Aggregate Demand Chapter 9

Chapter 9 – Aggregate Demand 1. Consumption. 2. The Consumption Function. 3. Investment. 4. Government & Net Export Spending. 5. Macro Failure. 6. Anticipating AD Shifts.

*************************** Note to self: This used to be Section 1. It transitions from Chapter 8 into this Chapter. Just talk this section through with an AD/AS graph on the board.

1. Macro Equilibrium & AD

Some Quick Review:

Macro Equilibrium AS and AD combine to determine macro equilibrium. Equilibrium is established where AS and AD intersect. e PRICE LEVEL REAL OUTPUT (quantity per year) QE PE Aggregate demand supply E

The Desired Adjustment Any particular macro equilibrium point may be undesirable. All economists agree that short-run unemployment is possible. Will the economy self-adjust ? If not, government might have to step in to increase AD to reach full employment.

Escaping a Recession REAL OUTPUT (quantity per year) PRICE LEVEL (average price) AS (Aggregate supply) E1 QE PE AD2 AD1 QF

…New Stuff…

1. Consumption

Four Components of Aggregate Demand To adjust AD, we need to understand AD and how various factors will affect it. The Four Components of Aggregate Demand are: Consumption (C) Investment (I) Government spending (G) Net exports (X - M) If we can increase the spending of any one of these components, we increase AD. LO1

Building an AD Curve

Consumption Consumption: spending by consumers on final goods and services. accounts for over two-thirds of total spending (GDP). LO1

Income and Consumption Consumers tend to spend most of their disposable incomes. (Disposable income: - the after-tax income of consumers: - personal income less personal taxes.) LO1

Income and Consumption By definition, all disposable income is either: consumed (spent ), or … saved (not spent). Disposable income = Consumption + Saving YD = C + S LO1

U.S. Consumption and Income $7000 2000 6000 1999 C = YD 1998 5000 1996 1994 4000 1992 CONSUMPTION (billions of dollars per year) 1990 1988 3000 1986 1984 2000 1982 1980 1000 Actual consumer spending 45° $1000 2000 3000 4000 5000 6000 7000 DISPOSABLE INCOME (billions of dollars per year) LO1

Income, Consumption, & AD If we can model consumer spending… …then we can predict consumer spending… … and more effectively manipulate the AD curve.

Income, Consumption, & AD Keynes described the consumption- income relationship in two ways: AVERAGE propensity to consume: - “APC" MARGINAL propensity to consume: - “MPC" LO1

Income, Consumption, & AD Average propensity to consume: The “AVERAGE” rate of spending. A ratio of: total consumption to total disposable income: Example: LO1

Average Propensity to Save Example: LO1

APC v. APS So… Since YD = C + S… - or - Example:

Marginal Propensity to Consume The ratio of: changes in consumption to changes in disposable income. - The fraction of each additional (marginal) dollar of disposable income spent on consumption. LO1

Marginal Propensity to Consume Example: LO1

Marginal Propensity to Save the fraction of each additional (marginal) dollar of disposable income not spent on consumption. Example: LO1

MPC vs. MPS YD = C + S So… Example:

The MPC and MPS MPS = 0.20 MPC = 0.80 LO1

Review If the MPC is .90 and the APC is .95: 1. What is the APS? 2. What is the MPS? 3. What is the level of spending if disposable income (Yd) is $600? 4. How much would be saved from an additional $100 of disposable income. 5. What are the four components of AD? .05 .1 $570 $10 C, I, G, (X-M)

Review 2 If the MPC is .85 and the APC is .98: 1. What is the APS? 2. What is the MPS? 3. What is the level of spending if disposable income (Yd) is $1200? 4. How much would be saved from an additional $100 of disposable income. 5. What are the four components of AD? .02 .15 $1176 $15 C, I, G, (X-M)

2. The Consumption Function

The Consumption Function a mathematical relationship that helps predict consumer behavior. Based in part on the concept of marginal propensity to consume. LO1

The Consumption Function Keynes distinguished two kinds of consumer spending. Autonomous: Spending not influenced by current income, Income-dependent: Spending that is determined by current income. LO1

The Consumption Function These two determinants of consumption are summarized in an equation called the consumption function. Income -dependent consumption Autonomous consumption Total consumption + = (***Informal, “theoretical” equation: not the mathematical equation!) LO1

Autonomous Consumption -consumption that occurs independent of income level. Autonomous determinants of consumption include: Expectations. Wealth. Credit. (Taxes) ?!? LO1

Expectations Examples: People who anticipate a pay raise often increase spending before extra income is received. People who expect to be laid off tend to save more and spend less. LO1

Wealth An individual’s wealth affects his willingness and ability to consume. The wealth effect: a change in consumer spending… …caused by… a change in the value of owned assets. LO1

Credit Availability of credit allows people to spend more than their current income. The cost of credit fluctuates. The need to pay past debt may limit current consumption. LO1

Taxes Taxes are the link between total and disposable income. Tax cuts give consumers more disposable income to spend. LO1

Income-Dependent Consumption This is delineated by one’s marginal propensity to consume (MPC): MPC x Disposable Income

The Consumption Function The mathematical relationship indicating the (desired) rate of consumer spending at various income levels. It combines autonomous and income- dependent consumption into one formula. It provides a precise basis for predicting how changes in income (YD) affect consumer spending (C) … …and therefore, AD! LO1

The Consumption Function 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. LO1

Review What are/is: The 4 components of AD? APC? APS? MPC? MPS? The mathematical relationship of APC to APS? MPC? MPS? The mathematical relationship of MPC to MPS? The two types of consumption?

