Char Lee Econ Lecture 22

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 ManagementIn our first lecture we introduced Aggregate

DemandWe 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 ManagementIn 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

Investment

GovernmentPurchases

Net Exports

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.

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

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

Investors

Government

Firms(produce the

domestic product)

Consumers

Financial SystemRest of the

Saving (S)

Consumption (C)

I) C + I

C + I + GImports (IM

Exports (X)C

+ I + G +

Transfers

Disposable

Income (DI)

National Income (Y)

(X – IM)

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

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

Investors

Government

Firms(produce the

domestic product)

Consumers

Financial SystemRest of the

Saving (S)

Consumption (C)

I) C + I

C + I + GImports (IM

Exports (X)C

+ I + G +

Transfers

Disposable

Income (DI)

National Income (Y)

(X – IM)

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

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 AboutDo 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?

IncomeII. The Circular Flow of Spending, Production and IncomeIII. Consumer Spending and Income: The important

ConsumptionConsumption 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 12Motor Vehicles 253Household Equipment

Other 125Nondurable Goods 1,545 30Food 772Clothing & Apparel 264Energy 133Other 375Services 2,974 58Housing 779Household operation 310Transportation 205Medical Care 816Other 865Total 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 CenturyHousing 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 864Equals: Personal Disposable Income 5,586 Less: Personal outlays (consumption +interest)

Equals: Personal Saving 272Memo: Saving as percent of personal DI

Consumption, Saving, and Income

(1)Disposable

Income ($)

(2) Net saving

(+) or dissaving (-)

(3)Consumptio

24,000 -110 24,11025,000 0 25,00026,000 +150 25,85027,000 +400 26,60028,000 +760 27,24029,000 +1,170 27,83030,000 +1,640 28,360

FIGURE 24-2 Consumer Spending and Disposable Income

Real consumer spending

Real disposable income

World War II

The Great Depression B

2000 1990 1980 1970 1960 1950 1940 1930 0

$6,500

Consumption, Saving, and IncomeClearly consumption and DI are

relatedWhen DI rises, consumption risesWhen DI falls, consumption fallsHowever we are still unclear on how

much DI influences consumption

Consumption, Saving, and IncomeTo 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.

$3,244 $5,677

$5,237

$2,869

2001 2000

1999 1998

1996 1994

1992 1990 1991

1989 1988 1987 1986

1980 1984

1979 1978

1964 1960

1945 1943 1942

1947 1941

1939 1929

Real Disposable Income

Consumer Spending and IncomeAssume 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

$200 billion

$180 billion

1360 1300 1180 1100

1900 1700 1500 1300 1100 900

ing 1963

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 IncomeIf 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

Real Disposable Income, DI

5,200 4,800 4,400 4,000 3,600 3,200 0

$4,200

TABLE 24-1 Consumption and Income in Hypothetical Economy

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 75.

A Consumption FunctionDerived from the Equation C = 100 + .75Y

C Y 1 0 0 7 5.AGGREGATEINCOME, Y

(BILLIONS OF DOLLARS)

AGGREGATE CONSUMPTION, C

0 10080 160

100 175200 250400 400600 550800 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,

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

AGGREGATE CONSUMPTION, C

0 10080 160

100 175200 250400 400600 550800 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

CanadaUnited States

NetherlandsUnited Kingdom

GermanyItaly

JapanFrance

GLOBAL PERSPECTIVEAverage Propensities to Consume,Selected Nations, 1999

Statistical Abstract of the United States, 2000

Shifts in the consumption functionThe 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

Shifts of consumption

function Rea

Movements along consumption function

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: WealthNot just income, but total amount of

income accumulatedThe more money I have, the more I

will be willing to spendE.G. stock market booms and busts

Shifts in the consumption function: Price LevelHigher 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 rateHigh interest rate => lower consumptionLow 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 expectationsIf 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 QuestionWhy 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

Why The Tax Rebate Failed in 1975 and 2001The 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.

InvestmentInvestment is the most volatile of all

AD componentsDoes not follow movements in

disposable income like consumptionA 3.2 percent drop in growth rate

from 2000-2001 was accompanied by a 14.1 percent drop in the growth rate of investment

InvestmentBecause 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

InvestmentVolatility of investment is largely

attributed to expectations of the future, which directly affect the state of business confidence

Difficult to measure, much less controlThus, economists concentrate on

controlling other determinants of investment

Determinants of InvestmentThe level of investment is

determined by:

RevenuesCostsExpectations

Revenue as a determinant of investmentInvestment 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 investmentCapital is a durable good (lasts a

long time)Costs included in costs of capital:

1. Price2. Interest Rate3. Taxes

Expectations as a determinant of investmentInvestment 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

Propensity to ConsumeV. Factors that Shift the Consumption FunctionVI. The Extreme Variability of InvestmentVII.The Determinants of Net ExportsVIII.How predictable is AD?

Net ExportsNet Exports are the third leg of AD

to be discussedNX are also extremely variableNet Exports are determined by:1. National Incomes2. Relative prices and exchange

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 ChinaBy 1-digit SITC commodityIn millions of dollars

Source: US Census Bureau

National Income and ImportsImports are positively related to

income and outputWhen 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

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

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 RatesConsider a CharLeenese car that

costs 3 million CharLeenese CharsIf 1 dollar = 100 Chars, then:1 car = $30,000But if the exchange rate changes1 dollar = 150 Chars, then:1 car = $20,000

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 UpAggregate 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 UpExamining 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 UpThere is clearly a relationship between

consumption and disposable incomeThe 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 UpMarginal 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 UpBecause 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 UpInvestment 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 UpNet 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 UpAD 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

Char Lee Econ Lecture 22

Education

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