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24
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
Contents
● Aggregate Demand, Domestic Product, and
National Income
● The Circular Flow of Spending, Production
and Income
● Consumer Spending and Income: The
Important Relationship
● The Consumption Function and the
Marginal Propensity to Consume
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Contents (continued)
● Factors that Shift the Consumption Function
● The Extreme Variability of Investment
● The Determinants of Net Exports
● How Predictable is Aggregate Demand
● Appendix: National Income Accounting
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
AD, Domestic Product, and
National Income
● Aggregate Demand
♦ the total amount that all consumers, business
firms, and government agencies are willing to
spend on final goods and services
● Consumer Expenditure
♦ the total amount spent by consumers on newly
produced goods and services (excluding
purchases of new homes, which are considered
investment goods)
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
AD, Domestic Product, and
National Income
● Investment Spending
♦ the sum of the expenditures of business firms
on new plant and equipment and households on
new homes. Financial “investments” are not
included, nor are resales of existing physical
assets.
● Government Purchases
♦ the goods and services purchased by all levels
of government.
Copyright© 2003 Southwestern/Thomson Learning All rights reserved.
AD, Domestic Product, and
National Income
● Net Exports
♦ the difference between U.S. exports and U.S.
imports.
♦ Indicates the difference between what we sell
to foreigners and what we buy from them
● AD = C + I + G + (X - IM)
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AD, Domestic Product, and
National Income
● National Income
♦ the sum of the incomes that all individuals in
the economy earned in the forms of wages,
interest, rents, and profits.
♦ Excludes government transfer payments
♦ Pre-tax
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AD, Domestic Product, and
National Income
● Disposable Income
♦ the sum of the incomes of all the individuals in
the economy after all taxes have been deducted
and all transfer payments have been added
● DI = GDP - Taxes + Transfers = Y - T
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Circular Flow of Spending,
Production, and Income
● Circular flow diagram: shows the
relationship of the different components of
expenditure and income
● National income = domestic product
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24-1 The Circular Flow of
Expenditures and Income
FIGURE
Rest of the
World
Financial System
3
2
Investors
Consumers
4
1
Government
5
6
Firms
(produce the
domestic product)
Consumer Spending and
Income
● A scatter diagram with U.S. data shows the
close relationship between real disposable
income and real consumer spending.
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24-2 Consumer Spending
and Disposable Income
FIGURE
$6,500
6,000
5,500
5,000
Billions of 1996 Dollars
4,500
4,000
3,500
Real disposable income
3,000
2,500
World
2,000 The Great War II
Depression
1,500
Real consumer spending
1,000
500
0
1930
1940
1950
1960
1970
1980
1990
2000
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24-3 Consumer Spending
and Disposable Income
FIGURE
2001
2000
1999
1998
1997
Real Consumer Spending
$5,237
1995
1994
1992
1990
1991
1989
1988
1987
1986
1996
1985
1984
1979
1980
1976
1978
$2,869
1974
1970
1964
1960
1955
1947
1945
1941
1942 1943
1939
1929
0
$3,244
Real Disposable Income
$5,677
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24-4 Consumer Spending
and Disposable Income
FIGURE
Real Consumer Spending
1900
1963
1700
1500
1360
1300
B
$180 billion
1180
A
1100
$200
900
0
1947
900
1100
billion
1300
1500
1700
1900
Real Disposable Income
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Consumer Spending and
Income
● When the data are converted into a
consumption function diagram--with
income on one axis and consumption on the
other--the relationship between real
consumer spending and real disposable
income is almost linear, with a slope of
about 0.9.
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The Consumption Function
and the MPC
● Consumption function
♦ illustrates the relationship between total
consumer expenditures and total disposable
income in the economy, holding constant all
other determinants of consumer spending.
■MPC =  consumption   disposable income
♦ Can be used to estimate the initial effect on
consumer spending of a tax cut
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24-5 A Consumption
Function
FIGURE
C
$4,200
3,900
3,600
$300
3,300
3,000
$400
2,700
0
3,200 3,600 4,000 4,400 4,800 5,200
Real Disposable Income,DI
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24-1 Consumption and
Income in Hypothetical Economy
TABLE
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Factors That Shift the
Consumption Function
●  disposable income  movement along a
consumption function
●  any other variable that affects
consumption  shift in the entire
consumption function
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24-6 Shifts of the
Consumption Function
FIGURE
Real Consumer Spending
Movements along
consumption function
C1
C0
C2
A
Shifts of
consumption
function
Real Disposable Income
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Factors That Shift the
Consumption Function
● Consumption function shifted by changes
in:
♦ Wealth
♦ Price level
♦ Real interest rate
♦ Expectations of future income
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?
Why The Tax Rebate Failed
in 1975 and 2001
● The tax cuts failed to stimulate consumption
very much because they were perceived as
only temporary.
● People probably figured out that it would
not make much difference to their long-term
well-being, and therefore did not change
their spending habits much.
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24-2 Incomes of Three
Consumers
TABLE
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The Extreme Variability of
Investment
● Investment spending is the most volatile of
all spending components.
● Volatility caused in part by sudden changes
in business confidence.
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The Determinants of Net
Exports
● Our imports rise when our GDP rises and
fall when our GDP falls.
● Our exports are relatively insensitive to our
own GDP, but are directly related to GDPs
of our trading partners.
● Our exports rise when our prices fall and
vice-versa; our imports rise when prices fall
in the economies of our trading partners.
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How Predictable is
Aggregate Demand?
● While the consumption function seems like
a simple tool, it is actually quite difficult to
predict consumer spending.
● An activist fiscal policy may not have much
effect at all on spending, if people anticipate
that taxes will be changed frequently.
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Appendix: National
Income Accounting
Defining GDP: Exceptions to
the Rules
● GDP = sum of the money values of all final
goods and services produced during a
specified period of time
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Defining GDP: Exceptions to
the Rules
● Government outputs = valued at the cost of
the inputs needed to produce them
● Inventories are treated as though they were
bought by the firms that produced them,
even though these purchases do not really
take place
● Investment goods = final products
demanded by the firms that hold them
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GDP as the Sum of Final
Goods and Services
● GDP as the sum of all final demands in one
year
♦ Sum of expenditures on all final goods and
services
♦ GDP = C + I + G + (X - IM)
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24-3 GDP in 2001 as the
Sum of Final Demands
TABLE
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GDP as the Sum of All Factor
Payments
● GDP as sum of incomes (or factor
payments)
♦ GDP as the sum of all factor payments
♦ Value of factors’ outputs = value of incomes
♦ GDP = wages + interest + rents + profits +
purchases from other firms
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24-4 GDP in 2001 as the
Sum of Incomes
TABLE
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GDP as the Sum of Values
Added
● GDP as the sum of values added
♦ GDP = sum of values added to goods in all
firms
♦ Value added = firm’s revenue from selling a
product minus the amount paid for goods and
services purchased from other firms
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24-5 An Illustration of
Final and Intermediate Goods
TABLE
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24-6 An Illustration of
Value Added
TABLE
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GDP as the Sum of Values
Added
● The expenditure, income, and production
definitions of GDP are all equivalent.
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