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4.Gross domestic product is the total volume of final goods and services produced in the country.

5.National income is the sum of the before-tax wages, interest, rents, and profits earned by all individuals in the economy. By necessity, it must be approximately equal to domestic product.

6.Disposable income is the sum of the incomes of all individuals in the economy after taxes and transfers. It is the chief determinant of consumer expenditures.

7.All of these concepts, and others, can be depicted in a circular flow diagram that shows expenditures on all four sources flowing into business firms and national income flowing out.

8.The close relationship between consumer spending (C) and disposable income (DI) is called the consumption function. Its slope, which is used to predict the change in consumption that will be caused by a change in income taxes, is called the marginal propensity to consume (MPC).

9.Changes in disposable income move us along a given consumption function. Changes in any of the other variables that affect C shift the entire consumption function. Among the most important of these other variables are

Aggregate Demand and the Powerful Consumer

167

total consumer wealth, the price level, and expected future incomes.

10.Because consumers hold so many money-fixed assets, they lose purchasing power when prices rise, which leads them to reduce their spending.

11.The government often tries to manipulate aggregate demand by influencing private consumption decisions, usually through changes in the personal income tax. But this policy did not work well in 1975 or 2001.

12.Future income prospects help explain why. The 1975 tax cut was temporary and therefore left future incomes unaffected. The 2001 tax cut was also advertised as a one-time event.

13.Investment is the most volatile component of aggregate demand, largely because it is closely tied to confidence and expectations.

14.Policy makers cannot influence confidence in any reliable way, so policies designed to spur investment focus on more objective, although possibly less important, determinants of investment—such as interest rates and taxes.

15.Net exports depend on GDPs and relative prices both domestically and abroad.

Aggregate demand 154 Consumer expenditure (C) 154 Investment spending (I) 155 Government purchases (G) 155

Net exports (X 2 IM)	155
C 1 I 1 G 1 (X 2 IM)	155

National income 155

| KEY TERMS |

Disposable income (DI) 155 Circular flow diagram 155 Transfer payments 157 Scatter diagram 158 Consumption function 160

Marginal propensity to consume (MPC) 160

Movements along versus shifts of the consumption function 161–162

Money-fixed assets 162

Temporary versus permanent tax changes 164

| TEST YOURSELF |

1.What are the four main components of aggregate demand? Which is the largest? Which is the smallest?

2.Which of the following acts constitute investment according to the economist’s definition of that term?

a.Pfizer builds a new factory in the United States to manufacture pharmaceuticals.

b.You buy 100 shares of Pfizer stock.

c.A small drugmaker goes bankrupt, and Pfizer purchases its factory and equipment.

d.Your family buys a newly constructed home from a developer.

e.Your family buys an older home from another family. (Hint: Are any new products demanded by this action?)

3.On a piece of graph paper, construct a consumption function from the data given here and determine the MPC.

		Consumer	Disposable
	Year	Spending	Income
	2003	$1,200	$1,500
	2004	1,440	1,800
	2005	1,680	2,100
	2006	1,920	2,400
2007		2,160	2,700

4.In which direction will the consumption function shift if the price level rises? Show this on your graph from the previous question.

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| DISCUSSION QUESTIONS |

1.Explain the difference between investment as the term is used by most people and investment as defined by an economist.

2.What would the circular flow diagram (Figure 1) look like in an economy with no government? Draw one for yourself.

3.The marginal propensity to consume (MPC) for the United States as a whole is roughly 0.90. Explain in words what this means. What is your personal MPC at this stage in your life? How might that change by the time you are your parents’ age?

4.Look at the scatter diagram in Figure 3. What does it tell you about what was going on in this country in the years 1942 to 1945?

5.What is a consumption function, and why is it a useful device for government economists planning a tax cut?

6.Explain why permanent tax cuts are likely to lead to bigger increases in consumer spending than temporary tax cuts do.

7.In 2001 and again in 2003, Congress enacted changes in the tax law designed to promote saving. If such saving incentives had been successful, how would the consumption function have shifted?

