TodayI. Aggregate Demand, Domestic Product, and
National IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
Demand Management
In our first lecture we introduced Aggregate Demand
We discussed different ways the government can shift the AD curve
1. Increase/decrease government spending2. Influence private spending through
-Tax cuts-Other policy tools
Demand Management
In 2000 George W. Bush wanted to increase consumer spending, so they issued a tax rebate
But consumers actually wound up saving the large portion of the rebate, rather than using it to buy things.
This is similar to what happened when congress issued a tax rebate in 1975
Why did this tax cut fail to achieve the desired goal?
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
AD, 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
AD is a schedule, not a fixed number: It shows the different quantities of total
output demanded at different price levels
AD = C
Consumer Expenditure
+ I
Investment
+ G
GovernmentPurchases
+ NX
Net Exports
AD, Domestic Product, and National Income
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.
AD, Domestic Product, and National Income
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
BUT WAIT!!!
This is the exact same formula we used to calculate GDP last week!
How can these two be the same?1. Logically: All of the things people
are willing to buy must equal all of the things that people make and sell
2. Pictorially
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
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)
Circular Flow of Spending, Production, and Income
Circular flow diagram: shows the relationship of the different components of expenditure and incomeNational income=domestic productWages plus rents plus interest plus profits equals output
AD, Domestic Product, and National Income
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
Not all national income goes directly to consumers!
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)
National Income vs. Disposable IncomeNot all national income goes directly
to consumersSome money is deducted in the form
of taxesSome money is added in the form of
transfer paymentsDI = GDP - Taxes + Transfer Payments
= GDP – (Taxes – Transfers)= Y - T
AD, Domestic Product, and National Income
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
Some Questions To Think About:
Does flow of spending and income grow larger or smaller as we move around the circle?
Is the output that firms produce at point 5 (the GDP) equal to aggregate demand? What makes these two quantities equal if so? If not, what will happen?
Some Questions To Think About
Do the government’s accounts balance so that net of transfers equals government spending? If not, what happens?
Is our international trade balanced so that exports equal imports? What happens if we experience a trade surplus or trade deficit?
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The
important RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
Consumption
Consumption is the single largest component of GDP, about 66% over the last decade
Major components of consumption:CarsFoodMedical Care
Category of Consumption
Value of category (1996, $, billion)
Percent of total
Durable Goods 632 12
Motor Vehicles 253
Household Equipment
254
Other 125
Nondurable Goods 1,545 30
Food 772
Clothing & Apparel 264
Energy 133
Other 375
Services 2,974 58
Housing 779
Household operation 310
Transportation 205
Medical Care 816
Other 865
Total Consumption
5,151 100
Evolution of Consumption in the 20th Century
1918-US households spent 41% of income on food and drink
1999-19%Spending on apparel has fallen from 18%
of income to 6%1918-Americans spent 1% of income on
automobilesNow-23% of spending on vehicle related
transportation
Evolution of Consumption in the 20th Century
Housing has risen from 14% to 20% of national income during this period
Televisions, cell phones, and VCRs have increased entertainment expenses
Biggest increase in consumption spending has been for health care
Consumption, Income, and SavingConsumption, Income, and Saving
are all linkedPersonal saving is the part of
disposable income that is not consumedItem Amount, 1996 ($,
billion)
Personal Income 6,450
Less: Personal tax and nontax payments 864
Equals: Personal Disposable Income 5,586
Less: Personal outlays (consumption +interest)
5,314
Equals: Personal Saving 272
Memo: Saving as percent of personal DI
4.9%
Consumption, Saving, and Income
(1)Disposable
Income ($)
(2) Net saving
(+) or dissaving (-)
($)
(3)Consumptio
n ($)
24,000 -110 24,110
25,000 0 25,000
26,000 +150 25,850
27,000 +400 26,600
28,000 +760 27,240
29,000 +1,170 27,830
30,000 +1,640 28,360
FIGURE 24-2 Consumer Spending and Disposable Income
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
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
Consumption, Saving, and Income
Clearly consumption and DI are related
When DI rises, consumption risesWhen DI falls, consumption fallsHowever we are still unclear on how
much DI influences consumption
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
Consumption, Saving, and Income
To understand the way consumption affects national output, we need some new tools.
