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earned $100 in each of the years considered in the table. The consumer named
“Temporary” earned $100 in three of the four years but had a good year
in 1975. The consumer named “Permanent” enjoyed a per-
manent increase in income in 1975 and was therefore
Incomes of Three Consumers
clearly the richest.
Now let us use our common sense to figure out how Incomes in Each Year
much each of these consumers might have spent in 1975. Consumer 1974 1975 1976 1977 Total Income
Temporary and Permanent had the same income that year.
Constant $100 $100 $100 $100 $400
Do you think they spent the same amount? Not if they Temporary 100 120 100 100 420
had some ability to foresee their future incomes, because Permanent 100 120 120 120 460
Permanent was richer in the long run.

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164 The Macroeconomy: Aggregate Supply and Demand

Now compare Constant and Temporary. Temporary had 20 percent higher income
in 1975 ($120 versus $100), but only 5 percent more over the entire four-year period
($420 versus $400). Do you think his spending in 1975 was closer to 20 percent above
Constant™s or closer to 5 percent above it? Most people guess the latter.
The point of this example is that consumers very reasonably decide on their current
consumption spending by looking at their long-run income prospects. This should
come as no surprise to a college student. You are probably spending more than you
earn this year, but that does not make you a foolish spendthrift. On the contrary, you
know that your college education will likely give you a much higher income in the
future, and you are spending with that in mind.
To relate this example to the failure of the 1975 income tax cut, now imagine that the
three rows in Table 2 represent the entire economy under three different government
policies. Recall that 1975 was the year of the temporary tax cut. The first row (Constant)
shows the unchanged path of disposable income in the absence of a tax cut. The second
(Temporary) shows an increase in disposable income attributable to a tax cut for one
year only. The bottom row (Permanent) shows a policy that increases DI in every future
year by cutting taxes permanently in 1975. Which of the two lower rows do you imag-
ine would have generated more consumer spending in 1975? The bottom row (Perma-
nent), of course. What we have concluded, then, is this:
Permanent cuts in income taxes cause greater increases in consumer spending than do
temporary cuts of equal magnitude.
The application of this analysis to the 1975 and 2001 tax rebates is immediate. The
1975 tax cut was advertised as a one-time increase in after-tax income, like that experi-
enced by Temporary in Table 2. No future income was affected, so consumers did not
increase their spending as much as government officials had hoped. Ironically, the 2001
tax rebate checks actually represented the first installment of a projected permanent tax
reduction. But they were so widely advertised as a one-time event that most people
receiving the checks probably thought they were temporary.
We have, then, what appears to be a general principle, backed up by both historical
evidence and common sense. Permanent changes in income taxes have more significant
effects on consumer spending than do temporary ones. This conclusion may seem ob-
vious, but it is not a lesson you would have learned from an introductory textbook
prior to 1975. It is one we learned the hard way, through bitter experience.

Next, we turn to the most volatile component of aggregate demand: investment spending.9
While Figure 2 showed that consumer spending follows movements in disposable income
quite closely, investment spending swings from high to low levels with astonishing speed.
For example, when real GDP in the United States slowed abruptly from a 3.7 percent
growth rate in 2000 to a sluggish 0.8 percent rate in 2001, a drop of about 3 percentage
points, the growth rate of real investment spending dropped from 5.7 percent to minus
7.9 percent, a swing of over 13 percentage points. What accounts for such dramatic
changes in investment spending?
Several factors that influence how much businesses want to invest were discussed in
the previous chapter, including interest rates, tax provisions, technical change, and the

We repeat the warning given earlier about the meaning of the word investment. It includes spending by businesses

and individuals on newly produced factories, machinery, and houses. But it excludes sales of used industrial plants,
equipment, and homes as well as purely financial transactions, such as the purchases of stocks and bonds.

