Chapter 4

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
Aggregate demand
Total amount All consumers, business firms, & government agencies Spend: final goods and services

Components of aggregate demand

Consumer expenditure (C, consumption) Investment spending (I) Government purchases (G) Net exports (X-IM)

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

Aggregate Demand
I - Investment spending
Sum of expenditures
Business firms - new plant & equipment Households - new homes

Not included
Financial investments

Re-sales of existing physical assets

Aggregate Demand
G - Government purchases
Goods & services Purchased by all levels of government

X-IM - Net exports

X exports
Sell to foreigners

IM imports
Buy from foreigners

Aggregate demand = C + I + G + (X-IM)

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National Income
National income
Total income - all individuals in economy
Wages, interest, rents, profits

Excludes
Government transfer payments

Before taxes / deductions

National Income
Disposable income (DI)
Total income - all individuals in economy After taxes deducted After transfer payments - added Spend and save

Transfer payments
Sums of money Form government to certain individuals Outright grants
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Circular Flow: Spending, Production, Income

Disposable income, DI = C+S
Consumption (C) Savings (S)

Leakages
S, IM, Taxes

Injections
I, G, X, Transfers

Figure 1
The circular flow of expenditures and income

Circular Flow: Spending, Production, Income

Aggregate demand = C+I+G+(X-IM) = Gross national income National income = Domestic product DI=GDP - Taxes + Transfer Payments =GDP - (Taxes - Transfers) =Y - T

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Consumer Spending and Income

Consumer spending - responds
Change in income taxes

If DI increases
C increases

If DI decreases
C falls
Vertical change Slope Horizontal change
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Figure 2
Consumer spending and disposable income

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Consumer Spending and Income

Scatter diagram graph
Relationship between two variables Each year a point in diagram Coordinates of each years point
Values of two variables - year

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Figure 3
Scatter diagram: consumer spending &disposable income

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Figure 4
Scatter diagram of consumer spending and disposable income, 19471963

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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
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Consumption Function & MPC

Change in C MPC Change in DI that produces the change in C

Estimate initial effect of tax cut - on C

Estimate MPC = Amount of tax cut MPC

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

Year

(1) Consumption, C

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 0.75 0.75 0.75 0.75

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Figure 5
A consumption function
C

Real Consumer Spending, C

$4,200
3,900 3,600 3,300 3,000

2,700
0 3,200 3,600 4,000 4,400 4,800 5,200 Real Disposable Income, DI
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Factors that Shift the Consumption Function

Change: disposable income
Movement along - consumption function

Change: other determinants of C

Shift - consumption function

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Figure 6
Shifts of the consumption function
Movements along consumption function Real Consumer Spending C1 C0 C2 A

Shifts of consumption function

Real Disposable Income

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Factors that Shift the Consumption Function

Other determinants of C
Wealth
Stock market boom: upward shift

Price level
Money-fixed assets

Real interest rate Future income expectations

Permanent cuts in income taxes Greater increase in C Than temporary cuts
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Table 2
Incomes of three consumers
Incomes each year Consumer Constant Temporary Permanent 1974 $100 100 100 1975 $100 120 120 1976 $100 100 120 1977 $100 100 120 Total Income $400 420 460

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Extreme Variability Of Investment

Investment spending (I)
Volatility
Interest rates Tax provisions Technical change Strength of economy

State of business confidence Expectations about future

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Determinants of Net Exports

Income levels
GDP rises
Imports rise

GDP falls
Imports fall

Exports - relatively insensitive to GDP

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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
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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
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APPENDIX

National income accounting 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
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APPENDIX

GDP exceptions to the rule Government output

Valued at cost of inputs

Inventories
Counted in GDP

Investment goods
Intermediate goods Included in GDP

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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

Doesnt include
Exchanges of existing assets
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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 Dont include transfer payments

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APPENDIX

GDP: sum of final goods and services Nations total output Y=C+I+G+(X-IM)
Shares of GDP - used up by
Consumers (C) Investors (I) Government (G) Foreigners (X-IM)

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

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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

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Table 4
Gross Domestic Product in 2007: sum of incomes
Item Compensation of employees (wages)
plus

Amount $7,878 603 65 2,638 1,595 1,043

v

Item

Amount

Net national product

plus

12,250
v

Net interest
plus

Depreciation
equals

1,687
v

Rental income
plus

Gross national product

minus

13,937
v

Profits Corporate profits Proprietors income

plus

Income received from other countries

plus

818 722
v

Indirect business taxes and misc. items

equals

Income paid to other countries

equals

1,042
v

Gross domestic product

13,841

National income
plus

12,221
v

Statistical discrepancy
equals

29
v

Net national product

12,250
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APPENDIX

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

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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

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Table 5
An illustration of final and intermediate goods
Item Bushel of soybeans Bag of soy meal Gallon of soy sauce Gallon of soy sauce used as seasoning Seller Farmer Miller Factory Restaurant Buyer Miller Factory Restaurant Consumers Price $3 4 8 10 Total: $25

Addendum: Contribution to GDP $10

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Table 6
An illustration of value added
Item Bushel of soybeans Bag of soy meal Gallon of soy sauce Gallon of soy sauce used as seasoning Seller Farmer Miller Factory Restaurant Buyer Miller Factory Restaurant Consumers Price $3 4 8 10 Value Added $3 1 4 2

Total: $25
Addendum: Contribution to GDP Final Product Sum of value added $10 $10

$10 n

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