1. Keynesian Economics

2. Flow of the Economy SPENDING b y four groups INCOME received by people PRODUCTION by firms

3. Income and Consumption  Circular Flow: - Production ------- - Income ------- - Spending ------ - Production ------- ………

4. Production  National Product (Y): GDP, GNP  Net Domestic Product NDP = GDP - Depreciation  National Income NI = NDP - indirect business taxes

5. Income  National Income (NI) or  Personal Income  Disposable income (DI) DI = NI - Net Tax  Net Tax = Tax - Transfer payment

6. Spending  Aggregate Expenditure (AE) or  Aggregate Demand (AD)  Spending by four groups of economic agents:

7. Four economic agents  Consumers  Firms  Government  Rest of the World

8. Their spending consist of four major components of AE  Consumer expenditure: Consumption C  Firms spending: Investment I  Government purchase: G  Spending by the rest of the world: –Net exports = Export – Import X - IM

9. Aggregate Expenditure (AE)  AE = C + I + G + (X - IM )  Injection C, I, G, X  Leakage S, IM  Anything that will add to the demand/spending on American produced goods is “injection”

10. 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. Demand Determination Aggregate Supply (AS) Aggregate Expenditure (AE) Or AD GDP (Y) Not constrained

12. Demand determination  Keynesian economics emphasizes the demand side  During the great depression, the supply side is not constrained (not binding)  The GDP (Y) is determined by the demand side  That is, determined by total spending

13. Components of Total Spending  Components of the total spending C, I, G and X-IM  Aggregate Expenditure (AE)  AE = C + I + G + ( X – IM )

14. Consumption C  The lion of share of AE  About 70% of AE  Stable during the business cycle

15. Income and Consumption  Consumption and Income DI   C  The relationship between DI and C  The Consumption Function

16. Consumption function C DI (Disposable Income) C 0

17. 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

18. 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

19. 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

20. Consumption and Income in Hypothetical Economy Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

21. Consumption Function 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

22. The Consumption Function  Equation form C = 300 + 0.75 DI  General form C = a + b DI

23. Properties of the Consumption Function  Upward sloping: Slope > 0  Slope < 1  Intercept "the subsistence level". 

24. Marginal Propensity to Consume  Marginal Propensity to Consume (MPC)  Increase in consumption due to a dollar increase in DI  Slope of the consumption function C C  MPC = ---------- DI DI  0 < MPC < 1

25. Marginal Propensity to Consume  Consumers distribute their incremental income between consumption and savings  0 < MPC < 1

26. The Consumption Function  Movement vs Shift in the Consumption function  Movement along the consumption function If DI changes

27. Shifts of the Consumption Function Copyright © 2003 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

28. Shifters of The Consumption Function  Wealth Wealth Effect Price level  Wealth Effect Example: the stock crash in 1929, a negative wealth effect  Expected future income.  Demographics

29. Tax Cut and Consumption  1964, tax reduction. Success.  1968 temporary tax increase. Failure.  1975 temporary tax cut. Failure.  1981-84 Tax cut. Success.  Reasons

30. Permanent versus Temporary Tax Change C DI (Disposable Income) C 0 C’ By temporary tax cut By permanent tax cut

31. Saving  DI = C + S  The remaining balance after consumption goes to saving. DI = C + S

32. Saving  Marginal Propensity to Save (MPS) S S  MPS = ---------- DI DI  The sum of MPC and MPS equals one. 1 = MPC + MPS 1 = MPC + MPS