8.(More difficult) Between 1990 and 1991, real disposable income (in 2000 dollars) barely increased at all, owing to a recession. (It rose from $5,324 billion to $5,352 billion.) Use the data on real consumption expenditures given on the inside back cover of this book to compare the change in C to this $28 billion change in DI. Explain why dividing the two does not give a good estimate of the marginal propensity to consume.

| APPENDIX | National Income Accounting

The type of macroeconomic analysis presented in this book dates from the publication of John Maynard Keynes’s The General Theory of Employment, Interest, and Money in 1936. But at that time, there was really no way to test Keynes’s theories because the necessary data did not exist. It took some years for the theoretical notions used by Keynes to find concrete expression in real-world data.

The system of measurement devised for collecting and expressing macroeconomic data is called national income accounting.

The development of this system of accounts ranks as a great achievement in applied economics, perhaps as important in its own right as was Keynes’s theoretical work. Without it, the practical value of Keynesian analysis would be severely limited. Economists spent long hours wrestling with the many difficult conceptual questions that arose as they translated the theory into numbers. Along the way, some more-or-less arbitrary decisions and conventions had to be made. You may not agree with all of them, but the accounting framework that was devised, though imperfect, is eminently serviceable.

DEFINING GDP:

EXCEPTIONS TO THE RULES

We first encountered the concept of gross domestic product (GDP) in Chapter 5.

Gross domestic product (GDP) is the sum of the money values of all final goods and services produced during a specified period of time, usually one year.

However, the definition of GDP has certain exceptions that we have not yet noted.

First, the treatment of government output involves a minor departure from the principle of using market prices. Unlike private products, the “outputs” of government offices are not sold; indeed, it is sometimes even difficult to define what those outputs are. Lacking prices for outputs, national income accountants fall back on the only prices they have: prices for the inputs from which the outputs are produced. Thus:

Government outputs are valued at the cost of the inputs needed to produce them.

This means, for example, that if a clerk at the Department of Motor Vehicles who earns $20 per hour spends one-half hour torturing you with explanations of why you cannot get a driver’s license, that particular government “service” increases GDP by $10.

Second, some goods that are produced but not sold during the year are nonetheless counted in that year’s GDP. Specifically, goods that firms add to their inventories count in the GDP even though they do not pass through markets.

National income statisticians treat inventories as if they were “bought” by the firms that produced them, even though these “purchases” do not actually take place.

Finally, the treatment of investment goods can be thought of as running slightly counter to the rule that GDP includes only final goods. In a broad sense, factories, generators, machine tools, and the like might be considered intermediate goods. After all, their owners want them only for use in producing other goods,

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not for any innate value that they possess. But this classification would present a real problem. Because factories and machines normally are never sold to consumers, when would we count them in GDP? National income statisticians avoid this problem by defining investment goods as final products demanded by the firms that buy them.

Now that we have a more complete definition of what the GDP is, let us turn to the problem of actually measuring it. National income accountants have devised three ways to perform this task, and we consider each in turn.

GDP AS THE SUM OF FINAL GOODS AND SERVICES

The first way to measure GDP is the most natural, because it follows so directly from the circular flow diagram (Figure 1). It also turns out to be the most useful definition for macroeconomic analysis. We simply add up the final demands of all consumers, business firms, government, and foreigners. Using the symbols Y, C, I, G, and (X 2 IM) as we did in the chapter, we have:

Y 5 C 1 I 1 G 1 (X 2 IM)

The I that appears in the actual U.S. national accounts is called gross private domestic investment.

We will explain the word gross presently. Private indicates that government investment is considered part of G, and domestic means that, say, machinery sold by American firms to foreign companies is included in exports rather than in I (investment).

Gross private domestic investment (I) includes business investment in plant, equipment, and software; residential construction; and inventory investment.

We repeat again that only these three things are investment in national income accounting terminology.

As defined in the national income accounts, investment includes only newly produced capital goods, such as machinery, factories, and new homes. It does not include exchanges of existing assets.

product that government uses up for its own purposes—to pay for armies, bureaucrats, paper, and ink—whereas transfer payments merely shuffle purchasing power from one group of citizens to another. Except for the administrators needed to run these programs, real economic resources are not used up in this process.

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 are used up by consumers, investors, government, and foreigners, respectively. Because transfer payments 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 transfers in G, the same spending would get counted twice: once in G and then again in C.

The final component of GDP is net exports, which are simply exports of goods and services minus imports of goods and services. Table 3 shows GDP for 2007, in both nominal and real terms, computed as the sum of C 1 I 1 G 1 (X 2 IM). Note that the numbers for net exports in the table are actually negative. We will say much more about America’s trade deficit in Part 4.

