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Ironically, the villain of the piece is actually the economy’s strong productivity growth. If manufacturing and telecommunications workers had not become more productive over time, their real wages would not have risen. In that case, the real wages of teachers and doctors would not have had to keep pace, so their services would not have grown ever more expensive. Paradoxically, the enormous productivity gains that have blessed our economy and raised our standard of living also account for the problem of rising tuition costs. In the most literal sense, we are the victims of our own success.

GROWTH IN THE DEVELOPING COUNTRIES6

Ernest Hemingway once answered a query of F. Scott Fitzgerald’s by agreeing that, yes, the rich are different—they have more money! Similarly, whereas the main determinants of economic growth—increases in capital, improving technology, and rising workforce skills—are the same in both rich and poor countries, they look quite different in what is often called the Third World. This chapter has focused on growth in the industrialized countries so far. So let us now review the three pillars of productivity growth from the standpoint of the developing nations, using China as the most outstanding recent example of success.

The Three Pillars Revisited

Capital We noted earlier that many poor countries are poorly endowed with capital. Given their low incomes, they simply have been unable to accumulate the volumes of business capital (factories, equipment, and the like) and public capital (roads, bridges, airports, and so on) that we take for granted in the industrialized world. In a super-rich country like the United States, $150,000 or more worth of capital stands behind a typical worker, while in a poor African country the corresponding figure may be less than $500. No wonder the American worker is vastly more productive than his African counterpart.

But accumulating more capital can be exceptionally difficult in the developing world. We noted earlier that rich countries have a choice about how much of their resources to devote to current consumption versus investment for the future. But building capital for the future is a far more difficult task in poor countries, where much of the population may be living on the edge of survival and have little if anything to save for the future. For this reason, it has long been believed that development assistance, sometimes called foreign aid, is a crucial ingredient for growth in the developing world. Indeed, the World Bank was established in 1944 precisely to make low-interest development loans to poor countries.

Development assistance has always been controversial. Critics of foreign aid argue that the money is often not well spent. Without honest and well-functioning governments, well-defined property rights, and so on, they argue, the developing countries cannot and will not make good use of the assistance they receive. Supporters of foreign aid counter that the donor countries have been far too stingy. The United States, for example, donates only about 0.1 percent of its GDP each year. Can grants that amount to $60 per person— which is a fairly typical figure for the recipient countries—really be expected to make much difference?

While foreign aid can be critical in certain instances, it has certainly not been the secret to China’s success. Instead, the Chinese have shown a remarkable willingness and ability to save and invest—nearly half of GDP in recent years—despite their relatively low incomes. In addition, China has welcomed foreign direct investment, often by multinational corporations, which it has received in great volume.

Development assistance

(“foreign aid”) refers to outright grants and low-interest loans to poor countries from both rich countries and multinational institutions like the World Bank. The purpose is to spur economic development.

Foreign direct investment is the purchase or construction of real business assets—such as factories, offices, and machinery—in a foreign country.

Multinational corporations are corporations, generally large ones, that do business in many countries. Most, but not all, of these corporations have their headquarters in developed countries.

6 This section can be skipped in shorter courses.

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Technology You need only visit a poor country to see that the level of technology is generally far below what we in the West are accustomed to. In principle, this handicap should be easy to overcome. As noted in our discussion of the convergence hypothesis, people in poor countries don’t have to invent anything; they can just adopt technologies that have already been invented in the rich countries. And indeed, a number of formerly poor countries have followed this strategy with great success. South Korea, which was destitute in the mid-1950s, is a prime example. China is doing this today. Indeed, much of the foreign direct investment flowing into China brings Western technology along with it.

But as we observed earlier, many of the developing nations, especially the poorest ones, seem unable to join this “convergence club.” They may lack the necessary scientific and engineering know-how. They may be short on educated workers. They may be woefully undersupplied with the necessary infrastructure, such as transportation and communications systems. Or they may simply be plagued by incompetent or corrupt governments. Whatever the reasons, they have been unable emulate the technological advances of the West.

