In this section we look at the demand for output, and we discuss the components of the aggregate demand for domestically produced goods and services, the different purposes for which GDP is demanded. Total demand for domestic output is made up of four components:
(1) consumption spending by households.(C)
(2) investment spending by businesses and households.(I)
(3) government (federal, state, and local) purchases of goods and services.(G)
(4) foreign demand for our net exports.(NX)
These four categories account, definitionally, for all spending. The fundamental national income accounting identity is Y = C + I + G + NX
MEMORIZE THIS IDENTITY: You will use it repeatedly in this course and in organizing your thinking about the macroeconomy. We now look more closely at each of the four components.
CONSUMPTION
A breakdown of the demand for goods and services by components of demand. The chief component of demand is consumption spending by the household sector. This includes spending on anything from food to golf lessons, but it also involves, as we shall see in discussing investment, consumer spending on durable goods such as automobiles spending that might be regarded as investment rather than consumption. The percentage of GDP accounted for by consumption in both Korea and Dubai. Note that the consumption share is not constant by any means. Observe, that Korea consumes a far smaller share of its GDP than is the case in Dubai. Given the share of government spending, higher consumption (or lower saving), as we will see in a moment, means either less investment or larger trade deficits.
GOVERNMENT
Next in size we have government purchases of goods and services. This component of GDP includes such items as national defense expenditures, costs of road paving by state and local governments, and salaries of government employees. We draw attention to the use of certain words in connection with government spending. We refer to government spending on goods and services as purchases of goods and services. In addition, the government makes transfer payments, payments that are made to people without their providing a current service in exchange. Typical transfer payments are social security benefits and unemployment benefits. Transfer payments are not counted as part of GDP because transfers are not part of current production. We speak of transfers plus purchases as government expenditure. The federal government budget was on the order of $3,000 billion ($3.0 trillion) in the year 2004, $3,000 billion in 20011, and was projected to come close to $5,000 billion as stimulus spending continued through 2016. In a typical year, about a third of federal expenditure is on goods and services. Total government spending, both items that are counted in GDP and items that are not, plays a large role in determining how the economy is split between the public sector and the private sector. In Dubai federal, state, and local spending account for a little over a third of the economy.
INVESTMENT
Gross private domestic investment requires some definitions. First, throughout this book, the term investment means additions to the physical stock of capital. As we use the term, investment does not include buying a bond or purchasing stock in Apple Computer. Investment includes housing construction, building of machinery, construction of factories and offices, and additions to a firm’s inventories of goods. If we think of investment more generally as any current activity that increases the economy’s ability to produce output in the future, we would include not only physical investment but also what is known as investment in human capital. Human capital is the knowledge and ability to produce that is embodied in the labor force. Investment in education can be regarded as investment in human capital, but the official accounts treat personal educational expenditures as consumption and public educational expenditures as government spending. The classification of spending as consumption or investment is to a significant extent a matter of convention. From the economic point of view, there is little difference between a household’s building up an inventory of peanut butter and a grocery store’s doing the same. Nevertheless, in the national income accounts, the individual’s purchase is treated as a personal consumption expenditure, whereas the store’s purchase is treated as inventory investment. Although these borderline cases clearly exist, we can apply a simple rule of thumb: Investment is associated with the business sector’s adding to the total incomes system of accounts (TISA). The definition of investment is broadened to include investment in human capital, which means that total investment in that system is more than one - third of GDP. But in this book and in the official national income accounts, investment counts only additions to the physical capital stock. physical stock of capital, including inventories. Officially, however, all household expenditures (except new housing construction) are counted as consumption spending. This is not quite so bad as it might seem, since the accounts do separate households’ purchases of durable goods like cars and refrigerators from their other purchases. Net investment is gross investment minus depreciation.
