Aggregate Demand

Chapter 9

Introduction

n The Great Depression was a springboard for the Keynesian approach to economic policy.

Keynes’ Questions:

n What are the components of aggregate demand?

n What determines the level of spending for each component?

n Will there be enough demand to maintain full employment?

Macro Equilibrium

n Aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium.

Macro Equilibrium

n Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Macro Equilibrium

n Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

Macro Equilibrium

n Equilibrium is established where AS and AD intersect.

The Desired Adjustment

n Macro equilibrium may or may not be at full-employment.

n All economists recognize that short-run macro failure of unemployment is possible.

The Desired Adjustment

n A central macroeconomic debate is over whether AS and AD will shift on their own to reach full employment.

The Desired Adjustment

n John Maynard Keynes asserted that high unemployment was likely to be caused by deficient aggregate demand.

The Desired Adjustment

n Keynes said that a market driven aggregate demand curve might not shift when needed.

Escaping a Recession

In analyzing AD, we ask:

n Who is buying the output of the economy?

n What factors influence their purchase decisions?

Four Components of Aggregate Demand

n Consumption (C)

n Investment (I)

n Government spending (G)

n Net exports (X - IM)

Consumption

n Consumption expenditures are spending by consumers on final goods and services.

n Consumer expenditures account for two-thirds of total spending.

Income and Consumption

n Keynes believed that the amount consumers decide to spend is determined by their disposable income.

n Disposable income is the after-tax income of consumers—personal income less personal taxes.

Income and Consumption

n By definition, all disposable income is either consumed (spent ) or saved (not spent).

Income and Consumption

n Saving is that part of disposable income not spent on current consumption; disposable income less consumption.

U.S. Consumption and Income

Consumption vs. Saving

n Keynes described the consumption-income relationship in two ways:

l As the ratio of total consumption to total disposable income.

l As the relationship of changes in consumption to changes in disposable income.

Consumption vs. Saving

n The average propensity to consume (APC) is total consumption in a given period divided by total disposable income.

Average Propensity to Save

n By definition, disposable income is either consumed (spent on consumption) or saved.

APS = 1 – MPS

The Marginal Propensity to Consume

n The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.

The Marginal Propensity to Consume

n It is the change in consumption divided by the change in disposable income.

Marginal Propensity to Save

n The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption.

MPS = 1 – MPC

The MPC and MPS

The Consumption Function

n The consumption function is a mathematical relationship that helps to predict consumer behavior.

Autonomous Consumption

n Keynes noted that consumption is not completely determined by current income.

n Some consumption is autonomous (independent of income).

Autonomous Consumption

n The nonincome determinants of consumption include expectations, wealth, credit, taxes, and price levels.

Expectations

n People who anticipate a pay raise often increase spending before extra income is received.

n People who expect to be laid off tend to save more and spend less.

Wealth

n The amount of wealth an individuals own affects their willingness and ability to consume.

n The wealth effect is a change in consumer spending caused by a change in the value of owned assets.

Credit

n Availability of credit allows people to spend more than their current income.

n The need to pay past debt may limit current consumption.

Taxes

n Taxes are the link between total and disposable income.

n Tax cuts give consumers more disposable income.

Price Levels

n Rising price levels reduce real value of money and may cause people to curtail spending.

Income-Dependent Consumption

n Keynes distinguished two kinds of consumer spending.

l Spending not influenced by current income, and

l Spending that is determined by current income.

Income-Dependent Consumption

n These determinants of consumption are summarized in the equation called the consumption function.

Income-Dependent Consumption

n The consumption function is the mathematical relationship indicating the rate of desired consumer spending at various income levels.

Income-Dependent Consumption

n The consumption function provides a precise basis for predicting how changes in income (Y_D) effect consumer spending (C).

C = a + bY_D

One Consumer’s Behavior

n We expect that even with an income level of zero, there will be some consumption.

n This is the autonomous consumption.

n We expect consumption to rise with income based on the consumer’s MPC.

One Consumer’s Behavior

n Dissaving occurs when current consumption exceeds current income – a negative saving flow.

The 45-Degree Line

n The 45-degree line represents all points where consumption and income are exactly equal.

C = Y_D

The 45-Degree Line

n The slope of the consumption function equals the marginal propensity to consume.

Justin’s Consumption Function

Justin’s Consumption Function

The Aggregate Consumption Function

n Repeated studies suggest that consumers increase their consumptions as their incomes increase

Shifts of the Consumption Function

n A change in the values of a or b in the consumption function (C = a + bY_D) will shift the function to a new position.

n A change in the variable a will cause a parallel shift of the function.

