1. 8 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 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. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #1 ●Identify the 5 components of GDP and use a circular flow diagram to illustrate them.

3. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. AD, Domestic Product, and National Income ●Aggregate Demand ●Consumer Expenditure ●Aggregate Demand ●Consumer Expenditure

4. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. AD, Domestic Product, and National Income ●Investment Spending ●Government Purchases ●Investment Spending ●Government Purchases

5. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. AD, Domestic Product, and National Income ●Net Exports

6. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. AD = ●AD = ♦THIS FORMULA CONSTITUTES THE CALCULATION OF GDP!! ●AD = ♦THIS FORMULA CONSTITUTES THE CALCULATION OF GDP!!

7. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. AD, Domestic Product, and National Income ●National Income ♦ ●National Income ♦

8. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. AD, Domestic Product, and National Income ●Disposable Income ♦ ●DI = ●Disposable Income ♦ ●DI =

9. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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 ●Circular flow diagram: shows the relationship of the different components of expenditure and income ●National income = domestic product

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

11. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem ●Answer this question using the information provided. The following amounts are known: ●NI:10,000 ●T:2,000 ●Tr:800 ●C:7500 ●I:700 ●G:2,500 ●Im:1,300 ●X: 600 ● ●Find a) disposable income, b) savings, c) Net exports, d) domestic product ●Answer this question using the information provided. The following amounts are known: ●NI:10,000 ●T:2,000 ●Tr:800 ●C:7500 ●I:700 ●G:2,500 ●Im:1,300 ●X: 600 ● ●Find a) disposable income, b) savings, c) Net exports, d) domestic product

12. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #2 ●Explain the relationship between C and Income. Illustrate this using the consumption function.

13. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Consumer Spending and Income ●A scatter diagram with U.S. data shows the close relationship between real disposable income and real consumer spending.

14. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 24-3 Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserved. $3,244$5,677 $5,237 $2,869 Real Consumer Spending 0 2001 2000 1999 1998 1997 1995 1976 1996 1994 1992 19901991 1989 1988 1987 1986 1985 1980 1984 1979 1978 1974 1970 1964 1960 1955 1945 1943 1942 1947 1941 1939 1929 Real Disposable Income

15. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 24-4 Consumer Spending and Disposable Income Copyright © 2003 South-Western/Thomson Learning. All rights reserved. B A $200 billion $180 billion 1900 1700 1500 1360 1300 1180 1100 900 19001700150013001100900 1947 Real Disposable Income Real Consumer Spending 1963 0

16. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Consumer Spending and Income ● ●

17. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Consumption Function and the MPC ●Consumption function ■ ■MPC = ■ ●Consumption function ■ ■MPC = ■

18. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. FIGURE 24-5 A Consumption Function Copyright © 2003 South-Western/Thomson Learning. All rights reserved. C $400 $300 Real Disposable Income,DI 5,2004,8004,4004,0003,6003,2000 2,700 3,000 3,300 3,600 3,900 $4,200

19. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. TABLE 24-1 Consumption and Income in Hypothetical Economy Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Factors That Shift the Consumption Function ●  disposable income  ●  any other variable that affects consumption  ●  disposable income  ●  any other variable that affects consumption 

21. FIGURE 6: Shifts of the Consumption Function Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Shifts of consumption function Real Consumer Spending Real Disposable Income Movements along consumption function C 2 C 1 C 0 A

22. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Using the MPC ●Government hopes to raise C by $30b. If the MPC is.9, how much would the Government cut taxes by? ●Government hopes to raise C by $100b. If the MPC is.8, how much would the Government increase Tr. by? ●Government hopes to raise C by $30b. If the MPC is.9, how much would the Government cut taxes by? ●Government hopes to raise C by $100b. If the MPC is.8, how much would the Government increase Tr. by?

23. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Why The Tax Rebate Failed in 1975 and 2001 ●.●.●.●. ●.●.●.●. ?

24. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Goal #4 Explain the and graph the determinants of investment spending and net exports.

25. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Extreme Variability of Investment ●.● ●.● ●.● ●.●

26. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Determinants of Net Exports ●.●.●.●.●.●. ●.●.●.●.●.●.

27. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. How Predictable is Aggregate Demand? ●.●.●.●. ●.●.●.●.

28. Appendix: National Income Accounting

29. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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

30. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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 ●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

31. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. 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) ●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)

32. TABLE 3: GDP in 2004 as the Sum of Final Demands Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

33. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●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 ●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 GDP as the Sum of All Factor Payments

34. TABLE 4: GDP in 2004 as the Sum of Incomes Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

35. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. GDP as the Sum of Values Added ●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 ●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

36. TABLE 5: An Illustration of Final and Intermediate Goods Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

37. TABLE 6: An Illustration of Value Added Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

38. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. GDP as the Sum of Values Added ●The expenditure, income, and production definitions of GDP are all equivalent.