TABLE 3

Gross Domestic Product in 2007 as the Sum of Final Demands

		Nominal	Real
	Item	Amount*	Amount†
	Personal consumption	$9,734	$8,278
	expenditures (C)
	Gross private domestic	2,125	1,826
	investment (I)
	Government purchases	2,690	2,022
	of goods and ser vices (G)
	Net expor ts (X 2 IM)	2708	2556
	Expor ts (X)	1,643	1,410
	Impor ts (IM)	2,351	1,965
	Gross domestic product (Y)	13,841	11,567

*In billions of current dollars. †In billions of 2000 dollars.

SOURCE: U.S. Department of Commerce. Totals do not add up precisely due to rounding and method of deflating.

The symbol G, for government purchases, represents the volume of current goods and services purchased by all levels of government. Thus, all government payments to its employees are counted in G, as are all of its purchases of goods. Few citizens realize, however, that the federal government spends most of its money, not for purchases of goods and services, but rather on transfer payments—literally, giving away money—either to individuals or to other levels of government.

The importance of this conceptual distinction lies in the fact that G represents the part of the national

GDP AS THE SUM OF ALL

FACTOR PAYMENTS

We can count up the GDP another way: by adding up all incomes in the economy. Let’s see how this method handles some typical transactions. Suppose General Electric builds a generator and sells it to General Motors for $1 million. The first method of calculating GDP simply counts the $1 million as part of I. The second method asks: What incomes resulted from

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170 PART 2 The Macroeconomy: Aggregate Supply and Demand

producing this generator? The answer might be something like this:

	Wages of GE employees	$400,000
	Interest to bondholders	50,000
	Rentals of buildings	50,000
	Profits of GE stockholders	100,000

The total is $600,000. The remaining $400,000 is accounted for by inputs that GE purchased from other companies: steel, circuitry, tubing, rubber, and so on. But if we traced this $400,000 back even further, we would find that it is accounted for by the wages, interest, and rentals paid by these other companies, plus their profits, plus their purchases from other firms. In fact, for every firm in the economy, there is an accounting identity that says:

Wages paid HInterest paid11

Revenue from sales 5 Rentals paid 1 Profits earned 1

Purchases from other firms

Why must this always be true? Because profits are the balancing item; they are what is left over after the firm has made all other payments. In fact, this accounting identity really reflects the definition of profits: sales revenue less all costs.

Now apply this accounting identity to all firms in the economy. Total purchases from other firms are precisely what we call intermediate goods. What, then, do we get if we subtract these intermediate transactions from both sides of the equation?

	H	Wages paid 1
Revenue from sales minus		Interest paid 1
purchases from other firms 5		Rentals paid 1
		Profits earned

On the right-hand side, we have the sum of all factor incomes: payments to labor, land, and capital. On the left-hand side, we have total sales minus sales of intermediate goods. This means that we have sales of final goods, which is precisely our definition of GDP. Thus, the accounting identity for the entire economy can be rewritten as follows:

GDP 5 Wages 1 Interest 1 Rents 1 Profits

This definition gives national income accountants another way to measure the GDP.

Table 4 shows how to obtain GDP from the sum of all incomes. Once again, we have omitted a few details in our discussion. By adding up wages, interest, rents, and profits, we obtain only $11,180 billion, whereas GDP in 2007 was $13,841 billion. When sales taxes, excise taxes, and the like are added to the sum of wages,

TABLE 4

Gross Domestic Product in 2007 as the Sum of Incomes

Item	Amount
Compensation of employees (wages)	$7,874
plus
Net interest	603
plus
Rental income	65
plus
Profits	2,638
Corporate profits	1,595
Proprietors’ income	1,043
plus
Indirect business taxes and misc. items	1,041
equals
National income	12,221
plus
Statistical discrepancy	29
equals
Net national product	12,250
plus
Depreciation	1,687
equals
Gross national product	13,937
minus
Income received from other countries	818
plus
Income paid to other countries	722
equals
Gross domestic product	13,841

NOTE: Amounts are in billions of current dollars.

SOURCE: U.S. Department of Commerce. Totals do not add up precisely due to rounding.

interest, rents, and profits, we obtain what is called national income—the sum of all factor payments, including indirect business taxes.

