INTRODUCTION AGGREGATE DEMAND MACRO EQUILIBRIUM MACRO EQUILIBRIUM THE DESIRED ADJUSTMENT THE DESIRED ADJUSTMENT

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1 Chapter 9 AGGREGATE DEMAND INTRODUCTION The Great Depression was a springboard for the Keynesian approach to economic policy. Keynes asked: 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? 2 MACRO EQUILIBRIUM Aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium. Remember: Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus. MACRO EQUILIBRIUM Equilibrium is established where AS and AD intersect. Equilibrium (macro) is the combination of price level and real output that is compatible with both aggregate demand and aggregate supply. 3 4 THE DESIRED ADJUSTMENT Macro equilibrium may or may not be at fullemployment. All economists recognize that short-run macro failure of unemployment is possible. A central macroeconomic debate is over whether AS and AD will shift on their own to reach full employment. THE DESIRED ADJUSTMENT John Maynard Keynes asserted that high unemployment was likely to be caused by deficient aggregate demand. Keynes said that a market driven aggregate demand curve might not shift when needed. Government would have to intervene to shift the AD curve rightward to reach full employment. 5 6

2 ESCAPING A RECESSION IN ANALYZING AD, WE ASK: verage price) PRICE LEVEL (av P E E 1 Q E Q F REAL OUTPUT (quantity per year) AS (Aggregate supply) AD 2 AD 1 Who is buying the output of the economy? What factors influence their purchase decisions? Four Components of Aggregate Demand: Consumption (C) Investment (I) Government spending (G) Net exports (X - IM) 7 8 CONSUMPTION Consumption expenditures are spending by consumers on final goods and services. Consumer expenditures account for two-thirds of total spending. INCOME AND CONSUMPTION Keynes believed that the amount consumers decide to spend is determined by their disposable income. Disposable income is the after-tax tax income of consumers personal income less personal taxes INCOME AND CONSUMPTION U.S. CONSUMPTION AND INCOME By definition, all disposable income is either consumed (spent) or saved (not spent). Disposable income = Consumption + Saving Y D = C + S of dollars per year) CONSUMPTION (billions o $ C = Y D Actual consumer spending 45 0 $ DISPOSABLE INCOME (billions of dollars per year) 11 12

3 CONSUMPTION VS. SAVING Keynes described the consumption-income relationship in two ways: As the ratio of total consumption to total disposable income. As the relationship of changes in consumption to changes in disposable income. CONSUMPTION VS. SAVING The average propensity to consume (APC)is total consumption in a given period divided by total disposable income. Total consumption APC = Total disposable income Total saving APS = Total disposable income = = C YD S YD AVERAGE PROPENSITY TO SAVE By definition, disposable income is either consumed (spent on consumption) or saved. APS = 1 APC THE MARGINAL PROPENSITY TO CONSUME The marginal propensity to consume (MPC)is the fraction of each additional (marginal) dollar of disposable income spent on consumption THE MARGINAL PROPENSITY TO CONSUME It is the change in consumption divided by the change in disposable income. Change in Consumption MPC = Change in Disposable Income = C YD MARGINAL PROPENSITY TO SAVE The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption. MPS = 1 MPC MPS = Change in Saving Change in Disposable Income S = YD 17 18

4 THE MPC AND MPS AUTONOMOUS CONSUMPTION Keynes noted that consumption is not completely determined by current income. Some consumption is autonomous (independent of income). The non-income determinants of consumption include expectations, wealth, credit, taxes, and price levels. MPS = 0.20 MPC = NON-INCOME: EXPECTATIONS 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. NON-INCOME: WEALTH The amount of wealth an individuals own affects their willingness and ability to consume. The wealth effect is a change in consumer spending caused by a change in the value of owned assets NON-INCOME: CREDIT Availability of credit allows people to spend more than their current income. The need to pay past debt may limit current consumption. NON-INCOME: TAXES Taxes are the link between total and disposable income. Tax cuts give consumers more disposable income

5 NON-INCOME: PRICE LEVELS Rising price levels reduce real value of money and may cause people to curtail spending. INCOME-DEPENDENT CONSUMPTION Keynes distinguished two kinds of consumer spending. Spending not influenced by current income, and Spending that is determined by current income INCOME-DEPENDENT CONSUMPTION These determinants of consumption are summarized in the equation called the consumption function. INCOME-DEPENDENT CONSUMPTION The consumption function is the mathematical relationship indicating the rate of desired consumer spending at various income levels. Total Consumption = Autonomous Consumption + Income Dependant Consumption The consumption function is a mathematical relationship that helps to predict consumer behavior INCOME-DEPENDENT CONSUMPTION The consumption function provides a precise basis for predicting how changes in income (Y D ) effect consumer spending (C). C = a + by C = a + by D where: C = current consumption a = autonomous consumption b = marginal propensity to consume Y D = disposable income ONE CONSUMER S BEHAVIOR We expect that even with an income level of zero, there will be some consumption. This is the autonomous consumption. We expect consumption to rise with income based on the consumer s MPC. Dissaving occurs when current consumption exceeds current income a negative saving flow

