1. Chapter 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

2. Outline Chapter 7 covered economic growth potential –determinants of potential GDP actualNow 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)

3. Aggregate Demand Aggregate demand –Total amount –All consumers, business firms, & government agencies –Spend on final goods and services Components of aggregate demand C –Consumer expenditure (C, consumption) I –Investment spending (I) G –Government purchases (G) X-IM –Net exports (X-IM) 3

4. 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

5. 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

6. 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

7. Aggregate Demand AD=C+I+G+(X-IM)

8. National Income National income –Total income - all individuals in economy Wages, interest, rents, profits –Excludes Government transfer payments –Before –Before taxes / deductions 8

9. National Income Disposable income (DI) –Total income - all individuals in economy –After –After taxes – deducted –After transfer payments - added –Spend and save Transfer payments –Sums of money –Form government – to certain individuals –Outright grants 9

10. Circular Flow: Spending, Production, Income Disposable income, DI = C+S –Consumption (C) –Savings (S) “Leakages” –S, IM, Taxes “Injections” –I, G, X, Transfers 10

11. The circular flow of expenditures and income Figure 1 11

12. 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

13. Consumer Spending and Income Consumer spending - responds –Change in income taxes If DI increases –C – increases If DI decreases –C – falls 13

14. Consumer spending and disposable income Figure 2 14

15. 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

16. Scatter diagram: consumer spending &disposable income Figure 3 16

17. Scatter diagram of consumer spending and disposable income, 1947–1963 Figure 4 17

18. 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

19. Consumption Function & MPC Estimate initial effect of tax cut - on C –Estimate MPC = Amount of tax cut ˣ MPC 19

20. Consumption and income in a hypothetical economy Table 1 20 Year (1) Consumption, C (2) Disposable Income, DI (3) Marginal Propensity to Consume, MPC 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 0.75

21. A consumption function Figure 5 21 C 2,700 3,000 3,300 3,600 3,900 Real Consumer Spending, C $4,200 3,2003,6004,00004,4004,800 Real Disposable Income, DI 5,200

22. Factors that Shift the Consumption Function Change: disposable income along –Movement along - consumption function Change: other determinants of C –Shift –Shift - consumption function 22

23. Shifts of the consumption function Figure 6 23 C0C0 Real Consumer Spending Real Disposable Income A C2C2 C1C1 Movements along consumption function Shifts of consumption function

24. 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

25. Incomes of three consumers 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! Table 2 25 Incomes each year Consumer1974197519761977Total Income Constant Temporary Permanent $100 100 $100 120 $100 100 120 $100 100 120 $400 420 460

26. 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

27. Determinants of Net Exports Income levels –GDP rises Imports – rise –GDP falls Imports – fall –Exports - relatively insensitive to GDP 27

28. 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

29. 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

30. 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

31. APPENDIX 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

32. 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

33. 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

34. 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

35. 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

36. Gross Domestic Product, 2007: sum of final demands Table 3 36 ItemNominal Amount*Real Amount† 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) $9,732 2,1332 2,691 -713 1,640 2,353 13,843 $8,276 1,831 2,022 -560 1,408 1,968 11,567 *In billions of current dollars †In billions of 2000 dollars

37. 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

38. Gross Domestic Product in 2007: sum of incomes Table 4 38 ItemAmount Compensation of employees (wages) plus Net interest plus Rental income plus Profits Corporate profits Proprietors’ income plus Indirect business taxes and misc. items equals National income plus Statistical discrepancy equals Net national product $7,878 603 65 2,638 1,595 1,043 v 1,042 v 12,221 v 29 v 12,250 ItemAmount Net national product plus Depreciation equals Gross national product minus Income received from other countries plus Income paid to other countries equals Gross domestic product 12,250 v 1,687 v 13,937 v 818 722 v 13,841

39. APPENDIX GDP: sum of all factor payments Net national product (NNP) Gross national product (GNP) Depreciation –Portion of capital equipment - Used up 39

40. 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

41. An illustration of final and intermediate goods Table 5 41 ItemSellerBuyerPrice Bushel of soybeans Bag of soy meal Gallon of soy sauce Gallon of soy sauce used as seasoning Farmer Miller Factory Restaurant Miller Factory Restaurant Consumers $3 4 8 10 Total: $25 Addendum: Contribution to GDP $10

42. An illustration of value added Table 6 42 ItemSellerBuyerPriceValue Added Bushel of soybeans Bag of soy meal Gallon of soy sauce Gallon of soy sauce used as seasoning Farmer Miller Factory Restaurant 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