NET EXPORTS
The item “Net exports” is for domestic spending on foreign goods and foreign spending on domestic goods. When foreigners purchase goods we produce, their spending adds to the demand for domestically produced goods. Correspondingly, that part of our spending that purchases foreign goods has to be subtracted from the demand for domestically produced goods. Accordingly, the difference between exports and imports, called net exports, is a component of the total demand for our goods. Canada net exports have been negative since the 1990s, reflecting a high level of imports and a lower level of exports; note, though, that net exports have been close to zero in some years (trade has been nearly balanced) and very negative in others (Canada has had a large balance of trade deficit). The role of net exports in accounting for GDP can be illustrated with an example. Assume that personal sector spending was higher by $1.5 billion. How much higher would GDP be? If we assume that government and investment spending remained unchanged, The GDP accounts record as investment business sector additions to the stock of capital. Some government spending, for instance, for roads or schools, also adds to the capital stock. Estimates of the capital stock owned by government are available in Fixed Reproducible Tangible Wealth in Canada, 1997–2000 (Canada. Bureau of Economic Analysis, National Income and Wealth Division, 2002). For the most recent statistics.
we might be tempted to say that GDP would have been $2 billion higher. That is correct if all the additional spending had fallen on domestic goods (e.g., cars built in Detroit). The other extreme, however, is that all the additional spending had fallen on imports (e.g., Jaguars imported from the U.K.). In that event, consumption would have been up $2 billion and net exports would have been down $2 billion, with no net effect on GDP.
RECAP From this section you should remember:
•Demand for GDP is split into four components: consumption, investment, government spending, and net exports, according to the identity of the purchaser.
• Y = C + I + G + NX .
• The relative sizes of the demand sectors vary across countries and across time, but rough numbers to remember for Dubai are consumption, 71 percent; investment, 11 percent; government purchases of goods and services, 21 percent; and net exports, negative.
A SIMPLE ECONOMY
We denote the value of output in our simple economy, which has neither a government nor foreign trade, by Y . Consumption is denoted by C and investment spending by I . The first key identity is that output produced equals output sold.
Question: What happens to unsold output?
Answer: We count the accumulation of inventories as part of investment (as if the firms sold the goods to themselves to add to their inventories), and therefore all output is either consumed or invested. Output sold can be expressed in terms of the components of demand as the sum of consumption and investment spending. Accordingly, we can write Y = C + I
The next step is to establish a relation among saving, consumption, and GDP. How will income be allocated? Part will be spent on consumption, and part will be saved. Thus we can write Y = S + C where S denotes private sector saving. Identity tells us that the whole of income is allocated to either consumption or saving. Next, identities and can be combined to read C + I = Y = C + S The left-hand side of identity shows the components of demand, and the right hand side shows the allocation of income. The identity emphasizes that output produced is equal to output sold. The value of output produced is equal to income received, and income received, in turn, is spent on goods or saved. Identity can be slightly reformulated to show the relation between saving and investment. Subtracting consumption from each part of identity, we have I = Y - C = S shows that in this simple economy investment is identically equal to saving . One can think of what lies behind this relationship in a variety of ways. In a very simple economy, the only way the individual can save is by undertaking an act of physical investment for example, by storing grain or building an irrigation channel. In a slightly more sophisticated economy, one could think of investors financing their investing by borrowing from individuals who save.
REINTRODUCING THE GOVERNMENT AND FOREIGN TRADE
We now reintroduce the government sector and the external sector. We denote government purchases of goods and services by G and all taxes by TA . Transfers to the private sector (including interest on the public debt) are denoted by TR. Net exports (exports minus imports) are denoted by NX. We return to the identity between output produced and sold, taking account now of all components of demand, including G and NX.
Accordingly, we restate the fundamental identity: Y = C + I + G + NX
Next we turn to the derivation of the very important relation between output and disposable income. Now we have to recognize that part of income is spent on taxes and that the private sector receives net transfers ( TR ) in addition to national income. Disposable income ( YD ) is thus equal to income plus transfers less taxes: YD = Y + TR - TA
Decisions about saving are made by businesses as well as directly by consumers. It is convenient to ignore the existence of corporations and consolidate, or add together, the entire private sector. “ Government” here means the federal government plus state and local governments.
Written by: Adetoro Abdulhakeem
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