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Property rights 140
services 146



| TEST YOURSELF |
1. The following table shows real GDP per hour of work in Would such a pattern help explain U.S. productivity
four imaginary countries in the years 1997 and 2007. By performance since the mid-1970s? Why?
what percentage did labor productivity grow in each 3. Which of the following prices would you expect to rise
country? Is it true that productivity growth was highest rapidly? Why?
where the initial level of productivity was the lowest?
a. Cable television rates
For which countries?
b. Football tickets
c. Internet access
Output per Hour
d. Household cleaning services
1997 2007
e. Driving lessons
Country A $40 $48
Country B $25 $35 4. Two countries have the production possibilities frontier
Country C $2 $3 (PPF) shown in Figure 3 on page 139. But Consumia
Country D $ 0.50 $ 0.60 chooses point C, whereas Investia chooses point I.
Which country will have the higher PPF the following
year? Why?
2. Imagine that new inventions in the computer industry
5. Show on a graph how capital formation shifts the pro-
affect the growth rate of productivity as follows:
duction function. Use this graph to show that capital for-
mation increases labor productivity. Explain in words
Year of Following 5 Years 10 Years 20 Years why labor is more productive when the capital stock is
Invention Year Later Later Later larger.
0% 0%
21% 12% 14%




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Licensed to:

Chapter 7 151
Economic Growth: Theory and Policy



| DISCUSSION QUESTIONS |
1. Explain the different objectives of (long-run) growth 4. Explain why the best educational policies to promote faster
policy versus (short-run) stabilization policy. growth might be different in the following countries.
2. Explain why economic growth might be higher in a a. Mozambique
country with well-established property rights and a sta- b. Brazil
ble political system compared with a country where
c. France
property rights are uncertain and the government is
5. Comment on the following: “Sharp changes in the vol-
unstable.
ume of investment in the United States help explain
3. Chapter 6 pointed out that, because faster capital for-
both the productivity slowdown in 1973 and the produc-
mation comes at a cost (reduced current consumption),
tivity speed-up in 1995.”
it is possible for a country to invest too much. Suppose
6. Discuss some of the pros and cons of increasing develop-
the government of some country decides that its busi-
ment assistance, both from the point of view of the donor
nesses are investing too much. What steps might it take
country and the point of view of the recipient country.
to slow the pace of capital formation?




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Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:




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.
J O H N M AY NA R D K EY N E S



T he last chapter focused on the determinants of potential GDP”the economy™s ca-
pacity to produce. We turn our attention now to the factors determining actual
GDP”how much of that potential is actually utilized. Will the economy be pressing
against its capacity, and therefore perhaps also having trouble with inflation? Or will
there be a great deal of unused capacity, and therefore high unemployment?
The theory that economists use to answer such questions is based on the two con-
cepts we first introduced in Chapter 5: aggregate demand and supply. The last chapter
examined the long-run determinants of aggregate supply, a topic to which we will return
in Chapter 10. In this chapter and the next, we will construct a simplified model of ag-
gregate demand and learn the origins of the aggregate demand curve.
While aggregate supply rules the roost in the long run, Chapter 5™s whirlwind tour
of U.S. economic history suggested that the strength of aggregate demand holds the
key to the economy™s condition in the short run. When aggregate demand grows
briskly, the economy booms. When aggregate demand is weak, the economy stagnates.
The model we develop to understand aggregate demand in this chapter and the
next will teach us much about this process. But it is too simple to deal with policy is-
sues effectively, because the government and the financial system are largely ignored.
We remedy these omissions in Part 3, where we give government spending, taxation,
and interest rates appropriately prominent roles. The influence of the exchange rate
between the U.S. dollar and foreign currencies is then considered in Part 4.




CONTENTS
ISSUE: DEMAND MANAGEMENT AND THE ORNERY THE CONSUMPTION FUNCTION AND THE DETERMINANTS OF NET EXPORTS
CONSUMER THE MARGINAL PROPENSITY National Incomes
TO CONSUME Relative Prices and Exchange Rates
AGGREGATE DEMAND, DOMESTIC
PRODUCT, AND NATIONAL INCOME FACTORS THAT SHIFT THE CONSUMPTION HOW PREDICTABLE IS AGGREGATE
FUNCTION DEMAND?
THE CIRCULAR FLOW OF SPENDING,
PRODUCTION, AND INCOME ISSUE REVISITED: WHY THE TAX REBATES | APPENDIX | National Income Accounting
FAILED IN 1975 AND 2001 Defining GDP: Exceptions to the Rules
CONSUMER SPENDING AND INCOME:
THE EXTREME VARIABILITY OF GDP as the Sum of Final Goods and Services
THE IMPORTANT RELATIONSHIP
INVESTMENT GDP as the Sum of All Factor Payments
GDP as the Sum of Values Added




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Licensed to:
Part 2
154 The Macroeconomy: Aggregate Supply and Demand