There are no easy solutions to this problem. One common suggestion is to encourage foreign direct investment by multinational corporations. Industrial giants like Toyota (Japan), IBM (United States), Siemens (Germany), and others bring their advanced technologies with them when they open a factory or office in a developing nation. They can train local workers and improve local transportation and communications networks. But, of course, these companies are foreign, and they come to make a profit—both of which may cause resentment in the local population.

For this and other reasons, many developing countries have not always welcomed foreign investment. China, as mentioned above, is a big exception: It has welcomed foreign investment with enthusiasm, especially for the technology it brings, and it has learned avidly and openly from the West. However, multinational companies are rarely tempted to open factories in the poorest developing countries, such as those in sub-Saharan Africa, where skilled labor is in short supply, transportation systems may be inadequate, and governments are often unstable and unreliable.

TABLE 4

Average Educational Attainment

in Selected Countries, 2000*

	United States	12.3
	Canada	11.4
	South Korea	10.5
	Japan	9.7
	United Kingdom	9.4
	Italy	7.0
	Mexico	6.7
	India	4.8
	Brazil	4.6
	Sudan	1.9

* For people older than 25 years of age

SOURCE: Web site accompanying R. Barro and J.-W. Lee, “International Data on Educational Attainment: Updates and Implications,” CID Working paper No. 42, Harvard University, 2000, http://www.cid.harvard.edu/ciddata/ ciddata.html.

Education and Training Huge discrepancies exist between the average levels of educational attainment in the rich and poor countries. Table 4 shows some data on average years of schooling in selected countries, both developed and developing. The differences are dramatic—ranging from a high of 12.3 years in the United States to less than 5 years in India and less than 2 years in the Sudan. In most industrialized countries, universal primary education and high rates of high school completion are already realities. But in many poor countries, even completing grade school may be the exception, leaving rudimentary skills such as reading, writing, and basic arithmetic in short supply. In such cases, expanding and improving primary education—including keeping children in school until they reach the age of 12—may be among the most cost-effective growth policies available. The problem is particularly acute in many traditional societies, where women are second-class citizens—or worse. In such countries, the education of girls may be considered unimportant or even inappropriate.

China, again, offers a stunning contrast. It is raising the educational attainment of its population rapidly. It is sending legions of students abroad to study science, engineering, business, and economics (among other things). And it is seeking to develop world-class universities of its own.

Some Special Problems of the Developing Countries

Accumulating capital, improving technology, and enhancing workforce skills are common ingredients of growth in rich and poor countries alike. But many Third World countries also must contend with some special handicaps to growth that are mostly absent in the West.

Geography Americans often forget how blessed we are geographically. We live in a temperate climate zone, on a land mass that has literally millions of acres of flat, fertile

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land that is ideal for agriculture. The fact that our nation literally stretches “from sea to shining sea” also means we have many fine seaports. Contrast this splendid set of geographical conditions with the situation of the world’s poorest region: sub-Saharan Africa. Many African nations are landlocked, have extremely hot climates, and/or are terribly short on arable land.

Health People in the rich countries rarely think about such debilitating tropical diseases as malaria. But they are rampant in many developing nations, especially in Africa. The AIDS epidemic, of course, is ravaging the continent. Although improvements in public health are important in all countries, they are literally matters of life and death in the poorest nations. And there is a truly vicious cycle here: Poor health is a serious impediment to economic growth, and poverty makes it hard to improve health standards.

Governance Complaining about low-quality or dishonest government is a popular pastime in many Western democracies. Americans do it every day. But most governments in industrialized nations are paragons of virtue and efficiency compared to the governments of some (though certainly not all) developing nations. As we have noted in this chapter, political stability, the rule of law, and respect for property rights are all crucial requirements for economic growth. By the same token, corruption and overregulation of business are obvious deterrents to investment. Lawlessness, tyrannical rule, and war are even more serious impediments. Unfortunately, too many poor nations have been victimized by a succession of corrupt dictators and tragic wars. It need hardly be said that those conditions are not exactly conducive to economic growth.