Shifts of the Consumption Function

n An increase in consumer confidence will increase autonomous consumption, shifting the consumption function up.

Shift in the Consumption Function

Shifts vs. Movements

n Incomes declined and consumer confidence fell during the 2001 recession.

l Declining income prompted a movement along the consumption function.

l Falling consumer confidence shifted the function downward.

Shifts vs. Movements

Shifts of Aggregate Demand

n Shifts in the consumption function are reflected in shifts of the aggregated demand curve.

Shifts of Aggregate Demand

n A downward shift of the consumption function implies a reduction (a leftward shift) in aggregate demand.

Shifts of Aggregate Demand

n An upward shift of the consumption function implies an increase (a rightward shift) of the aggregate demand.

AD Effects of Consumption Shifts

Shift Factors

n Shift factors include all of the non income determinants of consumption.

l Changes in consumer confidence (expectations).

l Changes in wealth.

l Changes in credit conditions.

l Changes in tax policy.

Shifts and Cycles

n Shifts in aggregate demand can cause macro instability.

n Aggregate demand shifts may originate from consumer behavior.

Shifts and Cycles

n If consumer spending increases abruptly, demand pull inflation will follow.

Investment

n Investment are expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories.

Determinants of Investment

n The following factors determine the amount of investment that occurs in an economy:

l Expectations.

l Interest rates.

l Technology and innovation.

Expectations

n Expectations play a critical role in investment decisions.

n Favorable expectations for future sales are a necessary condition for investment spending.

Interest Rates

n Businesses typically borrow money to invest in new plants or equipment.

n The higher the interest rate, the costlier it is to invest and thus the lower the investment spending.

n More investment occurs at lower rates.

Investment Demand

Technology and Innovation

n New technology changes the demand for investment goods.

Shifts of Investment

n Predictions about investment spending assume that investor expectations are stable.

n This is often not the case.

Altered Expectations

n Business expectations are determined by business confidence in future sales.

l An upsurge in confidence shifts the aggregate demand curve to the right.

l When investment spending declines, aggregate demand shifts to the left.

Empirical Instability

n Investment spending fluctuates more than consumption.

n Abrupt changes in investment were the cause of the 1990-91 recession.

Volatile Investment Spending

Government Spending

n The government sector (federal, state, and local) currently spends over $2 trillion a year on goods and services.

n Government spending decisions are made independently of current income.

Net Exports

n Net exports can be both uncertain and unstable, creating further shifts of aggregate demand.

Macro Failure

n Keynes had two chief concerns about macro equilibrium:

l The market’s macro-equilibrium might not give us full employment or price stability.

l Even if the market’s macro-equilibrium were at full employment and price stability, it might not last.

Undesired Equilibrium

n Market participants make independent spending decisions.

n There’s no reason to expect that the sum of their expenditures will generate exactly the right amount of aggregate demand.

Recessionary GDP Gap

n Keynes worried that equilibrium GDP may not occur at full-employment GDP.

l Equilibrium GDP is the value of total output (real GDP) produced at macro equilibrium (AS=AD).

l Full-employment GDP is the value of total output (real GDP) produced at full employment.

Recessionary GDP Gap

n A recessionary GDP gap is the amount by which equilibrium GDP falls short of full-employment GDP.

Recessionary GDP Gap

n Recessionary GDP gaps lead to cyclical unemployment.

Macro Failures

Macro Failures

Inflationary GDP Gap

n The economy might exceed its full-employment/price stability capacity causing an inflationary GDP gap.

n An inflationary GDP gap is the amount by which equilibrium GDP exceeds full-employment GDP.

Inflationary GDP Gap

n Inflationary GDP gaps lead to demand-pull inflation.

Macro Failures

Macro Failures

Doomed to Macro Failure?

n The goal is to produce at full employment, BUT,

n Equilibrium GDP may be greater or less than full-employment GDP.

Unstable Equilibrium

n Recurrent shifts of aggregate demand could cause a business cycle.

n The business cycle is alternating periods of economic growth and contraction.

Macro Failures

n If aggregate demand is too little, too great, or too unstable, the economy will not reach and maintain the goals of full employment and price stability.

Self-Adjustment?

n The critical question is whether undesirable outcomes will persist.

l Classical economists asserted that markets self-adjust so that macro failures would be temporary.

l Keynes didn’t think that was likely to happen.

Looking for AD Shifts

n Policymakers use the Index of Leading Indicators to forecast changes in GDP.

Aggregate Spending

End of Chapter 9