AD’s Role in a Recession and Recovery In the Great Recession, spending decreased across the board and layoffs occurred in many industries. AD declined. It shifted left away from full-employment GDP as the country fell into recession. To escape from recession, AD must increase. The AD curve must shift to the right toward full-employment GDP. It is fundamental Keynesian reasoning that recessions are caused by AD shifting left and cured by AD shifting right.

AD’s Role in a Recession and Recovery In this chapter we explore what is behind the AD curve. Specifically, what causes AD to shift? 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? We will look at the components of AD and what causes each component to increase or decrease.

Learning Objectives 09-01. Know what the major components of aggregate demand are. 09-02. Know what the consumption function tells us. 09-03. Know the determinants of investment spending. 09-04. Know how and why AD shifts occur. 09-05. Know how and when macro failure occurs. We will review the chapter based on these objectives.

Macro Equilibrium In the macro model, AD and AS intersect. This is macro equilibrium. Macro equilibrium: the combination of price level and real output that is compatible with both AD and AS. The rate of output equals the rate of spending. If there are no disturbances, the economy gravitates to macro equilibrium. The economy can be in macro equilibrium at any level of output: at full employment, in a recession, or in an overheated state.

Disposable income = Consumption + Saving Consumption (C) Consumption (C): expenditure by consumers on final goods and services. Accounts for over two-thirds of total spending. Consumers tend to spend most of their disposable income (YD) – that is, income remaining after taxes. They save the rest. Saving (S): Disposable income not spent as consumption (C). C is by far the largest component. This is the reason why most policy levers attempt to “stimulate” consumer spending. The economic concept of saving as “not spending” might need to be elaborated upon. Disposable income = Consumption + Saving YD = C + S

Average Propensity to Consume (APC) APC: total consumption in a given time period divided by total disposable income. In 2010 U.S. consumers had an APC of 0.942. They saved only 6 cents out of each dollar of disposable income. APC can be greater than 1 if credit is used to finance current consumption. APC = Total consumption = C Total disposable income YD We spend, on average, over 94% of our disposable income. If we rely on a line of credit, spending can go over 100% of income.

Marginal Propensity to Consume (MPC) MPC: the fraction of each additional (marginal) dollar of disposable income spent on consumption. MPC is not as high as APC since consumers do not respond to the next dollar earned in the same way as past dollars. As income rises, more saving can occur. MPC = Change in consumption = ΔC Change in disposable income ΔYD It might be necessary to reinforce the difference between “average” and “marginal.” Here, “marginal” means what happens to the next increment of income earned. Typically the next increment of income will be partitioned, with more going to saving than the previous income. Thus MPC < APC, and later MPS > APS.

Marginal Propensity to Save (MPS) MPS: the fraction of each additional (marginal) dollar of disposable income not spent on consumption – that is, saved. Since added disposable income is either spent or saved, the MPC + MPC = 1 always. MPS = 1 - MPC Since the only things the consumer can do with disposable income are spend it or save it, this relation is obvious.

The Consumption Function The two determinants of consumption are Autonomous consumption. Income-dependent consumption. “Autonomous” in this instance means determined by something other than income. People who have no income still buy things, either with retrieved savings or borrowed funds.

The Consumption Function Autonomous consumption: consumer spending not dependent on current income. people consume even if they have no income… … by borrowing or drawing down savings. They expect future income changes. They perceive greater wealth and increase spending, and vice versa. There is availability of credit. Tax increases and rebates alter their disposable income. Income-dependent consumption: consumer spending that increases as income increases, and vice versa. Income-dependent: as income increases, more will be spent. Also, less drawing down on savings and less borrowing will occur.

The Consumption Function Together they make up the consumption function: The consumption function allows us to predict how much the consumption component of AD will change when incomes change. C = a + bYD where C = current consumption a = autonomous consumption b = marginal propensity to consume YD = disposable income The term bYD represents income-dependent consumption. Also, b is the slope of the consumption function. b = MPC. And a is the intercept of the consumption function on the Y-axis. It is the consumption amount when income = 0.