We need to look at how many extra dollars of consumption are induced by each extra dollar of disposable income
This relationship is shown by the consumption function
Consumer Spending and Income
A scatter diagram with U.S. data shows the close relationship between real disposable income and real consumer spending.
FIGURE 24-3 Consumer Spending and Disposable Income
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
$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
Consumer Spending and Income
Assume in 1963 you want to calculate how much an increase in disposable income will increase consumption
You could look at a scatter diagram of consumption vs. DI of the years leading up until that year
FIGURE 24-4 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
1900 1700 1500 1300 1100 900
1947
Real Disposable Income
Rea
l C
on
sum
er S
pe
nd
ing
1963
0
Consumer 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.
Consumer Spending and Income
If there were a tax cut of $10 billion, effectively increasing DI by that amount, according to the graph how much would you expect consumption to increase by?
How much would you expect savings to increase by?
The 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
FIGURE 24-5 A Consumption Function
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
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
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
A Consumption FunctionFor simplicity, we assume that points of aggregate consumption, when plotted against aggregate income, lie along a straight line.
C a bY= • The slope of the The slope of the
consumption function (consumption function (bb) is ) is called the called the marginal marginal propensity to consume propensity to consume (MPC),(MPC), or the fraction of a or the fraction of a change in income that is change in income that is consumed, or spent.consumed, or spent.
0 1 b<
A Consumption FunctionDerived from the Equation C = 100 + .75Y
At a national income of zero, consumption is $100 billion (a).For every $100 billion increase in income (Y), consumption rises by $75 billion (C).
C Y 1 0 0 7 5.
A Consumption FunctionDerived from the Equation C = 100 + .75Y
C Y 1 0 0 7 5.
AGGREGATEINCOME, Y
(BILLIONS OF DOLLARS)
AGGREGATE CONSUMPTION, C
(BILLIONS OF DOLLARS)
0 100
80 160
100 175
200 250
400 400
600 550
800 700
1,000 850
Consumption and SavingSince there are only two places income can go: consumption or saving, the fraction of additional income that is not consumed is the fraction saved. The fraction of a change in income that is saved is called the marginal propensity to save (MPS).
M P C + M P S 1
• Once we know how much consumption will result Once we know how much consumption will result from a given level of income, we know how much from a given level of income, we know how much saving there will be. Therefore,saving there will be. Therefore,
S Y C
Marginal Propensity to Consume: Again
MPC = Change in Consumption_____________________________________________
Change in DI that produces the change in Consumption
An Aggregate Consumption FunctionDerived from the Equation C = 100 + .75Y
C Y 1 0 0 7 5.
AGGREGATEINCOME, Y
(BILLIONS OF DOLLARS)
AGGREGATE CONSUMPTION, C
(BILLIONS OF DOLLARS)
0 100
80 160
100 175
200 250
400 400
600 550
800 700
1,000 850
Marginal Propensity to Consume
MPC = Change in Consumption_____________________________________________
Change in DI that produces the change in Consumption
MPC = $75_____$100
= 0.75
Marginal Propensity to Consume
To estimate the initial effect of a tax cut on consumer spending,economists must first estimate the MPC and then multiply the amount of the tax cut by the estimated MPC
Because they never know the true MPC with certainty, their prediction is always subject to some margin of error
(Baumol, 2004)
.80 .85 .90 .95 1.0
.986
.976
.972
.940
.907
.873
.869
.842
Canada
United States
Netherlands
United Kingdom
Germany
Italy
Japan
France
GLOBAL PERSPECTIVEAverage Propensities to Consume,Selected Nations, 1999
Statistical Abstract of the United States, 2000
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
Shifts in the consumption function
The consumption function does not always stand still
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
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Shifts of consumption
function
Rea
l Co
nsu
mer
Sp
end
ing
Real Disposable Income
Movements along consumption function
C2
C1
C0
A
Factors That Shift the Consumption Function
Consumption function shifted by changes in: Wealth Price level Real interest rate Expectations of future income
Shifts in the consumption function: Wealth
Not just income, but total amount of income accumulated
The more money I have, the more I will be willing to spend
E.G. stock market booms and busts
Shifts in the consumption function: Price Level
Higher prices lower consumptionLower prices raise consumption
Higher price levels = lower level of real wealth
Lower price levels = higher level of real wealth
Shifts in the consumption function: The real interest rate
High interest rate => lower consumption
Low interest rate => raise consumption
Makes sense theoretically, BUT
Studies have shown that interest rates have little to no influence on consumption
Shifts in the consumption function: future expectations
If people think they will make more money in the future, they will be more willing to consume today
If people are not optimistic about the future, they will be more likely to save today
A Return to our Initial Question
Why didn’t the tax rebates of 1975 and 2001 result in the intended increase of consumption?
