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where Y represents GDP and T represents taxes net of transfers or simply net taxes. Dispos-
able income flows unimpeded to consumers at point 1, and the cycle repeats.
Figure 1 raises several complicated questions, which we pose now but will not try to
answer until subsequent chapters:
• Does the flow of spending and income grow larger or smaller as we move clock-
wise around the circle? Why?
• Is the output that firms produce at point 5 (the GDP) equal to aggregate demand?
If so, what makes these two quantities equal? If not, what happens?
The next chapter provides the answers to these two questions.
• Do the government™s accounts balance, so that what flows in at point 6 (net taxes)
is equal to what flows out at point 3 (government purchases)? What happens if
they do not balance?
This important question is first addressed in Chapter 11 and then recurs many times,
especially in Chapter 15, which discusses budget deficits and surpluses in detail.
• Is our international trade balanced, so that exports equal imports at point 4? More
generally, what factors determine net exports, and what consequences arise from
trade deficits or surpluses?
We take up these questions in the next two chapters but deal with them more fully in Part 4.
However, we cannot dig very deeply into any of these issues until we first understand
what goes on at point 1, where consumers make decisions. So we turn next to the deter-
minants of consumer spending.



CONSUMER SPENDING AND INCOME: THE IMPORTANT RELATIONSHIP
Recall that we started the chapter with a puzzle: Why did consumers respond so weakly
to tax rebates in 2001 and 1975? An economist interested in predicting how consumer
spending will respond to a change in income taxes must first ask how consumption (C)
relates to disposable income (DI), because a tax increase decreases after-tax income and a
tax reduction increases it. So this section examines what we know about how consumer
spending is influenced by changes in disposable income.
Figure 2 on the next page depicts the historical paths of C and DI for the United States
since 1929. The association is extremely close, suggesting that consumption will rise
whenever disposable income rises and fall whenever income falls. The vertical distance
between the two lines represents personal saving: disposable income minus consumption.



This definition omits a few minor details, which are explained in the appendix.
5




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Part 2
158 The Macroeconomy: Aggregate Supply and Demand



F I GU R E 2 $8,500
Consumer Spending
8,000
and Disposable Income
7,500

7,000

6,500

6,000

5,500
Billions of 2000 Dollars




5,000

4,500

4,000

3,500
Real disposable income
3,000

2,500
World
War II
2,000 Real consumer spending
The Great
Depression
1,500

1,000

500
0
1930 1940 1950 1960 1970 1980 1990 2000 2010




Notice how little saving consumers did during the Great Depression of the 1930s (when
the two lines run very close together); how much they did during World War II, when
many consumer goods were either unavailable or rationed; and how little saving con-
sumers have done lately.
Of course, knowing that C will move in the same direction as DI is not enough for pol-
icy planners. They need to know how much one variable will go up when the other rises a
given amount. Figure 3 presents the same data as in Figure 2, but in a way designed to
help answer the “how much” question.
Economists call such pictures scatter diagrams, and they are very useful in predicting
A scatter diagram is a
graph showing the relation- how one variable (in this case, consumer spending) will change in response to a change in
ship between two variables another variable (in this case, disposable income). Each dot in the diagram represents the
(such as consumer spending
data on C and DI corresponding to a particular year. For example, the point labeled “1996”
and disposable income).
shows that real consumer expenditures in 1996 were $5,619 billion (which we read off the
Each year is represented by a
vertical axis), while real disposable incomes amounted to $6,081 billion (which we read off
point in the diagram, and the
the horizontal axis). Similarly, each year from 1929 to 2007 is represented by its own dot in
coordinates of each year™s
Figure 3.
point show the values of the
two variables in that year. To see how such a diagram can assist fiscal policy planners, imagine that you were a
member of Congress way back in 1964, contemplating a tax cut. (In fact, Congress did cut
taxes that year.) Legislators want to know how much additional consumer spending may
be stimulated by tax cuts of various sizes. To assist your imagination, the scatter diagram
in Figure 4 on page 160 removes the points for 1964 through 2007 that appear in Figure 3;
after all, these data were unknown in 1964. Years prior to 1947 have also been removed
because, as Figure 2 showed, both the Great Depression and wartime rationing disturbed
the normal relationship between DI and C. With no more training in economics than you
have right now, what would you suggest?



Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Chapter 8 159
Aggregate Demand and the Powerful Consumer



F I GU R E 3
Scatter Diagram of Consumer Spending and Disposable Income


2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
Real Consumer Spending




$5,619 1996
1995
1994
1992
1990 1991
1989
1988
1987
1986
1985
1984
1979 1980
1978
1976
$3,036
1974
1970


1964
1960
1955
1947
1945
1941
1942 1943
1939
1929


0 $3,432 $6,081
Real Disposable Income

NOTE: Figures are in billions of 2000 dollars.




One rough-and-ready approach is to get a ruler, set it down on Figure 4, and sketch a
straight line that comes as close as possible to hitting all the points. That has been done
for you in the figure, and you can see that the resulting line comes remarkably close to
touching all the points. The line summarizes, in a very rough way, the normal relation-
ship between income and consumption. The two variables certainly appear to be closely
related.
The slope of the straight line in Figure 4 is very important.6 Specifically, we note that it is
Vertical change $180 billion
Slope 5 5 0.90
5
Horizontal change $200 billion

Because the horizontal change involved in the move from A to B represents a rise in dis-
posable income of $200 billion (from $1,300 billion to $1,500 billion), and the correspon-
ding vertical change represents the associated $180 billion rise in consumer spending



To review the concept of slope, see the appendix to Chapter 1, pages 14“16.
6




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 2
160 The Macroeconomy: Aggregate Supply and Demand



F I GU R E 4
Scatter Diagram of
1900
Consumer Spending
and Disposable
Income, 1947“1963 1963
1700




Real Consumer Spending
1500
B
1360
1300
$180 billion
A
1180
1100
$200
billion
900 1947


0 900 1100 1300 1500 1700 1900
Real Disposable Income


NOTE: Figures are in billions of 2000 dollars.




(from $1,180 billion to $1,360 billion), the slope of the line indicates how consumer
spending responds to changes in disposable income. In this case, we see that each addi-
tional $1 of income leads to 90 cents of additional spending.
Now let us return to tax policy. First, recall that each dollar of tax cut increases dispos-
able income by exactly $1. Next, apply the finding from Figure 4 that each additional dol-
lar of disposable income increases consumer spending by about 90 cents. The conclusion
is that a tax cut of, say, $9 billion”which is about what happened in 1964”would be ex-
pected to increase consumer spending by about $9 3 0.9 5 $8.1 billion.

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