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aggregate demand
the total amount that all consumers, business firms, government agencies, and foreigners spend on final goods and services.
From potential GDP to actual GDP
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•Is the economy well below potential so high unemployment?
•Is the economy pressing against capacity so possible high inflation?
From aggregate supply to aggregate demand
•Aggregate supply matters in the long run
•Aggregate demand in the short run
•Aggregate demand
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The total amount that all consumers, business firms, government agencies, and foreigners spend on final goods and services
•Aggregate demand is a schedule, not a fixed value
•Depends on the price level
•Four main components
•Consumer expenditure C
•The total amount spent by consumers on newly produced goods and services
•Excludes purchases of new homes, which are considered investment goods
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•Investment spending I
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The sum of the expenditures of business firms on new plants, equipment, and software and of households on new homes
•Financial "investments" are not included
•Nor are resales of existing physical assets
•Government purchases G
•The goods (such as airplanes and paper clips) and services (such as school teaching and police protection) purchased by all levels of government
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•Net exports X - I M
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The difference between exports and imports
•Difference between what we sell to foreigners and what we buy from them
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•Aggregate Demand = C + I + G + (X - I M)
•Two measures of income:
disposable income national income
national income
Sum of the incomes that all individuals in the economy earn
▶Wages, interest, rents, and profits
▶Excludes government transfer payments
▶No deductions for income taxes
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••Disposable income
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Sum of the incomes of all individuals in the economy
•after all taxes have been deducted
and all transfer payments have been added
•National income and domestic product must be equal
•Suppose a firm produces and sells $100 worth of output. Where does the money go?
• Workers wages, interest on loans, rent on property
•These payments represent income to someone
•The rest is profit
•Wages + interest + rents + profits = National income = Value of output.
•National income to disposable income D I
•Government takes out taxes and adds in transfer payments
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•Transfer payments
•Sums of money that the government gives certain individuals as outright grants
•Social Security and unemployment benefits
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•D I = G D P - Taxes + Transfer Payments
•D I = G D P - (Taxes - Transfers)
•D I = Y - T
•How is consumer spending influenced by changes in disposable income?
•As disposable income increases (decreases) consumer spending increases (decreases)
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•By how much does spending change?
•Scatter diagram
•Graph that show the relationship between two variables
•Each year is represented by a point in the diagram
•The coordinates of each year's point show the values of the two variables in that year
circular flow diagram
Goods > Households > Factors Market > Firms
•What does the slope of the line tell you?
•How much will spending change for each additional dollar in income
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Slope = Vertical Change / Horizontal Change
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Slope = $180 billion / $200 billion = 0.90
•Each additional dollar in disposable income leads to a $0.90 increase in spending
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•How can this help the government with tax policy?
•Government cuts taxes by $9 billion
•Incomes increase by $9 billion
Spending increases by $8.1 billion (0.90 x $9)
consumer expenditure (c)
the total amount spent by consumers on newly produced goods and services (excluding purchases of new homes, which are considered investment goods).
•Consumption function
•Shows the relationship between total consumer expenditures and total disposable income in the economy
•Holds all other determinants of consumer spending constant
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•Marginal propensity to consume (MPC)
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Ratio of changes in consumption to changes in disposable income
•Slope of consumption function
•Formula for M P C:
•M P C = Change in C divided by the change in D I that produces that change in C
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•Why the M P C matters for estimating the effect of a tax cut:
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M P C tells us how much additional spending will be induced by a $1 change in income
•To estimate the initial effect of a tax cut on consumer spending:
•Estimate the M P C
•Multiply M P C by the amount of the tax cut
•If the government cuts taxes by $40 billion, and M P C = 0.75, spending rises by . . .
▶$40 x 0.75 = $30 billion
•Why is this estimate subject to some margin of error.?
•What factors other than disposable income would lead to a change in consumption spending?
