1. Aggregate Demand Chapter 9 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. 9-2 Aggregate Demand By working through the demand side of the macro economy we’ll better understand business cycles and their causes –What are the components of aggregate demand? –What determines the level of spending for each? –Will there be enough to maintain full employment?

3. 9-3 Macro Equilibrium The forces of aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply

4. 9-4 The Desired Adjustment All economists recognize that short-run macro failure is possible The debate is over whether the economy will self-adjust to full employment If not, government might have to step in and adjust AD to reach full employment

5. 9-5 Escaping a Recession AS (Aggregate supply) AD 1 E1E1 REAL OUTPUT PRICE LEVEL AD 2 QFQF QEQE PEPE

6. 9-6 Components of Aggregate Demand The four components of aggregate demand are –Consumption (C) –Investment (I) –Government spending (G) –Net exports (X – M)

7. 9-7 Consumption Consumption: Expenditure by consumers on final goods and services Consumer expenditures account for over two- thirds of total spending in the U.S.

8. 9-8 Income and Consumption Most consumers spend most of whatever income they have Disposable income (DI): After-tax income of consumers

9. 9-9 U.S. Consumption and Income DISPOSABLE INCOME (billions of dollars per year) $1000200030004000 Actual consumer spending 6000 5000 4000 3000 2000 1000 0 500060007000 45° $7000 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 1999 2000 CONSUMPTION (billions of dollars per year) C = Y D

10. 9-10 Consumption vs. Saving All disposable income is either consumed (spent) or saved (not spent) Saving: That part of disposable income not spent on current consumption

11. 9-11 Consumption vs. Saving To determine effect on AD, need to consider fractions of DI consumed and saved –In terms of averages - the ratios of total consumption and saving to total disposable income –In terms of marginal decisions - relationship of changes in consumption and saving to changes in disposable income

12. 9-12 Consumption vs. Saving The proportion of total disposable income spent on consumer goods and services is the average propensity to consume (APC)

13. 9-13 Consumption vs. Saving The proportion of total disposable income saved is the average propensity to save (APS)

14. 9-14 Consumption vs. Saving Marginal propensity to consume (MPC): The fraction of each additional (marginal) dollar of disposable income spent on consumption

15. 9-15 Consumption vs. Saving Marginal propensity to save (MPS): The fraction of each additional (marginal) dollar of disposable income not spent on consumption

16. 9-16 MPC and MPS MPS = 0.20MPC = 0.80

17. 9-17 The Consumption Function It is useful to know what drives consumption in order to help predict consumer behavior Keynes distinguished two kinds of consumer spending –Spending that is not influenced by current income (autonomous) –Spending that is determined by current income

18. 9-18 Autonomous Consumption Consumption that is independent of income is influenced by non-income determinants: –Expectations –Wealth –Credit –Taxes

19. 9-19 Income-Dependent Consumption Consumption function: A mathematical relationship indicating the rate of desired consumer spending at various income levels income - dependent consumption autonomous consumption Total consumption 

20. 9-20 The consumption function provides a basis for predicting how changes in income effect consumer spending Income-Dependent Consumption

21. 9-21 Income-Dependent Consumption 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

22. 9-22 One Consumer’s Behavior Even with an income level of zero there will be some consumption Consumption will rise with income based on the consumer’s MPC Dissaving: Consumption expenditure in excess of disposable income; a negative saving flow

23. 9-23 A Consumption Function

24. 9-24 The 45-Degree Line In a graph of the consumption function, the 45- degree line represents all points where consumption and income are exactly equal, or C = Y D The slope of the consumption function is the marginal propensity to consume

25. 9-25 A Consumption Function $400 $50100150200250300350400450 C = Y D Saving Dissaving Consumption Function C = $50 + 0.75Y D $125 A C D E B G

26. 9-26 The Aggregate Consumption Function Repeated studies suggest that in the aggregate consumers increase consumption as income increases The consumption function summarizes this behavior

27. 9-27 Shifts of the Consumption Function A change in the a or b parameters will move the consumption function to a new position A change in a will cause a parallel shift up or down of the function A change in b alters the slope of the function

28. 9-28 Shift in the Consumption Function a1a1 C = a 1 + bY D C = a 2 + bY D a2a2 CONSUMPTION (C) DISPOSABLE INCOME 0 Decreased confidence

29. 9-29 Shifts of Aggregate Demand Shifts in the consumption function are reflected in shifts of the aggregate demand curve –A downward shift of the consumption function implies a leftward shift in aggregate demand –An upward shift of the consumption function implies a rightward shift in aggregate demand

30. 9-30 AD Effects of Consumption Shifts Y0Y0 f2f2 f1f1 Q2Q2 Q1Q1 P1P1 C1C1 AD 1 Shift = f 1 – f 2 Expenditure Income C2C2 Price Level Real Output AD 2

