Download Chapter 8 - Aggregate Demand and the powerful consumer

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 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)
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)
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 AD
6
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
– Before taxes / deductions
8
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
9
Circular Flow: Spending, Production, Income
• Disposable income, DI = C+S
– Consumption (C)
– Savings (S)
• “Leakages”
– S, IM, Taxes
• “Injections”
– I, G, X, Transfers
10
Figure 1
The circular flow of expenditures and income
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
Vertical change
Slope 
Horizontal change
13
Figure 2
Consumer spending and disposable income
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
Figure 3
Scatter diagram: consumer spending &disposable income
16
Figure 4
Scatter diagram of consumer spending and
disposable income, 1947–1963
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 function
18
Consumption Function & MPC
Change in C
MPC 
Change in DI that produces the change in C
• Estimate initial effect of tax cut - on C
– Estimate MPC
= Amount of tax cut ˣ MPC
19
Table 1
Consumption and income in a hypothetical economy
Year
(1)
Consumption, C
(2)
Disposable
Income, DI
2002
2003
2004
2005
2006
2007
$2,700
3,000
3,300
3,600
3,900
4,200
$3,200
3,600
4,000
4,400
4,800
5,200
(3)
Marginal Propensity
to Consume, MPC
0.75
0.75
0.75
0.75
0.75
20
Figure 5
A consumption function
Real Consumer Spending, C
C
$4,200
3,900
3,600
3,300
3,000
2,700
0
3,200 3,600 4,000 4,400 4,800 5,200
Real Disposable Income, DI
21
Factors that Shift the Consumption Function
• Change: disposable income
– Movement along - consumption function
• Change: other determinants of C
– Shift - consumption function
22
Figure 6
Shifts of the consumption function
Real Consumer Spending
Movements along
consumption function
C1
C0
C2
A
Shifts of consumption
function
Real Disposable Income
23
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
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Table 2
Incomes of three consumers
Incomes each year
Consumer
1974
1975
1976
1977
Total Income
Constant
Temporary
Permanent
$100
100
100
$100
120
120
$100
100
120
$100
100
120
$400
420
460
• 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!
25
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)
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Table 3
Gross Domestic Product, 2007: sum of final demands
Item
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)
Nominal Amount*
Real Amount†
$9,732
2,1332
2,691
$8,276
1,831
2,022
-713
1,640
2,353
13,843
-560
1,408
1,968
11,567
*In billions of current dollars
†In billions of 2000 dollars
36
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
Table 4
Gross Domestic Product in 2007: sum of incomes
Item
Amount
Item
Amount
Compensation of employees (wages)
$7,878
Net national product
12,250
plus
Net interest
603
plus
Rental income
plus
Indirect business taxes and
misc. items
equals
National income
plus
Statistical discrepancy
equals
Net national product
v
Depreciation
1,687
equals
65
plus
Profits
Corporate profits
Proprietors’ income
plus
Gross national product
minus
2,638
1,595
1,043
v
1,042
v
Income received from
other countries
v
13,937
v
818
plus
Income paid to
other countries
equals
Gross domestic product
722
v
13,841
12,221
v
29
v
12,250
38
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
Table 5
An illustration of final and intermediate goods
Item
Bushel of soybeans
Bag of soy meal
Gallon of soy sauce
Gallon of soy sauce used as seasoning
Seller
Buyer
Price
Farmer
Miller
Factory
Restaurant
Miller
Factory
Restaurant
Consumers
$3
4
8
10
Total: $25
Addendum: Contribution to GDP $10
41
Table 6
An illustration of value added
Item
Bushel of soybeans
Bag of soy meal
Gallon of soy sauce
Gallon of soy sauce used as seasoning
Seller
Buyer
Price
Value
Added
Farmer
Miller
Factory
Restaurant
Miller
Factory
Restaurant
Consumers
$3
4
8
10
$3
1
4
2
Total: $25
$10 n
Addendum: Contribution to GDP
Final Product
Sum of value added
$10
$10
42