1. PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
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Aggregate Demand and the
Powerful Consumer
Men are disposed, as a rule and on the average, to
increase their consumption as their income increases,
but not by as much as the increase in their income.
JOHN MAYNARD KEYNES

2. Aggregate Demand
• Aggregate demand
–Total amount that all
• Consumers
• Business firms
• Government agencies
• Foreigners
–Spend on final goods and services
–Is a schedule, not a fixed number
• The numerical value depends on the price
level
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Aggregate Demand
• Components of aggregate demand
–Consumer expenditure (C, consumption)
–Investment spending (I)
–Government purchases (G)
–Net exports (X-IM)
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4. Aggregate Demand
• C - Consumer expenditure / consumption
–Total amount spent by consumers
–On newly produced goods and services
• Excluding purchases of new homes
–2/3 of total spending
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5. Aggregate Demand
• I - Investment spending
–Sum of expenditures of business firms
• On new plant, equipment, and software
–And households on new homes
–Not included
• Financial “investments”
• Re-sales of existing physical assets
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6. Aggregate Demand
• G - Government purchases
–All the goods and services purchased by
all levels of government
• X-IM - Net exports
–Difference between exports (X) and
imports (IM)
• Aggregate demand
C + I + G + (X-IM)
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7. National Income
• National income
–Sum of the incomes
–That all individuals in the economy earn
• In the forms of wages, interest, rents, and
profits
–Excludes government transfer payments
–Is calculated before any deductions are
taken for income taxes
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8. National Income
• Disposable income (DI)
–Sum of the incomes of all individuals in
the economy
–After all taxes have been deducted and all
transfer payments have been added
–How much consumers have available to
spend and save
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9. National Income
• Transfer payments
–Sums of money
–That the government gives certain
individuals as outright grants
• Rather than as payments for services
rendered to employers
–Examples
• Social Security and unemployment benefits
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10. Circular Flow
• Disposable income, DI = C+S
–Consumption (C)
–Savings (S)
• “Leakages”
–S, IM, Taxes
• “Injections”
–I, G, X, Transfers
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11. Figure 1
The Circular Flow of Expenditures and Income
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12. Circular Flow
• Aggregate demand
= C+I+G+(X-IM)
= Gross national income
• National income
= Domestic product
• DI
=GDP - Taxes + Transfer Payments
=GDP - (Taxes – Transfers)
=Y - T
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13. Consumer Spending and Income
• Consumer spending - responds
–Change in income taxes
• If DI increases
–C – increases
• If DI decreases
–C – falls
13
changeHorizontal
changeVertical
Slope =
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14. Figure 2
Consumer Spending and Disposable Income
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15. Consumer Spending and Income
• Scatter diagram – graph
–Graph showing the relationship between
two variables
–Each year: a point in the diagram
• Coordinates of each year’s point: values of
the two variables in that year
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16. Figure 3
Scatter Diagram of Consumer Spending and Disposable
Income
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17. Figure 4
Scatter Diagram of Consumer Spending and Disposable
Income, 1947–1963
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18. The C Function and the MPC
• Consumption function, C
–Relationship between
• Total consumer expenditures
• Total disposable income in the economy
–Holding all other determinants of
consumer spending constant
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19. The C Function and the MPC
• Marginal propensity to consume (MPC)
–Ratio of changes in consumption to
changes in disposable income
–Slope of consumption function
–How much more consumers will spend if
DI rises by $1
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CinchangetheproducesthatDIinChange
CinChange
=MPC

20. The C Function and the MPC
• To estimate the initial effect of a tax cut
on consumer spending
–Estimate the MPC
–Multiply the amount of the tax cut by the
estimated MPC
–Prediction – subject to some margin of
error
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21. Table 1
Consumption and Income in a Hypothetical Economy
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22. Figure 5
A Consumption Function
22
C
2,700
3,000
3,300
3,600
3,900
RealConsumerSpending,C
$4,200
3,200 3,600 4,0000 4,400 4,800
Real Disposable Income, DI
5,200
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23. Factors that Shift the C Function
• Movement along a given C function
–Change in disposable income
• Shift of the C function
–Change in other determinants of C
• Wealth
• Price level
• Real interest rate
• Future income expectations
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24. Figure 6