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Chapter 8 165
Aggregate Demand and the Powerful Consumer

strength of the economy. Sometimes these determinants change abruptly, leading to
dramatic variations in investment. But perhaps the most important factor accounting for
the volatility of investment spending was not discussed much in Chapter 7: the state of
business confidence, which in turn depends on expectations about the future.
Although confidence is tricky to measure, it does seem obvious that businesses
will build more factories and purchase more new machines when they are optimistic.
Correspondingly, their investment plans will be very cautious if the economic outlook
appears bleak. Keynes pointed out that psychological perceptions such as these are sub-
ject to abrupt shifts, so that fluctuations in investment can be a major cause of instability
in aggregate demand.
Unfortunately, neither economists nor, for that matter, psychologists have many good
ideas about how to measure”much less control”business confidence. So economists usu-
ally focus on several more objective determinants of investment that are easier to quantify
and even influence”factors such as interest rates and tax provisions.

Another highly variable source of demand for U.S. products is foreign purchases of U.S.
goods”our exports. As we observed earlier in this chapter, we obtain the net contribution
of foreigners to U.S. aggregate demand by subtracting imports, which is the portion of do-
mestic demand that is satisfied by foreign producers, from our exports to get net exports.
What determines net exports?

National Incomes
Although both exports and imports depend on many factors, the predominant one is
income levels in different countries. When American consumers and firms spend more on
consumption and investment, some of this new spending goes toward the purchase of
foreign goods. Therefore:
Our imports rise when our GDP rises and fall when our GDP falls.
Similarly, because our exports are the imports of other countries, our exports depend on
their GDPs, not on our own. Thus:
Our exports are relatively insensitive to our own GDP, but are quite sensitive to the
GDPs of other countries.
Putting these two ideas together leads to a clear implication: When our economy grows
faster than the economies of our trading partners, our net exports tend to shrink. Con-
versely, when foreign economies grow faster than ours, our net exports tend to rise.
Events since the 1990s illustrate this point dramatically. When the U.S. economy stagnated
between 1990 and 1992, our net exports rose from 2$55 billion to 2$16 billion. (Remem-
ber, 216 is a larger number than 255!) Since then, growth in the United States has gener-
ally outstripped growth abroad, and U.S. net exports have plummeted from 2$16 billion
in 1992 to 2$560 billion in 2007.

Relative Prices and Exchange Rates
Although GDP levels here and abroad are important influences on a country™s net exports,
they are not the only relevant factors. International prices matter, too.
To make things concrete, let™s focus on trade between the United States and Japan. Sup-
pose American prices rise while Japanese prices fall, making U.S. goods more expensive
relative to Japanese goods. If American consumers react to these new relative prices by
buying more Japanese goods, U.S. imports rise. If Japanese consumers react to the same rel-
ative price changes by buying fewer American products, U.S. exports fall. Both reactions
reduce America™s net exports.

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166 The Macroeconomy: Aggregate Supply and Demand

Naturally, a decline in American prices (or a rise in Japanese prices) does precisely the
opposite. Thus:
A rise in the prices of a country™s goods will lead to a reduction in that country™s net ex-
ports. Analogously, a decline in the prices of a country™s goods will raise that country™s
net exports. Similarly, price increases abroad raise the home country™s net exports,
whereas price decreases abroad have the opposite effect.
This simple idea holds the key to understanding how exchange rates among the
world™s currencies influence exports and imports”an important topic that we will con-
sider in depth in Chapters 18 and 19. The reason is that exchange rates translate foreign
prices into terms that are familiar to home country customers”their own currencies.
Consider, for example, Americans interested in buying Japanese cars that cost
¥3,000,000. If it takes ¥100 to buy a dollar, these cars cost American buyers $30,000. But if
the dollar is worth ¥150, those same cars cost Americans just $20,000, and consumers in
the United States are likely to buy more of them. These sorts of responses help explain
why American automakers lost market share to Japanese imports when the dollar rose
against the yen in the late 1990s. They also explain why, today, so many U.S. manufactur-
ers want to see the value of the Chinese yuan rise.