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•Movement versus shifts of the consumption function
•Movement caused by:
•A change in disposable income
•Shift caused by:
•A change in some other variable, holding disposable income constant
•Wealth
•Stock market
factors that shift consumption function
•Higher stock prices leads to higher wealth
•Holding income constant, consumption spending rises
•Consumption function shifts up
•Housing
• factors that shift consumption function
Lower price of houses leads to lower wealth
•Holding income constant, consumption spending falls
•Consumption function shifts down
•Price level
•Money-fixed assets: bonds for example
•As the price level rises (falls), the purchasing power of the asset falls (rises)
•As the price level rises (falls), the consumption function falls (rises)
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•Real interest rate
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Higher real interest rates should encourage saving and discourage spending
•But interest rates have negligible effects on consumption decisions
•So changes in real interest rates do not shift consumption function
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•Future income expectations
•Expectations of higher (lower) future income, lead to more (less) consumption today
•Investment spending most volatile component of aggregate demand
•Between 2007 and 2009:
•Real G D P growth fell by 4.4% (1.9% to minus 2.5%)
•Growth rate of real business investment spending fell by 21.4% (6.9% to minus 14.5%) percent
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Why is investment spending so volatile?
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Interest rates, tax provisions, technical change, and the strength of the economy
•Business confidence
•Expectations of the future
•Keynes and animal spirits
•What determines investment in housing?
•Consumer incomes
•Interest rates on home mortgages
•Expected rate of price appreciation or depreciation
•Housing boom, 2001-2006
•What would cause net exports to rise or fall?
•Changes in national income
•Our imports rise (fall) when our G D P rises (falls)
•Our exports are relatively insensitive to our G D P
•But sensitive to the G D Ps of other countries
•When our economy grows faster than our trading partners, net exports fall
•What would cause net exports to rise or fall?
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Relative prices and exchange rates
•Suppose U.S. prices rise, while prices in Mexico fall
•U.S goods now more expensive relative to Mexican goods
•U.S imports from Mexico rise, U.S. exports to Mexico fall
•U.S net exports fall
•In general:
•A rise (drop) in the prices of a country's goods, decreases (increases) net exports
•Price increases (decreases) abroad, increase (decrease) the home country's net exports
aggrgative demand hard to predict
consumption,inverstment, net exports, gov purchases
•Consumption
•Wealth depends on unexpected changes in stock prices, house prices etc.
•Uncertainty of how consumers will respond to tax changes
•Investment
•Business confidence and expectations
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Net exports
•Uncertain developments in other countries
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Government purchases
•Politics, military and national security events
consumption function
shows the relationship between total consumer expenditures and total disposable income in the economy, holding all other determinants of consumer spending constant.
•National income accounting
•System of measurement devised for collecting and expressing macroeconomic data
C + I + G + (X - IM)
C = total spending by consumers
I = total investment (spending on goods and services) by businesses
G = total spending by government (federal, state, and local)
(Ex - Im) = net exports (exports - imports)
disposable income
the sum of the incomes of all individuals in the economy after all taxes have been deducted and all transfer payments have been added.
government purchases (G)
refer to the goods (such as airplanes and paper clips) and services (such as school teaching and police protection) purchased by all levels of government.
investment spending (I)
the sum of the expenditures of business firms on new plant, equipment, software and households on new homes. Financial "investments" are not included and neither are resales of existing physical assets.
marginal propensity to consume (MPC)
the ratio of the change in consumption relative to the change in disposable income that produces the change in consumption. On a graph, it appears as the slope of the consumption function.
money-fixed assets
an asset whose value is a fixed number of dollars.
movement along the consumption function
national income
the sum of the incomes that all individuals in the economy earn in the forms of wages, interest, rents, and profits. It excludes government transfer payments and is calculated before any deductions are taken for income taxes.
net exports (X - IM)
the difference between exports (X) and imports (IM). It indicates the difference between what we sell to foreigners and what we buy from them.
permanent tax change
personal savings rate
the ratio of consumer saving to disposable income.
scatter diagram
a graph showing the relationship between two variables (such as consumer spending and disposable income). Each year is represented by a point in the diagram, and the coordinates of each year's point show the values of the two variables in that year.
shifts of consumption functions
temporary tax change
transfer payments
sums of money that the government gives certain individuals as outright grants rather than as payments for services rendered to employers. Some common examples are Social Security and unemployment benefits.