National income is the sum of the incomes that all individuals in the country earn in the forms of wages, interest, rents, and profits. It includes indirect business taxes but excludes transfer payments and makes no deduction for income taxes.

Notice that national income is a measure of the factor incomes of all Americans, regardless of whether they work in this country or somewhere else. Likewise, incomes earned by foreigners in the United States are excluded from (our) national income. We will return to this distinction shortly.

But, reading down Table 4, we next encounter a new concept: net national product (NNP), a measure of production. For reasons explained in the chapter, NNP is conceptually identical to national income. However, in practice, national income accountants estimate income and production independently; and so the two measures are never precisely equal. The difference in 2007 was $29 billion, or just 0.2 percent of NNP; it is called the statistical discrepancy.

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Moving further down the table, the only difference between NNP and gross national product (GNP) is depreciation of the nation’s capital stock. Thus the adjective “net” means excluding depreciation, and “gross” means including it. GNP is thus a measure of all final production, making no adjustment for the fact that some capital is used up each year and thus needs to be replaced. NNP deducts the required replacements to arrive at a net production figure.

Depreciation is the value of the portion of the nation’s capital equipment that is used up within the year. It tells us how much output is needed just to maintain the economy’s capital stock.

From a conceptual point of view, most economists feel that NNP is a more meaningful indicator of the economy’s output than is GNP. After all, the depreciation component of GNP represents the output that is needed just to repair and replace worn-out factories and machines; it is not available for anybody to consume.10 Therefore, NNP seems to be a better measure of production than GNP.

Alas, GNP is much easier to measure because depreciation is a particularly tricky item. What fraction of his tractor did Farmer Jones “use up” last year? How much did the Empire State Building depreciate during 2007? If you ask yourself difficult questions like these, you will understand why most economists believe that we can measure GNP more accurately than NNP. For this reason, most economic models are based on GNP.

The final two adjustments that bring us to GDP return to a fact mentioned earlier. Some American citizens earn their incomes abroad, and some of the payments made by American companies are paid to foreign citizens. Thus, to obtain a measure of total production in the U.S. domestic economy (which is GDP) rather than a measure of the total production by U.S. nationals (which is GNP), we must subtract the income that Americans receive for factors supplied abroad and add the income that foreigners receive for factors supplied here. The net of these two adjustments is a very small number, as Table 4 shows. Thus, GDP and GNP are almost equal.

In Table 4, you can hardly help noticing the preponderant share of employee compensation in total factor payments—about 70 percent. Labor is by far the most important factor of production. The return on land is well under 1 percent of factor payments, and interest accounts for about 5 percent. Profits account for the remaining 24 percent, although the size of corporate profits (just 12 percent of GDP in 2007) is much less than the public thinks. If, by some magic stroke, we could convert all corporate profits into wages without

10 If the capital stock is used for consumption, it will decline, and the nation will wind up poorer than it was before.

upsetting the economy’s performance, the average worker would get a raise of about 20 percent!

GDP AS THE SUM OF VALUES ADDED

It may strike you as strange that national income accountants include only final goods and services in GDP. Aren’t intermediate goods part of the nation’s product? Of course they are. The problem is that, if all intermediate goods were included in GDP, we would wind up doubleand triple-counting certain goods and services and therefore get an exaggerated impression of the actual level of economic activity.

To explain why, and to show how national income accountants cope with this difficulty, we must introduce a new concept, called value added.

The value added by a firm is its revenue from selling a product minus the amount paid for goods and services purchased from other firms.

The intuitive sense of this concept is clear: If a firm buys some inputs from other firms, does something to them, and sells the resulting product for a price higher than it paid for the inputs, we say that the firm has “added value” to the product. If we sum up the values added by all firms in the economy, we must get the total value of all final products. Thus:

GDP can be measured as the sum of the values added by all firms.

To verify this fact, look back at the accounting identity in the left column bottom of page 170. The left-hand side of this equation, sales revenue minus purchases from other firms, is precisely the firm’s value added. Thus:

Value added 5 Wages 1 Interest 1 Rents 1 Profits

Because the second method we gave for measuring GDP is to add up wages, interest, rents, and profits, we see that the value-added approach must yield the same answer.

