Demand for Domestic Output of Incomes: 5 Components

The following points highlight the five main components of demand for domestic output of incomes. The components are: 1. Consumption 2. Government 3. Investment 4. Net Exports 5. Final Sales

Component of Demand # 1. Consumption:

A look at the data about components of demand for any country. It shows that the chief components of demand are consumption spending by the personal sector.

This includes anything from food to golf lessons, but involves also, as well shall see in discussing investment, consumer spending on durable goods such as automobiles-spending which might be regarded as investment rather than consumption.

Component of Demand # 2. Government:

Next in importance we have government purchases of goods and services. Here we have such items as national defense expenditures, 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, and we speak of transfers plus purchases as government expenditure. The federal government budget, of the order of Rs. 1,000 billion, refers to federal government expenditure. Less than half that sum is for federal government purchases of goods and services.

Component of Demand # 3. Investment:

Gross private domestic investment requires some definitions. First throughout this book, 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 TISCO. Practically, investment includes housing construction, building of machinery, business construction, 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 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 labour force.

Education can be regarded as investment in human capital. In 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 GNP. But in this book we mean by investment only additions to the physical capital stock.

The classification of spending as consumption or investment remains to a significant extent a matter of convention. From the economic point of view, there is little difference between a household building up an inventory of peanut butter and a grocery store 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 investment in the from of inventory investment. Although these borderline cases clearly exist, we can apply a simple rule of thumb that investment is associated with the business sector’s adding to the physical stock of capital, including inventories.

Similar issues arise in the treatment of household sector expenditures. For instance, how should we treat purchases of automobiles by households? Since automobiles usually last for several years, it would seem sensible to classify household purchases of automobiles as investments. We would then treat the use of automobiles as providing consumption services. (We could think of imputing a rental income to owner occupied automobiles.)

However, the convention is to treat all household expenditures 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. When consumer spending decisions are studied in detail, expenditures on consumer durables are usually treated separately.

In passing, we note that in Table 2.1, investment is defined as “gross” and “domestic”. It in gross in the sense that depreciation is not deducted. Net investment is gross investment minus depreciation. Thus NNP is equal to net investment plus the other categories of spending in Table 2.1.

The term domestic means that this is investment spending by domestic residents but is not necessarily spending on goods produced within this country. It may well be an expenditure that fall on foreign goods. Similarly, consumption and government spending may also be partly for imported goods. On the other hand, some of domestic output is sold to foreigners.

Component of Demand # 4. Net Exports:

The item “Net exports” appears in Table 2.1 to show the effects of domestic spending on foreign goods and foreign spending on domestic goods on the aggregate demand for domestic output. The total demand for the goods we produce includes exports, the demand from foreigners for our goods.

It excludes imports; the part of our domestic spending that is not for our own goods. Accordingly, the difference between exports and imports, called net exports, is a component of the total demand for our goods. Net exports were negative in 1985, reflecting a high level of imports and a low level of exports. The point can be illustrated with an example.

Assume that instead of having spent Rs. 2.582 billion, the personal sector had spent Rs. 20 billion more.

What would GNP have been? If we assume that government and investment spending had been the same as in Table 2.1, we might be tempted to say that GNP would have been Rs. 20 billion higher. That is correct if all the additional spending had fallen on our goods.

The other extreme, however, is the case where all the additional spending falls on imports. In that event, consumption would be up Rs. 20 billion and net exports would be down Rs. 20 billion, with no net effect on GNP

Component of Demand # 5. Final Sales:

Sometimes it is important to distinguish total spending by domestic residents from the level of output produced. The two can differ because spending can exceed output when net imports are positive or it can fall short of output when net exports are positive.

In the national income accounts total spending by domestic residents is called gross domestic purchases and is defined as follows:

Gross domestic purchase = GNP + imports – exports

Although gross domestic purchases refer to total spending by domestic residents, it is also useful to have a concept of spending that net out changes in inventories. This is final sales to domestic purchasers and is defined as

Final sales to domestic purchasers = GNP + imports – exports – inventory change

The emphasis here is on final spending. The definition of final sales is useful because it helps clarify the allocation of output of alternative uses and points out that there are three separate possible sources of disturbances to output changes in final sales, changes in net exports, and changes in inventories.

This point can be seen by simply rearranging the definition to put output on the left-hand side:

GNP s final sales to domestic residents + net exports + inventory change.