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changes 164
C 1 I 1 G 1 (X 2 IM) 155 Marginal propensity to consume
(MPC) 160
National income 155

1. What are the four main components of aggregate 3. On a piece of graph paper, construct a consumption
demand? Which is the largest? Which is the smallest? function from the data given here and determine the
2. Which of the following acts constitute investment accord-
ing to the economist™s definition of that term?
Consumer Disposable
a. Pfizer builds a new factory in the United States to
Year Spending Income
manufacture pharmaceuticals.
2003 $1,200 $1,500
b. You buy 100 shares of Pfizer stock.
2004 1,440 1,800
c. A small drugmaker goes bankrupt, and Pfizer pur- 2005 1,680 2,100
chases its factory and equipment. 2006 1,920 2,400
2007 2,160 2,700
d. Your family buys a newly constructed home from a
e. Your family buys an older home from another family. 4. In which direction will the consumption function shift if
(Hint: Are any new products demanded by this the price level rises? Show this on your graph from the
action?) previous question.

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Part 2
168 The Macroeconomy: Aggregate Supply and Demand

1. Explain the difference between investment as the term is 6. Explain why permanent tax cuts are likely to lead to big-
used by most people and investment as defined by an ger increases in consumer spending than temporary tax
economist. cuts do.
2. What would the circular flow diagram (Figure 1) look 7. In 2001 and again in 2003, Congress enacted changes in
like in an economy with no government? Draw one for the tax law designed to promote saving. If such saving
yourself. incentives had been successful, how would the con-
sumption function have shifted?
3. The marginal propensity to consume (MPC) for the
United States as a whole is roughly 0.90. Explain in 8. (More difficult) Between 1990 and 1991, real disposable
words what this means. What is your personal MPC at income (in 2000 dollars) barely increased at all, owing to
this stage in your life? How might that change by the a recession. (It rose from $5,324 billion to $5,352 billion.)
time you are your parents™ age? Use the data on real consumption expenditures given on
the inside back cover of this book to compare the change
4. Look at the scatter diagram in Figure 3. What does it tell
in C to this $28 billion change in DI. Explain why divid-
you about what was going on in this country in the
ing the two does not give a good estimate of the
years 1942 to 1945?
marginal propensity to consume.
5. What is a consumption function, and why is it a useful
device for government economists planning a tax cut?

| APPENDIX | National Income Accounting
The type of macroeconomic analysis presented in this However, the definition of GDP has certain exceptions
book dates from the publication of John Maynard that we have not yet noted.
Keynes™s The General Theory of Employment, Interest, and First, the treatment of government output in-
Money in 1936. But at that time, there was really no volves a minor departure from the principle of using
way to test Keynes™s theories because the necessary market prices. Unlike private products, the “out-
data did not exist. It took some years for the theoreti- puts” of government offices are not sold; indeed, it is
cal notions used by Keynes to find concrete expression sometimes even difficult to define what those out-
in real-world data. puts are. Lacking prices for outputs, national income
accountants fall back on the only prices they have:
The system of measurement devised for collecting and
prices for the inputs from which the outputs are
expressing macroeconomic data is called national
produced. Thus:
income accounting.
Government outputs are valued at the cost of the inputs
The development of this system of accounts ranks
needed to produce them.
as a great achievement in applied economics, perhaps
as important in its own right as was Keynes™s theoreti- This means, for example, that if a clerk at the Depart-
cal work. Without it, the practical value of Keynesian ment of Motor Vehicles who earns $20 per hour
analysis would be severely limited. Economists spent spends one-half hour torturing you with explanations
long hours wrestling with the many difficult concep- of why you cannot get a driver™s license, that particu-
tual questions that arose as they translated the theory lar government “service” increases GDP by $10.
into numbers. Along the way, some more-or-less arbi- Second, some goods that are produced but not sold
trary decisions and conventions had to be made. You during the year are nonetheless counted in that year™s
may not agree with all of them, but the accounting GDP. Specifically, goods that firms add to their inven-
framework that was devised, though imperfect, is em- tories count in the GDP even though they do not pass
inently serviceable. through markets.
National income statisticians treat inventories as if they
DEFINING GDP: were “bought” by the firms that produced them, even
EXCEPTIONS TO THE RULES though these “purchases” do not actually take place.

Finally, the treatment of investment goods can be
We first encountered the concept of gross domestic thought of as running slightly counter to the rule that
product (GDP) in Chapter 5. GDP includes only final goods. In a broad sense, fac-
tories, generators, machine tools, and the like might be
Gross domestic product (GDP) is the sum of the money
considered intermediate goods. After all, their owners
values of all final goods and services produced during a
want them only for use in producing other goods,
specified period of time, usually one year.

