University:
California State University, Northridge
Course:
ECON 500 | Survey of Economics
Academic year:

2024
Views:

433

Pages:

20
Author:

smammarejv5

Aggregate Demand and the Powerful Consumer Part 1 Outline ● AD, domestic product, and national income ● Circular flow of spending, production and income ● Consumption f(x) and mpc Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Real World Puzzle: Demand Management and the Consumer ● Gov can shift AD in two ways: 1. 2. ● ● ↑G when AD is weak or ↓G when AD is strong. ↓taxes when AD is weak or ↑taxes when AD is strong. Consumer expenditures (C) account for 2/3 of GDP. The link between taxes and C seems direct yet sometimes a tax cut does little to ↑AD. ♦ E.g., Bush tax cut of 2001 after 9/11 and Ford tax cut of 1975 after OPEC oil shocks did not boost AD as hoped. Consumers decided to save their tax rebates. AD, Domestic Product, and National Income ● ♦ ● Aggregate Demand: total amount that all consumers, businesses, government, and foreigners want to spend on U.S. final goods and services. AD is not a fixed number! It is a downward sloping curve that depends on P level, consumer incomes, business confidence, gov policies, and events in foreign countries. AD has 4 components: 1. 2. 3. 4. Consumer expenditure (C) Investment spending (I) Government purchases (G) Net exports (X-IM) AD, Domestic Product, and National Income ● Consumer Expenditure: total amount spent by consumers on newly produced goods and services (excluding purchases of new homes, which are considered I goods). ● Investment Spending: sum of the expenditures of firms on new plant and equipment and households on new homes. Financial “investments,” like stocks and bonds, are not included, nor are resales of existing physical assets. AD, Domestic Product, and National Income ● Government Purchases: goods and services purchased by all levels of government. ● Net Exports: U.S. exports minus U.S. imports. ♦ Part of the D for U.S. goods comes from foreign countries and some components of C are not U.S. made. ● AD: C + I + G + X – IM AD, Domestic Product, and National Income ● National Income: sum of all incomes that all individuals earned in the forms of wages, interest, rents, and profits. ♦ Excludes transfer payments and income tax ● Disposable Income: sum of all incomes that all individuals earned after all taxes have been deducted and all transfer payments have been added. ● Transfer Payments: sums of money that certain individuals receive from the gov as outright grants. ♦ E.g., SSI and UI benefits AD, Domestic Product, and National Income ● DI = GDP - Taxes + Transfers = Y – T ● National income = GDP ♦ When a firm produces and sells $100M worth of output, it pays most of its proceeds (say $90M) out to workers (wages); lenders (interest); and landlord (rent). The rest is profit of $10M which is income for the firm’s owners. ♦ When we add up all wages, interest, rent, and profit in the economy to obtain national income, we have also arrived at the value of output or GDP. Circular Flow of Spending, Production, and Income ● Circular flow diagram shows the relationship of the different components of expenditure and income 1. DI flows into consumers’ pockets and C and S flow out. C stays in the system and S “leaks out.” I is “injected” into the system. G is “injected” into the system. X is injected into the system, while IM leak out. We now have the full amount of AD, C + I + G + X – IM. AD arrives at the firms; and firms produce domestic product. Gov does two things to national income (or GDP) → siphons off taxes and adds back transfer payments. 2. 3. 4. 5. 6. FIGURE 1. The Circular Flow of Expenditures and Income Rest of the World Financial System 3 2 Investors Consumers 4 1 Government 5 6 Firms (produce the domestic product) Consumer Spending and Income ● Why did consumers respond to tax cuts as expected in 1964 and 1980s but not in 1975 and 2001? ● Economists want to predict how C responds to ∆ taxes. ♦ ↑taxes → ↓DI and ↓taxes → ↑DI ♦ Need to understand how C responds to ∆DI ● Examine the historical paths of C and DI (Fig. 2). ♦ Suggests ↑C whenever ↑DI and ↓C whenever ↓DI. ♦ DI – C = S. ♦ S is unusually small during Great Depression and large during WWII when C goods were unavailable or rationed. FIGURE 2. Consumer Spending and Disposable Income $8,000 $7,500 $7,000 $6,500 6,000 5,500 Billions of 2000 Dollars 5,000 4,500 4,000 Real disposable income 3,500 3,000 2,500 2,000 1,500 The Great Depression World War II Real consumer spending 1,000 500 0 2004 1930 1940 1950 1960 1970 1980 1990 2000 Consumer Spending and Income ● Knowing that C and DI move in the same direction is not enough for policymakers. ● Need to know by how much C will rise when ↑DI. ● A scatter diagram (Fig. 3) can help determine the relationship between 2 variables (like C and DI). ♦ Graph showing how 2 variables are related. ♦ Each data point gives the values of C and DI in 1 year. ♦ Can assist policymakers. FIGURE 3. Consumer Spending and Disposable Income 2004 2003 2002 2001 2000 1998 1997 $5,619 1995 1994 1992 1990 1991 1989 1988 1987 1986 1984 1979 1980 1978 1976 1974 $3,036 1996 1985 1970 Real Consumer Spending 1964 1960 1955 1947 1945 1941 1942 1943 1939 1929 0 $3,432 Real Disposable Income $6,081 1999 Consumer Spending and Income ● Imagine it is 1963 and you must decide whether to recommend to Congress a tax cut of $5B, $10B, or $15B. ♦ Your forecasts of AD (C, I, G, X-IM) suggest it will be weak in 1964. ● Use a scatter diagram (Fig. 4) that removes all years after 1963 and unusual years from Depression and WWII. ● Trace a line that best fits the data. This line describes CDI relationship. FIGURE 4. Consumer Spending and Disposable Income Real Consumer Spending 1900 1963 1700 1500 1360 1300 1180 B $180 billion A 1100 $200 900 0 1947 900 1100 billion 1300 1500 1700 Real Disposable Income 1900 Consumer Spending and Income ● Slope = ∆C/∆DI = $180B/$200B = 0.90 ● Each add $ of DI → $0.90 of add spending. ● So how much consumer spending is induced by a tax cut of $5B, $10B, or $15B? ♦ $5B tax cut → ↑$4.5B in C ♦ $10B tax cut → ↑$9B in C ♦ $15B tax cut → ↑$13.5B in C ● In 1964, policymakers cut taxes by about $9B. ● Predict how C responds to a tax cut: rise in C = tax cut amount x mpc The Consumption Function and the MPC ● Consumption function: shows the relationship between total consumer expenditures and total DI in the economy, holding all other determinants of C fixed. ● Slope of C f(x) = MPC = ∆C/∆DI ♦ MPC tells us how much add spending will be induced by a $1 change in DI. ♦ For each $1 tax cut, economists expect C to rise by $1 x mpc. ● Never know mpc with certainty so predicted effect of a tax cut on C is subject to some margin of error. ● In 1963, economists multiplied $9B tax cut by estimated mpc (0.90) and concluded C would rise by $8.1B –which was very accurate. TABLE 1. Consumption and Income in Hypothetical Economy FIGURE 5. A Hypothetical Consumption Function C $4,200 3,900 3,600 $300B 3,300 3,000 $400B 2,700 0 3,200 3,600 4,000 4,400 4,800 5,200 Real Disposable Income, in billions of dollars MPC = $300/$400 = 0.75

Aggregate Demand and the Powerful Consumer, Part 1

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