Aggregate Demand and the Powerful Consumer

Macroeconomics Prof. Rushen Chahal

2/12/2012 Prof. Rushen Chahal

Chapter 7
Definitions: Aggregate Demand, Domestic Product, and National Income The Circular Flow of Spending, Production and Income Consumer Spending and Income: The important Relationship The Consumption Function and the Marginal Propensity to Consume 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
2/12/2012 Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

Domestic product combine all goods and services into one product. There is only one product, and it represents all products.
Gross Domestic Product GDP is the sum of the money values of all final goods and services produced in the domestic economy and sold on organized markets in a specified period of time, usually a year.
2/12/2012 Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

Aggregate Demand the total amount that all consumers, 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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Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

C = Consumption the total amount spend by consumers on newly produced goods and services (excluding new homes, which are counted as investment goods) I = Investment the total amount spent by firms on new capital (plants, equipment, etc.) and by households on new homes
Investment does NOT include any financial investment (stocks, bonds, etc.) or the resale of existing assets (example: a dumpling firm sells a computer that it bought 2 years ago)

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Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

G = Government Spending goods (Ex: airplanes, computers) and services (Ex: school teaching, police protection) purchased by any level of government X = Exports I = Imports X IM = Net Exports (Exports Imports) the difference between what we sell to foreigners and what we buy from them (this can be positive or negative)

2/12/2012

Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

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

Recall that if the government increases taxes or decreases spending then AD will shift to the left (decrease), and if it decreases taxes or increases spending then AD will shift to the right (increase)
2/12/2012 Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

National Income (Y) the sum of the incomes that all individuals in the economy earned in the forms of wages, interest, rents, and profits
National Income = wages + interest + rents + profits It excludes government transfer payments (money that 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

 Disposable Income (DI) the sum of the incomes of all individuals in the economy after all taxes have been deducted and after all transfer payments have been added
Disposable income is how much money consumers actually have to spend or to save Transfer Payments money that the government takes from some people (taxes) and gives to other people
2/12/2012 Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

DI = GDP (Taxes [taken] Transfers [taken and given back]) DI = GDP Taxes [taken] + Transfers [taken and given back] DI = GDP Taxes [taken] DI = Y T DI = GDP Taxes

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Prof. Rushen Chahal

Definitions: AD, Domestic Product, and National Income

National income and disposable income are NOT the same!
National income is the value of all output Disposable income is how much of the output goes to consumers (National income disposable income) is what goes to the government

National Income (Y) = GDP Disposable Income (DI) = GDP Taxes =Y-T
2/12/2012 Prof. Rushen Chahal

Circular Flow of Spending, Production, and Income

National Income (Y) = Gross Domestic Product (GDP)
In other words: National Income (Y) = value of all output (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)
2/12/2012 Prof. Rushen Chahal

FIGURE

24-1 The Circular Flow of Expenditures and Income

Rest of the World
2 3

Financial System

Investors

Consumers

Government

5 6

Firms (produce the domestic product)

2/12/2012

Prof. Rushen Chahal

Circular Flow of Spending, Production, and Income

We now know GDP = National Income (Y) Part of Y goes to the government (G) and part goes to consumers (DI)
The government spends G on output from firms Part of DI 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 output from firms [CAPITAL output, not consumer goods!!!]), so S = I (Investment)

We now have GDP = Y = C + I + G, but this is not complete

2/12/2012 Prof. Rushen Chahal

Circular Flow of Spending, Production, and Income

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 some of 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)

2/12/2012

Prof. Rushen Chahal

Circular Flow of Spending, Production, and Income

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
2/12/2012 Prof. Rushen Chahal

FIGURE

24-1 The Circular Flow of Expenditures and Income

Rest of the World
2 3

Financial System

Investors

Consumers

Government

5 6

Firms (produce the domestic product)

