Behavior of
Aggregate Demand
Increase/Decrease
Shift Right/Left
Recessionary/Inflationary Gaps
Major Questions to Address
• 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?
Four Components of Aggregate
Demand
•
•
•
•
Consumption (C)
Investment (I)
Government spending (G)
Net exports (X - IM)
Consumption
Big but Stable
Two Components
– Autonomous Consumption
– Income-Dependent (Induced) Consumption
Income and Consumption
• By definition, all disposable income is
either consumed (spent ) or saved (not
spent).
Disposable income = Consumption + Saving
YD = C + S
CONSUMPTION (billions of dollars per year)
U.S. Consumption and Income
$7000
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
6000
C = YD
5000
4000
3000
2000
1000
45°
0
$1000
Actual consumer spending
2000
3000
4000
5000
DISPOSABLE INCOME (billions of dollars per year)
6000
7000
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.
Change in Consumption
C
MPC =
=
Change in Disposable Income 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
The Consumption Function
• The consumption function is a mathematical
relationship that helps to predict consumer
behavior.
Autonomous income - dependent
Total consumptio n 

consumptio n
consumptio n
• The consumption function provides a precise
basis for predicting how changes in income
(YD) effect consumer spending (C).
C = a + bYD
where:
C = current consumption
a = autonomous consumption (constant)
b = marginal propensity to consume (slope)
YD = disposable income
Autonomous Consumption
• The non income determinants of
consumption include
–
–
–
–
–
expectations,
wealth,
credit,
taxes,
and price levels.
Consumption Function
$400
C = YD
E
Saving
D
C
Dissaving
Consumption Function
C = $50 + 0.75YD
B
$125
G
A
$50
100
150
200
250
300
350
400
450
CONSUMPTION (C) (dollars per year)
Shift in the Consumption
Function
C = a2 + bYD
C = a1 + bYD
a2
a1
0
DISPOSABLE INCOME(dollars per year)
AD Effects of Consumption
Shifts
Expenditure
Price Level
C2
Shift = f2 – f1
f2
C1
f1
P1
AD1
Y0
Income
Q1
AD2
Q2 Real Output
Investment
Small but Volatile
• Investment are expenditures on new plant,
equipment, and structures (capital) in a given
time period, plus changes in business
inventories.
• investment depends on:
– Expectations.
– Interest rates.
– Technology and innovation.
Interest Rate (percent per year)
Investment Demand
11
10
9
8
7
6
5
4
3
2
1
0
Better expectations
C
A
B
I2
Initial expectations
11
Worse expectations
100
200
300
400
I3
500
Planned Investment Spending (billions of dollars per year)
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.
GDP Gaps
• equilibrium GDP may not occur at fullemployment 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.
Recessionary GDP Gap
130
AD
AS
120
110
100
E
90
Recessionary
GDP gap
80
70
65
60
3
4
5
6
7
REAL GDP
8
9
10
11
12 13
Full-employment GDP
Equilibrium GDP
Inflationary GDP Gap
Demand-pull inflation: (too much AD)
PRICE
LEVEL
AS
AD3
E3
P3
E1
P*
QF
QE3
Q3
The Keynesian Cross
The Keynesian cross relates
aggregate expenditure to total income
(output).
At equilibrium, aggregate expenditure
equals income (output).
Aggregate Expenditures
• Aggregate expenditures are the rate of total
expenditure desired at alternative levels of
income, ceteris paribus, at a given price
level
• Aggregate expenditures is the sum of C,
I, G, and NX, at a given price level
The Consumption Shortfall
ZF
Expenditure
$3000
2350
CF
Total output
2000
Output not
purchased by
consumers
1500
1000
500
45°
0
Consumption function
(C)= $100 + 0.75YD
1000
2000
Income (Output)
YF
3000
Aggregate Expenditures includes
Nonconsumer Spending
• Investors, governments, and net export
buyers add to consumer spending to equal
aggregate expenditure.
Expenditure Equilibrium
• Equilibrium is the point where aggregate
expenditure and 45 degree lines meet.
