Product Markets and National Output

Product Markets and

National Output

Chapter 12

Discussion TopicsCircular flow of paymentsComposition and measurement of gross

domestic productConsumption, saving and investmentEquilibrium national income and output

Circular Flow Diagramfor the

General Economy

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Financial Markets

Circular Flow of PaymentsWe can measure macroeconomic

activity in either: Resource markets (Expenditures) Product markets (Income) Result is the same

There are 4 major sectors to the overall economy

4

Government

HouseholdsBusinesses

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Financial Markets

Circular Flow of Payments

5

NetSaving

NetBorrowing

Financial Markets Businesses are net borrowers Households are net savers Government is a net borrower

Government

HouseholdsBusinesses

Net GovernmentBorrowing

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Government

Circular Flow of Payments

6

NetSaving

NetBorrowing

Financial Markets Businesses are net borrowers Households are net savers Government is a net borrower

Government Receives net tax inflows from businesses

and households

Net GovernmentBorrowing

Net TaxesNet Taxes

Businesses HouseholdsFinancial Markets

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HouseholdsFinancial MarketsBusinesses

Government

Circular Flow of Payments

7

NetSaving

NetBorrowing

Expenditures Businesses: Investment expenditures Gov’t makes expenditures Households: Consumption expenditures

Net GovernmentBorrowing

Net TaxesNet Taxes

Total Expenditures(National Product) C

onsumer E

xpenditures

Gov’t Exp.Business Expenditures

Product Markets

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Businesses

Government

Circular Flow of Payments

8

NetSaving

NetBorrowing

Income Businesses: Receive total expenditures from Product Markets Households: Receive wages, rents, interest and profits in

resource markets for labor and capital services

Net GovernmentBorrowing

Net TaxesNet Taxes

Total Expenditures(National Product) C

onsumer E

xpenditures

Tota

l Exp

endi

ture

s

Gov’t Exp.Business Expenditures

Resource Markets

Product Markets

Wages + Rents + Interest + Profits

Financial Markets Households

Retained Earnings

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Measurement of U.S. Output

9

A nation’s annual output is referred to as the Gross Domestic Product (GDP)

Two approaches to measure GDP levels Expenditures Approach: Measures activity

in the product market Consume Expenditures, Investment,

Government Expenditures, Net Exports Income Approach: Measures activity in the

resources market Wages, Rents, Interest, Profits

Measurement ofGross Domestic Product

10

11

Bil. $ GDP %

Gross Domestic Product (GDP) 14,660.2

Personal Consumption Expenditures

Total   10,351.9 70.6    Goods   3,427.6   23.4  

Services   6,924.3   47.2  

Gross Private Domestic Investment

Total   1,821.4 12.4    Fixed Invest. Total 1,752.8   12.0  

  Nonresidential Structures 381.8     2.6

  Producers Durable Equip. 1,030.7     7.0

  Residential 340.4     2.4 Δ Inventory 68.5   0.4  

Net Exports of Goods and Services

Net exports   -515.5 -3.5    Exports   1,837.1   12.5  Imports   2,352.6   -16.0  

Government Consumption

Expenditures and Gross Investment

Total   3,002.3 20.5    Federal Total 1,214.4   8.3  

  Defense 817.8     5.6  Nondefense 396.6     2.7State & Local   1,788.0   12.2  

2010 U.S. Gross Domestic Product

GDP = C + I + G + (X – M)

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Measurement of U.S. Output

12

Recession: A general slowdown in economic activityGDP, employment, investment spending,

capacity utilization, household incomes business profits and inflation all ↓

One definition: 2 consecutive quarters of declines in real GDP

NBER definition: a significant ↓ in economic activity spread across the economyLasting more than a few months↓ in real GDP, real income, employment,

industrial production, and wholesale-retail sales

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-3.00

-1.75

-0.50

0.75

2.00

3.25

4.50

5.75

7.00

8.25

Real % Change in U.S. GDP

Measurement of U.S. Output

A % change below zero represents a recession

0

1974-75

1981-82

1990-91

2008-09

13

What’s in GDP?

14

15 Page 226

Types of consumerexpenditures…

Types of investmentexpenditures…

16 Page 226

Calculation of net exports…

Not inGDP…

Types of governmentexpenditures…

Understanding the Domestic

Determinants of GDP,C, I and G

17

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Autonomous orfixed consumption

Aggregate Consumption Function

Disposable personal income (DPI) = personal income after payment of taxes

Aggregate consumption function slope defined as the marginal propensity to consume (MPC) whereMPC = C ÷ YD

and YD is disposable incomeMPC = $2,100 ÷ $3,000 = 0.70

18

GDP = C + I + G + (X – M)

Aggregate: Total U.S. economy

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Aggregate Consumption Function

The consumption functionin this graph can beexpressed mathematically as:C = AC + MPC x DPI→ C = $1,500 + 0.70 x $3,000 = $3,600 (Bil)(consumers would be dis-savingby $600 (Bil))

19

GDP = C + I + G + (X – M)

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An ↑ in DPI to $4,000 (Bil) would ↑ expenditures to $4,300 (Bil)(Dis-saving would ↓ to $300 (Bil))

Aggregate Consumption Function

C = $1,500 + .70 x $4,000 = $4,300 (Bil)

20

GDP = C + I + G + (X – M)

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Aggregate Consumption Function

C = $1,500 + .70 x $5,000 = $5,000 (Bil)

An ↑ in DPI to $5,000 (Bil) would ↑ expenditures to $5,000 (Bil)

(Dis-saving would ↓ to 0)

