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INTRODUCTION AGGREGATE DEMAND MACRO EQUILIBRIUM MACRO EQUILIBRIUM THE DESIRED ADJUSTMENT THE DESIRED ADJUSTMENT

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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

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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

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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 

(4)

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

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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

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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

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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

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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

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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

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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

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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

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