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Chapter 8 169
Aggregate Demand and the Powerful Consumer

not for any innate value that they possess. But this product that government uses up for its own
classification would present a real problem. Because purposes”to pay for armies, bureaucrats, paper, and
factories and machines normally are never sold to ink”whereas transfer payments merely shuffle pur-
consumers, when would we count them in GDP? chasing power from one group of citizens to another.
National income statisticians avoid this problem Except for the administrators needed to run these
by defining investment goods as final products programs, real economic resources are not used up in
demanded by the firms that buy them. this process.
Now that we have a more complete definition of In adding up the nation™s total output as the sum of
C 1 I 1 G 1 (X 2 IM), we sum the shares of GDP that
what the GDP is, let us turn to the problem of actually
measuring it. National income accountants have de- are used up by consumers, investors, government,
vised three ways to perform this task, and we consider and foreigners, respectively. Because transfer pay-
each in turn. ments merely give someone the capability to spend on
C, it is logical to exclude transfers from our definition
of G, including in C only the portion of these transfer
payments that consumers spend. If we included trans-
AND SERVICES fers in G, the same spending would get counted twice:
once in G and then again in C.
The first way to measure GDP is the most natural,
The final component of GDP is net exports, which
because it follows so directly from the circular flow
are simply exports of goods and services minus im-
diagram (Figure 1). It also turns out to be the most
ports of goods and services. Table 3 shows GDP for
useful definition for macroeconomic analysis. We
2007, in both nominal and real terms, computed as
simply add up the final demands of all consumers,
the sum of C 1 I 1 G 1 (X 2 IM). Note that the num-
business firms, government, and foreigners. Using
bers for net exports in the table are actually negative.
the symbols Y, C, I, G, and (X 2 IM) as we did in the
We will say much more about America™s trade deficit
chapter, we have:
in Part 4.
Y 5 C 1 I 1 G 1 (X 2 IM)
The I that appears in the actual U.S. national ac-
counts is called gross private domestic investment. Gross Domestic Product in 2007 as the Sum
of Final Demands
We will explain the word gross presently. Private indi-
cates that government investment is considered part Nominal Real
of G, and domestic means that, say, machinery sold by Item Amount* Amount†
American firms to foreign companies is included in Personal consumption $9,734 $8,278
exports rather than in I (investment). expenditures (C)
Gross private domestic 2,125 1,826
Gross private domestic investment (I) includes busi-
investment (I)
ness investment in plant, equipment, and software; resi- Government purchases 2,690 2,022
dential construction; and inventory investment. of goods and services (G)
Net exports (X 2 IM) 2708 2556
We repeat again that only these three things are invest- Exports (X) 1,643 1,410
ment in national income accounting terminology. Imports (IM) 2,351 1,965
Gross domestic product (Y) 13,841 11,567
As defined in the national income accounts, investment
includes only newly produced capital goods, such as ma- *In billions of current dollars.
chinery, factories, and new homes. It does not include †In billions of 2000 dollars.
SOURCE: U.S. Department of Commerce. Totals do not add up precisely due to
exchanges of existing assets. rounding and method of deflating.

The symbol G, for government purchases, repre-
sents the volume of current goods and services
purchased by all levels of government. Thus, all govern-
ment payments to its employees are counted in G, as
are all of its purchases of goods. Few citizens realize,
We can count up the GDP another way: by adding up
however, that the federal government spends most of
all incomes in the economy. Let™s see how this method
its money, not for purchases of goods and services, but
handles some typical transactions. Suppose General
rather on transfer payments”literally, giving away
Electric builds a generator and sells it to General
money”either to individuals or to other levels of
Motors for $1 million. The first method of calculating
GDP simply counts the $1 million as part of I. The
The importance of this conceptual distinction lies
second method asks: What incomes resulted from
in the fact that G represents the part of the national

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

producing this generator? The answer might be TA BL E 4
something like this: Gross Domestic Product in 2007 as the Sum of Incomes

Item Amount
Wages of GE employees $400,000
Interest to bondholders 50,000 Compensation of employees (wages) $7,874
Rentals of buildings 50,000 plus
Profits of GE stockholders 100,000 Net interest 603
Rental income 65
The total is $600,000. The remaining $400,000 is ac- plus
counted for by inputs that GE purchased from other Profits 2,638
companies: steel, circuitry, tubing, rubber, and so on. Corporate profits 1,595
Proprietors™ income 1,043
But if we traced this $400,000 back even further, we
would find that it is accounted for by the wages, inter-
Indirect business taxes and misc. items 1,041
est, and rentals paid by these other companies, plus equals
their profits, plus their purchases from other firms. In 12,221
National income
fact, for every firm in the economy, there is an account- plus
Statistical discrepancy 29
ing identity that says:
Wages paid 1

Net national product
Interest paid 1
Depreciation 1,687
Rentals paid 1
Revenue from sales 5 equals
Profits earned 1 13,937
Gross national product
Purchases from minus
other firms Income received from other countries 818
Why must this always be true? Because profits are Income paid to other countries 722
the balancing item; they are what is left over after the equals
Gross domestic product 13,841
firm has made all other payments. In fact, this ac-
counting identity really reflects the definition of prof- NOTE: Amounts are in billions of current dollars.
its: sales revenue less all costs. SOURCE: U.S. Department of Commerce. Totals do not add up precisely due to
Now apply this accounting identity to all firms in the
economy. Total purchases from other firms are pre-
cisely what we call intermediate goods. What, then, do interest, rents, and profits, we obtain what is called
we get if we subtract these intermediate transactions national income”the sum of all factor payments,
from both sides of the equation? including indirect business taxes.

Wages paid 1 National income is the sum of the incomes that all indi-
Revenue from sales minus Interest paid 1 viduals in the country earn in the forms of wages, inter-
5 Rentals paid 1
purchases from other firms est, rents, and profits. It includes indirect business taxes
Profits earned but excludes transfer payments and makes no deduc-
tion for income taxes.


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