Division of GDP Between Consumption and
(Economics 100b; Spring 1996)
Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
January 31, 1996
Aggregate Demand: Consumption
Last time we set up the simple supply side of our full-employment
Output is determined by the available capital stock and labor supply,
and by the technological efficiency at production--how good the
technology is at turning labor and capital into output. The real wage
is set, under perfect competition, and for the economy as a whole, by
the requirement of labor market equilibrium: firms want to hire no
more workers than the available labor force--but they do want to hire
everyone in that available labor force. The real return to capital is
set by the requirement of capital market equilibrium: capital is
sufficiently expensive that firms don't want to hire any more than
the economy's accumulated capital stock--but they do want to hire
that accumulated capital stock.
A first component of aggregate demand is government purchases: the
purchase by federal, state, and local governments of goods and
services. "G" does not include government transfers (remember,
they show up later, in net taxes). The government's choices of
spending on goods and services and of net taxea are together
summarized as the governmetn's fiscal policy--and the
difference between government purchases and net taxes, the deficit
(DEF) is an often used measure of fiscal policy: actions to enlarge
the deficit are seen as expansionary--or inflationary:
expansionary if you like them, inflationary if you don't. Actions to
shrink the deficit or run a surplus are contractionary (or, if
you like them, prudent).
Aggregate Demand: Consumption
Consumption is the largest component of aggregate demand. Individuals
receive income--wages and profits from the capital they own.
Total income is total national product: Y.
Some of this income is taxed away. Some of this income is augmented
by a government that writes entitlement checks to individuals:
transfer payments. At the extremely broad aggregate level at
which we are working, and modelling the economy, only the net flow
from individuals to the government matters: T is net taxes, is
the difference between taxes and transfer payments.
Disposable income is Y - T
What do people do with their disposable income? They save some of it
(recall private saving, S-sub-p). They spend the rest on
consumption goods--services, non-durable commodities, and
consumer durables. Note that the line between consumption and
saving is somewhat arbitrary: why is the purchase of a car
consumption and not saving? Why is the purchase of a
house saving and not consumption.
At the level of the aggregate economy, there is a pretty constant and
pretty stable relationship between consumers' disposable
incomes and how much the spend on consumption. We call this the
"consumption function". And we call the rate at which consumption
increases as income increases the MPC, the marginal propensity to
We have a very strong belief that the MPC is going to be between zero
and one--that people will spend some of any extra addition to
their income on consumption (that is, they will not save all of it),
but that they will not spend all of the extra addition to
their income on consumption (that is, they will save some of it).
MPC varies depending on whether the increase in income is seen as
permanent or as transitory. Kennedy-Johnson tax cut
back in 1964 (or Reagan tax cut back in 1981) as opposed to
the--explicitly temporary--Vietnam War tax surcharges of
Remember George Bush's "withholding" change proposal?
The single most important determinant of investment is "the" interest
rate--or perhaps I should say, "the" interest rate combined with the
marginal product of capital, the MPK, the R* above.
Investment depends upon the interest rate because investment
decisions are long-term decisions, made with both eyes firmly on the
future. You build a new factory, you live with that factory for
Businesses face a number of different investment opportunities, all
of them with uncertain and different returns. Businesses try to guess
which projects are worthwhile--and a key element in that assessment
is the cost of the financing to make the investments, either in terms
of the dividends, coupons, or bank interest that will have to be paid
once the money is obtained; or in terms of the money lost if you take
the cash you were going to use for investment and instead did
something else with it--threw it back into the financial markets, and
clipped coupons yourself.
Thus we write I=I(r), where r denotes the real interest rate--and I
is a decreasing function of r.
The interest rates quoted in the newspapers are all nominal
interest rates. We are going to use little-i for nominal interest
rates. The interest rates that matter for businesses are real
interest rates--with inflation, or at least expected inflation,
If it costs you ten percent per year to borrow, but if inflation is
also ten percent per year, then the reali interest rate is
zero: you have to pay back, when the loan comes due next year, no
larger a bundle of real commodities than you got this year. Thus we
want to talk about real interest rates, but--because future inflation
rates have not happened yet, and are uncertain--real interest rates
are uncertain and, in a sense, unobservable.
This cramps our style considerably.
Types of Interest Rates
There are lots of interest rates. They all move together--rise and
fall together--so there is some justification for talking about "the"
interest rate. Tax treatment, credit risk--the risk that the borrower
will not repay--liquidity, term to maturity, are all reasons for
interest rates to differ and fan out.
One--important--source of variation in real interest rates,
noted above, is inflation.
Another important source of variation in interest rates is the
term to maturity. Long-term rates and short-term rates. Term
structure. Typical term structure. Relationship of stock market to
What is the price of a stock going to be?
What ensures that aggregate demand and aggregate supply match up?
That the quantity of goods demanded by consumers, by firms for
investment, and by the government adds up to the quantity produced by
Think back to last time's circular flow diagram:
Total production is equal to incomes...
A bunch of those incomes are spent immediately--private consumption
and government. So subtract C and G from incomes and from output, and
what do you get?
On the "incomes" side, you get private savings minus the
On the "output" side, you get investment...
So the circular flow balances--the economy is in full employment
equilibrium--only if private savings is equal to the sum of
investment and government deficit.
Are there any factors in our model to make this so?
Well, consider financial markets--the market for loanable funds.
Suppose the real interest rate r is low, so that firms seek to