Autonomous Consumption Determinants of Autonomous consumption: Expectations. Wealth. Credit. Taxes. LO1

The Consumption Function C = a + bYD Income -dependent consumption Autonomous consumption Total consumption + = where: C = current consumption a = autonomous consumption b = marginal propensity to consume YD = disposable income LO1

The Consumption Function

The 45-Degree Line The 45-degree line represents all points where consumption and income are exactly equal. C = YD LO1

Consumer Behavior Even with an income level of zero: there will be some consumption (autonomous). Consumption will rise with income based on the MPC. Slope = MPC. LO1

Consumer Behavior Dissaving: current consumption exceeds current income a negative saving flow. LO1

Justin’s Consumption Function LO1

Justin’s Consumption Function $400 C = YD E Saving D C Consumption Function C = $50 + 0.75YD Dissaving B $125 G A $50 100 150 200 250 300 350 400 450 LO1

The Aggregate Consumption Function Repeated studies suggest that consumers increase their consumptions as their incomes increase. LO1

Application Given C = 100 + .9YD If YD = $1,400., then: What is C ? What is the savings level? If C = $1,000., then: What is YD ? What is the slope of this consumption function? Graphically, what is the Y intercept? $1,360 $40 $1,000 $0.00

Application 2. Suppose the MPC in an economy is 0.7. The APC is initially 0.8 and disposable income is $10 billion. If disposable income increases to $14 billion, what is the new level of consumption? A). $10.8 billion. C). $8 billion. B). $11.2 billion. D). $12.8 billion.

Shifts of the Consumption Function Changing the a or b values in the consumption function (C = a + bYD) will shift the function to a new position. A change in the a variable will cause a parallel shift of the function. Caused by changes in expectations, wealth, or credit. LO1

Shift in the Consumption Function C = a1 + bYD CONSUMPTION (C) (dollars per year) DISPOSABLE INCOME(dollars per year) C = a2 + bYD Decreased confidence a1 a2 LO1

Shifts of Aggregate Demand Shifts in the consumption function: are reflected in shifts of AD: Consumption function ↑ = AD to the right: Consumption function ↓ = AD to the left: LO2

Review 1. What are the two main types of consumption that make up the consumption function? 2. What is the importance of the consumption function? 3. What are the determinants of autonomous consumption? 4. What is the determinant of income-dependent consumption? 5. What is the consumption function?

AD Effects of Consumption Shifts Expenditure Price Level AD1 C1 f1 Shift = f1 – f2 C2 P1 f2 AD2 Y0 Income Q2 Q1 Real Output ***The AD curve will shift if: - autonomous consumption changes, or… - consumer incomes change. LO2

AD Effects of Consumption Shifts Expenditure Price Level AD1 C1 f1 Shift = f1 – f2 C2 P1 f2 AD2 Y0 Income Q2 Q1 Real Output LO2

Shift Factors The AD curve will shift if consumer incomes change, or… autonomous consumption changes. LO2

Shift Factors The shift factors that can alter autonomous consumption include: Changes in expectations (consumer confidence). Changes in wealth. Changes in credit conditions. Changes in tax policy. LO2

Shifts and Cycles AD shifts may originate from consumer behavior. AD shifts = macro instability. LO2

Review Consumption function: 1. Suppose the MPC in an economy is 0.7. The APC is initially 0.8 and disposable income is $10 billion. If disposable income increases to $14 billion, what is the new level of consumption? $10.8 billion If disposable income increases from $9,000 billion to $11,000 billion, and consumption increases from $9,500 billion to $11,000 billion, the MPC must be: 0.75

3. Investment

Investment Investment: expenditures on (production of) new plant, equipment, and structures (capital), … in a given time period, … plus changes in business inventories. LO1

Determinants of Investment The following factors determine the amount of investment that occurs in an economy: Interest rates. Expectations. Technology and innovation. LO1

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 the lower the investment spending. LO1

Investment Demand A B 11 11 Interest Rate (percent per year) Planned Investment Spending (billions of dollars per year) 100 200 300 400 500 10 9 8 7 6 5 4 3 2 1 11 A B LO1

Expectations Expectations: play a critical role in investment decisions. are determined by business confidence in future sales. Confidence ↑ = AD shift to the right. LO1

