Chap009 4 (2010)

Aggregate Demand

• By working through the demand side of the macro economy we’ll better understand business cycles and their causes– What are the components of aggregate

demand?– What determines the level of spending for

each?– Will there be enough to maintain full

employment?

Macro Equilibrium

• The forces of aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium

• Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply

The Desired Adjustment

• All economists recognize that short-run macro failure is possible

• The debate is over whether the economy will self-adjust to full employment

• If not, government might have to step in and adjust AD to reach full employment

Escaping a Recession

AS (Aggregate supply)

AD1

E1

REAL OUTPUT

PR

ICE

LE

VE

L

AD2

QFQE

PE

Components of Aggregate Demand

• The four components of aggregate demand are– Consumption (C)– Investment (I)– Government spending (G)– Net exports (X – M)

Consumption

• Consumption: Expenditure by consumers on final goods and services

• Consumer expenditures account for over two-thirds of total spending in the U.S.

Income and Consumption

• Most consumers spend most of whatever income they have

• Disposable income (DI): After-tax income of consumers

– DI personal income personal taxes

U.S. Consumption and Income

DISPOSABLE INCOME (billions of dollars per year)

$1000 2000 3000 4000

Actual consumer spending

6000

5000

4000

3000

2000

1000

0 5000 6000 7000

45°

$7000

19801982

19841986

19881990

19921994

1996

19981999

2000

CO

NSU

MPT

ION

(bill

ions

of d

olla

rs p

er y

ear)

C = YD

Consumption vs. Saving

• All disposable income is either consumed (spent) or saved (not spent)

• Saving: That part of disposable income not spent on current consumption

DY C SDisposable income consumption saving


• To determine effect on AD, need to consider fractions of DI consumed and saved– In terms of averages - the ratios of total

consumption and saving to total disposable income

– In terms of marginal decisions - relationship of changes in consumption and saving to changes in disposable income


• The proportion of total disposable income spent on consumer goods and services is the average propensity to consume (APC)

D

total consumption CAPC

total disposable income Y


• The proportion of total disposable income saved is the average propensity to save (APS)

1APS APC

D

total saving SAPS

total disposable income Y


• Marginal propensity to consume (MPC): The fraction of each additional (marginal) dollar of disposable income spent on consumption

D

Change in Consumption CMPC

Change in Disposable Income Y


• Marginal propensity to save (MPS): The fraction of each additional (marginal) dollar of disposable income not spent on consumption

D

Change in Saving SMPS

Change in Disposable Income Y

1MPS MPC

MPC and MPS

MPS = 0.20 MPC = 0.80

The Consumption Function

• It is useful to know what drives consumption in order to help predict consumer behavior

• Keynes distinguished two kinds of consumer spending– Spending that is not influenced by current

income (autonomous)– Spending that is determined by current

income

Autonomous Consumption

• Consumption that is independent of income is influenced by non-income determinants:– Expectations – people get a raise, spend it in

advance, expect economy to be poor, save.– Wealth – affects willingness to spend– Credit – need to pay past debt affects spending– Taxes – tax cuts give consumers more

disposable income to spend

Income-Dependent Consumption

• Consumption function: A mathematical relationship indicating the rate of desired consumer spending at various income levels

income -dependent

consumption

autonomous consumption

Total consumption

• The consumption function provides a basis for predicting how changes in income effect consumer spending


DC a bY where :

current consumption autonomous consumption

marginal propensity to consume disposable incomeD

C a

b Y


• The consumption function tells us:– How much consumption will be included in

aggregate demand at the prevailing price level

– How the consumption component of AD will change (shift) when incomes change

One Consumer’s Behavior

• Even with an income level of zero there will be some consumption

• Consumption will rise with income based on the consumer’s MPC

• Dissaving: Consumption expenditure in excess of disposable income; a negative saving flow

A Consumption Function

The 45-Degree Line

• In a graph of the consumption function, the 45-degree line represents all points where consumption and income are exactly equal, or

C = YD

• The slope of the consumption function is the marginal propensity to consume

A Consumption Function$400

$50 100 150 200 250 300 350 400 450

C = YD

Saving

DissavingConsumption Function

C = $50 + 0.75YD$125

A

C

D

E

B

G

The Aggregate Consumption Function

• Repeated studies suggest that in the aggregate consumers increase consumption as income increases

• The consumption function summarizes this behavior

Shifts of the Consumption Function

• A change in the a or b parameters will move the consumption function to a new position

• A change in a will cause a parallel shift up or down of the function

• A change in b alters the slope of the function

DC a bY

Shift in the Consumption Function

a1

C = a1 + bYD

C = a2 + bYD

a2

CO

NS

UM

PT

ION

(C

)

