Aggregate Demand and the Powerful Consumer Chapter 8

From Potential to Actual GDP

• From aggregate supply to aggregate demand• In the long run, aggregate supply “rules

the roost”. Full employment of labor(L), capital(K) and technology determine the level of potential output of the economy – potential GDP.

• In the short run, aggregate demand rules.

Aggregate Demand

• Aggregate Demand (AD)• Total amount that all consumers, business

firms, government agencies and foreigners spend on final goods and services

• The level of aggregate demand is affected by the price level

3

Aggregate Demand

• Four main components of aggregate demand (also referred to as aggregate expenditure).

• Consumer expenditure (C)• Total amount spent by consumers on newly

produced goods and services• About 2/3 of total spending• Items not included: purchase of used goods,

purchases of new homes and imported consumer goods and components

4

Aggregate Demand

• Investment spending (I)• Sum of

• business purchases of new plant, equipment, and software

• new home construction• change in inventories

• Does not include financial “investments”• Does not include resales of existing

physical assets

5

Aggregate Demand

• Government purchases (G)• All the goods and services purchased by all

levels of government: federal, state and local.• Government transfer payments are not

included• Money redistributed from one group of citizens (taxpayers)

to another (the poor, the unemployed, the elderly) are transfer payments

• Why? Not associated with production of goods and services • Included in government budgets as outlays • Not included in the government purchase component of

GDP6

Aggregate Demand

• Net exports (NX)• Difference between exports (X) and imports

(IM)

• Aggregate Demand (AD) is the sum of C + I + G + (X-IM)

AD = C + I + G + (X – IM)

National Income

• National income• Sum of incomes that all factors of

production• Includes wages, interest, rents, and profits• Excludes government transfer payments• Is calculated before any deductions are

taken for income taxes

8

Circular Flow. Spending, Production, Income

• National income and domestic product must be equal• Money a firm earns for its output represents

income to someone• Wages, interest, rent and profit

• Therefore, Wages + Interest + Rent + Profit = Value of output

Simple Circular Flow

Income ($)

Labor

Goods (bread)

Expenditure ($)

Households Firms

The circular flow diagram shows the income received and payments made by each sector of the economy.

From the Appendix: National Income Accounting• National income accounting

• System of measurement devised for collecting and expressing macroeconomic data such as GDP and national income.

• Gross domestic product (GDP)• Sum of money values of all final goods and

services produced over a specified period of time, usually one year within the geographic boundary of a country

• GDP = C + I + G + (X – IM)

11

How to Calculate GDP -The Expenditure Approach • Four types of final users in the economy:

Household Sector – Consumption (C)

Business Sector – Investment (I)

Government Sector – Government Purchases (G)

Foreign Sector – Net Exports (NX)

• Expenditure approach: GDP = C+I+G+NX– Adding the value of goods and services

purchased by each type of final user

The Expenditure Approach to GDP

• Consumption spending (C) – Part of GDP purchased by households as

final users– represents about 2/3 of total GDP– Items not included:

• Imported consumption goods and components

• New home construction• Purchase of used goods

13

The Expenditure Approach to GDP

• Consumption spending (C) – Items included even though households

don’t actually buy them• Total value of food products produced on

farms that are consumed by the farmers and their families themselves

• Total value of housing services provided by owner-occupied homes

14

The Expenditure Approach to GDP

• Private investment (I) – Business purchases of plant,

equipment, and software

– New home construction

– Changes in inventories

15

The Expenditure Approach to GDP• Government purchases (G )

– Spending by federal, state, and local governments on goods and services and government investment in bridges, highways, etc.

16

The Expenditure Approach to GDP• Net exports (NX)

– Total exports minus total imports• Total exports (EX)

– U.S. production that is purchased by foreigners

• Total imports (IM)– Americans’ purchases of goods produced

outside of the United States

17

18

Table 3 Gross Domestic Product in 2013 as the Sum of Final Demands

How to Calculate GDPThe Factor Payment (Income) Approach

• 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

19

20

Table 4 Gross Domestic Product in 2013 as the Sum of Incomes

Value Added Approach to GDP

• Value added – Revenue a firm receives – Minus amount paid for goods and services

purchased from other firms (intermediate goods)

• Value-added approach – GDP = sum the values added by all firms in

the economy – Value added = Wages + Interest + Rents + Profits

21

Value Added at Different Stages of Production Notebook example

22

The Factor Payments Approach – Using the Notebook Paper Example

Value Added goes to the factors of production

Exercise

A farmer grows a bushel of wheat and sells it to a miller for $1.00.

The miller turns the wheat into flour and sells it to a baker for $3.00.

The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00.

The engineer eats the bread.

Compute:• value added at each stage of production• GDP

Exercise

Value added - farmer = ?

Value added - miller = ?

Value added - baker = ?

Total Value added = ? = GDP

Measuring GDP: A Summary

26

Calculating Real GDP

Nominal GDP measures the value of all final goods and services using current prices.

Real GDP measures the value of all final goods and services using the prices of a base year.

Real GDP controls for inflation

Changes in nominal GDP can be due to: changes in prices (P) changes in quantities of output produced (Q) Remember: total sales = P x Q

Changes in real GDP can only be due to changes in quantities (Q), because real GDP is constructed using constant base-year prices. P is held constant

Example - Calculation of Real GDP(NOTE: Numerical Calculation of Real GDP presented in this and the next 4 slides is not covered in the text)

201120102009

205$100200$102192$100good B

1,050$361,000$31900$30good A

QPQPQP

Compute nominal GDP in each year

Compute real GDP in each year using 2009 as the base year.

Example - Calculation of Real GDP

Nominal GDP multiply P & Q from same year2009: $46,200 = $30 900 + $100 192 2010: $51,400 = $31 x 1000 + $102 x 2002011: $58,300 = $36 x 1050 + $100 x 205

Real GDP multiply each year’s Q by 2009 P2009: $46,200 = $30 x 900 + $100 x 192 2010: $50,000 = $30 x 1000 + $100 x 200 2011: $52,000 = $30 1050 + $100 205

GDP Deflator

The inflation rate is the percentage increase in the overall level of prices.

One measure of the price level is the GDP Deflator, defined as

Nominal GDPGDP deflator = 100

Real GDP

Self Test

52,000

50,000

$46,200

Real GDPGDP

deflator

58,3002011

51,4002010

n.a.$46,2002009

inflationrate

Nominal GDP

Use your previous answers to compute the GDP deflator in each year.

Use GDP deflator to compute the inflation rate from 2009 to 2010, and from 2010 to 2011.

Answers

52,000

50,000

$46,200

Real GDP

112.1

102.8

100.0

GDP deflator

9.05%58,3002011

2.8%51,4002010

n.a.$46,2002009

inflationrate

Nom. GDP

Calculate the growth rate in NGDP for 2011.Calculate the Growth rate in RGDP for 2011.