1. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Aggregate Demand Chapter 9

2. 2 Keynes’ Questions: 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?

3. 3 Macro Equilibrium Aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium.

4. 4 Macro Equilibrium Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. LO1

5. 5 Macro Equilibrium 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.

6. 6 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.

7. 7 The Desired Adjustment All economists agree that short-run unemployment is possible. The debate is over whether the economy will self-adjust to full employment. If not, government might have to step in to increase AD to reach full employment.

8. 8 Escaping a Recession AS (Aggregate supply) AD 1 E1E1 REAL OUTPUT (quantity per year) PRICE LEVEL (average price) AD 2 QFQF QEQE PEPE

9. 9 Four Components of Aggregate Demand Consumption (C) Investment (I) Government spending (G) Net exports (X - IM) LO1

10. 10 Consumption Consumption expenditures are spending by consumers on final goods and services. Consumer expenditures account for over two-thirds of total spending. LO1

11. 11 Income and Consumption Most consumers spend most of whatever income they have. Disposable income is the after-tax income of consumers – personal income less personal taxes. LO1

12. 12 Income and Consumption By definition, all disposable income is either consumed (spent ) or saved (not spent). Disposable income = Consumption + Saving Y D = C + S LO1

13. 13 Income and Consumption Saving is that part of disposable income not spent on current consumption; disposable income less consumption. LO1

14. 14 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 LO1

15. 15 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. LO1

16. 16 Average Propensity to Consumption The average propensity to consume (APC) is total consumption in a given period divided by total disposable income. LO1

17. 17 Average Propensity to Save By definition, disposable income is either consumed (spent on consumption) or saved. APS = 1 – MPS LO1

18. 18 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. LO1

19. 19 The Marginal Propensity to Consume The MPC is the change in consumption divided by the change in disposable income. LO1

20. 20 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 LO1

21. 21 The MPC and MPS MPS = 0.20MPC = 0.80 LO1

22. 22 The Consumption Function The consumption function is a mathematical relationship that helps to predict consumer behavior. LO1

23. 23 Autonomous Consumption Some consumption is autonomous (independent of income). The nonincome determinants of consumption include expectations, wealth, credit, and taxes. LO1

24. 24 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. LO1

25. 25 Wealth An individual’s wealth affects his willingness and ability to consume. The wealth effect is a change in consumer spending caused by a change in the value of owned assets. LO1

26. 26 Credit Availability of credit allows people to spend more than their current income. The need to pay past debt may limit current consumption. LO1

27. 27 Taxes Taxes are the link between total and disposable income. Tax cuts give consumers more disposable income to spend. LO1

28. 28 Income-Dependent Consumption Keynes distinguished two kinds of consumer spending. Spending not influenced by current income, and Spending that is determined by current income. LO1

29. 29 Income-Dependent Consumption These determinants of consumption are summarized in the equation called the consumption function. Income - dependent consumption Autonomous consumption Total consumption  LO1

30. 30 Income-Dependent Consumption The consumption function is the mathematical relationship indicating the rate of desired consumer spending at various income levels. LO1

31. 31 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 D where: C = current consumption a = autonomous consumption b = marginal propensity to consume Y D = disposable income LO1

32. 32 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. LO1

33. 33 One Consumer’s Behavior We expect that even with an income level of zero, there will be some consumption. We expect consumption to rise with income based on the consumer’s MPC. LO1

34. 34 One Consumer’s Behavior Dissaving occurs when current consumption exceeds current income – a negative saving flow. LO1

35. 35 The 45-Degree Line The 45-degree line represents all points where consumption and income are exactly equal. C = Y D LO1

36. 36 The 45-Degree Line The slope of the consumption function is the marginal propensity to consume. LO1

37. 37 Justin’s Consumption Function LO1

38. 38 Justin’s Consumption Function $400 $50100150200250300350400450 C = Y D Saving Dissaving Consumption Function C = $50 + 0.75Y D $125 A C D E B G LO1

39. 39 The Aggregate Consumption Function Repeated studies suggest that consumers increase their consumptions as their incomes increase. LO1

40. 40 Shifts of the Consumption Function Changing the a or b values in the consumption function (C = a + bY D) will shift the function to a new position. A change in the a variable will cause a parallel shift of the function. LO1