The value-added concept is useful in avoiding double-counting. Often, however, intermediate goods are difficult to distinguish from final goods. Paint bought by a painter, for example, is an intermediate good. But paint bought by a do-it-yourselfer is a final good. What happens, then, if the professional painter buys some paint to refurbish his own garage? The intermediate good becomes a final good. You can see that the line between intermediate goods and final goods is a fuzzy one in practice.

If we measure GDP by the sum of values added, however, we need not make such subtle distinctions. In this method, every purchase of a new good or service counts, but we do not count the entire selling price, only the portion that represents value added.

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To illustrate this idea, consider the data in Table 5 and how they would affect GDP as the sum of final products. Our example begins when a farmer who grows soybeans sells them to a mill for $3 per bushel. This transaction does not count in the GDP because the miller does not purchase the soybeans for her own use. The miller then grinds up the soybeans and sells the resulting bag of soy meal to a factory that produces soy sauce. The miller receives $4, but GDP still has not increased because the ground beans are also an intermediate product. Next, the factory turns the beans into soy sauce, which it sells to your favorite Chinese restaurant for $8. Still no effect on GDP.

TABLE 5

An Illustration of Final and Intermediate Goods

	Item	Seller	Buyer	Price
	Bushel of soybeans	Farmer	Miller	$3
	Bag of soy meal	Miller	Factor y	4
	Gallon of soy sauce	Factor y	Restaurant	8
	Gallon of soy sauce
	used as seasoning	Restaurant	Consumers	10
			Total: $25
	Addendum: Contribution to GDP $10

But then the big moment arrives: The restaurant sells the sauce to you and other customers as a part of your meals, and you eat it. At this point, the $10 worth of soy sauce becomes part of a final product and does count in the GDP. Notice that if we had also counted the three intermediate transactions (farmer to miller, miller to factory, factory to restaurant), we would have come up with $25—21⁄2 times too much.

Why is it too much? The reason is straightforward. Neither the miller, the factory owner, nor the restaurateur values the product we have been considering for its own sake. Only the customers who eat the final product (the soy sauce) have increased their material well-being, so only this last transaction counts in the GDP. However, as we shall now see, value-added

calculations enable us to come up with the right answer ($10) by counting only part of each transaction. The basic idea is to count at each step only the contribution to the value of the ultimate final product that is made at that step, excluding the values of items produced at other steps.

Ignoring the minor items (such as fertilizer) that the farmer purchases from others, the entire $3 selling price of the bushel of soybeans is new output produced by the farmer; that is, the whole $3 is value added. The miller then grinds the beans and sells them for $4. She has added $4 minus $3, or $1 to the value of the beans. When the factory turns this soy meal into soy sauce and sells it for $8, it has added $8 minus $4, or $4 more in value. Finally, when the restaurant sells it to hungry customers for $10, a further $2 of value is added.

The last column of Table 6 shows this chain of creation of value added. We see that the total value added by all four firms is $10, exactly the same as the restaurant’s selling price. This is as it must be, for only the restaurant sells the soybeans as a final product.

TABLE 6

An Illustration of Value Added

					Value
Item	Seller	Buyer		Price	Added
Bushel of
soybeans	Farmer	Miller		$3	$3
Bag of soy
meal	Miller	Factor y		4	1
Gallon of
soy sauce	Factor y	Restaurant		8		4
Gallon of soy
sauce used
as seasoning	Restaurant	Consumers		10	2
		Total:		$25	$10
Addendum: Contribution to GDP
Final Products			$10
Sum of values added			$10

| SUMMARY |

1.Gross domestic product (GDP) is the sum of the money values of all final goods and services produced during a year and sold on organized markets. There are, however, certain exceptions to this definition.

2.One way to measure the GDP is to add up the final demands of consumers, investors, government, and foreigners: GDP 5 C 1 I 1 G 1 (X 2 IM).

3.A second way to measure the GDP is to start with all factor payments—wages, interest, rents, and profits—that

constitute the national income and then add indirect business taxes and depreciation.

4.A third way to measure the GDP is to sum up the values added by every firm in the economy (and then once again add indirect business taxes and depreciation).

5.Except for possible bookkeeping and statistical errors, all three methods must give the same answer.

