Aggregate Demand Chapter 9 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. 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? 9-2 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 9-3 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 9-4 Escaping a Recession PRICE LEVEL AS (Aggregate supply) E1 PE AD2 AD1 QE QF REAL OUTPUT 9-5 Components of Aggregate Demand • The four components of aggregate demand are – – – – Consumption (C) Investment (I) Government spending (G) Net exports (X – M) 9-6 Consumption • Consumption: Expenditure by consumers on final goods and services • Consumer expenditures account for over twothirds of total spending in the U.S. 9-7 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 9-8 U.S. Consumption and Income CONSUMPTION (billions of dollars per year) $7000 2000 6000 1999 1998 C = YD 1996 5000 4000 3000 2000 1980 1000 1982 1986 1984 1988 1990 1994 1992 Actual consumer spending 45° 0 $1000 2000 3000 4000 5000 6000 7000 DISPOSABLE INCOME (billions of dollars per year) 9-9 Consumption vs. Saving • All disposable income is either consumed (spent) or saved (not spent) Disposable income consumption saving YD C S • Saving: That part of disposable income not spent on current consumption 9-10 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 9-11 Consumption vs. Saving • The proportion of total disposable income spent on consumer goods and services is the average propensity to consume (APC) total consumption C APC total disposable income YD 9-12 Consumption vs. Saving • The proportion of total disposable income saved is the average propensity to save (APS) total saving S APS total disposable income YD APS 1 APC 9-13 Consumption vs. Saving • Marginal propensity to consume (MPC): The fraction of each additional (marginal) dollar of disposable income spent on consumption Change in Consumption C MPC Change in Disposable Income YD 9-14 Consumption vs. Saving • Marginal propensity to save (MPS): The fraction of each additional (marginal) dollar of disposable income not spent on consumption Change in Saving S MPS Change in Disposable Income YD MPS 1 MPC 9-15 MPC and MPS MPS = 0.20 MPC = 0.80 9-16 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 9-17 Autonomous Consumption • Consumption that is independent of income is influenced by non-income determinants: – – – – Expectations Wealth Credit Taxes 9-18 Income-Dependent Consumption • Consumption function: A mathematical relationship indicating the rate of desired consumer spending at various income levels Total consumption autonomous consumption income dependent consumption 9-19 Income-Dependent Consumption • The consumption function provides a basis for predicting how changes in income effect consumer spending C a bYD where : C current consumption a autonomous consumption b marginal propensity to consume YD disposable income 9-20 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 9-21 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 9-22 A Consumption Function Consumption = $50 + 0.75YD Disposable Autonomous Income (YD) Consumption + IncomeDependent Consumption = Total Consumption A $ 0 50 $ 0 $ 50 B 100 50 75 125 C 200 50 150 200 D 300 50 225 275 E 400 50 300 350 F 500 50 375 425 9-23 The 45-Degree Line • In a graph of the consumption function, the 45degree 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 9-24 A 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 9-25 The Aggregate Consumption Function • Repeated studies suggest that in the aggregate consumers increase consumption as income increases • The consumption function summarizes this behavior 9-26 Shifts of the Consumption Function C a bYD • 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 9-27 Shift in the Consumption Function C = a1 + bYD CONSUMPTION (C) C = a2 + bYD a1 a2 0 DISPOSABLE INCOME 9-28 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 9-29 AD Effects of Consumption Shifts Expenditure Price Level C1 Shift = f1 – f2 f1 C2 f2 P1 AD1 AD2 Y0 Income Q2 Q1 Real Output 9-30 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 9-31 Shifts and Cycles • Shifts in aggregate demand due to consumer behavior can cause macro instability – If consumer spending increases abruptly, demandpull inflation may follow – If consumer spending slows abruptly, a recession may occur 9-32 Investment • Investment represents another source of demand for output • Investment: Expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories 9-33 Determinants of Investment • The amount of investment depends on – Expectations: Favorable expectations for future sales are a necessary condition for investment – Interest rates: Lower rates increase investment spending, while higher rates do the opposite – Technology and innovation: Advances increase investment spending 9-34 Altered Expectations • Business expectations are determined by business confidence in future sales – An upsurge in confidence shifts the investment demand curve to the right – When business expectations worsen, investments get postponed or canceled and the investment demand curve shifts left 9-35 Investment Demand 11 Interest Rate (percent) 10 Better expectations 9 C A 8 7 B 6 I2 5 Initial expectations 4 I1 3 Worse expectations 2 I3 1 0 100 200 300 400 500 Planned Investment Spending 9-36 AD Shifts • Aggregate demand shifts when investment spending changes • The aggregate demand curve shifts right when investment spending increases and shifts left when investment spending declines 9-37 Empirical Instability • Investment spending fluctuates more than consumption • Abrupt changes in investment were the cause of the 2001 recession 9-38 Volatile Investment Spending Source: U.S. Bureau of Economic Analysis 9-39 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 9-40 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 9-41 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 9-42 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 9-43 Price Level Building an AD Curve P0 AD C I G QI QC QG X-M d QX-M Q0 Real GDP 9-44 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 9-45 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 9-46 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 fullemployment GDP 9-47 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 9-48 Macro Failures Macro Success: (perfect AD) PRICE LEVEL AS AD1 E1 P* QF REAL GDP 9-49 Macro Failures Cyclical Unemployment: (too little AD) PRICE LEVEL AS AD2 E1 P* P2 E2 Q2 QE2 recessionary GDP gap QF REAL GDP 9-50 A Recessionary GDP Gap Real GDP Demanded (in $ trillions) by: Price Net Aggregate Aggregate Consumers + Investors + Government + = Level Exports Demand 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 9-51 A Recessionary GDP Gap 9-52 Inflationary GDP Gap • Equilibrium GDP might exceed its fullemployment/price stability capacity • Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP 9-53 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 9-54 Macro Failures Demand-pull inflation: (too much AD) PRICE LEVEL AS AD3 E3 P3 E1 P* inflationary GDP gap QF QE3 Q3 9-55 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 9-56 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 9-57 Self-Adjustment? • 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 9-58 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 9-59 Aggregate Demand End of Chapter 9 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.