No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eighteen: The “macro” view of the economy 450 AGGREGATE DEMAND AND GDP Government policymakers typically try to mitigate economic instability by fiscal and/ or monetary policy managing aggregate demand , which is the sum of spending in the economy, or alternatively, the sum of income in an economy (since every person’s spending is someone else’s income). We calculate this as the Gross Domestic Product: GDP = C + I + NX + G where C is consumption spending, I is investment, NX represents net exports (exports – imports) and G is government spending. Let’s now unpack each of these definitions and terms. First, begin by watching this video: What is Gross Domestic Product (GDP)? When we think about total spending, a.k.a. aggregate demand, we are trying to capture the total economic activity in the economy—we want to consider what households are doing, what firms are spending on, and finally what the public sector is spending. Basically we want to capture anything that implies a collective use of resources on the production of final goods and services. Once we think about it that way, we’ll start to exclude things. For example, let’s begin with government spending. We do not consider social security taxes or payments to beneficiaries as government spending in the calculation of GDP, because these programs simply transfer wealth from one group of Americans to another group. Much of the government budget falls into the category of transfer payments, and is thus excluded from GDP, since one person’s spending necessarily implies another’s reduction in spending capability. So what would be included? Any purchases of physical goods and services or payment to government employees, such as police or military members, since these type of expenditures lead to the creation of government-provided goods and services. For the category of consumption, we want to capture all spending on final goods and services—think Walmart, Sears, Chipotle, and Amazon. All the clothes, food, cars, appliances, books, Breyer’s ice cream(!), and, yes, green beans are included here. Consumption is the largest component of GDP in the United States, typically around 70% of GDP, causing many macroeconomists to focus on consumption as the key to managing the economy. Indeed there is merit to that focus, given that the end goal of all Aggregate demand: the sum of spending in the economy, or, the sum of income in an economy