AD Shift Factors A change in consumption (C) causes AD to shift. Thus AD will shift in response to changes in Income. Expectations (consumer confidence). Wealth. Credit conditions. Tax policy. In 2008-2009, home equity fell (wealth decrease) and consumer confidence fell. AD shifted left, resulting in the Great Recession. Shifts in AD can be a cause of macro instability. AD shifts left when income falls, expectations worsen, wealth decreases, credit conditions tighten, and tax policy causes rising tax burdens. AD shifts right when income rises, expectations improve, wealth increases, credit conditions become more loose, and tax policy leads to lower tax burdens.

Investment Investment: expenditures on new plants, equipment, and structures, plus changes in inventories. Includes fixed investment and inventory investment. Favorable expectations of future sales are necessary for investment spending. Investment spending is inversely related to interest rates, ceteris paribus. Technological advances stimulate investment spending. Firms rank order potential investment projects by expected return on investment (ROI) and then compare them to the prevailing interest rate. Projects whose ROI > interest rate will be accepted and implemented. Those with ROI < interest rate will be rejected. If interest rates fall, more projects will be accepted, and vice versa.

The Investment Function Investment spending is inversely related to the interest rate. If expectations of future sales improve, the investment function shifts right, as will AD. Vice versa applies. Investment spending is the most volatile category of spending. If expectations of future sales improve, then ROI for that project rises, and the project might go from the reject pile to the accept pile. Since investment decisions are made at the executive level, projects can be turned on or off at a moment’s notice, which is the reason why investment spending is the most volatile component of AD. In the Great Recession of 2008-2009, it was the steep decline in investment spending that led the way for the large AD shift to the left.

Government Spending Because of balanced budget requirements, state and local spending will decrease when consumption and investment spending decrease. This contributes to instability. Because of deficit spending, federal spending can be increased to counter spending decreases in the other components. This is the basis of Keynesian demand-side policy. However, note that in a recession, federal tax receipts decline with income, and any increase in federal spending will generate a huge increase in both deficits and debt. This is exactly what happened in 2008-2009. Keynes countered his deficit hawk critics by saying that in a recession it was OK to run a deficit. He also said that in good economic times, the federal government should run a surplus to pay down the debt arising from the deficits. This aspect of Keynesianism has never been implemented.

Net Exports (X – M) Economic downturns in other lands lead to a decrease in U.S. exports (X), and vice versa. Economic downturns in the U.S. lead to a decrease in U.S. imports (M), and vice versa. If X – M decreases, AD shifts left. If X – M increases, AD shifts right. In the modern world, economic hard times seem to transcend borders. Thus both of these actions occur in an economic downturn. Lower X decreases GDP while lower M raises GDP (because it is subtracted).

Macro Failure Panel (a) is where we want to be. Panel (b) is when macro equilibrium occurs with high unemployment (too little AD). Panel (c) is when macro equilibrium occurs with too much inflation (too much AD). Panel (a) is where we want to be. Panel (b) is when macro equilibrium occurs with high unemployment (too little AD). Panel (c) is when macro equilibrium occurs with too much inflation (too much AD).

Macro Failure Two concerns about macro equilibrium: Macro equilibrium might not give us full employment or price stability. Even when macro equilibrium is perfectly positioned, it might not last. Equilibrium with cyclical unemployment (too little AD) occurs with a recessionary GDP gap. Equilibrium with demand-pull inflation (too much AD) occurs with an inflationary GDP gap. The recessionary GDP gap is the distance between equilibrium GDP and full-employment GDP, and represents the amount of GDP that needs to be added to the economy. The inflationary GDP gap is the distance between equilibrium GDP and full-employment GDP, and represents the amount of GDP that needs to be eliminated from the economy.

Recessionary GDP Gap Recessionary GDP gap: the amount by which equilibrium GDP falls short of full-employment GDP. At P*, too much would be produced. There are unsold inventories. We cut back production and lay off workers. Equilibrium occurs at P2 and QE, which is less than QF. AS Price level AD P* This is a graphical representation of a recessionary GDP gap. Recessionary GDP gap P2 Q2 QE QF Real GDP

Inflationary GDP Gap Inflationary GDP gap: the amount by which equilibrium GDP exceeds full-employment GDP. At P*, not enough would be produced. With inventories depleted, we begin to strain capacity and prices rise. Equilibrium occurs at P3 and QE, which is greater than QF. AD AS Price level P3 P* This is a graphical representation of the inflationary GDP gap. Inflationary GDP gap QF QE Q3 Real GDP