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Prof. Rushen Chahal

Consumer Spending and Income: The Important Relationship

Consumption, Income, and Saving are all linked Personal saving is the part of disposable income that is not consumed
Item Personal Income Less: Personal tax and nontax payments Equals: Personal Disposable Income Less: Personal outlays (consumption +interest) Equals: Personal Saving Memo: Saving as percent of personal DI
2/12/2012 Prof. Rushen Chahal

Amount, 1996 ($, billion), U.S. 6,450 864 5,586 5,314 272 4.9%

Consumer Spending and Income: The Important Relationship

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: Transportation Food Medical Care
2/12/2012 Prof. Rushen Chahal

Consumer Spending and Income: The Important Relationship

The following graphs with U.S. data show the close relationship between real consumer spending and real disposable income

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Prof. Rushen Chahal

FIGURE

3: Consumer Spending and Disposable Income

2004
2003 2002 2001 2000 1998 1997

1999

$5,619

1995 1994 1992 1990 1991 1989 1988 1987 1986 1985 1984 1979 1980 1976 1974

1996

$3,036
1964

1978

1970

Real Consumer Spending 1960

1955 1947 1945 1941 1942 1943 1939

1929
0

$3,432

$6,081

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Prof. Rushen Chahal

Real Disposable Income

4: Consumer Spending and Disposable Income Relationship

FIGURE
1900 Real Consumer Spending 1700 1963

1500 1360 1300 1180 1100 $200 900 1947 billion B $180 billion A

0
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900

1100

1300

1500

1700

1900

Real Disposable Income

Prof. Rushen Chahal

Consumer Spending and Income: The Important Relationship

When the data are converted into a consumption function diagram with income on the horizontal axis and consumption on the vertical axis the relationship between 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%, of DI
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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Prof. Rushen Chahal

The Consumption Function and the Marginal Propensity to Consume (MPC)

Consumption function shows the relationship between total 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 of changes in consumption (C) relative to changes in disposable income (DI)
MPC = the slope of the consumption function MPC = ( consumption z ( disposable income
Example: Michael gives you $400. You spend $300. What is your MPC?
MPC = 300 z 400 = 0.75
2/12/2012 Prof. Rushen Chahal

FIGURE

24-5 A Consumption Function

C

$4,200 3,900 3,600 3,300 3,000 2,700 0 3,200 3,600 4,000 4,400 4,800 5,200 Real Disposable Income,DI
2/12/2012 Prof. Rushen Chahal

$300 $400

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

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Prof. Rushen Chahal

The Consumption Function and the Marginal Propensity to Consume (MPC)

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 If DI increases by 100 million RMB and MPC is 0.9, then consumers would spend 90 million RMB (C would rise by 90 million RMB) and save 10 million RMB (S would increase by 10 million RMB)
If S is not invested, then AD will increase by 90 million RMB; if S is invested, 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 (Marginal Propensity to Save) = 0.1; MPC + MPS = 1 (which is 100%)
2/12/2012 Prof. Rushen Chahal

The Consumption Function and the Marginal Propensity to Consume (MPC)

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)
2/12/2012 Prof. Rushen Chahal

GLOBAL PERSPECTIVE
Average Propensities to Consume, Selected Nations, 1999
.80 .85 .90 .95 1.0 .986 .976 .972 .940 .907 .873 .869 .842

Canada United States Netherlands United Kingdom Germany Italy Japan France
2/12/2012

Prof. Rushen Chahal Abstract of the United States, 2000 Statistical

Factors that Shift the Consumption Function

( disposable income movement along a consumption function
In this case the consumption function does NOT shift

( any other variable that affects consumption shift in the entire consumption function
In this case the consumption function DOES shift
2/12/2012 Prof. Rushen Chahal

24-6 Shifts of the Consumption Function Notice that the

FIGURE
Movements along consumption function Real Consumer Spending C1

C0 C2 A

consumption function shifts UP and DOWN; it does NOT shift left or right like the demand and supply curves

Shifts of consumption function

Real Disposable Income

2/12/2012 Prof. Rushen Chahal

Factors that Shift the Consumption Function

Consumption function shifted by changes in:
Wealth Price level Real interest rate Expectations of future income

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Prof. Rushen Chahal

Factors that Shift the Consumption Function

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?
2/12/2012 Prof. Rushen Chahal

Factors that Shift the Consumption Function

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), you now have lower real wealth.