21

GDP = C + I + G + (X – M)

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Aggregate Consumption Function

How can we determine what DPI results in dis-savings being 0? Intersection of 450 line

from the origin with the aggregate consumption function

Line shows where DPI = consumption expenditures

22

450

GDP = C + I + G + (X – M)

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Aggregate Consumption Function

23

What would happen if aggregate income ↑ to $6,000 (Bil)

C = $1,500 + .70 x $6,000 = $5,700 (Bil)→a savings of $300 Bil. Not surprising given that only 70% of

DPI is being used for consumer expenditures

Aggregate Savings

24

As noted above, the slope of the aggregate consumption function is the MPC (= C ÷ DPI)

Savings is defined as: S = DPI – CAssumes that DPI can either be spent

or saved

→ The Marginal Propensity to Save (MPS) is defined as: MPS = 1.0 – MPCThe % of DPI that will put towards

savings Page 228 and 230

When the savings rate ↑ significantly, a recession is often near

25

GDP = C + I + G + (X – M)

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Aggregate Consumption Function

Example of fiscal policy: A ↓ in the tax rate ↑

consumption as DPI (= PI – Taxes) ↑

26

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Aggregate Consumption Function

Alternatively: An ↑ in the tax rate

↓ consumption as DPI is ↓

27

GDP = C + I + G + (X – M)

Concept of Wealth

28

Wealth is the net worth of a person, household, or nationNet worth is the value of all assets owned net

of all liabilities owedNet Worth = Assets - Liabilities

Assets = Anything tangible or intangible that is capable of being owned or controlled to produce value

Liabilities = an obligation of an entity arising from past transactions or events Liabilities are debts and obligations of an

economic agent and represent creditors claim on assets

For national wealth calculations net liabilities are those owed to the rest of the world

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Real Wealth Effect on Consumption

Suppose stock market prices ↑, ↑ real wealth of consumers by $700 (Bil)

29

GDP = C + I + G + (X – M)

This would ↑ AC by $700

C = $2,200 + .70 x DPI

C = $1,500 + .70 x DPI

30 Page 230

Real Wealth Effect

C = $2,200 + .70 x $4,000 = $5,000

Wealth effect:Shifts the curve

upward for each income level

At $4,000 (Bil)↑ consumer spending to $5,000 (Bil)

↑ dis-saving to $1,000 (Bil) from $300 (Bil)

↑ debt relative to income

Real Wealth Effect on Consumption GDP = C + I + G

+ (X – M)

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Aggregate Investment Function

I = AI – MEI x IR

Investment function slope is the marginal efficiency of investment (MEI)

MEI = I ÷ IRI = f(IR)

GDP = C + I + G + (X – M)

31

Level of autonomousinvestment spending(i.e., independent of IR)IR = interest rate

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Aggregate Investment Function

I = $475 – 25(9.0)

Level of investmentexpenditures wouldbe $250 at an interestrate of 9% if MEI = 25

32

GDP = C + I + G + (X – M)

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Aggregate Investment Function

If IR ↓ to 7% investmentexpenditures would ↑from $250 to $300.

I = $475 – 25 x 7.0 = $300

33

GDP = C + I + G + (X – M)

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Effects of Profit Expectationson Aggregate Investments

I = $525 – 25(7.0)

An ↑ in profit expectations → AI ↑ and planned

investment expend. at the same IR

At 7% IR investment ↑by $50

GDP = C + I + G + (X – M)

34

Understanding the Product Market

Equilibrium

35

Aggregate ExpendituresConsumption expenditures function (Bil $):

C = $1,500 + 0.70 x DPIInvestment expenditures function (Bil $):

I = $475 – 25 x IRGovernment expenditures function (Bil $):

G = $880Aggregate Expenditures (AE) = C + I + G

If the interest rate (IR) = 7% AE = ($1,500 + 0.70 x DPI) + ($475 – 25 x 7) + $880

= $2,680 + (0.70 x DPI)

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GDP = C + I + G + (X – M) = AE + (X – M)

C I G

36

Aggregate Expenditures Aggregate expenditures equation: AE = $2,680 + 0.70 x (NI – Taxes Paid)

where NI (National Income) = Wages + Rents + Interest + Profits

Lets assume that the amount of taxes = $400 If national income is $6,000, then

AE = $2,680+ 0.70 x ($6,000 - $400) = $6,600

which represents the 1st line in Table 12.4 Repeating this for other levels of national

income generates the following graph Page 235

DPI

GDP = AE + (X – M)

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Aggregate Expenditures Curve

Total autonomousdomestic spending…

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Aggregate Expenditures Curve

National Income

Point where C + I + G = NI

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Deriving The Aggregate Demand Curve

Demand equals supply Corresponding price level

Aggregatedemand curve

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Aggregate Supply Curve

Three distinct rangesof aggregate supplycurve

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Aggregate Supply Curve

End of depressionor Keynesian range

Maximum potentialoutput in the shortrun…

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YFE represents full employment outputYE represents current or actual outputYPOT represents potential or maximum output

Product Market Equilibrium

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Product Market Equilibrium

Planned spending exceedsfull employment output,causing higher inflationarypressures in economy.

Planned spending less thanfull employment output,causing underutilization ofeconomy’s resources.

YE > YFE

YFE > YE

SummaryGDP consists of C, I, G and (X-M) Consumption influenced by disposable

income and wealthInvestment influenced by interest rates

and profit expectationsProduct market equilibrium occurs where

aggregate demand equals aggregate supply

Inflationary and recessionary gaps occur when economy not at full employment output