41. 41 Shift in the Consumption Function a1a1 C = a 2 + bY D C = a 1 + bY D a2a2 CONSUMPTION ( C ) (dollars per year) DISPOSABLE INCOME(dollars per year) 0 Decreased confidence LO1

42. 42 Shifts of Aggregate Demand Shifts in the consumption function are reflected in shifts of the aggregated demand curve. LO2

43. 43 Shifts of Aggregate Demand 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. LO2

44. 44 AD Effects of Consumption Shifts Y0Y0 f1f1 f2f2 Q1Q1 Q2Q2 P1P1 C2C2 AD 2 Shift = f 2 – f 1 Expenditure Income C1C1 Price Level Real Output AD 1 LO2

45. 45 Shift Factors The AD curve will shift if consumer incomes changes or autonomous consumption changes. LO2

46. 46 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

47. 47 Shifts and Cycles Shifts in aggregate demand can cause macro instability. Aggregate demand shifts may originate from consumer behavior. LO2

48. 48 Investment Investment are expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories. LO1

49. 49 Determinants of Investment The following factors determine the amount of investment that occurs in an economy: Expectations. Interest rates. Technology and innovation. LO1

50. 50 Expectations Expectations play a critical role in investment decisions. Favorable expectations for future sales are a necessary condition for investment spending. LO1

51. 51 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

52. 52 Technology and Innovation New technology changes the demand for investment goods. LO1

53. 53 Investment Demand 11 Interest Rate (percent per year) Planned Investment Spending (billions of dollars per year) 100200300400500 10 9 8 7 6 5 4 3 2 1 0 C I2I2 I3I3 1 Better expectations B A Initial expectations Worse expectations LO1

54. 54 Shifts of Investment Investor expectations are often volatile. LO1

55. 55 Altered Expectations Business expectations are determined by business confidence in future sales. An upsurge in confidence shifts the aggregate demand curve to the right. LO1

56. 56 AD Shifts Aggregate demand shifts when investment spending changes. The aggregate demand curve shifts to the left when investment spending declines. LO2

57. 57 Empirical Instability Investment spending fluctuates more than consumption. Abrupt changes in investment were the cause of the 2001 recession. LO2

58. 58 Volatile Investment Spending LO2

59. 59 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. LO1

60. 60 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. LO1

61. 61 Net Exports Net exports can be both uncertain and unstable, creating further shifts of aggregate demand. LO1

62. 62 The AD Curve 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. LO1

63. 63 Building an AD Curve QCQC Q2Q2 P1P1 AD 2 Shift = f 2 – f 1 Price Level Real Output AD 1 LO1

64. 64 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 the market’s macro-equilibrium were at full employment and price stability, it might not last. LO3

65. 65 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

66. 66 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 ). Full-employment GDP is the value of total output (real GDP) produced at full employment. LO3

67. 67 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. LO3

68. 68 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. LO3

69. 69 Macro Failures PRICE LEVEL REAL GDP Macro Success: (perfect AD) AD 1 AS P* E1E1 QFQF LO3

70. 70 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 LO3

71. 71 A Recessionary GDP Gap LO3

72. 72 A Recessionary GDP Gap LO3

73. 73 Inflationary GDP Gap The economy might exceed its full- employment/price stability capacity causing an inflationary GDP gap. An inflationary GDP gap is the amount by which equilibrium GDP exceeds full-employment GDP. LO3

74. 74 Inflationary GDP Gap An inflationary GDP gap leads to demand-pull inflation. Demand-pull inflation is an increase in the price level initiated by excessive aggregate demand. LO3

75. 75 Macro Failures PRICE LEVEL REAL GDP Macro Success: (perfect AD) AD 1 AS P* E1E1 QFQF LO3

76. 76 Macro Failures PRICE LEVEL Demand-pull inflation: (too much AD) AS P* E1E1 QFQF AD 3 E3E3 P3P3 Q3Q3 Q E3 inflationary GDP gap LO3

77. 77 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

78. 78 Unstable Equilibrium Recurrent shifts of aggregate demand could cause a business cycle. The business cycle is alternating periods of economic growth and contraction. LO3

79. 79 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

80. 80 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.

81. 81 Looking for AD Shifts Average workweek Unemployment claims Delivery times Credit Materials prices Equipment orders Stock prices Money supply New orders Building permits Inventories Policymakers use the Index of Leading Indicators to forecast changes in GDP:

82. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Aggregate Demand End of Chapter 9