Largely due to this concept of expectations of the future
Examine three consumers, named “No Change,” “Temporary Rise,” and “Permanent Rise.”
TABLE 24-2 Incomes of Three Consumers
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Why 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.
??
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
Investment
Investment is the most volatile of all AD components
Does not follow movements in disposable income like consumption
A 3.2 percent drop in growth rate from 2000-2001 was accompanied by a 14.1 percent drop in the growth rate of investment
Investment
Because investment is volatile, it can have a major impact on AD, which affects output and employment in the short run
Investment also leads to capital accumulation, which also increases potential output and growth in the long run
Investment
Volatility of investment is largely attributed to expectations of the future, which directly affect the state of business confidence
Difficult to measure, much less control
Thus, economists concentrate on controlling other determinants of investment
Determinants of Investment
The level of investment is determined by:
RevenuesCostsExpectations
Revenue as a determinant of investment
Investment depends upon the revenues that will be generated by the state of overall economic activity
Investment is thus very cyclical:Business downturn 1979-82, output fell sharply and investment fell by 22 percent
Costs as a determinant of investment
Capital is a durable good (lasts a long time)
Costs included in costs of capital:1. Price2. Interest Rate3. Taxes
Expectations as a determinant of investment
Investment is a gamble on the futureBusinesses spend much energy
analyzing investments and trying to narrow the uncertainties about their investments
If future expectations are positive, businesses will invest more now
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII.The Determinants of Net ExportsVIII.How predictable is AD?
Net Exports
Net Exports are the third leg of AD to be discussed
NX are also extremely variableNet Exports are determined by:1. National Incomes2. Relative prices and exchange
rates
1-digit SITC Commodity Exports Imports(0) Food and Live Animals 472.95 1,021.17 (1) Beverages and Tobacco 4.93 32.53 (2) Crude Materials, Inedible, Except Fuels 2,566.50 614.03 (3) Mineral Fuels, Lubricants and Related Materials 59.77 729.76 (4) Animal and Vegetable Oils, Fats and Waxes 20.90 7.48 (5) Chemicals and Related Products, N.E.S. 2,325.37 1,809.46 (6) Manufactured Goods Classified Chiefly by Material 1,271.89 10,286.90 (7) Machinery and Transport Equipment 8,067.82 34,946.75 (8) Miscellaneous Manufactured Articles 1,240.14 49,475.39 (9) Commodities and Transactions, N.E.S. 222.76 1,139.49 Total 16,253.03 100,062.96
Year 2000 – US Trade with China
By 1-digit SITC commodityIn millions of dollars
Source: US Census Bureau
National Income and Imports
Imports are positively related to income and output
When GDP rises, US imports increase because some of the C + G + I come from foreign producers, and America uses foreign made inputs (like oil or steel)
When GDP falls, imports fall
National Income and Exports
Exports depend on foreign nations levels of output and income
As foreign output rises, their demand for national products increases, as some of their C + I + G comes from our own nation
Thus, as foreign output and income rises, national exports increase
As foreign output and income falls, exports fall
National Income and Net Exports
When our economy grows faster than economies we trade with, net exports shrink
When economies we trade with grow faster than our economy, net exports grow
US Economy stagnated 1990-1992 =>net exports rose from -$55 billion to -$16 billion,
US Economy grew faster than other economiesnet exports fell from -$16 billion to -$380 billion
Relative Prices and Net Exports
Relative prices are also important in determining net exports
When comparing relative prices, we are looking at a rise or decline in the price of goods in two different countries
If the prices rise in our country and fall in another country, our goods are now more expensive relative to the other country
Relative Prices and Net Exports
A rise in the relative prices of a country’s goods will reduce net exports
