Aggregate Demand and Supply

¶ … Graph/Table Which Must Also Be Included in the Paper: Explain the difference between personal income and disposable income. How can personal income increase by a lower amount than disposable income? Personal income is income received by individuals from all possible sources. This includes wages, and income from dividends paid on investments. The largest component of total income is wages and salaries, a figure that can be estimated using payrolls and earnings data from the employment report.

Beyond that, there are many other categories of income, including rental income, government subsidy payments, interest income, and dividend income. Personal income is a decent indicator of future consumer demand, but it is not perfect. Recessions usually occur when consumers stop spending, which then drives down income growth. Looking solely at income growth, one may therefore miss the turning point when consumers stop spending. Like real GDP per capita, real disposable income is a measure of economic well-being.

It specifically focuses on the amount of income available for private consumption and spending. Real disposable income takes into consideration the reality that "take-home pay" is heavily influenced by not only gross income, but also by factors such as government transfer levels, taxation levels, and inflation. Therefore, personal income can increase at a lower rate than disposable income when tax cuts are given and inflation threatens those that have retained savings. For example, laborers in the 70's had a higher personal income than they did in the 60's.

However, with double-digit inflation and high taxes, their disposable income was much lower. 2) What is the wealth effect? How does an increase in wealth affect aggregate demand? The wealth effect is an increase in consumer spending that results from the perceived wealth created by the escalating value of stock market portfolios.

This is counter-intuitive, as one would reason that consumer spending would jump as people were leaving the market, as we saw real estate expenditures increase dramatically as stock market prices fell (this was also due to lowered interest rates) or bond spreads tighten as people switch from equity to debt in a stagnating market with high interest rates. The wealth effect, however, has more to do with the psychology of consumers, who self-identify as being wealthier and expect to be able to sell their portfolios for a higher value.

Such people might also see themselves as having a smaller monthly obligation to contribute to their retirement plans, freeing up cash to throw at consumer cyclicals and consumer durables. Increased demand causes spending expectations to rise, which drive stock prices up even more as companies are expected to grow to meet demand.

This is what is known as a "virtuous circle." One would think such a process would be curtailed because less credit would be available to companies wishing to expand, but this problem is solved by increased foreign direct investment. When the aggregate value of personal property increases, so does consumer demand. Keynesian economists blame over-consumption in such economies for higher interest rates, and usually suggest an interest rate hike to cool down spending. However, interest rates in a global economy rely more heavily on fluctuations in the international currency market.

The dollar's relative stability and its use as a reserve currency has always helped to stave off such inflation. The following graph shows how a gradual increase in consumption coincided with business investment over the course of the 1990's.

A source: http://www.pelonline.org/econoboom.html 3) Explain how a decrease in income taxes could offset the negative impact of reduced wealth on total spending? A decrease in income taxes would create higher rates of disposable income, offsetting higher retirement contributions and the sense of loss that accompanies a bear market. It should be understood, however, that tax adjustments have to be timed properly in order to have the right effect on the economy.

The federal government has already lowered interest rates in order to re-vitalize the economy; the chief result has been a housing boom. Speculators have traditionally tried to foresee interest rate fluctuations and adjust bond spreads and currency exchange rates accordingly. The corollary is true as well, as the fed sometimes increases interest rates in order to curb spending and prevent inflation. The chief problem with engineering similar changes to the tax code is that such a process is slow.

Interest rate changes are announced immediately so as to keep the market as efficient as possible, as investors can't be expected to wait for forthcoming information. For instance, during the Florida election crisis, the stock market started to decline because investors were waiting for information that would materially affect the outcome of their investment decisions. The same is true of a proposed tax cut. Tax cuts must be approved at three levels of government before being passed into law after being introduced to the house floor by a committee.

Additionally, the proposed tax cuts.