1. Aggregate Demand
Chapter 9

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

3. ***************************
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.

4. 1. Macro Equilibrium & AD

5. Some Quick
Review:

6. 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

7. 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.

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

9. …New Stuff…

10. 1. Consumption

11. 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

12. Building an AD Curve

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

14. 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

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

16. 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

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

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

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

20. Average Propensity to Save
Example:
LO1

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

22. 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

23. Marginal Propensity to Consume
Example:
LO1

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

25. MPC vs. MPS
YD = C + S
So…
Example:

26. The MPC and MPS
MPS = 0.20
MPC = 0.80
LO1

27. 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)

28. 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)

29. 2. The Consumption Function

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

31. 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

32. 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

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

34. 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

35. 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

36. 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

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

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

39. 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

40. 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

41. 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?

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

43. 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

44. The Consumption Function

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

46. 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

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

48. Justin’s Consumption Function
LO1

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

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

51. 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

52. 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.

53. 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

54. 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

55. 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

56. 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?

57. 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

58. 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

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

60. 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

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

62. 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

63. 3. Investment

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

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

66. 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

67. 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

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

69. 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

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

71. Investment Demand Investment demand given11
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

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

73. 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

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

75. Volatile Investment Spending
LO2

76. 4. Government Spending and Net Export Spending

77. 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

78. 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

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

80. 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

81. Building an AD Curve

82. Review
1. Suppose a consumption function is given as C = $ YD. 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 = $ YD. If disposable income is $400, consumption is: What is the level of savings?

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

84. 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.

85. 5. Macro Failure

86. 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

87. 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

88. 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

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

90. 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

91. 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

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

93. A Recessionary GDP Gap
LO3

94. A Recessionary GDP Gap
LO3

95. 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

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

97. 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

98. 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

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

100. 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

101. 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.

102. 6. Anticipating AD Shifts

103. 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.

104. Looking for AD Shifts

105. Aggregate Demand
End of Chapter 9