MACROECONOMICS. Major Components of GDP. Consumption. Real consumption as a share of GDP. In this chapter, look for the answers to these questions:

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1 Major Components of GDP P R I N C I P L E S O F MACROECONOMICS F I F T H E D I T I O N N. G R E G O R Y M A N K I W PowerPoint Slides by Luiggi Donayre 2007 Thomson South-Western, all rights reserved In this chapter, look for the answers to these questions: What is the consumption function? What is the marginal propensity to consume? What variables shift the consumption function? What are the demand-side and supply-side roles of consumption and savings? Why is investment highly procyclical and volatile? How can the government reduce its deficit? MAJOR COMPONENTS OF GDP 1 Consumption Real consumption as a share of GDP Consumption is the largest component of GDP. It consists of all gg&ss bought by households. The only exception is the purchase of new houses (counted as residential investment). The share of consumption has risen from about 64% in the 1950s to about 74% in recent years. 72.0% 70.0% 68.0% 66.0% 64.0% 62.0% 60.0% Jan-60 Jan-62 Jan-64 Jan-66 Jan-68 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 MAJOR COMPONENTS OF GDP 2 MAJOR COMPONENTS OF GDP 3 1

2 Percent change from 4 quarters earlier Average growth rate Growth rates of real GDP, consumption 10 Real GDP Consumption MAJOR COMPONENTS OF GDP 4 Consumption This increase in consumption has been a source of strength for U.S. aggregate demand. Strong consumption leads to high sales and high output. Demand side argument: consumption increases output. High consumption implies low savings. Thus, the increase in consumption has led to a reduction in the savings rate. Supply side argument: low savings imply fewer resources for capital accumulation. MAJOR COMPONENTS OF GDP 5 Consumption and income Psychological law fundamental psychological law : the more income people have, the more they will consume (J.M. Keynes, 1936). Equivalently, when peoples incomes fall, they will consume less. This law can be seen at work in recessions and booms. Usually, consumption declines (or, at least, its growth slows substantially) in recessions, and it grows fast in booms. Consumption and income Marginal propensity to consume (MPC) The MPC refers to the change in consumption that occurs from a change in income: the amount that will be spent from an additional $1 of income It is assumed to be between 0 and 1. It is positive because of the psychological law. Conversely, the marginal propensity to save (MPS) is the reciprocal of the MPC: MPS = 1 - MPC MAJOR COMPONENTS OF GDP 6 MAJOR COMPONENTS OF GDP 7 2

3 Consumption is described by: where: C = a + by C = consumption a = autonomous consumption b = MPC The constant a is literally the amount of consumption necessary no matter how much income a person has. Movements along the consumption function associated with changes in disposable income. Holding everything else constant, if disposable income Y changes, then there s a movement a long the curve. Relation between slope and the consumption function The algebraic consumption function describes a standard linear equation of slope-intercept form. MAJOR COMPONENTS OF GDP 8 MAJOR COMPONENTS OF GDP 9 Wealth changes: distinction between wealth and income. If consumers have high wealth, they will spend more for every level of income: Wealth is a stock variable. It s the value of all possessions of a person at a point in time. Income is a flow variable. It s the amount earned over a period of time. High consumer wealth will cause a larger value of a. That is, an upward shift in the consumption function. C a 0 a 1 High wealth Low wealth Example: a drop in stock market prices causes a decrease in wealth. Thus, consumption decreases at every value of Y. It s an exogenous consumption shock Y MAJOR COMPONENTS OF GDP 10 MAJOR COMPONENTS OF GDP 11 3

4 Interest rates The interest rate is a reward for savings. So, if interest rates are high, people will save more. This discourages consumption. The link between interest rates and consumption constitutes one way in which the Fed affects overall macroeconomic activity. If interest rates decline, consumers will spend more at every level of income: C a 0 a 1 Low interest rates High interest rates Example: an reduction in interest rates shrinks the reward for savings. Therefore, at every value of Y, consumers save less. It s an exogenous consumption shock that causes a to shift. Y MAJOR COMPONENTS OF GDP 12 MAJOR COMPONENTS OF GDP 13 Expect. of future income: consumer confidence. Consumers make their spending decisions based, not only on current income or wealth, but also with an eye toward future conditions. Index of consumer confidence: monthly survey of American consumers. When the index falls, Americans are more concerned about the future and therefore, cut back their spending plans. - A weaker consumer index shifts the consumption function downward. Temporary vs. permanent tax shocks Permanent tax shocks will have a bigger affect on consumption, since they will affect not only current, but also future conditions. - Ex.: Ronald Reagan proposed tax cuts to permanently reduce the tax rates. - Ex.: George Bush tried to stimulate the economy in 2008 by sending a $600 check to every person who filed a 2007 tax return. MAJOR COMPONENTS OF GDP 14 MAJOR COMPONENTS OF GDP 15 4

