macro economics -aggregate demand and the powerful consumer

8/3/2019 Macro Economics -Aggregate Demand and the Powerful Consumer

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Aggregate Demand and thePowerful ConsumerMacroeconomics

Prof. Rushen Chahal

2/12/2012 Prof. Rushen Chahal


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Chapter 7

Definitions: Aggregate Demand, Domestic Product, andNational Income

The Circular Flow of Spending, Production and Income

Consumer Spending and Income: The important Relationship The Consumption Function and the Marginal Propensity toConsume

Factors that Shift the Consumption Function

The Extreme Variability of Investment

The Determinants of Net Exports

How Predictable is AD?

Chapter 7 Appendix: National Income Accounting



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Definitions: AD, Domestic Product, andNational Income

Domestic product combine all goods andservices into one product. There is only one

product, and it represents all products.

Gross Domestic Product GDP is the sum of themoney values of all final goods and services

produced in the domestic economy and sold onorganized markets in a specified period of time,

usually a year.



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Aggregate Demand the total amount that allconsumers, business firms, and government

agencies spend on FINAL goods and services.

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

What are C, I, G, X, and IM?



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C = Consumption the total amount spend by consumerson newly produced goods and services (excluding newhomes, which are counted as investment goods)

I = Investment the total amount spent by firms on newcapital (plants, equipment, etc.) and by households onnew homes

Investment does NOT include any financial investment (stocks,bonds, etc.) or the resale of existing assets (example: a dumplingfirm sells a computer that it bought 2 years ago)



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G = Government Spending goods (Ex: airplanes,computers) and services (Ex: school teaching, policeprotection) purchased by any level of government

X = Exports I = Imports

X IM = Net Exports (Exports Imports) thedifference between what we sell to foreigners and whatwe buy from them (this can be positive or negative)



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So, AD = C + I + G + (X IM) Aggregate Demand = Consumption + Investment

+ Government Spending + Net Exports

Recall that if the government increases taxesor decreases spending then AD will shift to the

left (decrease), and if it decreases taxes orincreases spending then AD will shift to theright (increase)



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National Income (Y) the sum of the incomesthat all individuals in the economy earned in

the forms ofwages, interest, rents, and

profits

National Income = wages + interest + rents +profits

It excludes government transfer payments (moneythat you get for free from the government, ex:

scholarship) and is calculated before income is

taxed (pre-tax income)2/12/2012 Prof. Rushen Chahal


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Disposable Income (DI) the sum of theincomes of all individuals in the economy afterall taxes have been deducted and after all

transfer payments have been added

Disposable income is how much money consumersactually have to spend or to save

Transfer Payments money that the governmenttakes from some people (taxes) and gives to otherpeople



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DI = GDP (Taxes [taken] Transfers [takenand given back])

DI = GDP Taxes [taken] + Transfers [takenand given back]

DI = GDP Taxes [taken]

DI = Y T

DI = GDP Taxes



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National income and disposable income areNOT the same!National income is the value of all output

Disposable income is how much of the output goesto consumers (National income disposable income) is what

goes to the government

National Income (Y) =GD

P Disposable Income (DI) = GDP Taxes= Y - T



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Circular Flow of Spending, Production,and Income

National Income (Y) = Gross DomesticProduct (GDP)

In other words: National Income (Y) = value of alloutput (Q*P)

Why? Assume a firm sells 100 RMB of output (Q*P)

It pays 70 RMB wages to its workers It pays 15 RMB interest to people who lent it money It pays 5 RMB rent to the landlord It pays 10 RMB profit to stockholders or private owners

So the value of output = wages + interest + rent + profit So GDP (Q*P) = National Income (Y)



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FIGURE 24-1 The Circular Flow ofExpenditures and Income

1

3

6

5

4

2

Investors

Government

Firms(produce the

domestic product)

Consumers

Financial System

Rest of theWorld



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We now know GDP = National Income (Y)

Part of Y goes to the government (G) and part goes toconsumers (DI)

The government spendsG

on output from firms Part ofDI is spent by consumers on output from firms; this is

consumption: C

The rest, DI C, is saved; this is savings, S

In a simple model S = I: all savings S are invested (spent on outputfrom firms [CAPITAL output, not consumer goods!!!]), so S = I(Investment)

We now have GDP = Y = C + I + G, but this is notcomplete



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We now have GDP = Y = C + I + G (not complete)

In a simple model there is NO trade

If we add trade to our model, then some of the goods and

services we make are sold to foreigners (Exports:X), and someof the goods and services we buy come from foreigners

(Imports: IM)

If we make and sell more X, GDP increases

If we buy more IM, GDP decreases

X IM = Net Exports (this can be positive + or negative - )

GDP = Y = C + I + G + (X IM)



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GDP = Y = C + I + G + (X IM) Gross Domestic Product = National Income =

Consumption + Investment + Government

Spending + Net Exports

Recall that AD = C + I + G + (X IM)

Therefore:

GDP = Y = C + I + G + (X IM) = AD



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FIGURE 24-1 The Circular Flow ofExpenditures and Income

1

3

6

5

4

2

Investors

Government

Firms(produce the

domestic product)

Consumers

Financial System

Rest of theWorld



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Consumer Spending and Income: TheImportant Relationship

Consumption, Income, and Saving are all

linked

Personal saving is the part of disposableincome that is not consumed

Item Amount, 1996 ($,billion), U.S.

