increases– C – increases

• If DI decreases– C – falls

13

change Horizontalchange Vertical

Slope

Consumer spending and disposable income

Figure 2

14

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

15

Scatter diagram: consumer spending &disposable income

Figure 3

16

Scatter diagram of consumer spending and disposable income, 1947–1963

Figure 4

17

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 function18

Consumption Function & MPC

• Estimate initial effect of tax cut - on C– Estimate MPC

= Amount of tax cut ˣ MPC

19

C in change the produces that DI in ChangeC in ChangeMPC

Consumption and income in a hypothetical economy

Table 1

20

Year(1)

Consumption, C

(2)Disposable Income, DI

(3) Marginal Propensity

to Consume, MPC

200220032004200520062007

$2,7003,0003,3003,6003,9004,200

$3,2003,6004,0004,4004,8005,200

0.750.750.750.750.75

A consumption function

Figure 5

21

C

2,700

3,000

3,300

3,600

3,900

Rea

l Con

sum

er S

pend

ing,

C

$4,200

3,200 3,600 4,0000 4,400 4,800

Real Disposable Income, DI

5,200

Factors that Shift the Consumption Function

• Change: disposable income– Movement alongalong - consumption function

• Change: other determinants of C– ShiftShift - consumption function

22

Shifts of the consumption function

Figure 6

23

C0

Rea

l Con

sum

er S

pend

ing

Real Disposable Income

A

C2

C1Movements along

consumption function

Shifts of consumption

function

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 24

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!

Table 2

25

Incomes each year

Consumer 1974 1975 1976 1977 Total Income

ConstantTemporaryPermanent

$100100100

$100120120

$100100120

$100100120

$400420460

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

26

Determinants of Net Exports

• Income levels– GDP rises

• Imports – rise

– GDP falls• Imports – fall

– Exports - relatively insensitive to GDP

27

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

28

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

29

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

APPENDIX

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

31

APPENDIX

GDP – exceptions to the rule• Government output

– Valued at cost of inputs

• Inventories– Counted in GDP

• Investment goods– Intermediate goods

– Included in GDP

32

APPENDIX

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 33

APPENDIX

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

34

APPENDIX

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)

35

Gross Domestic Product, 2007: sum of final demands

Table 3

36

Item Nominal Amount* Real Amount†

Personal consumption expenditures (C)Gross private domestic investment (I)Government purchases of goods and services (G)Net exports (X - IM) Exports (X) Imports (IM)Gross domestic product (Y)

$9,7322,13322,691

-7131,640 2,353

13,843

$8,2761,8312,022

-5601,4081,968

11,567

*In billions of current dollars†In billions of 2000 dollars

APPENDIX

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

37

Gross Domestic Product in 2007: sum of incomes

Table 4

38

Item Amount

Compensation of employees (wages) plusNet interest plusRental income plusProfits Corporate profits Proprietors’ income plusIndirect business taxes and misc. items equalsNational income plusStatistical discrepancy equalsNet national product

$7,878

603

65

2,6381,5951,043

v

1,042v

12,221v

29v

12,250

Item Amount

Net national product plusDepreciation equalsGross national product minusIncome received from other countries plusIncome paid to other countries equalsGross domestic product

12,250v

1,687v

13,937v

818

722 v

13,841

APPENDIX

GDP: sum of all factor payments• Net national product (NNP)• Gross national product (GNP)• Depreciation

– Portion of capital equipment - Used up

39

APPENDIX

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

40

An illustration of final and intermediate goods

Table 5

41

Item Seller Buyer Price

Bushel of soybeans Bag of soy mealGallon of soy sauceGallon of soy sauce used as seasoning

FarmerMiller

FactoryRestaurant

MillerFactory

RestaurantConsumers

$348

10

Total: $25

Addendum: Contribution to GDP $10

An illustration of value added

Table 6

42

Item Seller Buyer Price ValueAdded

Bushel of soybeans Bag of soy mealGallon of soy sauceGallon of soy sauce used as seasoning

FarmerMiller

FactoryRestaurant

MillerFactory

RestaurantConsumers

$348

10

$3142

Total: $25 $10 n

Addendum: Contribution to GDP

Final Product Sum of value added

$10$10