AGGREGATE DEMAND
Chapter 9
INTRODUCTION
The Great Depression was a springboard for the Keynesian approach to economic policy.
Keynes asked:
What are the components of aggregate demand?
What are the components of aggregate demand?
What determines the level of spending for each component?
Will there be enough demand to maintain full employment?
2
MACRO EQUILIBRIUM
Aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium.
Remember:
Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.
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.
3
MACRO EQUILIBRIUM
Equilibrium is established where AS and AD intersect.
I Equilibrium (macro) is the combination of
I Equilibrium (macro) is the combination of price level and real output that is
compatible with both aggregate demand and aggregate supply.
4
THE DESIRED ADJUSTMENT
Macro equilibrium may or may not be at full- employment.
All economists recognize that short-run macro failure of unemployment is possible
failure of unemployment is possible.
A central macroeconomic debate is over whether AS and AD will shift on their own to reach full employment.
5
THE DESIRED ADJUSTMENT
John Maynard Keynes asserted that high unemployment was likely to be caused by deficient aggregate demand.
Keynes said that a market driven aggregate
Keynes said that a market driven aggregate demand curve might not shift when needed.
I Government would have to intervene to shift the AD curve rightward to reach full employment.
6
ESCAPING A RECESSION
AS (Aggregate supply)
verage price)
E1
REAL OUTPUT (quantity per year) AD1
PRICE LEVEL (av
AD2
QF QE PE
7
IN ANALYZING AD, WE ASK:
Who is buying the output of the economy?
What factors influence their purchase decisions?
Four Components of Aggregate Demand:
Consumption (C)
Investment (I)
Government spending (G)
Net exports (X - IM)
8
CONSUMPTION
Consumption expenditures are spending by consumers on final goods and services.
Consumer expenditures account for two-thirds of total spending
of total spending.
9
INCOME AND CONSUMPTION
Keynes believed that the amount consumers decide to spend is determined by their disposable income.
Disposable income is the after tax income of
Disposable income is the after-tax income of consumers—personal income less personal taxes.
10
INCOME AND CONSUMPTION
By definition, all disposable income is either consumed (spent) or saved (not spent).
Disposable income = Consumption + Saving YD= C + S
11
U.S. CONSUMPTION AND INCOME
6000 5000 4000
$7000
19921993199419951996199719981999 2000
of dollars per year)
C = YD
DISPOSABLE INCOME (billions of dollars per year)
$1000 2000 3000 4000 Actual consumer spending 4000
3000 2000 1000
0 5000 6000 7000
45°
1980198119821983198419851986198719881989199019911992
CONSUMPTION (billions o
12
CONSUMPTION VS. SAVING
Keynes described the consumption-income relationship in two ways:
As the ratio of total consumption to total disposable income.
income.
As the relationship of changes in consumption to changes in disposable income.
13
CONSUMPTION VS. SAVING
The average propensity to consume (APC) is total consumption in a given period divided by total disposable income.
YD
= C income disposable Total
n consumptio Total
= APC
YD
= S income disposable Total
saving Total
= APS
14
AVERAGE PROPENSITY TO SAVE
By definition, disposable income is either consumed (spent on consumption) or saved.
APS = 1 – APC
15
THE MARGINAL PROPENSITY TO CONSUME
The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.
16
THE MARGINAL PROPENSITY TO CONSUME
It is the change in consumption divided by the change in disposable income.
Ch i C i C
MPC = Change in Consumption
Change in Disposable Income= C YD
17
MARGINAL PROPENSITY TO SAVE
The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption.
MPS = 1 MPC MPS = 1 – MPC
18
YD
= S Income Disposable in
Change
Saving in Change
=
MPS
THE MPC AND MPS
MPS = 0.20 MPC = 0.80
19
AUTONOMOUS CONSUMPTION
Keynes noted that consumption is not completely determined by current income.
Some consumption is autonomous (independent of income)
(independent of income).
The non-income determinants of consumption include expectations, wealth, credit, taxes, and price levels.
20
NON-INCOME: EXPECTATIONS
People who anticipate a pay raise often increase spending before extra income is received.
People who expect to be laid off tend to save
People who expect to be laid off tend to save more and spend less.
21
NON-INCOME: WEALTH
The amount of wealth an individuals own affects their willingness and ability to consume.
The wealth effect is a change in consumer spending caused by a change in the value of spending caused by a change in the value of owned assets.
22
NON-INCOME: CREDIT
Availability of credit allows people to spend more than their current income.
The need to pay past debt may limit current consumption
consumption.
23
NON-INCOME: TAXES
Taxes are the link between total and disposable income.
Tax cuts give consumers more disposable income
income.
24
NON-INCOME: PRICE LEVELS
Rising price levels reduce real value of money and may cause people to curtail spending.