Personal Income 6,450Less: 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%2/12/2012 Prof. Rushen Chahal


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Consumption is the single largest component of

National Income (for the U.S. and most

countries), about 66% over the last decade

Major components of consumption:

TransportationFood

Medical Care



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The following graphs with U.S. data show theclose relationship between real consumer

spending and real disposable income



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FIGURE 3: Consumer Spending andDisposable Income

Real Disposable Income0

Real Consumer Spending

$3,036

$5,619

$6,081$3,432

19291939

19411947

1942 19431945

19551960

1964

1970

19741978

19791984

1980

1985

1986 1987

1988 198919911990

1992

1994 1996

1976

1995

1997

1998 1999

2000

20012002

2003

2004



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FIGURE 4: Consumer Spending andDisposable Income Relationship

B

A

$200billion

$180 billion

1900

1700

1500

13601300

1180

1100

900

19001700150013001100900

1947

Real Disposable Income

RealConsumerSpending 1963

0



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When the data are converted into a consumption functiondiagram with income on the horizontal axis andconsumption on the vertical axis the relationshipbetween real consumer spending and real disposable

income is almost linear, with a slope of about 0.9

What does this mean? This means that C is about 0.9, or 90%, ofDI

Ex: if you have 1 RMB (DI), you spend 9 mao (C), and savings (S)

= 1 mao Ex: if you have 100 RMB (DI), you spend 90 RMB (C), and

savings (S) = 10 RMB



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The Consumption Function and theMarginal Propensity to Consume (MPC)

Consumption function shows the relationship betweentotal consumer spending (C) and total disposable income(DI) All other determinants of consumer spending (C) are held

constant

Marginal Propensity to Consume (MPC) the ratio ofchanges in consumption (C) relative to changes indisposable income (DI)

MPC = the slope of the consumption function MPC = ( consumption z ( disposable income

Example: Michael gives you $400. You spend $300. What is yourMPC?

MPC = 300 z 400 = 0.75



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FIGURE 24-5 A ConsumptionFunction

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



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TABLE 24-1 The Consumption Function andthe Marginal Propensity to Consume (MPC)



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Suppose that MPC = 0.9 Assume there is a tax cut of 100 million RMB. What will this do

to AD? The tax cut of 100 million RMB will increase DI by 100 million

RMB

IfDI increases by 100 million RMB and MPC is 0.9, thenconsumers would spend 90 million RMB (C would rise by 90million RMB) and save 10 million RMB (S would increase by 10million RMB)

If S is not invested, then AD will increase by 90 million RMB; if S isinvested, AD will increase by 100 million RMB

So a tax cut (ceteris paribus) will INCREASE AD

Notice in the above example that MPC = 0.9 and MPS (MarginalPropensity to Save) = 0.1; MPC + MPS = 1 (which is 100%)



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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)



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.80 .85 .90 .95 1.0

.986

.976

.972

.940

.907

.873

.869

.842

Canada

United States

Netherlands

United Kingdom

Germany

ItalyJapan

France

GLOBAL PERSPECTIVEAverage Propensities to Consume,

Selected Nations, 1999

Statistical Abstract of the United States, 20002/12/2012 Prof. Rushen Chahal


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Factors that Shift the ConsumptionFunction

( disposable income movement along aconsumption function

In this case the consumption function does NOTshift

( any other variable that affects consumption shift in the entire consumption function

In this case the consumption functionDOES shift



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FIGURE 24-6 Shifts of theConsumption Function

Shifts of

consumptionfunctionR

e

alConsumerSpe

nding

Real Disposable Income

Movements alongconsumption function

C2

C1

C0

A

Notice that the

consumptionfunction shiftsUP andDOWN; itdoes NOT

shift left orright like thedemand andsupply curves



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Consumption function shifted by changes in:

Wealth

Price level

Real interest rate

Expectations of future income



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Wealth Income Savings

Investments (stocks, bonds, etc.) Physical assets (houses, cars, jewelry, gold, etc.)

How would an increase or decrease in any of these

affect wealth? How would an increase or decrease in wealth

affect the consumption function?



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Price level Higher price levels = lower level of real wealth

Lower price levels = higher level of real wealth

Why? Assume your income is 100 RMB per week. If the

price of domestic product rises (ceteris paribus), younow have lower real wealth.

What will higher or lower price levels do to theconsumption function?



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Real interest rate Higher interest rate => lower consumption

Lower interest rate => raise consumption

Why? Assume the interest rate rises. If you loan (save and

invest) more money, you will earn MORE profit. Tosave more money, you must lower your consumption.

Note: our models tell us that this is what should happen.However, studies have shown that changes in interestrates have little effect on consumption.



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Factors That Shift the ConsumptionFunction

Expectations of future income Expect more income in the future => consume more today Expect less income in the future => consume less today

Why? People tend to consume about the same amount for each year of

their life, instead of consuming everything in one time period. Theymust divide their expected lifetime income by their expectedlifetime to get the same consumption for each year of life.

