Product
Markets and
National Output
Chapter 12
Discussion Topics
Circular flow of payments
Composition and measurement of gross
domestic product
Consumption, saving and investment
Equilibrium national income and output
Circular Flow Diagram
for the
General Economy
Circular Flow of Payments
We 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
Government
Businesses
4
Financial
Markets
Households
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Circular Flow of Payments
Financial Markets
 Businesses are net borrowers
 Households are net savers
 Government is a net borrower
Government
Net Government
Borrowing
Businesses
5
Net
Borrowing
Financial
Markets
Net
Saving
Households
Page 224
Circular Flow of Payments
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 Taxes
Government
Net Taxes
Net Government
Borrowing
Businesses
6
Net
Borrowing
Financial
Markets
Net
Saving
Households
Page 224
Circular Flow of Payments
Expenditures
 Businesses: Investment expenditures
 Gov’t makes expenditures
 Households: Consumption expenditures
Product Markets
Business Expenditures
Net Taxes
Gov’t Exp.
Government
Net Taxes
Net Government
Borrowing
Businesses
7
Net
Borrowing
Financial
Markets
Net
Saving
Consumer Expenditures
Total Expenditures
(National Product)
Households
Page 224
Circular Flow of Payments
 Income
 Businesses: Receive total expenditures from Product Markets
 Households: Receive wages, rents, interest and profits in
resource markets for labor and capital services
Product Markets
Total Expenditures
Business Expenditures
Businesses
Gov’t Exp.
Net Taxes
Government
Net Taxes
Net Government
Borrowing
Net
Borrowing
Financial
Markets
Net
Saving
Consumer Expenditures
Total Expenditures
(National Product)
Households
Retained Earnings
Wages + Rents + Interest + Profits
8
Resource Markets
Page 224
Measurement of U.S. Output
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
9
Page 225
Measurement of
Gross Domestic Product
10
2010 U.S. Gross Domestic Product
Bil. $
Gross Domestic Product (GDP)
Personal Total
Consumption
Goods
Expenditures
Services
Total
Gross Private
Domestic Investment
Net Exports of
Goods and Services
Government
Consumption
Expenditures and
Gross Investment
11
GDP %
14,660.2
10,351.9
3,427.6
6,924.3
1,821.4
Fixed Invest. Total
Nonresidential
Structures
Producers
Durable Equip.
Residential
Δ Inventory
Net exports
Exports
Imports
Total
Federal Total
Defense
Nondefense
1,752.8
State & Local
1,788.0
70.6
23.4
47.2
GDP = C + I +
G + (X – M)
12.4
12.0
381.8
2.6
1,030.7
7.0
340.4
68.5
-515.5
1,837.1
2,352.6
3,002.3
1,214.4
817.8
396.6
2.4
0.4
-3.5
12.5
-16.0
20.5
8.3
5.6
2.7
12.2
Measurement of U.S. Output
Recession:
A general slowdown in
economic activity
 GDP, 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
economy
12
 Lasting more than a few months
 ↓ in real GDP, real income, employment,
industrial production, and wholesale-retail
sales
Page 225
Measurement of U.S. Output
Real % Change in U.S. GDP
8.25
7.00
A % change below zero
represents a recession
5.75
4.50
3.25
2.00
0.75
0
-0.50
1990-91
1974-75
-1.75
1981-82
2008-09
-3.00
13
Page 227
What’s in GDP?
14
Types of consumer
expenditures…
Types of investment
expenditures…
15
Page 226
Calculation of net exports…
Types of government
expenditures…
Not in
GDP…
16
Page 226
Understanding the
Domestic
Determinants of GDP,
C, I and G
17
Aggregate Consumption Function
Aggregate: Total U.S. economy
GDP = C + I + G
+ (X – M)
Aggregate consumption
function slope defined as the
marginal propensity to consume
(MPC) where
MPC = C ÷ YD
and YD is disposable income
MPC = $2,100 ÷ $3,000 = 0.70
Autonomous or
fixed consumption
18
Disposable personal income (DPI) =
personal income after payment of taxes
Page 228
Aggregate Consumption Function
GDP = C + I + G
+ (X – M)
The consumption function
in this graph can be
expressed mathematically as:
C = AC + MPC x DPI
→ C = $1,500 + 0.70 x $3,000
= $3,600 (Bil)
(consumers would be dis-saving
by $600 (Bil))
19
Page 228
Aggregate Consumption Function
GDP = C + I + G
+ (X – M)
An ↑ in DPI to $4,000 (Bil)
would ↑ expenditures to
$4,300 (Bil)
(Dis-saving would ↓ to $300
(Bil))
C = $1,500 + .70 x $4,000 = $4,300 (Bil)
20
Page 228
Aggregate Consumption Function
GDP = C + I + G
+ (X – M)
An ↑ in DPI to $5,000
(Bil) would ↑
expenditures to $5,000
(Bil)
(Dis-saving would ↓ to 0)
C = $1,500 + .70 x $5,000 = $5,000 (Bil)
21
Page 228
Aggregate Consumption Function
GDP = C + I + G
+ (X – M)
How can we determine
what DPI results in dissavings being 0?