ISSUE: DEMAND MANAGEMENT AND THE ORNERY CONSUMER
In Chapter 5, we suggested that the government sometimes wants to shift the
aggregate demand curve. It can do so a number of ways. One direct approach
is to alter its own spending, spending freely when private demand is weak
and tightening the budget when private demand is strong. Alternatively, the
government can take a more indirect route by using taxes and other policy
tools to influence private spending decisions. Because consumer expenditures
constitute more than two-thirds of gross domestic product, the consumer presents the
most tempting target.
A case in point arose after the 2000 election, when the long boom of the 1990s ended
abruptly and economic growth in the United States slowed to a crawl. President
George W. Bush decided that consumer spending needed a boost, and Congress passed
a multiyear tax cut in 2001. One provision of the tax cut gave taxpayers an advance re-
bate on their 2001 taxes. Checks ranging as high as $600 went out starting in July 2001.
There should be no mystery about how changes in personal taxes are expected to affect
consumer spending. Any reduction in personal taxes leaves consumers with more
after-tax income to spend; any tax increase leaves them with less. The linkage from
taxes to spendable income to consumer spending seems direct and unmistakable, and,
in a certain sense, it is.
Yet the congressional debate over the tax bill sent legislators and journalists scurry-
ing to the scholarly evidence on a similar episode 26 years earlier. In the spring of 1975,
as the U.S. economy hit a recessionary bottom, Congress enacted a tax rebate to spur
consumer spending. But that time consumers did not follow the wishes of the president
and Congress. They saved a substantial share of their tax cuts, rather than spending
them. As a result, the economy did not receive the expected boost.
Perhaps the legislators should have taken the 1975 episode to heart. Early estimates
of the effects of the 2001 rebates suggested that consumers spent relatively little of the
money they received. Thus, in a sense, history repeated itself. But why? Why did these
two temporary tax cuts seem to have so little effect? This chapter attempts to provide
some answers. But before getting involved in such complicated issues, we must build
some vocabulary and learn some basic concepts.



AGGREGATE DEMAND, DOMESTIC PRODUCT, AND NATIONAL INCOME
First, some vocabulary. We have already introduced the concept of gross domestic prod-
uct as the standard measure of the economy™s total output.1
For the most part, firms in a market economy produce goods only if they think they
can sell them. Aggregate demand is the total amount that all consumers, business firms,
Aggregate demand is the
total amount that all con- government agencies, and foreigners spend on U.S. final goods and services. The down-
sumers, business firms, ward-sloping aggregate demand curve of Chapter 5 alerted us to the fact that aggregate
government agencies, and
demand is a schedule, not a fixed number”the actual numerical value of aggregate demand
foreigners spend on final
depends on the price level. Several reasons for this dependence will emerge in coming
goods and services.
chapters.
Consumer expenditure (C) But the level of aggregate demand also depends on a variety of other factors”such as
is the total amount spent by consumer incomes, various government policies, and events in foreign countries. To
consumers on newly
understand the nature of aggregate demand, it is best to break it up into its major compo-
produced goods and services
nents, as we do now.
(excluding purchases of new
Consumer expenditure (consumption for short) is simply the total value of all con-
homes, which are considered
sumer goods and services demanded. Because consumer spending constitutes more than
investment goods).




See Chapter 5, pages 87“91.
1




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Licensed to:
Chapter 8 155
Aggregate Demand and the Powerful Consumer



Investment spending (I)
two-thirds of total spending, it is the main focus of this chapter. We represent it by the
is the sum of the expendi-
letter C.
tures of business firms on
Investment spending, represented by the letter I, was discussed extensively in the last
new plant and equipment
chapter. It is the amount that firms spend on factories, machinery, software, and the like, and households on new
plus the amount that families spend on new houses. Notice that this usage of the word in- homes. Financial “invest-
vestment differs from common parlance. Most people speak of investing in the stock mar- ments” are not included,
ket or in a bank account. But that kind of investment merely swaps one form of financial nor are resales of existing
physical assets.
asset (such as money) for another form (such as a share of stock). When economists speak
of investment, they mean instead the purchase of some new physical asset, such as a drill
Government purchases (G)
press, a computer, or a house. The distinction is important here because only investments refer to the goods (such as
by the economists™ definition constitute direct additions to the demand for newly airplanes and paper clips)
produced goods. and services (such as school
The third major component of aggregate demand, government purchases of goods and teaching and police protec-
tion) purchased by all levels
services, includes items such as paper, computers, airplanes, ships, and labor bought by
of government.
all levels of government. We use the symbol G for this variable.
The final component of aggregate demand, net exports, is simply defined as U.S. ex- Net exports, or X 2 IM, is
ports minus U.S. imports. The reasoning here is simple. Part of the demand for American the difference between ex-
goods and services originates beyond our borders”as when foreigners buy our wheat, ports (X) and imports (IM).
It indicates the difference
software, and banking services. So to obtain total demand for U.S. products, these goods
between what we sell to
and services must be added to U.S. domestic demand. Similarly, some items included in C
foreigners and what we buy
and I are made abroad. Think, for example, of beer from Germany, cars from Japan, and
from them.
shirts from Malaysia. These must be subtracted from the total amount




SOURCE: From The Wall Street Journal. Permission,
demanded by U.S. consumers if we want to measure total spending on U.S.
products. The addition of exports, X, and the subtraction of imports, IM, leads
to the following shorthand definition of aggregate demand:

Aggregate demand is the sum of C 1 I 1 G 1 (X 2 IM).

Cartoon Features Syndicate
The last concept we need for our vocabulary is a way to measure the total
income of all individuals in the economy. It comes in two versions: one for be-
fore-tax incomes, called national income, and one for after-tax incomes, called
disposable income.2 The term disposable income, which we will abbreviate DI,
is meant to be descriptive”it tells us how much consumers actually have
“When I refer to it as disposable
available to spend or to save. For that reason, it will play a prominent role in
income, don™t get the wrong idea.”
this chapter and in subsequent discussions.


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