FROM THE LONG RUN TO THE SHORT RUN

Most of this chapter has been devoted to explaining and evaluating the factors underpinning the growth rate of potential GDP. Over long periods of time, the growth rates of actual and potential GDP match up pretty well. But, just like people, economies do not always live up to their potential. As we observed in the previous chapter, GDP in the United States often diverges from potential GDP as a result of macroeconomic fluctuations. Sometimes it is higher; sometimes it is lower. Indeed, whereas this chapter has studied the factors that determine the rate at which the GDP of a particular country can grow from one year to the next, we know that GDP occasionally shrinks—during periods we call recessions. To study these fluctuations, we must supplement the long-run theory of aggregate supply, which we have just described, with a short-run theory of aggregate demand— a task that begins in the next chapter.

| SUMMARY |

1.More capital, improved workforce quality (which is normally measured by the amount of education and training), and better technology all raise labor productivity and therefore shift the production function upward. They constitute the three main pillars of growth.

2.The growth rate of labor productivity depends on the rate of capital formation, the rate of improvement of workforce quality, and the rate of technical progress. So growth policy concentrates on speeding up these processes.

3.Capital formation can be encouraged by low real interest rates, favorable tax treatment, rapid technical

change, rapid growth of demand, and a climate of political stability that respects property rights. Each of these factors is at least influenced by policy.

4.Policies that increase education and training—the second pillar of growth—can be expected to make a country’s workforce more productive. They range from universal primary education to postgraduate fellowships in science and engineering.

5.Technological advances can be encouraged by more education, by higher rates of investment, and also by direct expenditures—both public and private—on research and development (R&D).

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6.The convergence hypothesis holds that countries with lower productivity levels tend to have higher productivity growth rates, so that poor countries gradually close the gap on rich ones.

7.One major reason to expect convergence is that technological know-how can be transferred quickly from the leading nations to the laggards. Unfortunately, not all countries seem able to benefit from this information transfer.

8.Productivity growth slowed precipitously in the United States around 1973, and economists are still not sure why.

9.Productivity growth in the United States has speeded up again since 1995, largely as a result of the information technology (IT) revolution.

10.Because many personal services—such as education, medical care, and police protection—are essentially

handicraft activities that are not amenable to labor-sav- ing innovations, they suffer from a cost disease that makes them grow ever more expensive over time.

11.The same three pillars of economic growth—capital, technology, and education—apply in the developing countries. But on all three fronts, conditions are much more difficult there—and improvements are harder to obtain.

12.The rich countries try to help with all three pillars by providing development assistance, and multinational corporations sometimes provide capital and better technology via foreign direct investment. But both of these mechanisms are surrounded by controversy.

13.Growth in many of the poor countries is also held back by adverse geographical conditions and/or corrupt governments.

Human capital 136 Convergence hypothesis 137 Capital 138

Investment 138 Capital formation 138 Property rights 140

| KEY TERMS |

On-the-job training 141		Development assistance 147
Invention	142	Foreign direct investment	147
Innovation	142	Multinational corporations	147

Research and development (R&D) 142

Cost disease of the personal services 146

| TEST YOURSELF |

1.The following table shows real GDP per hour of work in four imaginary countries in the years 1997 and 2007. By what percentage did labor productivity grow in each country? Is it true that productivity growth was highest where the initial level of productivity was the lowest? For which countries?

				Output per Hour
				1997	2007
	Countr y A	$40			$48
	Countr y B	$25			$35
	Countr y C	$		2	$	3
	Countr y D	$		0.50	$	0.60

2.Imagine that new inventions in the computer industry affect the growth rate of productivity as follows:

Year of	Following	5 Years	10 Years	20 Years
Invention	Year	Later	Later	Later
0%	21%	0%	12%	14%

Would such a pattern help explain U.S. productivity performance since the mid-1970s? Why?

