chap009 4 (2010)
TRANSCRIPT
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?
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
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
Escaping a Recession
AS (Aggregate supply)
AD1
E1
REAL OUTPUT
PR
ICE
LE
VE
L
AD2
QFQE
PE
Components of Aggregate Demand
• The four components of aggregate demand are– Consumption (C)– Investment (I)– Government spending (G)– Net exports (X – M)
Consumption
• Consumption: Expenditure by consumers on final goods and services
• Consumer expenditures account for over two-thirds of total spending in the U.S.
Income and Consumption
• Most consumers spend most of whatever income they have
• Disposable income (DI): After-tax income of consumers
– DI personal income personal taxes
U.S. Consumption and Income
DISPOSABLE INCOME (billions of dollars per year)
$1000 2000 3000 4000
Actual consumer spending
6000
5000
4000
3000
2000
1000
0 5000 6000 7000
45°
$7000
19801982
19841986
19881990
19921994
1996
19981999
2000
CO
NSU
MPT
ION
(bill
ions
of d
olla
rs p
er y
ear)
C = YD
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
DY C SDisposable income consumption saving
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
Consumption vs. Saving
• The proportion of total disposable income spent on consumer goods and services is the average propensity to consume (APC)
D
total consumption CAPC
total disposable income Y
Consumption vs. Saving
• The proportion of total disposable income saved is the average propensity to save (APS)
1APS APC
D
total saving SAPS
total disposable income Y
Consumption vs. Saving
• Marginal propensity to consume (MPC): The fraction of each additional (marginal) dollar of disposable income spent on consumption
D
Change in Consumption CMPC
Change in Disposable Income Y
Consumption vs. Saving
• Marginal propensity to save (MPS): The fraction of each additional (marginal) dollar of disposable income not spent on consumption
D
Change in Saving SMPS
Change in Disposable Income Y
1MPS MPC
MPC and MPS
MPS = 0.20 MPC = 0.80
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
Autonomous Consumption
• Consumption that is independent of income is influenced by non-income determinants:– Expectations – people get a raise, spend it in
advance, expect economy to be poor, save.– Wealth – affects willingness to spend– Credit – need to pay past debt affects spending– Taxes – tax cuts give consumers more
disposable income to spend
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
• The consumption function provides a basis for predicting how changes in income effect consumer spending
Income-Dependent Consumption
DC a bY where :
current consumption autonomous consumption
marginal propensity to consume disposable incomeD
C a
b Y
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
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
A Consumption Function
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 = YD
• The slope of the consumption function is the marginal propensity to consume
A Consumption Function$400
$50 100 150 200 250 300 350 400 450
C = YD
Saving
DissavingConsumption Function
C = $50 + 0.75YD$125
A
C
D
E
B
G
The Aggregate Consumption Function
• Repeated studies suggest that in the aggregate consumers increase consumption as income increases
• The consumption function summarizes this behavior
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
DC a bY
Shift in the Consumption Function
a1
C = a1 + bYD
C = a2 + bYD
a2
CO
NS
UM
PT
ION
(C
)
DISPOSABLE INCOME0
Decreased confidence
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
AD Effects of Consumption Shifts
Y0
f2
f1
Q2 Q1
P1
C1
AD1
Shift = f1 – f2
Expenditure
Income
C2
Price Level
Real Output
AD2
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
Shifts and Cycles
• Shifts in aggregate demand can cause macro instability.
• Aggregate demand shifts may originate from consumer behavior.
LO2
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
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
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
Building an AD Curve
QCQ0
P0
AD
Pri
ce L
evel
Real GDP
QGQI QX-M
C I G X-Md
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
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
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
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
Macro Failures
PRICE LEVEL
REAL GDP
Macro Success: (perfect AD)
AD1
AS
P*E1
QF
Macro Failures
PRICE LEVEL
REAL GDP
Cyclical Unemployment: (too little AD)
AS
P*E1
QF
AD2
E2
Q2
P2
QE2
recessionary GDP gap
A Recessionary GDP Gap
Real GDP Demanded (in $ trillions) by:
Price Level
Consumers + Investors + Government + Net
Exports =
Aggregate Demand
Aggregate Supply
130 3.0 0.25 1.5 0.25 5.0 12.0
120 3.5 0.50 1.5 0.50 6.0 11.5
110 4.0 0.75 1.5 0.75 7.0 11.0
100 4.5 1.00 1.5 1.0 8.0 10.0
90 5.0 1.25 1.5 1.25 9.0 9.0
80 5.5 1.50 1.5 1.50 10.0 7.0
70 6.0 1.75 1.5 1.75 11.0 5.0
60 6.5 2.0 1.5 2.0 12.0 3.0
A Recessionary GDP Gap
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
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
Macro Failures
PRICE LEVEL
Demand-pull inflation: (too much AD)
AS
P*E1
QF
AD3
E3P3
Q3QE3
inflationary GDP gap
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
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
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
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