Extreme example:

If you expect to live for 80 years and your expected lifetimeincome is 80 RMB, then you would want to spend 1 RMB ineach year.

You would not want to spend 1 Jiao each year until your last yearand then spend 79.21 RMB in the last year of your life.



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Factors That Shift the ConsumptionFunction

Why can a tax cut fail to increase the consumptionfunction, and therefore fail to increase AD? Thishappened in the U.S. in 1975 and 2001.

A tax cut will increase Disposable Income (DI) There is a difference between a TEMPORARY tax cut and a

PERMANENT tax cut

A temporary tax cut (DI increases only for a short time) will notcause a big change in expectations of future income, BUT a

permanent tax cut (DI increases permanently) will cause a bigchange in expectations of future income

If the government wants to increase AD with a tax cut, it mustconvince people that the tax cut will be PERMANENT



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Investment spending is often extremely variable, and often the mostvariable part ofGDP

A 3.2 percent drop in growth rate from 2000-2001 in the U.S. wasaccompanied by a 14.1 percent drop in the growth rate of investment

Investment is affected by

Business confidence and expectations about the future

The level and growth of demand

Technology

The real interest rate (cost of borrowing to invest) Taxes

We discussed all of the above factors in chapter 6 except businessconfidence and expectations about the future



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Business confidence and expectations about the future

Investment is a gamble on the future; it is risky

Businesses spend many resources analyzing investments to limit

risk If future expectations are positive, businesses will invest more

Business confidence might be the most influential factor ofInvestment, and it can change unexpectedly

It is very difficult to predict business confidence

http://www.investopedia.com/terms/e/expectationsindex.asp



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Net Exports are determined by:

National Incomes

Relative prices and exchange rates



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National Incomes (GDPs) When Chinas national income rises, imports rise

When Chinas national income falls, imports fall

When foreign national incomes rise, exports rise

When foreign national incomes fall, exports fall

Our imports rise when ourGDP rises and falls when our

GDP falls Our exports are relatively insensitive to our own GDP, but

very sensitive to GDPs of other countries



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National Incomes (GDPs)

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

Example:

The U.S. economy stagnated from 1990-1992 => net exports rose

from -$55 billion to -$16 billion, US Economy grew faster than other economies from 1992 to 2000

=> net exports fell from -$16 billion to -$380 billion



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Relative prices and exchange rates Our exports rise when our prices fall and vice-versa; our imports

rise when prices fall in the economies of our trading partners andvice versa

If exchange rates change, then prices change Example:

Consider a PaulGuo car that costs 3 million BaoLou in PaulGuo Assume 1 RMB = 100 Baolou 1 car = 30,000 RMB

Now assume the the exchange rate changes 1 RMB = 150 BaoLou 1 car = 20,000 RMB When the RMB appreciated(became worth more BaoLou), the cost

of the PaulGuo car decreased



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How Predictable is AD?

GDP (Q*P) = National Income (Y) = C + I + G + (X - IM) = AD

AD is not an easy thing to predict

C = Consumption can be affected by changes in wealth, prices,expectations of future income, and possible the interest rate; thesethings often change unexpectedly

As the 1975 and 2001 tax rebates showed, its also difficult to influenceconsumption through temporary tax cuts or rebates

I = Investment is highly volatile (it changes unexpectedly) This is partly because investment is so strongly related to expectations of

the future and confidence, which is next to impossible to calculate, muchless control

G = Government spending can be very unpredictable

(X IM) = Net exports are partially determined by other countries



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Appendix: National Income

Accounting

Macroeconomics



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Defining GDP: Exceptions to theRules

GDP = sum of the money values of all finalgoods and services produced during a specified

period of time



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Defining GDP: Exceptions to theRules

Government outputs = valued at the cost of theinputs needed to produce them

Inventories are treated as though they werebought by the firms that produced them, eventhough these purchases do not really take place

Investment goods = final products demandedby the firms that hold them



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GDP as the Sum of Final Goodsand Services

GDP as the sum of all final demands in oneyear

Sum of expenditures on all final goods andservices

GDP = C + I + G + (X - IM)



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TABLE 3: GDP in 2004 as the Sum of FinalDemands



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GDP as the Sum of All FactorPayments

GDP as sum of incomes (or factor payments)

GDP as the sum of all factor payments

Value of factors outputs = value of incomes

GDP = wages + interest + rents + profits +purchases from other firms



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TABLE 4: GDP in 2004 as the Sum ofIncomes



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GDP as the Sum of Values Added

GDP as the sum of values added

GDP = sum of values added to goods in all firms

Value added = firms revenue from selling aproduct minus the amount paid for goods and

services purchased from other firms



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TABLE 5: An Illustration of Final andIntermediate Goods



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TABLE 6: An Illustration of Value Added



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National Income Accounting

The expenditure, income, and productiondefinitions ofGDP are all equivalent (they all

give the same money value forGDP).

2/12/2012 Prof Rushen Chahal

macro economics -aggregate demand and the powerful consumer

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