24 Aggregate Demand and the Powerful Consumer Men are disposed, as a rule and on the average, to...

24

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, 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

● 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

ContentsContents

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

● 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

● 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

Contents (continued)Contents (continued)


Copyright© 2003 Southwestern/Thomson Learning All rights reserved.

AD, Domestic Product, and National IncomeAD, 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)

● 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)



● 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.

● 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.



● 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)

● 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)



● 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

● 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



● 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

● 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


Circular Flow of Spending, Production, and IncomeCircular 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

FIGURE 24-1 The Circular Flow of Expenditures and Income

FIGURE 24-1 The Circular Flow of Expenditures and Income

1

3

6

5

4

2

Investors

Government

Firms(produce the

domestic product)

Consumers

Financial SystemRest of the

World

Saving (S

)

Consumption (C

)

Inve

stm

ent (

I) C + I

Gov

ernm

ent

C + I + GImports

(IM)

Exports (X

)C

+ I +

G +

Tran

sfers

Disposable

Income (DI)

Taxes

Gross

National Income (Y)

(X – IM

)

Purch

ases

(G)


Consumer Spending and IncomeConsumer Spending and Income

● A scatter diagram with U.S. data shows the close relationship between real disposable income and real consumer spending.

● A scatter diagram with U.S. data shows the close relationship between real disposable income and real consumer spending.

FIGURE 24-2 Consumer Spending and Disposable Income



Real consumer spending

Real disposable income

World War II

The Great Depression B

illi

on

s o

f 1

99

6 D

oll

ars

2000 1990 1980 1970 1960 1950 1940 1930 0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,500

4,000

$6,500

6,000

5,500

5,000




$3,244 $5,677

$5,237

$2,869

Rea

l Co

nsu

mer

Sp

end

ing

0

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

Real Disposable Income




B

A

$200

billion

$180 billion

1900

1700

1500

1360 1300

1180

1100

900

1900 1700 1500 1300 1100 900

1947


Rea

l C

on

sum

er S

pe

nd

ing

1963

0


Consumer Spending and IncomeConsumer 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.

● 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.


The Consumption Function and the MPCThe Consumption Function and the MPC

● Consumption function♦ 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

● Consumption function♦ 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

FIGURE 24-5 A Consumption Function

FIGURE 24-5 A Consumption Function


C

$400

$300

Real Disposable Income, DI

5,200 4,800 4,400 4,000 3,600 3,200 0

2,700

3,000

3,300

3,600

3,900

$4,200

TABLE 24-1 Consumption and Income in Hypothetical Economy

TABLE 24-1 Consumption and Income in Hypothetical Economy



Factors That Shift the Consumption FunctionFactors That Shift the Consumption Function

disposable income movement along a consumption function

any other variable that affects consumption shift in the entire consumption function

disposable income movement along a consumption function

any other variable that affects consumption shift in the entire consumption function

FIGURE 24-6 Shifts of the Consumption Function

FIGURE 24-6 Shifts of the Consumption Function


Shifts of consumption

function

Rea

l Co

nsu

mer

Sp

end

ing


Movements along consumption function

C2

C1

C0

A


Factors That Shift the Consumption FunctionFactors That Shift the Consumption Function

● Consumption function shifted by changes in:♦ Wealth

♦ Price level

♦ Real interest rate

♦ Expectations of future income

● Consumption function shifted by changes in:♦ Wealth

♦ Price level

♦ Real interest rate

♦ Expectations of future income


Why The Tax Rebate Failed in 1975 and 2001Why 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.

● 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.

??

TABLE 24-2 Incomes of Three Consumers

TABLE 24-2 Incomes of Three Consumers



The Extreme Variability of InvestmentThe Extreme Variability of Investment

● Investment spending is the most volatile of all spending components.

● Volatility caused in part by sudden changes in business confidence.

● Investment spending is the most volatile of all spending components.

● Volatility caused in part by sudden changes in business confidence.


The Determinants of Net ExportsThe 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.

● 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.


How Predictable is Aggregate Demand?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.

● 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.

Appendix: National Income Accounting


Defining GDP: Exceptions to the RulesDefining GDP: Exceptions to the Rules

● GDP = sum of the money values of all final goods and services produced during a specified period of time

● GDP = sum of the money values of all final goods and services produced during a specified period of time


Defining GDP: Exceptions to the RulesDefining 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


GDP as the Sum of Final Goods and ServicesGDP 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)

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

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



● 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 PaymentsGDP as the Sum of All Factor Payments

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

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



GDP as the Sum of Values AddedGDP 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

TABLE 24-5 An Illustration of Final and Intermediate Goods

TABLE 24-5 An Illustration of Final and Intermediate Goods


TABLE 24-6 An Illustration of Value Added

TABLE 24-6 An Illustration of Value Added



GDP as the Sum of Values AddedGDP as the Sum of Values Added

● The expenditure, income, and production definitions of GDP are all equivalent.

● The expenditure, income, and production definitions of GDP are all equivalent.

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