Chapter 8 Aggregate Demand the Powerful Consumer Men

Chapter 8 Aggregate Demand 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) 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 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 • 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 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 C 1 C 0 C 2 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 24

Table 2 Incomes of three consumers Incomes each year Consumer 1974 1975 1976 1977 Total Income Constant Temporary Permanent $100 100 $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) 35

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 Compensation of employees (wages) $7, 878 Net national product 12, 250 plus v Net interest 603 Depreciation 1, 687 Rental income 65 Gross national product 13, 937 2, 638 1, 595 1, 043 Income received from other countries 818 Income paid to other countries 722 plus Profits Corporate profits Proprietors’ income plus v Indirect business taxes and misc. items 1, 042 National income 12, 221 equals plus v equals minus plus equals Gross domestic product v v v 13, 841 v Statistical discrepancy 29 Net national product 12, 250 equals v 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 Seller Bushel of soybeans Bag of soy meal Gallon of soy sauce used as seasoning Buyer Price Farmer Miller Factory Restaurant Consumers $3 4 8 10 Total: $25 Addendum: Contribution to GDP $10 41

Table 6 An illustration of value added Item Seller Bushel of soybeans Bag of soy meal Gallon of soy sauce used as seasoning Buyer Price Value Added Farmer 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 42