3.Which of the following prices would you expect to rise rapidly? Why?

a.Cable television rates

b.Football tickets

c.Internet access

d.Household cleaning services

e.Driving lessons

4.Two countries have the production possibilities frontier (PPF) shown in Figure 3 on page 139. But Consumia chooses point C, whereas Investia chooses point I. Which country will have the higher PPF the following year? Why?

5.Show on a graph how capital formation shifts the production function. Use this graph to show that capital formation increases labor productivity. Explain in words why labor is more productive when the capital stock is larger.

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| DISCUSSION QUESTIONS |

1.Explain the different objectives of (long-run) growth policy versus (short-run) stabilization policy.

2.Explain why economic growth might be higher in a country with well-established property rights and a stable political system compared with a country where property rights are uncertain and the government is unstable.

3.Chapter 6 pointed out that, because faster capital formation comes at a cost (reduced current consumption), it is possible for a country to invest too much. Suppose the government of some country decides that its businesses are investing too much. What steps might it take to slow the pace of capital formation?

4.Explain why the best educational policies to promote faster growth might be different in the following countries.

a.Mozambique

b.Brazil

c.France

5.Comment on the following: “Sharp changes in the volume of investment in the United States help explain both the productivity slowdown in 1973 and the productivity speed-up in 1995.”

6.Discuss some of the pros and cons of increasing development assistance, both from the point of view of the donor country and the point of view of the recipient country.

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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.

JOHN MAYNARD KEYNES

T he last chapter focused on the determinants of potential GDP—the economy’s capacity 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 concepts 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 aggregate 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 issues 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.

C O N T E N T S

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

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154	PART 2 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 rebate 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 scurrying 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

Aggregate demand is the total amount that all consumers, business firms, government agencies, and foreigners spend on final goods and services.

Consumer expenditure (C) is the total amount spent by consumers on newly produced goods and services (excluding purchases of new homes, which are considered investment goods).

First, some vocabulary. We have already introduced the concept of gross domestic product 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, government agencies, and foreigners spend on U.S. final goods and services. The down- ward-sloping aggregate demand curve of Chapter 5 alerted us to the fact that aggregate demand is a schedule, not a fixed number—the actual numerical value of aggregate demand depends on the price level. Several reasons for this dependence will emerge in coming chapters.

But the level of aggregate demand also depends on a variety of other factors—such as consumer incomes, various government policies, and events in foreign countries. To understand the nature of aggregate demand, it is best to break it up into its major components, as we do now.

Consumer expenditure (consumption for short) is simply the total value of all consumer goods and services demanded. Because consumer spending constitutes more than

1 See Chapter 5, pages 87–91.

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	CHAPTER 8	Aggregate Demand and the Powerful Consumer			155
	two-thirds of total spending, it is the main focus of this chapter. We represent it by the				Investment spending (I)
	letter C.				is the sum of the expendi-
	Investment spending, represented by the letter I, was discussed extensively in the last				tures of business firms on
					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
	asset (such as money) for another form (such as a share of stock). When economists speak				physical assets.
	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-
	services, includes items such as paper, computers, airplanes, ships, and labor bought by				tion) purchased by all levels
	all levels of government. We use the symbol G for this variable.				of government.
	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).
	software, and banking services. So to obtain total demand for U.S. products, these goods				It indicates the difference
	and services must be added to U.S. domestic demand. Similarly, some items included in C				between what we sell to
					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
			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:		Journal.
	Aggregate demand is the sum of C 1 I 1 G 1 (X 2 IM).
			TheFromWall Street	SyndicateFeatures
	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		SOURCE:	Cartoon
	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

	available to spend or to save. For that reason, it will play a prominent role in	“When I refer to it as disposable
		income, don’t get the wrong idea.”
	this chapter and in subsequent discussions.

THE CIRCULAR FLOW OF SPENDING, PRODUCTION, AND INCOME

Enough definitions. How do these three concepts—domestic product, total expenditure, and national income—interact in a market economy? We can answer this best with a rather elaborate diagram (Figure 1 on the next page). For obvious reasons, Figure 1 is called a circular flow diagram. It depicts a large tube in which an imaginary fluid circulates in the clockwise direction. At several points along the way, some of the fluid leaks out or additional fluid is injected into the tube.