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	| KEY TERMS		|
National income accounting 168	National income 170		Depreciation	171
Gross domestic product	Net national product		Value added	171
(GDP) 168	(NNP)	170
Gross private domestic	Gross national product
investment (I) 169	(GNP)	171

| TEST YOURSELF |

1.Which of the following transactions are included in the gross domestic product, and by how much does each raise GDP?

a.You buy a new Toyota, made in the United States, paying $25,000.

b.You buy a new Toyota, imported from Japan, paying $25,000.

c.You buy a used Cadillac, paying $12,000.

d.Google spends $500 million to increase its Internet capacity.

e.Your grandmother receives a Social Security check for $1,500.

f.Chrysler manufactures 1,000 automobiles at a cost of $15,000 each. Unable to sell them, the company holds the cars as inventories.

g.Mr. Black and Mr. Blue, each out for a Sunday drive, have a collision in which their cars are destroyed. Black and Blue each hire a lawyer to sue the other, paying the lawyers $5,000 each for services rendered. The judge throws the case out of court.

h.You sell a used computer to your friend for $100.

2.The following outline provides a complete description of all economic activity in Trivialand for 2007. Draw up versions of Tables 3 and 4 for Trivialand showing GDP computed in two different ways.11

i.There are thousands of farmers but only two big business firms in Trivialand: Specific Motors (an auto company) and Super Duper (a chain of food markets). There is no government and no depreciation.

ii.Specific Motors produced 1,000 small cars, which it sold at $6,000 each, and 100 trucks, which it sold at $8,000 each. Consumers bought 800 of the cars, and the remaining 200 cars were exported to the United States. Super Duper bought all the trucks.

iii.Sales at Super Duper markets amounted to $14 million, all of it sold to consumers.

iv.All farmers in Trivialand are self-employed and sell all of their wares to Super Duper.

v.The costs incurred by all of Trivialand’s businesses were as follows:

		Specific Motors	Super Duper		Farmers
	Wages	$3,800,000	$4,500,000	$	0
	Interest	100,000	200,000		700,000
	Rent	200,000	1,000,000	2,000,000
	Purchases	0	7,000,000		0
	of food

3.(More difficult) Now complicate Trivialand in the following ways and answer the same questions. In addition, calculate national income and disposable income.12

a.The government bought 50 cars, leaving only 150 cars for export. In addition, the government spent $800,000 on wages and made $1,200,000 in transfer payments.

b.Depreciation for the year amounted to $600,000 for Specific Motors and $200,000 for Super Duper. (The farmers had no depreciation.)

c.The government levied sales taxes amounting to $500,000 on Specific Motors and $200,000 on Super Duper (but none on farmers). In addition, the government levied a 10 percent income tax on all wages, interest, and rental income.

d.In addition to the food and cars mentioned in Test Yourself Question 2, consumers in Trivialand imported 500 computers from the United States at $2,000 each.

11 In Trivialand, net national product and net domestic product are the same. So there are no entries corresponding to “income received from other countries” or “income paid to other countries,” as in Table 4.

12 In this context, disposable income is national income plus transfer payments minus taxes.

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| DISCUSSION QUESTIONS |

1.Explain the difference between final goods and intermediate goods. Why is it sometimes difficult to apply this distinction in practice? In this regard, why is the concept of value added useful?

2.Explain the difference between government spending and government purchases of goods and services (G). Which is larger?

3.Explain why national income and gross domestic product would be essentially equal if there were no depreciation.

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DEMAND-SIDE EQUILIBRIUM:

UNEMPLOYMENT OR INFLATION?

A definite ratio, to be called the Multiplier, can be established between income and investment.

JOHN MAYNARD KEYNES

L et’s briefly review where we have just been. In Chapter 5, we learned that the interaction of aggregate demand and aggregate supply determines whether the economy will stagnate or prosper, whether our labor and capital resources will be fully employed or unemployed. In Chapter 8, we learned that aggregate demand has four components: consumer expenditure (C), investment (I), government purchases (G), and net exports (X 2 IM). It is now time to start building a theory that puts the pieces together

so we can see where the aggregate demand and aggregate supply curves come from. Because it is best to walk before you try to run, our approach is sequential. We begin

in this chapter by assuming that taxes, the price level, the rate of interest, and the international value of the dollar are all constant. None of these assumptions is true, of course, and we will dispense with all of them in subsequent chapters. But we reap two important benefits from making these unrealistic assumptions now. First, they enable us to construct a simple but useful model of how the strength of aggregate demand influences the level of gross domestic product (GDP)—a model we will use to derive specific numerical solutions. Second, this simple model enables us to obtain an initial answer to a question of great importance to policy makers: Can we expect the economy to achieve full employment if the government does not intervene?