31. 9-31 AD Shift Factors The AD curve will shift in response to –Changes in income –Changes in expectations (consumer confidence) –Changes in wealth –Changes in credit conditions –Changes in tax policy

32. 9-32 Shifts and Cycles Shifts in aggregate demand due to consumer behavior can cause macro instability –If consumer spending increases abruptly, demand- pull inflation may follow –If consumer spending slows abruptly, a recession may occur

33. 9-33 Investment Investment represents another source of demand for output Investment: Expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories

34. 9-34 Determinants of Investment The amount of investment depends on –Expectations: Favorable expectations for future sales are a necessary condition for investment –Interest rates: Lower rates increase investment spending, while higher rates do the opposite –Technology and innovation: Advances increase investment spending

35. 9-35 Altered Expectations Business expectations are determined by business confidence in future sales –An upsurge in confidence shifts the investment demand curve to the right –When business expectations worsen, investments get postponed or canceled and the investment demand curve shifts left

36. 9-36 Investment Demand 11 Interest Rate (percent) Planned Investment Spending 100200300400500 10 9 8 7 6 5 4 3 2 1 0 C I2I2 I3I3 I1I1 Better expectations B A Initial expectations Worse expectations

37. 9-37 AD Shifts Aggregate demand shifts when investment spending changes The aggregate demand curve shifts right when investment spending increases and shifts left when investment spending declines

38. 9-38 Empirical Instability Investment spending fluctuates more than consumption Abrupt changes in investment were the cause of the 2001 recession

39. 9-39 Volatile Investment Spending Source: U.S. Bureau of Economic Analysis

40. 9-40 Government Spending State-local government spending is slightly pro-cyclical If consumption and investment spending decline, state-local government receipts fall State-local spending subsequently falls, aggravating the leftward shift of the AD curve

41. 9-41 Government Spending The federal government is not constrained by tax receipts so it has counter-cyclical power The federal government can increase spending to counteract declines in consumption and investment spending

42. 9-42 Net Exports Net exports can be both uncertain and unstable, also affecting aggregate demand –Exports react to foreign demand, which is affected by foreign incomes, expectations, wealth, etc. –Imports are affected by the same factors affecting domestic consumption and investment demand

43. 9-43 The AD Curve Revisited The four components of spending 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

44. 9-44 Building an AD Curve QCQC Q0Q0 P0P0 AD Price Level Real GDP QGQG QIQI Q X-M CIGX-M d

45. 9-45 Macro Failure There are two chief concerns about macro equilibrium: –The market’s macro-equilibrium might not give us full employment or price stability –Even if macro-equilibrium were at full employment and price stability, it might not last

46. 9-46 Undesired Equilibrium Market participants make independent spending decisions There is no reason to expect that the sum of their expenditures will generate exactly the right amount of aggregate demand

47. 9-47 Recessionary GDP Gap Equilibrium may not occur at full-employment –Equilibrium GDP: The value of total output (real GDP) produced at macro equilibrium (AS=AD) Recessionary GDP gap: The amount by which equilibrium GDP falls short of full- employment GDP

48. 9-48 Recessionary GDP Gap The recessionary GDP gap represents unused productive capacity, lost GDP, and unemployed workers Cyclical unemployment: Unemployment attributable to a lack of job vacancies; that is, to inadequate aggregate

49. 9-49 Macro Failures PRICE LEVEL REAL GDP Macro Success: (perfect AD) AD 1 AS P* E1E1 QFQF

50. 9-50 Macro Failures PRICE LEVEL REAL GDP Cyclical Unemployment: (too little AD) AS P* E1E1 QFQF AD 2 E2E2 Q2Q2 P2P2 Q E2 recessionary GDP gap

51. 9-51 A Recessionary GDP Gap

52. 9-52 A Recessionary GDP Gap

53. 9-53 Inflationary GDP Gap Equilibrium GDP might exceed its full- employment/price stability capacity Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP

54. 9-54 Inflationary GDP Gap An inflationary GDP gap leads to demand-pull inflation Demand-pull inflation: An increase in the price level initiated by excessive aggregate demand

55. 9-55 Macro Failures PRICE LEVEL Demand-pull inflation: (too much AD) AS P* E1E1 QFQF AD 3 E3E3 P3P3 Q3Q3 Q E3 inflationary GDP gap

56. 9-56 Unstable Equilibrium GDP gaps are clearly troublesome, since goal is to produce at full employment Recurrent shifts of aggregate demand could cause a business cycle Business cycle: Alternating periods of economic growth and contraction

57. 9-57 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

58. 9-58 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

59. 9-59 The Leading Economic Indicators Policymakers use the Index of Leading Indicators to forecast changes in GDP Average workweek Unemployment claims New orders Delivery times Equipment orders Building permits Stock prices Money supply Interest rates Consumer confidence

60. Aggregate Demand End of Chapter 9 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin