1. and the Powerful Consumer24
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

2. 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
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3. 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
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4. 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)

5. 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.

6. 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)

7. AD, Domestic Product, and 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

8. 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

9. 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

10. FIGURE 24-1 The Circular Flow of Expenditures and Income
Rest of the
World
Financial System
C + I
Consumption (C)
Investment (I) 2 3
C + I + G
Purchases (G)
Imports (IM)
Saving (S)
Exports (X)
Investors 4
Government
C + I + G +
Consumers 1
Government
(X – IM)
Disposable
Firms
(produce the
domestic product)
Transfers
Taxes 5 6
Income (DI)
Gross
National
Income (Y)

11. Consumer Spending and Income
A scatter diagram with U.S. data shows the close relationship between real disposable income and real consumer spending.

12. FIGURE 24-2 Consumer Spending and Disposable Income
$6,500
6,000
5,500
5,000
4,500
4,000
3,500
Billions of 1996 Dollars
Real disposable income
3,000
2,500
World
War II
2,000
The Great
Depression
Real consumer spending
1,500
1,000
500
1930
1940
1950
1960
1970
1980
1990
2000
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13. FIGURE 24-3 Consumer Spending and Disposable Income
2001
2000
1999
1998
1997
1995
1976
1996
1994
1992
1990
1991
1989
1988
1987
1986
1985
1980
1984
1979
1978
1974
1970
1964
1960
1955
1945
1943
1942
1947
1941
1939
1929
$5,237
Real Consumer Spending
$2,869
$3,244
$5,677
Real Disposable Income
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14. FIGURE 24-4 Consumer Spending and Disposable Income
1900
1700
1963
1500
Real Consumer Spending B
1360
$180 billion
1300 A
1180
1100
$200
billion
1947
900
900
1100
1300
1500
1700
1900
Real Disposable Income
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15. 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.

16. The Consumption Function and the MPC
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

17. FIGURE 24-5 A Consumption Function
$4,200
3,900
3,600
$300
3,300
$400
3,000
2,700
3,200
3,600
4,000
4,400
4,800
5,200
Real Disposable Income, DI
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18. TABLE 24-1 Consumption and Income in Hypothetical Economy
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19. 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

20. FIGURE 24-6 Shifts of the Consumption Function
Movements along
consumption function C 1
Shifts of
consumption
function C C 2
Real Consumer Spending A
Real Disposable Income
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21. Factors That Shift the Consumption Function
Consumption function shifted by changes in:
Wealth
Price level
Real interest rate
Expectations of future income

22. Why The Tax Rebate Failed in 1975 and 2001?
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.

23. TABLE 24-2 Incomes of Three Consumers
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24. 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.

25. 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.

26. 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.

27. Appendix: National Income Accounting

28. 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

29. 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

30. 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)

31. TABLE 24-3 GDP in 2001 as the Sum of Final Demands
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32. 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

33. TABLE 24-4 GDP in 2001 as the Sum of Incomes
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34. 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

35. TABLE 24-5 An Illustration of Final and Intermediate Goods
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36. TABLE 24-6 An Illustration of Value Added
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37. GDP as the Sum of Values Added
The expenditure, income, and production definitions of GDP are all equivalent.