25
INCOME-DEPENDENT CONSUMPTION
Keynes distinguished two kinds of consumer spending.
Spending not influenced by current income, and
Spending that is determined by current income
Spending that is determined by current income.
26
INCOME-DEPENDENT CONSUMPTION
These determinants of consumption are summarized in the equation called the consumption function.
Total Consumption = Autonomous Consumption
+ Income Dependant Consumption
The consumption function is a mathematical relationship that helps to predict consumer
behavior. 27
INCOME-DEPENDENT CONSUMPTION
The consumption function is the mathematical relationship indicating the rate of desired consumer spending at various income levels.
28
INCOME-DEPENDENT CONSUMPTION
The consumption function provides a precise basis for predicting how changes in income (YD) effect consumer spending (C).
C = a + bY C = a + bYD
where:
C= current consumption a= autonomous consumption b= marginal propensity to consume YD= disposable income
29
ONE CONSUMER’S BEHAVIOR
We expect that even with an income level of zero, there will be some consumption.
This is the autonomous consumption.
W t ti t i ith i
We expect consumption to rise with income based on the consumer’s MPC.
Dissaving occurs when current consumption exceeds current income – a negative saving flow.
30
THE 45-DEGREE LINE
The 45-degree line represents all points where consumption and income are exactly equal.
The slope of the consumption function equals the marginal propensity to consume
the marginal propensity to consume.
C = YD
31
JUSTIN’S CONSUMPTION FUNCTION
Consumption = $50 + 0.75YD Disposable
Income (YD)
Autonomous
Consumption + Income-Dependent
Consumption = Total
Consumption A $ 0 50 $ 0 $ 50
B 100 50 75 125
C 200 50 150 200
D 300 50 225 275
E 400 50 300 350
F 500 50 375 425
32
JUSTIN’S CONSUMPTION FUNCTION
$400 C = YD
Saving
D
E
$50 100 150 200 250 300 350 400 450 Dissaving
Consumption Function C = $50 + 0.75YD
$125 A
C
B
G
33
SHIFTS OF THE CONSUMPTION FUNCTION
Repeated studies suggest that consumers increase their consumptions as their incomes increase
A change in the values of a or b in the
A change in the values of a or b in the consumption function (C = a + bYD) will shift the function to a new position.
A change in the variable awill cause a parallel shift of the function.
34
SHIFTS OF THE CONSUMPTION FUNCTION
An increase in consumer confidence will increase autonomous consumption, shifting the consumption function up.
I A decrease in consumer confidence will decrease autonomous consumption, shifting the consumption function down.
35
SHIFT IN THE CONSUMPTION FUNCTION
C = a2+ bYD
C = a1+ bYD
ollars per year)
a2
a1
CONSUMPTION (C) (do
DISPOSABLE INCOME(dollars per year) 0
36
SHIFTS VS. MOVEMENTS
Incomes declined and consumer confidence fell during the 2001 recession.
Declining income prompted a movement along the consumption function.
consumption function.
Falling consumer confidence shifted the function downward.
37
SHIFTS VS. MOVEMENTS
MPTION llars per year) Cg Cf
Shift g
f
C = a2+ bYD
C = a1+ bYD
CONSUM (billions of dol
DISPOSABLE INCOME (billions of dollars per year)
0 Y2 Y1
a1 Ch
Shift
a2
h
38
SHIFTS OF AGGREGATE DEMAND
Shifts in the consumption function are reflected in shifts of the aggregated demand curve.
A downward shift of the consumption function
A downward shift of the consumption function implies a reduction (a leftward shift) in aggregate demand.
An upward shift of the consumption function implies an increase (a rightward shift) of the aggregate demand.
39
AD EFFECTS OF CONSUMPTION SHIFTS
f
C2
Shift f f
Expenditure Price Level
Y0
f1
f2
Q1 Q2
P1
AD2
Shift = f2– f1
Income C1
Real Output AD1
40
SHIFT FACTORS
Shift factors include all of the non income determinants of consumption.
Changes in consumer confidence (expectations).
Changes in wealth
Changes in wealth.
Changes in credit conditions.
Changes in tax policy.
41
SHIFTS AND CYCLES
Shifts in aggregate demand can cause macro instability.
Aggregate demand shifts may originate from consumer behavior
consumer behavior.
If consumer spending increases abruptly, demand pull inflation will follow.
If consumer spending slows abruptly, a recession may occur.
42
INVESTMENT
Investment are expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in
business inventories.
business inventories.
The following factors determine the amount of investment that occurs in an economy:
Expectations.
Interest rates.
Technology and innovation.
43
DETERMINANTS
Expectations: Favorable expectations for future sales are a necessary condition for investment spending.
Interest Rates:
Businesses typically borrow money to invest in new plants or equipment.