DISPOSABLE INCOME0

Decreased confidence

Shifts of Aggregate Demand

• Shifts in the consumption function are reflected in shifts of the aggregate demand curve– A downward shift of the consumption function

implies a leftward shift in aggregate demand– An upward shift of the consumption function

implies a rightward shift in aggregate demand

AD Effects of Consumption Shifts

Y0

f2

f1

Q2 Q1

P1

C1

AD1

Shift = f1 – f2

Expenditure

Income

C2

Price Level

Real Output

AD2

AD Shift Factors

• The AD curve will shift in response to– Changes in income– Changes in expectations (consumer

confidence)– Changes in wealth– Changes in credit conditions– Changes in tax policy

Shifts and Cycles

• Shifts in aggregate demand can cause macro instability.

• Aggregate demand shifts may originate from consumer behavior.

LO2

Government Spending

• The federal government is not constrained by tax receipts so it has counter-cyclical power

• The federal government can increase spending to counteract declines in consumption and investment spending

Net Exports

• Net exports can be both uncertain and unstable, also affecting aggregate demand– Exports react to foreign demand, which is

affected by foreign incomes, expectations, wealth, etc.

– Imports are affected by the same factors affecting domestic consumption and investment demand

The AD Curve Revisited

• The four components of spending come together to determine aggregate demand

• By adding up the intended spending of these market participants we can see how much output will be demanded at the current price level

Building an AD Curve

QCQ0

P0

AD

Pri

ce L

evel

Real GDP

QGQI QX-M

C I G X-Md

Macro Failure

• There are two chief concerns about macro equilibrium:– The market’s macro-equilibrium might not give

us full employment or price stability– Even if macro-equilibrium were at full

employment and price stability, it might not last

Undesired Equilibrium

• Market participants make independent spending decisions

• There is no reason to expect that the sum of their expenditures will generate exactly the right amount of aggregate demand

Recessionary GDP Gap

• Equilibrium may not occur at full-employment– Equilibrium GDP: The value of total output

(real GDP) produced at macro equilibrium (AS=AD)

• Recessionary GDP gap: The amount by which equilibrium GDP falls short of full-employment GDP

Recessionary GDP Gap

• The recessionary GDP gap represents unused productive capacity, lost GDP, and unemployed workers

• Cyclical unemployment: Unemployment attributable to a lack of job vacancies; that is, to inadequate aggregate

Macro Failures

PRICE LEVEL

REAL GDP

Macro Success: (perfect AD)

AD1

AS

P*E1

QF

Macro Failures

PRICE LEVEL

REAL GDP

Cyclical Unemployment: (too little AD)

AS

P*E1

QF

AD2

E2

Q2

P2

QE2

recessionary GDP gap

A Recessionary GDP Gap

Real GDP Demanded (in $ trillions) by:

Price Level

Consumers + Investors + Government + Net

Exports =

Aggregate Demand

Aggregate Supply

130 3.0 0.25 1.5 0.25 5.0 12.0

120 3.5 0.50 1.5 0.50 6.0 11.5

110 4.0 0.75 1.5 0.75 7.0 11.0

100 4.5 1.00 1.5 1.0 8.0 10.0

90 5.0 1.25 1.5 1.25 9.0 9.0

80 5.5 1.50 1.5 1.50 10.0 7.0

70 6.0 1.75 1.5 1.75 11.0 5.0

60 6.5 2.0 1.5 2.0 12.0 3.0

A Recessionary GDP Gap

Inflationary GDP Gap

• Equilibrium GDP might exceed its full-employment/price stability capacity

• Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP

Inflationary GDP Gap

• An inflationary GDP gap leads to demand-pull inflation

• Demand-pull inflation: An increase in the price level initiated by excessive aggregate demand

Macro Failures

PRICE LEVEL

Demand-pull inflation: (too much AD)

AS

P*E1

QF

AD3

E3P3

Q3QE3

inflationary GDP gap

Unstable Equilibrium

• GDP gaps are clearly troublesome, since goal is to produce at full employment

• Recurrent shifts of aggregate demand could cause a business cycle

• Business cycle: Alternating periods of economic growth and contraction

Macro Failures

• 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?

• The critical question is whether undesirable outcomes will persist– Classical economists asserted that markets

self-adjust so that macro failures would be temporary

– Keynes didn’t think that was likely to happen

The Leading Economic Indicators

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

• Average workweek• Unemployment

claims• New orders• Delivery times• Equipment orders

• Building permits• Stock prices• Money supply• Interest rates• Consumer

confidence

Chap009 4 (2010)

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Transcript of Chap009 4 (2010)