To examine this system, start on the far left. At point 1 on the circle, we find consumers. Disposable income (DI) flows into their pockets, and two things flow out: consumption (C), which stays in the circular flow, and saving (S), which “leaks out.” This outflow depicts the fact that consumers normally spend less than they earn and save the balance. The “leakage” to saving, of course, does not disappear; it flows into the financial system via banks, mutual funds, and so on. We defer consideration of what happens inside the financial system to Chapters 12 and 13.

2 More detailed information on these and other concepts is provided in the appendix to this chapter.

National income is the sum of the incomes that all individuals in the economy earn in the forms of wages, interest, rents, and profits. It excludes government transfer payments and is calculated before any deductions are taken for income taxes.

Disposable income (DI) is the sum of the incomes of all individuals in the economy after all taxes have been deducted and all transfer payments have been added.

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The Macroeconomy: Aggregate Supply and Demand

	FIGURE 1
	The Circular Flow of	Financial System
	Expenditures and
	Income
		S
		a
		v
		i
		n
		g
		(
		S
		)
		Consumers

		ndit	ur
	pe			e
x
E				s

						)
					C
					(
					n
				o
				i
				t							m
			p							t
			m						s
		u						e
	s
	n						v
C	o					n
						I

Investors

1

	)
	I
	(
	t
e	n
	2
	r	n	m
	e
	v
	o
	G

				C			+		L
										)
										G
									s	(
								e
							s
					c	h	a
				r
			u
		P
n	t
e

Government

3

C

+

L +

G

4

Rest of the

World

										)
								IM			)
							(
					s					X
			t
			r						(
		o						s
	p						t
m						r
I				o
			p
		x
	E

C +

I + G +

( X

– I M )

D i

s

p

o s a

b l e

I n c o m e ( DI)

T T r a a

n x s e f s e

r s

Firms

5 (produce the domestic product)

6

			s					)
							Y
		s				(
	ro					e
G
					m
				o
			c
al In
Nation

In

c

ome

The upper loop of the circular flow represents expenditures, and as we move clockwise to point 2, we encounter the first “injection” into the flow: investment spending (I). The diagram shows this injection as coming from “investors”—a group that includes both business firms and home buyers.3 As the circular flow moves past point 2, it is bigger than it was before: Total spending has increased from C to C 1 I.

At point 3, there is yet another injection. The government adds its demand for goods and services (G) to those of consumers and investors (C 1 I). Now aggregate demand has grown to C 1 I 1 G.

The next leakage and injection come at point 4. Here we see export spending entering the circular flow from abroad and import spending leaking out. The net effect of these two forces may increase or decrease the circular flow, depending on whether net exports are positive or negative. (In the United States today, they are strongly negative.) In either case, by the time we pass point 4, we have accumulated the full amount of aggregate demand,

C 1 I 1 G 1 (X 2 IM).

The circular flow diagram shows this aggregate demand for goods and services arriving at the business firms, which are located at point 5. Responding to this demand, firms produce the domestic product. As the circular flow emerges from the firms, however, we rename it gross national income. Why? The reason is that, except for some complications explained in the appendix,

National income and domestic product must be equal.

Why is this so? When a firm produces and sells $100 worth of output, it pays most of the proceeds to its workers, to people who have lent it money, and to the landlord who owns the property on which the plant is located. All of these payments represent income to some individuals. But what about the rest? Suppose, for example, that the firm pays wages, interest, and rent totaling $90 million and sells its output for $100 million. What happens to the remaining $10 million? The firm’s owners receive it as profits. Because these owners are citizens of the country, their incomes also count in national income.4

3You are reminded that expenditure on housing is part of I, not part of C.

4Some of the income paid out by American companies goes to noncitizens. Similarly, some Americans earn income from foreign firms. This complication is discussed in the appendix to this chapter.

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