5 Temporary vs. permanent tax changes graphically: C a 0 a 1 A C B A reduction in taxes affects consumption differently, depending on whether the tax cut is temporary or permanently. In the former, the result will be a point like B. In the latter, the result will be a point like C. Consumption and saving When consumption rises, savings decline. But, why should we care about savings?: Savings and individual wealth accumulation - Savings build up personal wealth - Provide resources for Hh. after retirement Savings as a source of funds for investment - As explained in Ch. 13, savings are channeled by financial system into funds for businesses. Y 0 Y 1 Y MAJOR COMPONENTS OF GDP 16 MAJOR COMPONENTS OF GDP 17 Demand-side and supply-side roles of consumption and savings Investment According to demand-side: higher consumption stimulates business sales, and thus, Y. According to supply-side: higher consumption reduces savings, and thus, productivity. Which perspective is correct? Complex scenario and subject to debate. Simple answer: Demand-side perspective correct in short-run while supply-side one in the long-run. Investment is the second largest component of GDP. It is now about 16 percent of GDP, as compared to nearly 70 percent for consumption. But investment is highly volatile. Its jumps around a lot more. Investment is also highly procyclical. That is, it rises strongly when business cycle is good and falls steeply when business cycle is weak. MAJOR COMPONENTS OF GDP 18 MAJOR COMPONENTS OF GDP 19 5

6 Growth rates of real GDP, consumption, investment Percent 40 change Investment from 4 30 quarters earlier 20 Real GDP Consumption Investment Why does business investment slow significantly during recessions? When economy is slow, firms motivation to expand capacity utilization and/or introduce new products is low. Expectations channel: when business decide to increment their productive capacity, this involves a long-term commitment (think of the decision to build a new factory). -30 MAJOR COMPONENTS OF GDP MAJOR COMPONENTS OF GDP 21 Investment: cash flow and credit crunch To finance investment, firms can either use internal funds or external funds. The availability of internal funds is related to cash flow (i.e., the diff. btw a firm s revenue and its cash expenses). Firms use cash flow (CF) to invest. CF is associated with profits. Variations in profits cause variations in cash flows. Firms prefer to use cash flows because it is less costly. CF is highly procyclical. MAJOR COMPONENTS OF GDP 22 Investment: cash flow and credit crunch Those firms who invest using borrowed money are affected by credit crunches (i.e., the lack of available funding). As the availability of loans increases, so does investment. Low availability of funds implies that firms with lower credit ratings cannot get a loan. Or some may get partial financing. MAJOR COMPONENTS OF GDP 23 6

7 The investment function Investment is described by: I = d + ACC*Y The investment function Investment is described by: I = d + ACC*Y where: I = investment d = autonomous investment ACC = accelerator, ACC > 0 where: I = investment d = autonomous investment ACC = accelerator, ACC > 0 ACC captures the relationship between changes in I and changes in Y. Accelerator refers to the volatility of investment ACC captures the relationship between changes in I and changes in Y. Accelerator refers to the volatility of investment MAJOR COMPONENTS OF GDP 24 MAJOR COMPONENTS OF GDP 25 The investment function Movements along the investment function associated with changes in disposable income. Holding everything else constant, if disposable income Y changes, then there s a movement a long the curve. Everything else generates a shift in the investment curve: Interest rates, expectations, investment tax credits Government Sector Government spendings refers to the purchases of gg&ss by the Government. It includes things like military spending, hiring firms to build roads, and wages to gov. workers. The spending in G includes both, gov. consumption and gov. investment. In 2005, G was about 30% of GDP. Expenditure on gg&ss constituted 20% of GDP, while the remaining 10% was made up of transfers. MAJOR COMPONENTS OF GDP 26 MAJOR COMPONENTS OF GDP 27 7

8 Total Government Spending Federal vs. State & Local Spending 35.0% 25.0% 30.0% 20.0% Percent of GDP 25.0% 20.0% Percent of GDP 15.0% 10.0% 15.0% 5.0% 10.0% % Gov. Spending Gov Goods and Services Federal Spending State and Local Spending MAJOR COMPONENTS OF GDP 28 MAJOR COMPONENTS OF GDP 29 A mathematical model of AD AD is given by: Y = C + I + G Replacing each component yields: Y = (a + by) + (d +ACC*Y) + G Solving for Y: a d G Y 1 b ACC MAJOR COMPONENTS OF GDP 30 CHAPTER SUMMARY When people have more disposable income, they tend to consume more. Other variables such as wealth, interest rates, expectations and permanent tax shocks are likely to shift the consumption function. Investment is highly volatile and highly procyclical. The government does not have much room to reduce its budget deficit. MAJOR COMPONENTS OF GDP 31 8