Chapter 25 aggregate demand and the powerful consumer

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Aggregate Demand and the

Powerful ConsumerMen 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

Aggregate Demand

• Aggregate demand– Total amount that all

• Consumers• Business firms• Government agencies• Foreigners

– Spend on final goods and services

– Is a schedule, not a fixed number• The numerical value depends on the price

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Aggregate Demand

• Components of aggregate demand– Consumer expenditure (C, consumption)

– Investment spending (I)

– Government purchases (G)

– Net exports (X-IM)

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Aggregate Demand

• C - Consumer expenditure / consumption– Total amount spent by consumers

– On newly produced goods and services• Excluding purchases of new homes

– 2/3 of total spending


Aggregate Demand

• I - Investment spending – Sum of expenditures of business firms

• On new plant, equipment, and software

– And households on new homes

– Not included• Financial “investments”• Re-sales of existing physical assets


Aggregate Demand

• G - Government purchases– All the goods and services purchased by

all levels of government

• X-IM - Net exports– Difference between exports (X) and

imports (IM)

• Aggregate demand

C + I + G + (X-IM)


National Income

• National income– Sum of the incomes

– That all individuals in the economy earn • In the forms of wages, interest, rents, and

profits

– Excludes government transfer payments

– Is calculated before any deductions are taken for income taxes


National Income

• Disposable income (DI)– Sum of the incomes of all individuals in

the economy

– After all taxes have been deducted and all transfer payments have been added

– How much consumers have available to spend and save


National Income

• Transfer payments– Sums of money

– That the government gives certain individuals as outright grants• Rather than as payments for services

rendered to employers

– Examples• Social Security and unemployment benefits


Circular Flow

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

– Savings (S)

• “Leakages”– S, IM, Taxes

• “Injections”– I, G, X, Transfers


Figure 1The Circular Flow of Expenditures and Income


Circular Flow

• Aggregate demand = C+I+G+(X-IM)

= Gross national income

• National income = Domestic product

• DI=GDP - Taxes + Transfer Payments

=GDP - (Taxes – Transfers)

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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

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Figure 2Consumer Spending and Disposable Income


Consumer Spending and Income

• Scatter diagram – graph– Graph showing the relationship between

two variables

– Each year: a point in the diagram • Coordinates of each year’s point: values of

the two variables in that year


Figure 3Scatter Diagram of Consumer Spending and Disposable Income


Figure 4Scatter Diagram of Consumer Spending and Disposable Income, 1947–1963


The C Function and the MPC

• Consumption function, C– Relationship between

• Total consumer expenditures• Total disposable income in the economy

– Holding all other determinants of consumer spending constant



• Marginal propensity to consume (MPC)– Ratio of changes in consumption to

changes in disposable income

– Slope of consumption function

– How much more consumers will spend if DI rises by $1


C in change the produces that DI in ChangeC in ChangeMPC


• To estimate the initial effect of a tax cut on consumer spending– Estimate the MPC

– Multiply the amount of the tax cut by the estimated MPC

– Prediction – subject to some margin of error


Table 1Consumption and Income in a Hypothetical Economy


Figure 5A Consumption Function

22

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 C Function

• Movement along a given C function– Change in disposable income

• Shift of the C function– Change in other determinants of C

• Wealth • Price level• Real interest rate• Future income expectations


Figure 6Shifts of the Consumption Function

24

C0

Rea

l Con

sum

er S

pend

ing

Real Disposable Income

A

C2

C1Movements along

consumption function

Shifts of consumption

function



• Wealth – Stock market wealth

• Higher stock prices – increase in C function

– Houses • Lower price of houses – fall in C function

• Price level– Higher price level – lower purchasing

power of money-fixed assets



• Real interest rate– Interest rates have negligible effects on

consumption decisions

• Future income expectations – Permanent cuts in income taxes cause

greater increases in consumer spending

• Than do temporary cuts of equal magnitude


Table 2Incomes of Three Consumers


The Extreme Variability of I

• Investment spending (I)– The most volatile component of aggregate

demand

• Business investment – influenced by– Interest rates

– Tax provisions

– Technical change

– Strength of economy

– State of business confidence


The Extreme Variability of I

• Investment in housing – influenced by– Consumer incomes

– Interest rates

– Interest rates on home mortgages

– Expected rate of price appreciation (or depreciation)


Determinants of Net Exports

• Exports, X– Foreign purchases of U.S. goods

• Imports, IM– Portion of domestic demand that is

satisfied by foreign producers

• Net exports– Exports minus Imports



• Changes in national income– Our GDP rises

• Our imports rise

– Our GDP falls• Our imports fall

– Our exports• Relatively insensitive to our GDP• Sensitive to the GDPs of other countries



• Relative prices and exchange rates– Prices increase

• Net exports decrease

– Prices decline• Net exports increase

– Foreign prices increase• Net exports increase

– Foreign prices decrease• Net exports decrease


How Predictable is AD?

• 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


Appendix National income accounting

• National income accounting – System of measurement devised for

collecting and expressing macroeconomic data

• Gross domestic product (GDP)– Sum of money values

– All final goods and services

– Produced over a specified period of time• Usually one year


Appendix GDP – exceptions to the rule

• Government output– Valued at cost of inputs

• Inventories– Counted in GDP

• Investment goods– Intermediate goods

– Included in GDP


Appendix GDP: sum of final goods and services

• Y = C + I + G + (X – IM)• I = Gross private domestic investment

– Business investment

– Residential construction

– Inventory investment

– Includes only newly produced capital goods

– Doesn’t include exchanges of existing assets



• Y = C + I + G + (X – IM)• G = Government purchases

– Current goods and services

– Purchased by all levels of government

– Don’t include transfer payments



• 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)


Table 3Gross Domestic Product in 2009 as the Sum of Final Demands


Appendix GDP: sum of all factor payments

• GDP = National income– Add up all income in the economy

– GDP = Wages + Interest + Rents + Profits

– Includes indirect business taxes

– Excludes transfer payments

– No deduction for income taxes


Table 4Gross Domestic Product in 2009 as the Sum of Incomes


Appendix GDP: sum of all factor payments

• Net national product (NNP) – A measure of production

– Is conceptually identical to national income

• Gross national product (GNP)– NNP plus depreciation

• Depreciation– Portion of capital equipment used up


Appendix GDP: sum of value added

• Value added by a firm– Revenue from selling a product

– Minus amount paid for goods and services purchased from other firms

• GDP = sum of values added by all firms• Value added

= Wages + Interest + Rents + Profits


Table 5An Illustration of Final and Intermediate Goods


Table 6An Illustration of Value Added


Technology

Chapter 25 aggregate demand and the powerful consumer