• Recall that real GDP can be calculated as
the value of final goods and services, or as
the payments to all inputs in its production.
• In essence real output = income
Expenditure Equilibrium
$3500
AE = Y
Expenditure
3000
2500
Equilibrium
2000
E
1500
1000
500
45°
0
YE
$500
1000
1500
2000
2500
3000
Income (Output) (billions of dollars per year)
• When AE > Y, inventories depleting,
signals expansion
• When Y > AE, inventories increasing,
signals contraction
Aggregate Expenditure at
different price levels
Plots out Aggregate Demand
•Wealth,
•Int’l Trade and
•Money Demand Effects
Aggregate Expenditures
C + I + G + NX
YD= Y – tY = (1-t)Y
C = a + mpcYD = a + mpc (1-t)Y
I = I – di
G=G
NX = NX
AE=a + I – di + G + NX + mpc (1-t)Y
AE = AE + mpc (1-t)Y
Changes to Autonomous
Expenditure
Autonomous spending
• Autonomous Consumption
• Investment
• Gov’t Spending
• Net Exports
Shifts Aggregate Expenditure Up or Down
Shifts Aggregate Demand Right or Left
AE + mpc (1-t)
Y
Aggregate
Expenditures
C = a + mpc (1-t) Y
AE
G
I - di
NX
Y*
Y real
output/Income
AE1 + mpc (1-t) Y
AE0 + mpc (1-t) Y
Aggregate
Expenditures
AE1
AE 0
Y0
Y1
Y real
output/Income
An increase in autonomous aggregate expenditures has a much
larger increase in real output/income.
Multiplier Effect
AE1
AE 0
Y0
Y1
Multiplier Effect
• An increase in autonomous expenditures
increases income by a like amount
• With the increase in income, there is an
increase in induced consumption.
• The increase in consumption, again
increases income.
• The increase in consumption diminishes at
each step due to savings and taxes.
Deriving the Multiplier
ΔY =ΔAE + mpc(1-t)ΔAE + mpc(1-t)[mpc(1t)ΔAE] + mpc(1-t)[mpc(1-t)mpc(1-t)ΔAE]
+……
ΔY =ΔAE{1 + mpc(1-t)+ [mpc(1-t)]2 +
[mpc(1-t)]3 +……+ [mpc(1-t)] }
M = ΔY / ΔAE = 1 + mpc(1-t)+ [mpc(1-t)]2 +
[mpc(1-t)]3 +……+ [mpc(1-t)]
Multiplier derived
a) M = 1 + mpc(1-t)+ [mpc(1-t)]2 +
[mpc(1-t)]3 +……+ [mpc(1-t)]
b) M [mpc(1-t)] = mpc(1-t)+ [mpc(1-t)]2 +
[mpc(1-t)]3 +……+ [mpc(1-t)]
c) Subtract equation b from a, and we get
M - M [mpc(1-t)] = 1
or M (1 - mpc(1-t)) = 1
d) M = 1 / (1 - mpc(1-t))
Brass Tacks
• Suppose mpc=0.9, and t=0.15, then how much
would a $100 increase in autonomous
expenditure raise real income?
• M = 1 / (1 – 0.9(1 – 0.15)) = 1 / (1 – 0.9*0.85)
= 1 / (1 – 0.765) = 1 / 0.235 = 4.26
• ΔY = 4.26 * $100 = $426
Size of Multiplier
• Depends on the circular flow of income in
the economy
• In a macroeconomic equilibrium aggregate
expenditures equal national income
Circular Flow
Draw on the Board
Injections versus Leakages
Equilibrium
Investment + Government Spending + Exports
= Savings + Taxes + Imports
Multiplier Decreases as Leakages Increase
• With each increase in income that motivates
the multiplier,
– consumers save some portion,
– the government taxes another portion,
– and consumers may purchase imports
• With each leakage, the less the consumer
spends on domestic products, lowering the
amount of additional income in the next
round of the multiplier.