What will higher or lower price levels do to the consumption function?

2/12/2012 Prof. Rushen Chahal

Factors that Shift the Consumption Function

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. To save 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 interest rates have little effect on consumption.
2/12/2012 Prof. Rushen Chahal

Factors That Shift the Consumption Function

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. They must divide their expected lifetime income by their expected lifetime to get the same consumption for each year of life.
Extreme example: If you expect to live for 80 years and your expected lifetime income is 80 RMB, then you would want to spend 1 RMB in each year. You would not want to spend 1 Jiao each year until your last year and then spend 79.21 RMB in the last year of your life.

2/12/2012

Prof. Rushen Chahal

Factors That Shift the Consumption Function

Why can a tax cut fail to increase the consumption function, and therefore fail to increase AD? This happened 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 not cause a big change in expectations of future income, BUT a permanent tax cut (DI increases permanently) will cause a big change in expectations of future income If the government wants to increase AD with a tax cut, it must convince people that the tax cut will be PERMANENT

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Prof. Rushen Chahal

The Extreme Variability of Investment

Investment spending is often extremely variable, and often the most variable part of GDP A 3.2 percent drop in growth rate from 2000-2001 in the U.S. was accompanied 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 business confidence and expectations about the future

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Prof. Rushen Chahal

The Extreme Variability of Investment

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 of Investment, 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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Prof. Rushen Chahal

The Determinants of Net Exports

Net Exports are determined by:
National Incomes Relative prices and exchange rates

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Prof. Rushen Chahal

The Determinants of Net Exports

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 our GDP rises and falls when our GDP falls Our exports are relatively insensitive to our own GDP, but very sensitive to GDPs of other countries
2/12/2012 Prof. Rushen Chahal

The Determinants of Net Exports

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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Prof. Rushen Chahal

The Determinants of Net Exports

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 and vice 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
Prof. Rushen Chahal

2/12/2012

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; these things often change unexpectedly
As the 1975 and 2001 tax rebates showed, its also difficult to influence consumption 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, much less control

G = Government spending can be very unpredictable (X IM) = Net exports are partially determined by other countries

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Prof. Rushen Chahal

Appendix: National Income Accounting

Macroeconomics

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Prof. Rushen Chahal

Defining GDP: Exceptions to the Rules

GDP = sum of the money values of all final goods and services produced during a specified period of time

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Prof. Rushen Chahal

Defining GDP: Exceptions to the Rules

Government outputs = valued at the cost of the inputs needed to produce them Inventories are treated as though they were bought by the firms that produced them, even though these purchases do not really take place Investment goods = final products demanded by the firms that hold them

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Prof. Rushen Chahal

GDP as the Sum of Final Goods and Services

GDP as the sum of all final demands in one year
Sum of expenditures on all final goods and services GDP = C + I + G + (X - IM)

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Prof. Rushen Chahal

TABLE 3: GDP in 2004 as the Sum of Final Demands

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Prof. Rushen Chahal

GDP as the Sum of All Factor Payments

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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Prof. Rushen Chahal

TABLE 4: GDP in 2004 as the Sum of Incomes

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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 a product minus the amount paid for goods and services purchased from other firms

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Prof. Rushen Chahal

TABLE 5: An Illustration of Final and Intermediate Goods

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TABLE 6: An Illustration of Value Added

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National Income Accounting

The expenditure, income, and production definitions of GDP are all equivalent (they all give the same money value for GDP).

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Prof. Rushen Chahal