Aggregate demand is the total volume of goods and services purchased by consumers, businesses, government units, and foreigners. It can be expressed as the sum C + I + G + (X − IM), where C is consumer spending, I is investment spending, G is government purchases, and X − IM is net exports.
Aggregate demand is a schedule: The aggregate quantity demanded depends on (among other things) the price level. But, for any given price level, aggregate demand is a number.
Economists reserve the term investment spending to refer to purchases of newly produced factories, machinery, software, and houses.
Gross domestic product is the total volume of final goods and services produced in the country.
National income is the sum of the before-tax wages, interest, rents, and profits earned by all individuals in the economy. By necessity, it must be approximately equal to domestic product.
Disposable income is the sum of the incomes of all individuals in the economy after taxes and transfers. It is the chief determinant of consumer expenditures.
All of these concepts, and others, can be depicted in a circular flow diagram that shows expenditures on all four sources flowing into business firms and national income flowing out.
The close relationship between consumer spending (C) and disposable income (DI) is called the consumption function. Its slope, which is used to predict the change in consumption that will be caused by a change in income taxes, is called the marginal propensity to consume (MPC).
Changes in disposable income move us along a given consumption function. Changes in any of the other variables that affect C shift the entire consumption function. Among the most important of these other variables are total consumer wealth, the price level, and expected future incomes.
Because consumers hold so many money-fixed assets, they lose purchasing power when prices rise, which leads them to reduce their spending.
The government often tries to manipulate aggregate demand by influencing private consumption decisions, usually through changes in the personal income tax. But this policy did not work so well in 1975, 2008, or 2009.
Future income prospects help explain why. The 1975 tax cut was temporary and therefore left future incomes unaffected. The tax cuts in 2008 and 2009 were also advertised as one-time events.
Investment is the most volatile component of aggregate demand, largely because business investment is closely tied to confidence and expectations and because housing investment depends on the likely future behavior of house prices.
Policy makers cannot influence confidence in any reliable way, so policies designed to spur investment focus on more objective, although possibly less important, determinants of investment—such as interest rates and taxes.
Net exports depend on GDPs and relative prices both domestically and abroad.
What are the four main components of aggregate demand? Which is the largest? Which is the smallest?
Consumption (largest), government spending, investment, net exports (smallest—actually negative in the United States)
•Gross domestic product G D P
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Sum of money values of all final goods and services produced over a specified period of time, usually one year
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•Exceptions:
•Government outputs are valued at the cost of the inputs used to produce them
•Inventories are treated as if they were "bought" by the firms that produced them
•Investment goods are defined as final products demanded by the firms that buy them
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•Three ways to calculate G D P
•Add up the final demands of all consumers, business firms, government, and foreigners.
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•G D P = Y = C + I + G + X - I M
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•I is gross private domestic investment:
•Includes business investment in plant, equipment, software, and other intellectual, property products, new residential construction, and inventory investment
•Includes only newly produced capital goods
Does not include exchanges of existing assets
•G D P = Y = C + I + G + X - I M
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•G is
s Government purchases
•Volume of current goods and services purchased by all levels of government
•Does not include transfer payments because included in C
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•(X - IM) is Net exports
•National income
•Add up all income in the economy
•G D P = Wages + Interest + Rents + Profits
•Includes indirect business taxes
•Excludes transfer payments
•No deduction for income taxes
•Includes incomes of all Americans, whether they work in this country or another
•Net national product N N P
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A measure of production
•Conceptually the same as national income but statistical discrepancy
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Gross national product G N P
•N N P plus depreciation
•Portion of capital equipment used up
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•Gross domestic product G D P: Take G N P
•Subtract income received from other countries
•Add income paid to other countries
•Value added by a firm
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Revenue from selling a product
•Minus amount paid for goods and services purchased from other firms
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•G D P = Sum of values added by all firms
•Value added
•= Wages + Interest + Rents + Profits
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•Value added concept useful in avoiding double-counting
•Intermediate goods versus final goods