C O N T E N T S

	ISSUE: WHY DOES THE MARKET PERMIT	THE COORDINATION OF SAVING	THE MULTIPLIER AND THE AGGREGATE
	UNEMPLOYMENT?	AND INVESTMENT	DEMAND CURVE
	THE MEANING OF EQUILIBRIUM GDP	CHANGES ON THE DEMAND SIDE:	| APPENDIX A | The Simple Algebra of Income
	THE MECHANICS OF INCOME	MULTIPLIER ANALYSIS	Determination and the Multiplier
		The Magic of the Multiplier
	DETERMINATION		| APPENDIX B | The Multiplier with Variable
		Demystifying the Multiplier: How It Works
	THE AGGREGATE DEMAND CURVE		Imports
		Algebraic Statement of the Multiplier
	DEMAND-SIDE EQUILIBRIUM AND FULL	THE MULTIPLIER IS A GENERAL CONCEPT
	EMPLOYMENT

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176	PART 2 The Macroeconomy: Aggregate Supply and Demand
		ISSUE:	WHY DOES THE MARKET PERMIT UNEMPLOYMENT?

Economists are fond of pointing out, with some awe, the amazing achievements of free markets. Without central direction, they somehow get businesses to produce just the goods and services that consumers want—and to do so cheaply and efficiently. If consumers want less meat and more fish, markets respond. If people subsequently change their minds, markets respond again. Free markets seem able to coordinate literally millions of

decisions effortlessly and seamlessly.

Yet for hundreds of years and all over the globe, market economies have stumbled over one particular coordination problem: the periodic bouts of mass unemployment that we call recessions and depressions. Widespread unemployment represents a failure to coordinate economic activity in the following sense. If the unemployed were hired, they would be able to buy the goods and services that businesses cannot sell. The revenues from those sales would, in turn, allow firms to pay the workers. So a seemingly straightforward “deal” offers jobs for the unemployed and sales for the firms. But somehow this deal is not made. Workers remain unemployed and firms get stuck with unsold output.

Thus, free markets, which somehow manage to get rough diamonds dug out of the ground in South Africa and turned into beautiful rings that grooms buy for brides in Los Angeles, cannot seem to solve the coordination problem posed by unemployment. Why not? For centuries, economists puzzled over this question. By the end of the chapter, we will be well on the way toward providing an answer.

THE MEANING OF EQUILIBRIUM GDP

Equilibrium refers to a situation in which neither consumers nor firms have any incentive to change their behavior. They are content to continue with things as they are.

First, let’s put the four components of aggregate demand together to see how they interact, using as our organizing framework the circular flow diagram from the last chapter. In doing so, we initially ignore a possibility raised in earlier chapters: that the government might use monetary and fiscal policy to steer the economy in some desired direction. Aside from pedagogical simplicity, there is an important reason for doing so. One of the crucial questions surrounding stabilization policy is whether the economy would automatically gravitate toward full employment if the government simply left it alone. Contradicting the teachings of generations of economists before him, Keynes claimed it would not. But Keynes’s views are controversial to this day. We can study the issue best by imagining an economy in which the government never tries to manipulate aggregate demand, which is just what we do in this chapter.

To begin to construct such a model, we must first understand what we mean by equilibrium GDP. Figure 1, which repeats Figure 1 from the last chapter, is a circular flow diagram that will help us do this. As explained in the last chapter, total production and total income must be equal. But the same need not be true of total spending. Imagine that, for some reason, the total expenditures made after point 4 in the figure, C 1 I 1 G 1 (X 2 IM), exceed the output produced by the business firms at point 5. What happens then?

Because consumers, businesses, government, and foreigners together are buying more than firms are producing, businesses will start pulling goods out of their warehouses to meet demand. Thus, inventory stocks will fall—which signals retailers that they need to increase their orders and manufacturers that they need to step up production. Consequently, output is likely to rise.

At some later date, if evidence indicates that the high level of spending is not just a temporary aberration, manufacturers and retailers may also respond to buoyant sales performances by raising their prices. Economists therefore say that neither output nor the price level is in equilibrium when total spending exceeds current production.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.