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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 G D P to actual G D P
circular flow diagram
Goods > Households > Factors Market > Firms
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, holding all other determinants of consumer spending constant.
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)