The higher the interest rate, the costlier it is to invest and thus the lower the investment spending.
More investment occurs at lower rates.
New technology changes the demand for
investment goods. 44
INVESTMENT DEMAND
11
rcent per year) 10 9 8 7 6
C
I Better expectations
B A
Interest Rate (per
Planned Investment Spending (billions of dollars per year)
100 200 300 400 500
6 5 4 3 2 1 0
I2
I3 11
Initial expectations Worse expectations
45
SHIFTS OF INVESTMENT
Predictions about investment spending assume that investor expectations are stable.
This is often not the case.
46
ALTERED EXPECTATIONS
Business expectations are determined by business confidence in future sales.
An upsurge in confidence shifts the aggregate demand curve to the right.
demand curve to the right.
When investment spending declines, aggregate demand shifts to the left.
47
EMPIRICAL INSTABILITY
Investment spending fluctuates more than consumption.
Abrupt changes in investment were the cause of the 1990 91 recession
of the 1990-91 recession.
48
VOLATILE INVESTMENT SPENDING
+ 7
+ 2 + 3 + 4 + 5 + 6
arter (percent) C ti
+ 1+ 2 0 – 1 – 2 – 3 – 4– 5
1 1988 1989 1990
Calendar Quarter 1991 1992 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4
Change from Prior Qu Consumption
Investment
49
GOVERNMENT SPENDING
The government sector (federal, state, and local) currently spends over $2 trillion a year on goods and services.
Government spending decisions are made
Government spending decisions are made independently of current income.
50
NET EXPORTS
Net exports can be both uncertain and unstable, creating further shifts of aggregate demand.
51
MACRO FAILURE
Keynes had two chief concerns about macro equilibrium:
The market’s macro-equilibrium might not give us full employment or price stability.
full employment or price stability.
Even if the market’s macro-equilibrium were at full employment and price stability, it might not last.
52
UNDESIRED EQUILIBRIUM
Market participants make independent spending decisions.
There’s no reason to expect that the sum of their expenditures will generate exactly the their expenditures will generate exactly the right amount of aggregate demand.
53
RECESSIONARY GDP GAP
Keynes worried that equilibrium GDP may not occur at full-employment GDP.
Equilibrium GDP is the value of total output (real GDP) produced at macro equilibrium (AS=AD).
GDP) produced at macro equilibrium (AS AD).
Full-employment GDP is the value of total output (real GDP) produced at full employment.
54
RECESSIONARY GDP GAP
A recessionary GDP gap is the amount by which equilibrium GDP falls short of full-employment GDP.
I The gap represents unused productive capacity, lost GDP, and unemployed workers.
55
RECESSIONARY GDP GAP
Recessionary GDP gaps lead to cyclical unemployment.
GCyclical unemployment is the unemployment y p y p y attributable to a lack of job vacancies; that is, to inadequate aggregate demand.
56
MACRO FAILURES
PRICE LEVEL
Macro Success: (perfect AD)
AD1
AS
REAL GDP
P* E1
QF
57
MACRO FAILURES
PRICE LEVEL
Cyclical Unemployment: (too little AD) AS AD2
REAL GDP
P* E1
QF
E2
Q2
P2
QE2
recessionary GDP gap
58
INFLATIONARY GDP GAP
The economy might exceed its full-
employment/price stability capacity causing an inflationary GDP gap.
An inflationary GDP gap is the amount by which
An inflationary GDP gap is the amount by which equilibrium GDP exceeds full-employment GDP.
59
INFLATIONARY GDP GAP
Inflationary GDP gaps lead to demand-pull inflation.
GDemand-pull inflation is an increase in the p price level initiated by excessive aggregate demand.
60
MACRO FAILURES
PRICE LEVEL
Macro Success: (perfect AD)
AD1
AS
REAL GDP
P* E1
QF
61
MACRO FAILURES
PRICE LEVEL
Demand-pull inflation: (too much AD) AD3 AS
E3
P
P* E1
QF
P3 3
Q3
QE3
62
UNSTABLE EQUILIBRIUM
The goal is to produce at full employment BUT…
Equilibrium GDP may be greater or less than full-employment GDP.
R t hift f gg g t d d ld
Recurrent shifts of aggregate demand could cause a business cycle.
The business cycle is alternating periods of economic growth and contraction.
63
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.
stability.
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.
64
LOOKING FOR AD SHIFTS
Examples of leading indicators are:
Policymakers use the Index of Leading Indicators to forecast changes in GDP.
Examples of leading indicators are:
Average Workweek
Unemployment Claims
Delivery Times
Credit
Materials Prices
Equipment Orders
Stock Prices
Money Supply
New orders
Building Permits
Inventories
65
AGGREGATE SPENDING
End of Chapter 9