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.