Chapter 11 Homework Number 1, 4, 8, and 14

Chapter 12 The Role of Aggregate Demand in the Short Run

The Importance of Aggregate Demand in the Short Run The long-run model  aggregate supply runs the economy and cures for any economic problems. Keynesian short-run model  aggregate demand causes and cures economic problems.

Figure 12.1(a) Impact of Changing Aggregate Demand on Short-Run Equilibrium

Figure 12.1(b) Impact of Changing Aggregate Demand on Short-Run Equilibrium

Changes in Aggregate Demand Changes in aggregate demand can result from  Consumption  Investment  Government Spending  Net Exports  C+I+G+(X-M)

The Role of Consumption Consumption  Is the largest component of aggregate demand in the United States  Represents about 70% of total GDP  Is very stable and difficult to change

The Role of Consumption Factors that can affect consumption:  Household wealth and debt  Consumers’ optimism or pessimism about the future  The level of real interest rates  The overall price level  Households current stock of durable goods

Consumption and Income Most important determinant is disposable income.  Income that remains after all taxes are paid As disposable income increases, households generally spend more dollars. But…they spend a smaller percentage of each additional dollar of disposable income.

Consumption and Income (cont’d) The marginal propensity to consume (MPC) is the fraction of additional income that is spent on consumption:  Example: Suppose a family receives a $600 tax cut, of which it spends $400 on consumption goods.  The MPC is then $400/$600 =.67

Consumption and Income (cont’d) The marginal propensity to save (MPS) is the fraction of additional income that is saved:  Example: Suppose a family receives a $600 tax cut, of which it saves $200.  The MPS is then $200/$600 =.33

Consumption and Income (cont’d) The value of the MPC plus the value of the MPS must equal 100% Disposable income can only be consumed or saved.

Can we do it? (number 4) Based on the following information calculate the MPC  What is the MPS for this sample household?  If the income increases to $12,900 and the MPC remains the same what will be the amount of consumption at the new level of income? IncomeConsumption $12,000$12,100 $12,300$12,350 $12,600

Answer anyone?? The MPC and MPS for this household are:

The Role of Investment Unlike consumption, investment can and does easily change. Depends on:  Business expectations about economic performance  Interest rates  Tax policies

The Role of Investment Can be easily but not reliably changed.  Not a good candidate for policy makers who want to change aggregate demand.

The Role of Net Exports The amount of net exports is determined by:  The value of the dollar If the dollar appreciates, U.S. imports would increase and U.S. exports would decrease. But value is determined in a huge market, policy makers can’t do much to affect its value.  The economic health of other nations Cannot be influenced by U.S. policy makers

The Role of Government So…it is hard to use consumption, investment or net exports to alter aggregate demand. So…Keynes concluded that it was up to the government to use its own spending and taxes to change aggregate demand. The government could:  Be the spender of last resort, or  Cut taxes to encourage consumption.

Summary The long-run model predicts that real- world economies will adjust to equilibrium at the full employment level of real GDP.  The Great Depression demonstrated the shortcomings of the long-run model.  The Keynesian short-run model emerged as an explanation of and a cure for macroeconomic problems.

Chapter 12 homework Numbers 5, 10, 13, and 15