450
22
 Intersection of 450 line
from the origin with the
aggregate consumption
function
 Line shows where DPI =
consumption
expenditures
Page 228
Aggregate Consumption Function
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
23
Page 225
Aggregate Savings
 As noted above, the slope of the
aggregate consumption function is the
MPC (= C ÷ DPI)
 Savings is defined as:
S = DPI – C
Assumes that DPI can either be spent
or saved
 → The Marginal Propensity to Save
(MPS) is defined as: MPS = 1.0 – MPC
The % of DPI that will put towards
savings
24
Page 228 and 230
When the savings rate ↑
significantly, a recession is
often near
25
Aggregate Consumption Function
GDP = C + I + G
+ (X – M)
 Example of fiscal
policy:
 A ↓ in the tax rate ↑
consumption as DPI
(= PI – Taxes) ↑
26
Page 228
Aggregate Consumption Function
GDP = C + I + G
+ (X – M)
 Alternatively:
 An ↑ in the tax rate
↓ consumption as
DPI is ↓
27
Page 228
Concept of Wealth
 Wealth is the net worth of a person,
household, or nation
 Net worth is the value of all assets owned net
of all liabilities owed
Net 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
28
Page 230
Real Wealth Effect
on Consumption
GDP = C + I + G
+ (X – M)
C = $2,200 + .70 x DPI
Suppose stock market
prices ↑, ↑ real wealth
of consumers by $700
(Bil)
C = $1,500 + .70 x DPI
This would ↑
AC by $700
29
Page 230
RealWealth
Wealth Effect
Real
Effect
on Consumption
GDP = C + I + G
+ (X – M)
Wealth effect:
 Shifts the curve
C = $2,200 + .70 x $4,000 = $5,000
30
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
Page 230
Aggregate Investment Function
GDP = C + I + G
+ (X – M)
Investment function slope
is the marginal efficiency
of investment (MEI)
I = f(IR)
IR = interest rate
MEI = I ÷ IR
Level of autonomous
investment spending
(i.e., independent of IR)
I = AI – MEI x IR
31
Page 233
Aggregate Investment Function
GDP = C + I + G
+ (X – M)
Level of investment
expenditures would
be $250 at an interest
rate of 9% if MEI = 25
I = $475 – 25(9.0)
32
Page 233
Aggregate Investment Function
GDP = C + I + G
+ (X – M)
If IR ↓ to 7% investment
expenditures would ↑
from $250 to $300.
I = $475 – 25 x 7.0
= $300
33
Page 233
Effects of Profit Expectations
on Aggregate Investments
GDP = C + I + G
+ (X – M)
 An ↑ in profit
expectations
 → AI ↑ and planned
investment expend. at
the same IR
 At 7% IR investment
↑by $50
I = $525 – 25(7.0)
34
Page 233
Understanding the
Product Market
Equilibrium
35
Aggregate Expenditures
 Consumption expenditures function (Bil $):



C = $1,500 + 0.70 x DPI
Investment expenditures function (Bil $):
I = $475 – 25 x IR
Government expenditures function (Bil $):
G = $880
Aggregate Expenditures (AE) = C + I + G
 If the interest rate (IR) = 7%
AE = ($1,500 + 0.70 x DPI) + ($475 – 25 x 7) + $880
C
= $2,680 + (0.70 x DPI)
36
I
GDP = C + I + G
+ (X – M)
= AE + (X – M)
G
Page 235
Aggregate Expenditures
GDP = AE + (X – M)
 Aggregate expenditures equation:
AE = $2,680 + 0.70 x (NI – Taxes Paid)
DPI



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
Aggregate Expenditures Curve
Total autonomous
domestic spending…
Page 236
Aggregate Expenditures Curve
Point where
C + I + G = NI
National Income
Page 236
Deriving The Aggregate Demand Curve
Aggregate
demand curve
Demand equals supply
Corresponding price level
Page 237
Aggregate Supply Curve
Three distinct ranges
of aggregate supply
curve
Page 238
Aggregate Supply Curve
Maximum potential
output in the short
run…
End of depression
or Keynesian range
Page 238
Product Market Equilibrium
YFE represents full employment output
YE represents current or actual output
YPOT represents potential or maximum output
Page 238
Product Market Equilibrium
YE > YFE
YFE > YE
Planned spending exceeds
full employment output,
causing higher inflationary
pressures in economy.
Planned spending less than
full employment output,
causing underutilization of
economy’s resources.
Page 238
Summary
GDP consists of C, I, G and (X-M)
Consumption influenced by disposable
income and wealth
Investment influenced by interest rates
and profit expectations
Product market equilibrium occurs where
aggregate demand equals aggregate
supply
Inflationary and recessionary gaps occur
when economy not at full employment
output