Foreign countries will be less willing to buy our products, and we will be more willing to buy theirs
A drop in the relative prices of a country’s goods will increase net exports
We will be less willing to buy foreign country’s products, and they will be more willing to buy ours
Relative Prices and Net Exports
A rise in the relative prices of a foreign country’s goods will increase net exports
We will be less willing to buy their products, and they will be more willing to buy ours
A drop in the relative prices in a foreign country’s goods will decrease net exports
We will be more willing to buy their products, and they will be less willing to buy ours
Relative Prices and Exchange Rates
Consider a CharLeenese car that costs 3 million CharLeenese Chars
If 1 dollar = 100 Chars, then:1 car = $30,000But if the exchange rate changes1 dollar = 150 Chars, then:1 car = $20,000
TodayI. Aggregate Demand, Domestic Product, and National
IncomeII. The Circular Flow of Spending, Production and
IncomeIII. Consumer Spending and Income: The important
RelationshipIV. The consumption function and the Marginal
Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII. The Determinants of Net ExportsVIII.How predictable is AD?
How Predictable is Aggregate Demand?
AD is not the easiest thing in the world to predict
We can use consumer spending to help predict AD, but unexpected movements of the stock market or poor predictions of the future can affect the accurateness of this prediction
As the 1975 and 2001 tax rebates showed, it’s also difficult to influence consumption through temporary tax cuts or rebates
How Predictable is Aggregate Demand?
Investment is more volatile than consumption, and thus even more difficult to predict
This is partly because investment is so strongly related to expectations of the future and confidence, which is next to impossible to calculate, much less control
How Predictable is Aggregate Demand?
Net exports are affected both by developments at home, as well as developments abroad.
Thus, it’s not easy to predict net exports, as so much of their determination is out of our hands
Even government spending is not as predictable as you would think
To Sum Up
Aggregate Demand can be viewed as a schedule of different levels of output demanded at different prices levels
AD is comprised of consumption, investment, government spending, and net exports
To Sum Up
Examining the circular flow of expenditures and income diagram, we can see that national income and domestic product must, for the most part, be equal
Disposable income equals national income minus taxes plus transfers
To Sum Up
There is clearly a relationship between consumption and disposable income
The relationship can be graphically depicted in a scatter diagram, comparing DI to C
When we measure the general slope these points make, have calculated the marginal propensity to consume
To Sum Up
Marginal Propensity to Consume shows how much consumption will go up due to an increase in DI
The consumption function itself can be shifted up or down due to changes in wealth, price levels, and future income expectations
To Sum Up
Because both the 1975 and 2001 tax rebates were advertised as “one time only” rebates, people did not see any long term benefit from them.
As a result, they did not feel their future incomes were affected, so consumption did not rise as much as expected
To Sum Up
Investment is comprised mainly of inventory change, purchase of new housing, and purchase of capital by firms
Investment is extremely volatileInvestment is influenced by revenues,
costs, and expectationsWe generally focus on interest (one of the
costs of investment)
To Sum Up
Net exports are determined by national incomes and relative pricesNX are determined by both our national incomes, as well as foreign national incomesWe have little control over foreign prices as wellAs a result, NX is not very controllable
To Sum Up
AD is not an easy thing to predictConsumption can be affected by
unexpected changes in wealth in the future, or plain poor prediction of future market conditions
Investment is highly volatileNet exports are partially determined by
other countriesGovernment spending is not as
predictable as one would have guessed
NOW GO AWAY!
Next lecture Chapter 8
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