We have now learned enough to see why economists often have difficulty predicting ag-
gregate demand. Consider the four main components, starting with consumer spending.
Because wealth affects consumption, forecasts of spending can be thrown off by unex-
pected movements of the stock market or by poor forecasts of future prices. It may also be
difficult to anticipate how taxpayers will view changes in the income tax law. If the gov-
ernment says that a tax cut is permanent (as for example, in 1964), will consumers take the
government at its word and increase their spending accordingly? Perhaps not, if the gov-
ernment has a history of raising taxes after promising to keep them low. Similarly, when
(as in 1975) the government explicitly announces that a tax cut is temporary, will con-
sumers always believe the announcement? Or might they greet it with a hefty dose of
skepticism? Such a reaction is quite possible if there is a history of “temporary” tax
changes that stayed on the books indefinitely.
Swings in investment spending are even more difficult to predict, partly because they
are tied so closely to business confidence and expectations. Developments abroad also
often lead to surprises in the net export account. Even the final component of aggregate
demand, government purchases (G), is subject to the vagaries of politics and to sudden
military and national security events such as 9/11 and the Iraq war.
We could say much more about the determinants of aggregate demand, but it is best to
leave the rest to more advanced courses. For we are now ready to apply our knowledge of
aggregate demand to the construction of the first model of the economy. Although it is
true that income determines consumption, the consumption function in turn helps to de-
termine the level of income. If that sounds like circular reasoning, read the next chapter!

1. Aggregate demand is the total volume of goods and 2. Aggregate demand is a schedule: The aggregate quan-
services purchased by consumers, businesses, govern- tity demanded depends on (among other things) the
ment units, and foreigners. It can be expressed as the price level. But, for any given price level, aggregate
sum C 1 I 1 G 1 (X 2 IM), where C is consumer spend- demand is a number.
ing, I is investment spending, G is government 3. Economists reserve the term investment to refer to
purchases, and X 2 IM is net exports. purchases of newly produced factories, machinery, soft-
ware, and houses.

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Chapter 8 167
Aggregate Demand and the Powerful Consumer

4. Gross domestic product is the total volume of final total consumer wealth, the price level, and expected
goods and services produced in the country. future incomes.
10. Because consumers hold so many money-fixed assets,
5. National income is the sum of the before-tax wages, in-
they lose purchasing power when prices rise, which
terest, rents, and profits earned by all individuals in the
leads them to reduce their spending.
economy. By necessity, it must be approximately equal
to domestic product. 11. The government often tries to manipulate aggregate de-
mand by influencing private consumption decisions,
6. Disposable income is the sum of the incomes of all indi-
usually through changes in the personal income tax. But
viduals in the economy after taxes and transfers. It is the
this policy did not work well in 1975 or 2001.
chief determinant of consumer expenditures.
12. Future income prospects help explain why. The 1975 tax
7. All of these concepts, and others, can be depicted in a
cut was temporary and therefore left future incomes
circular flow diagram that shows expenditures on all
unaffected. The 2001 tax cut was also advertised as a
four sources flowing into business firms and national in-
one-time event.
come flowing out.
13. Investment is the most volatile component of aggregate
8. The close relationship between consumer spending (C)
demand, largely because it is closely tied to confidence
and disposable income (DI) is called the consumption
and expectations.
function. Its slope, which is used to predict the change
in consumption that will be caused by a change in 14. Policy makers cannot influence confidence in any reli-
income taxes, is called the marginal propensity to able way, so policies designed to spur investment focus
consume (MPC). on more objective, although possibly less important,
determinants of investment”such as interest rates
9. Changes in disposable income move us along a given
and taxes.
consumption function. Changes in any of the other vari-
ables that affect C shift the entire consumption function. 15. Net exports depend on GDPs and relative prices both
Among the most important of these other variables are domestically and abroad.

Aggregate demand 154 Disposable income (DI) 155 Movements along versus
shifts of the consumption
Consumer expenditure (C) 154 Circular flow diagram 155
function 161“162
Investment spending (I) 155 Transfer payments 157
Money-fixed assets 162
Government purchases (G) 155 Scatter diagram 158
Temporary versus permanent tax
Net exports (X 2 IM) 155 Consumption function 160


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