Shifts of the Consumption Function
24
C0
RealConsumerSpending
Real Disposable Income
A
C2
C1
Movements along
consumption function
Shifts of consumption
function
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25. Factors that Shift the C Function
• Wealth
–Stock market wealth
• Higher stock prices – increase in C function
–Houses
• Lower price of houses – fall in C function
• Price level
–Higher price level – lower purchasing
power of money-fixed assets
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26. Factors that Shift the C Function
• Real interest rate
–Interest rates have negligible effects on
consumption decisions
• Future income expectations
–Permanent cuts in income taxes cause
greater increases in consumer spending
• Than do temporary cuts of equal magnitude
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27. Table 2
Incomes of Three Consumers
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28. The Extreme Variability of I
• Investment spending (I)
–The most volatile component of
aggregate demand
• Business investment – influenced by
–Interest rates
–Tax provisions
–Technical change
–Strength of economy
–State of business confidence
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29. The Extreme Variability of I
• Investment in housing – influenced by
–Consumer incomes
–Interest rates
–Interest rates on home mortgages
–Expected rate of price appreciation (or
depreciation)
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30. Determinants of Net Exports
• Exports, X
–Foreign purchases of U.S. goods
• Imports, IM
–Portion of domestic demand that is
satisfied by foreign producers
• Net exports
–Exports minus Imports
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31. Determinants of Net Exports
• Changes in national income
–Our GDP rises
• Our imports rise
–Our GDP falls
• Our imports fall
–Our exports
• Relatively insensitive to our GDP
• Sensitive to the GDPs of other countries
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32. Determinants of Net Exports
• Relative prices and exchange rates
–Prices increase
• Net exports decrease
–Prices decline
• Net exports increase
–Foreign prices increase
• Net exports increase
–Foreign prices decrease
• Net exports decrease
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33. How Predictable is AD?
• Aggregate demand – difficult to predict
–Consumption
• Wealth, stock market
• Future prices, income tax law
–Investment
• Business confidence, expectations
–Government purchases
• Politics, military and national security events
–Net exports
• Development abroad
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34. Appendix
National income accounting
• National income accounting
–System of measurement devised for
collecting and expressing macroeconomic
data
• Gross domestic product (GDP)
–Sum of money values
–All final goods and services
–Produced over a specified period of time
• Usually one year
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35. Appendix
GDP – exceptions to the rule
• Government output
–Valued at cost of inputs
• Inventories
–Counted in GDP
• Investment goods
–Intermediate goods
–Included in GDP
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36. Appendix
GDP: sum of final goods and services
• Y = C + I + G + (X – IM)
• I = Gross private domestic investment
–Business investment
–Residential construction
–Inventory investment
–Includes only newly produced capital
goods
–Doesn’t include exchanges of existing
assets
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37. Appendix
GDP: sum of final goods and services
• Y = C + I + G + (X – IM)
• G = Government purchases
–Current goods and services
–Purchased by all levels of government
–Don’t include transfer payments
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38. Appendix
GDP: sum of final goods and services
• Nation’s total output
Y=C+I+G+(X-IM)
–Shares of GDP used up by
• Consumers (C)
• Investors (I)
• Government (G)
• Foreigners (X-IM)
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39. Table 3
Gross Domestic Product in 2009 as the Sum of Final
Demands
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40. Appendix
GDP: sum of all factor payments
• GDP = National income
–Add up all income in the economy
–GDP = Wages + Interest + Rents + Profits
–Includes indirect business taxes
–Excludes transfer payments
–No deduction for income taxes
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41. Table 4
Gross Domestic Product in 2009 as the Sum of Incomes
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42. Appendix
GDP: sum of all factor payments
• Net national product (NNP)
–A measure of production
–Is conceptually identical to national
income
• Gross national product (GNP)
–NNP plus depreciation
• Depreciation
–Portion of capital equipment used up
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43. Appendix
GDP: sum of value added
• Value added by a firm
–Revenue from selling a product
–Minus amount paid for goods and services
purchased from other firms
• GDP = sum of values added by all firms
• Value added
= Wages + Interest + Rents + Profits
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44. Table 5
An Illustration of Final and Intermediate Goods
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45. Table 6
An Illustration of Value Added
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