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Keynesian Economics Flow of the Economy SPENDING by four groups PRODUCTION by firms INCOME received by people Income and Consumption Circular Flow: - Production ------- Income ------- Spending ------ Production ------……… Production National Product (Y): GDP, GNP Net Domestic Product NDP = GDP - Depreciation National Income NI = NDP - indirect business taxes Income National Income (NI) or Personal Income Disposable income (DI) DI = NI - Net Tax Net Tax = Tax - Transfer payment Spending Aggregate Expenditure (AE) or Aggregate Demand (AD) Spending by four groups of economic agents: Four economic agents Consumers Firms Government Rest of the World Their spending consist of four major components of AE Consumer expenditure: Consumption C Firms spending: Investment I Government purchase: G Spending by the rest of the world: – Net exports = Export – Import X - IM Aggregate Expenditure (AE) AE = C + I + G + (X - IM ) Injection C, I, G, X Leakage S, IM Anything that will add to the demand/spending on American produced goods is “injection” The Circular Flow of Expenditures and Income Rest of the World Financial System 3 2 Investors Consumers 4 1 Government 5 6 Firms (produce the domestic product) Demand Determination Aggregate Supply (AS) Not constrained GDP (Y) Aggregate Expenditure (AE) Or AD Demand determination Keynesian economics emphasizes the demand side During the great depression, the supply side is not constrained (not binding) The GDP (Y) is determined by the demand side That is, determined by total spending Components of Total Spending Components of the total spending C, I, G and X-IM Aggregate Expenditure (AE) AE = C + I + G + ( X – IM ) Consumption C The lion of share of AE About 70% of AE Stable during the business cycle Income and Consumption Consumption and Income DI C The relationship between DI and C The Consumption Function Consumption function C C 0 DI (Disposable Income) Consumer Spending and Disposable Income 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 Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Consumer Spending and Disposable Income 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. A Consumption Function 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 Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Consumption and Income in Hypothetical Economy Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Consumption Function 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 The Consumption Function Equation form C = 300 + 0.75 DI General form C = a + b DI Properties of the Consumption Function Upward sloping: Slope > 0 Slope < 1 Intercept "the subsistence level". Marginal Propensity to Consume Marginal Propensity to Consume (MPC) Increase in consumption due to a dollar increase in DI Slope of the consumption function C MPC = ---------DI 0 < MPC < 1 Marginal Propensity to Consume Consumers distribute their incremental income between consumption and savings 0 < MPC < 1 The Consumption Function Movement vs Shift in the Consumption function Movement along the consumption function If DI changes Shifts of the Consumption Function Real Consumer Spending Movements along consumption function C1 C0 C2 A Shifts of consumption function Real Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Shifters of The Consumption Function Wealth Wealth Effect Price level Wealth Effect Example: the stock crash in 1929, a negative wealth effect Expected future income. Demographics Tax Cut and Consumption 1964, tax reduction. Success. 1968 temporary tax increase. Failure. 1975 temporary tax cut. Failure. 1981-84 Tax cut. Success. Reasons Permanent versus Temporary Tax Change C’ C C By permanent tax cut By temporary tax cut 0 DI (Disposable Income) Saving DI =C+S The remaining balance after consumption goes to saving. DI = C + S Saving Marginal Propensity to Save (MPS) S MPS = ---------DI The sum of MPC and MPS equals one. 1 = MPC + MPS