Investment Demand Better expectations C A B I2 Initial expectations 11 Interest Rate (percent per year) Planned Investment Spending (billions of dollars per year) 100 200 300 400 500 10 9 8 7 6 5 4 3 2 1 Better expectations 11 A C B I2 Initial expectations Worse expectations I3 LO1

Technology and Innovation New technology changes the demand for investment goods: Technological advances and corresponding cost reductions stimulate new investment spending. LO1

Investment Demand Investment demand given 11 Interest Rate (percent per year) Planned Investment Spending (billions of dollars per year) 100 200 300 400 500 10 9 8 7 6 5 4 3 2 1 Investment demand given availability of new technology 11 A B I2 Initial Investment Demand LO1

So…. AD Shifts The AD curve shifts: to the left when investment spending declines. to the right when investment spending increases. LO2

AD Effects of Consumption Shifts Price Level The AD curve shifts: to the left when investment spending declines. to the right when investment spending increases. AD1 AD2 Q2 Q1 Real Output LO2

Investment Instability Investment spending fluctuates more than consumption. Abrupt changes in investment were the cause of the 2001 recession. LO2

Volatile Investment Spending LO2

4. Government Spending and Net Export Spending

Government Spending State-local government spending is slightly pro-cyclical: If consumption and investment spending decline, state/local government tax receipts fall, State/local spending subsequently falls, aggravating the leftward shift of the AD curve. LO1

Government Spending The federal government can “deficit spend: it has counter-cyclical power. can increase spending to counteract declines in consumption and investment spending. LO1

Net Exports Net exports can be both uncertain and unstable, creating further shifts of aggregate demand. LO1

So… The four components of spending (C+I+G+(X-M)) 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. LO1

Building an AD Curve

Review 1. Suppose a consumption function is given as C = $175 + 0.85YD. The marginal propensity to save is: 2. If an increase in disposable income causes consumption to increase from $4,000 to $10,000 and causes saving to increase from $2,000 to $4,000 it can be inferred that the MPC equals: 3. Suppose the consumption function is C = $300 + 0.9YD. If disposable income is $400, consumption is: What is the level of savings?

Review What are the 3 determinants of investment spending? What is the major difference between Federal v. state/local spending (demand) during a recession?

Application 2. Suppose the MPC in an economy is 0.7. The APC is initially 0.8 and disposable income is $10 billion. If disposable income increases to $14 billion, what is the new level of consumption? A). $10.8 billion. C). $8 billion. B). $11.2 billion. D). $12.8 billion.

5. Macro Failure

Macro Failure - REVIEW There are two chief concerns about macro equilibrium: Undesirability: The market’s macro-equilibrium might not give us full employment or price stability. Instability: Even if the market’s macro-equilibrium were at full employment and price stability, it might not last. LO3

Undesired Equilibrium Market participants make independent spending decisions. There’s no reason to expect that the sum of their expenditures will generate exactly the right amount of aggregate demand. LO3

Recessionary GDP Gap (REVIEW): 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). Full-employment GDP: is the value of total output (real GDP) produced at full employment. LO3

Macro Success: (perfect AD) Macro Failures Macro Success: (perfect AD) PRICE LEVEL REAL GDP AS AD1 E1 P* QF LO3

Macro Failures – Recessionary GDP Gap Cyclical Unemployment: (too little AD) PRICE LEVEL REAL GDP AS AD2 E1 P* QF P2 E2 QE2 recessionary GDP gap LO3

Recessionary GDP Gap Recessionary GDP gap: the amount by which equilibrium GDP falls short of full-employment GDP. The GDP gap represents unused productive capacity, lost GDP, and … unemployed workers. LO3

Recessionary GDP Gap Recessionary GDP gap cyclical unemployment: inadequate AD lack of jobs. LO3

A Recessionary GDP Gap LO3

A Recessionary GDP Gap LO3

Inflationary GDP Gap Inflationary GDP gap: the amount by which equilibrium GDP exceeds full-employment GDP. leads to demand-pull inflation: an increase in the price level initiated by excessive aggregate demand. LO3

Macro Success: (perfect AD) Macro Failures Macro Success: (perfect AD) PRICE LEVEL REAL GDP AS AD1 E1 P* QF LO3

Macro Failures - Inflationary GDP Gap Demand-pull inflation: (too much AD) PRICE LEVEL AS AD3 E3 P3 QE3 E1 P* QF inflationary GDP gap LO3

Unstable Equilibrium GDP gaps are clearly troublesome: The goal is to produce at full employment, but Equilibrium GDP may be greater or less than full-employment GDP. LO3

Unstable Equilibrium Recurrent shifts of aggregate demand cause business cycles: alternating periods of economic growth and contraction. LO3

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. LO3

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.

6. Anticipating AD Shifts

Looking for AD Shifts Policymakers use the Index of Leading Indicators to forecast changes in GDP: Average workweek. Unemployment claims. Delivery times. Credit. Materials prices. Equipment orders. Stock prices. Money supply. New orders. Building permits. Inventories.

Looking for AD Shifts

Aggregate Demand End of Chapter 9