Keynesian Economics Flow of the Economy SPENDING b y four groups INCOME received by people PRODUCTION by firms Income and Consumption Circular Flow: - Production Income Spending Production Production National Product (Y): GDP, GNP Net Domestic Product NDP = GDP - Depreciation National Income NI = NDP - indirect business taxes Income National Income (NI) or Personal Income Disposable income (DI) DI = NI - Net Tax Net Tax = Tax - Transfer payment Spending Aggregate Expenditure (AE) or Aggregate Demand (AD) Spending by four groups of economic agents: Four economic agents Consumers Firms Government Rest of the World 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 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 The Circular Flow of Expenditures and Income 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) Demand Determination Aggregate Supply (AS) Aggregate Expenditure (AE) Or AD GDP (Y) Not constrained 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 Components of Total Spending Components of the total spending C, I, G and X-IM Aggregate Expenditure (AE) AE = C + I + G + ( X IM ) Consumption C The lion of share of AE About 70% of AE Stable during the business cycle Income and Consumption Consumption and Income DI C The relationship between DI and C The Consumption Function Consumption function C DI (Disposable Income) C 0 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 Real Disposable Income Consumer Spending and Disposable Income Copyright 2003 South-Western/Thomson Learning. All rights reserved. B A $200 billion $180 billion Real Disposable Income Real Consumer Spending 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 Consumption and Income in Hypothetical Economy Copyright 2003 South-Western/Thomson Learning. All rights reserved. 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 The Consumption Function Equation form C = DI General form C = a + b DI Properties of the Consumption Function Upward sloping: Slope > 0 Slope < 1 Intercept "the subsistence level". 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 Marginal Propensity to Consume Consumers distribute their incremental income between consumption and savings 0 < MPC < 1 The Consumption Function Movement vs Shift in the Consumption function Movement along the consumption function If DI changes 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 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 Tax Cut and Consumption 1964, tax reduction. Success. 1968 temporary tax increase. Failure. 1975 temporary tax cut. Failure. Tax cut. Success. Reasons Permanent versus Temporary Tax Change C DI (Disposable Income) C 0 C By temporary tax cut By permanent tax cut Saving DI = C + S The remaining balance after consumption goes to saving. DI = C + S 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