6 THE 45-DEGREE LINE The 45-degree line represents all points where consumption and income are exactly equal. The slope of the consumption function equals the marginal propensity to consume. JUSTIN S CONSUMPTION FUNCTION Disposable Income (YD) Autonomous Consumption Consumption = $ Y D + Income-Dependent Consumption = Total Consumption A $ 0 50 $ 0 $ 50 B C = Y D C D E F JUSTIN S CONSUMPTION FUNCTION $400 Dissaving B $125 A G C C = Y D D E Saving Consumption Function C = $ Y D $ SHIFTS OF THE CONSUMPTION FUNCTION Repeated studies suggest that consumers increase their consumptions as their incomes increase A change in the values of a or b in the consumption function (C = a + by D ) will shift the function to a new position. A change in the variable a will cause a parallel shift of the function SHIFTS OF THE CONSUMPTION FUNCTION SHIFT IN THE CONSUMPTION FUNCTION An increase in consumer confidence will increase autonomous consumption, shifting the consumption function up. A decrease in consumer confidence will decrease autonomous consumption, shifting the consumption function down. ollars per year) CONSUMPTION (C) (do a 2 a 1 C = a 2 + by D C = a 1 + by D 0 DISPOSABLE INCOME(dollars per year) 35 36

7 SHIFTS VS. MOVEMENTS SHIFTS VS. MOVEMENTS Incomes declined and consumer confidence fell during the 2001 recession. Declining income prompted a movement along the consumption function. Falling consumer confidence shifted the function downward. CONSUM MPTION (billions of dol llars per year) C f C g a 1 C h h g Shift f C = a 1 + by D C = a 2 + by D a 2 0 Y 2 Y 1 DISPOSABLE INCOME (billions of dollars per year) SHIFTS OF AGGREGATE DEMAND AD EFFECTS OF CONSUMPTION SHIFTS Shifts in the consumption function are reflected in shifts of the aggregated demand curve. A downward shift of the consumption function implies a reduction (a leftward shift) in aggregate demand. An upward shift of the consumption function implies an increase (a rightward shift) of the aggregate demand. Expenditure f f 2 f 1 Y 0 Price Level C 2 Shift = f 2 f 1 C 1 P 1 AD 1 AD 2 Income Q 1 Q 2 Real Output SHIFT FACTORS Shift factors include all of the non income determinants of consumption. Changes in consumer confidence (expectations). 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. If consumer spending increases abruptly, demand pull inflation will follow. If consumer spending slows abruptly, a recession may occur

8 INVESTMENT Investment are expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories. The following factors determine the amount of investment that occurs in an economy: Expectations. Interest rates. Technology and innovation. 43 DETERMINANTS Expectations: Favorable expectations for future sales are a necessary condition for investment spending. 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 thus the lower the investment spending. More investment occurs at lower rates. New technology changes the demand for investment goods. 44 INVESTMENT DEMAND SHIFTS OF INVESTMENT rcent per year) Interest Rate (per A Better expectations C B Worse expectations I Initial expectations Planned Investment Spending (billions of dollars per year) I 3 Predictions about investment spending assume that investor expectations are stable. This is often not the case ALTERED EXPECTATIONS Business expectations are determined by business confidence in future sales. An upsurge in confidence shifts the aggregate demand curve to the right. When investment spending declines, aggregate demand shifts to the left. EMPIRICAL INSTABILITY Investment spending fluctuates more than consumption. Abrupt changes in investment were the cause of the recession

9 VOLATILE INVESTMENT SPENDING arter (percent) Change from Prior Qu Consumption Investment Calendar Quarter GOVERNMENT SPENDING The government sector (federal, state, and local) currently spends over $2 trillion a year on goods and services. Government spending decisions are made independently of current income NET EXPORTS Net exports can be both uncertain and unstable, creating further shifts of aggregate demand. MACRO FAILURE Keynes had two chief concerns about macro equilibrium: The market s macro-equilibrium might not give us full employment or price stability. Even if the market s macro-equilibrium were at full employment and price stability, it might not last 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. RECESSIONARY GDP GAP 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). AD). Full-employment GDP is the value of total output (real GDP) produced at full employment

10 RECESSIONARY GDP GAP A recessionary GDP gap is the amount by which equilibrium GDP falls short of full-employment GDP. The gap represents unused productive capacity, lost GDP, and unemployed workers. RECESSIONARY GDP GAP Recessionary GDP gaps lead to cyclical unemployment. Cyclical unemployment is the unemployment attributable to a lack of job vacancies; that is, to inadequate aggregate demand MACRO FAILURES MACRO FAILURES Macro Success: (perfect AD) Cyclical Unemployment: (too little AD) PRICE LEVEL AS PRICE LEVEL AS AD 1 AD 2 P* E 1 P* E 1 P 2 E 2 recessionary GDP gap Q F REAL GDP Q 2 Q E2 Q F REAL GDP INFLATIONARY GDP GAP The economy might exceed its fullemployment/price stability capacity causing an inflationary GDP gap. An inflationary GDP gap is the amount by which equilibrium GDP exceeds full-employment GDP. INFLATIONARY GDP GAP Inflationary GDP gaps lead to demand-pull inflation. Demand-pull inflation is an increase in the price level initiated by excessive aggregate demand

11 MACRO FAILURES MACRO FAILURES Macro Success: (perfect AD) Demand-pull inflation: (too much AD) PRICE LEVEL AS PRICE LEVEL AD 3 AS AD 1 P 3 E 3 P* E 1 P* E 1 Q F REAL GDP Q F Q E3 Q UNSTABLE EQUILIBRIUM The goal is to produce at full employment BUT Equilibrium GDP may be greater or less than full-employment GDP. Recurrent shifts of aggregate g demand d could cause a business cycle. The business cycle is 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. The critical question is whether undesirable outcomes will persist. Classical economists asserted that markets selfadjust so that macro failures would be temporary. Keynes didn t think that was likely to happen LOOKING FOR AD SHIFTS Policymakers use the Index of Leading Indicators to forecast changes in GDP. Examples of leading indicators are: Average Workweek Stock Prices Unemployment Claims Money Supply Delivery Times New orders Credit Building Permits Materials Prices Inventories Equipment Orders End of Chapter 9 AGGREGATE SPENDING 65