Chapter 9, 10, 11, 17
Aggregate Demand and
Aggregate Supply
Chap 9,10,11 Vocabulary
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Investment demand
curve
MPC
MPS
Multiplier
Recessionary gap
Inflationary gap
Aggregate demand
Aggregate supply
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Determinants of AD
Determinants of AS
Productivity
Equilibrium price level
Real-balances effect
Interest rate effect
Foreign purchases
effect
Aggregate Expenditures (or Aggregate
Demand) Ch 9 Pg 160-165)
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The Aggregate Expenditures (AE)
approach was developed by John
Maynard Keynes. Aggregate demand is
directly related to AE.
The AE approach looks at total spending
in the economy:
C= Personal consumption (70%)
I = Investment Spending (15%)
G = Government Spending (15%)
Xn = Exports less Imports (?)
Keynes and the Long Run
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The British economist Sir John Maynard Keynes
(1883–1946), probably more than any other single
economist, created the modern field of
macroeconomics.
Published: The General Theory of Employment,
Interest and Money
In it he decried the tendency of many of his colleagues
to focus on how things work out in the long run:
“This long run (a Classical Economic
concept) is a misleading guide to current
affairs. In the long run we are all dead.
Economists set themselves too easy, too
useless a task if in tempestuous seasons
they can only tell us that when the storm is
long past the sea is flat again.”
Personal Consumption
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Personal Consumption is the largest
component of the AE (or AD)
approach
Consumption is most dependent
upon the level of Disposable
(spendable) Income (DI)
According to Keynes, we either
spend or consume our incomes.
Autonomous Spending
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Average Propensity to Consume (APC)
• Spending that occurs at a specific level of
income (and in a specific country). Based
upon historical patterns, the APC can be
anticipated for income levels.
• In determining the APC/APC, economists
assume that we either Spend or Save our
incomes, what is not spent is saved.
• And a very important concept is that
“consumption is dependant upon
disposable income”!!!!
2006 Disposable Income and Consumer Spending
Consumer
spending
$100,000
80,000
60,000
40,000
Disposable income was $43,799 and
Spending (APC) was $43,131.
20,000
0
$50,000
$100,000
Current disposable income
$150,000
APC/APS Continued
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The formula for the APC is:
• APC = consumption/income
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The formula for the APS is:
• APS = savings/income
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Since we either save or spend our income, the APC +
the APS = 1
A very important concept is that savings is related to
investment spending. Remember in the circular flow
model, savings is a leakage, and investment is an
injection. Savings creates investment spending.
We will not need to know these formulas, but we do
need to understand the concept of “autonomous”
spending.
Marginal Propensity to
Consume/Save (MPC and MPS)
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The Marginal Propensity to Consume is the
fraction of any change in disposable income that
is consumed.
MPC= Change in Consumption
Change in Disposable Income
The Marginal Propensity to Save is the fraction of
any change in disposable income that is saved.
MPS= Change in Savings
Change in Disposable Income
Marginal Propensities
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MPC + MPS = 1
• MPC = 1 – MPS
• MPS = 1 – MPC
Remember, people do two things with
their disposable income (or a change to
that income), consume it or save it! So
MPC + MPS must equal 1.
“Autonomous spending” is that spending
that occurs independent of the change in
income. The MPC and MPS only examines
how the “change” in income is consumed
or saved.
The Multiplier (pg 182-186)
MPC/MPS (pg 163-164)
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The Multiplier assumes that an initial change
in spending causes a larger change in the
GDP as the initial spending creates a chain of
spending as it works through the economy.
The Multiplier is based upon the Marginal
Propensity to Consume (MPC). The MPC
assumes that if a change in income occurs,
we will consume (MPC) a portion of the
change, and we will save (MPS) part of the
change. MPC and MPS are inversely related.
The Multiplier
Round 1
A change in
income of
$1,000
creates ……….
Round 2
Round 3
Income +
$1,000
$500
$250
Consumption
$500
$250
$125
Savings
$500
$250
$125
THE MULTIPLIER EFFECT
We use the following formula to find the multiplier
Multiplier = 1/MPS
(or 1/ 1-MPC)
Change
in GDP
= Multiplier x
initial change
in spending
For example, the tax rebate of 2008 totaled $80 billion and the
MPC was .2 (Multiplier = 1/1-.2 or 1.25), multiplier was 1.25.
So we consumed $16 billion (20%). $16 billion X 1.25 equals a
$20 billion increase in the GDP. Originally, the government
projected an MPC of .5 which would have resulted in $80
Billion increase in the GDP
The Current Economy
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The Marginal Propensities help
explain the political argument over
tax cuts versus increased
government spending. During a
recession (when tax cuts seem like a
good idea) people tend to spend less
and save more. Consequently tax
cuts may have less effect on the
GDP. We will continue looking at this
topic in chapter 12.
THE MULTIPLIER EFFECT
MPC and the Multiplier
MPC
Multiplier
.9
10
.8
5
.75
4
.67
.5
3
2
Chapter 11
Understanding Aggregate Demand
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Aggregate demand is
the total demand for
goods and services in
an entire economy.
The aggregate
demand curve plots
the total demand for
GDP as a function of
the price level.
The aggregate demand
curve slopes
downward.
Why the Aggregate Demand Curve
Slopes Downward
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The increase in spending that occurs
because the real value of money
increases when the price level falls is
called the Real Balances.
The interest rate effect: With a given
money supply in the economy, a lower
price level will lead to lower interest
rates and higher consumption and
investment spending.
The impact of foreign trade: A lower
price level makes domestic goods
cheaper relative to foreign goods.
Why the Aggregate Demand Curve is
Downward-Sloping?
Why the Aggregate Demand Curve is
Downward-Sloping?
Why the Aggregate Demand Curve is
Downward-Sloping?
Factors That Change Aggregate
Demand
Factors That Change Aggregate
Demand (Continued)
and indebtedness
4. Degree of excess capacity
5. Technology
The Components of Aggregate
Demand
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Aggregate Demand (also referred to as “Mainstream
Economics”) is Keynesian Economic Theory.
In our study of GDP accounting, we divided
GDP into four components:
• Consumption spending (C), investment
spending (Ig), government purchases (G), and
net exports (Xn).
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These four components (using In, net
investment) instead of Ig because Gross
Investment includes depreciation and inventory ) are
also four parts of aggregate demand because
the aggregate demand curve really just represents
total spending.
What is Investment Spending ?
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Money spent or expenditures on:
• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• New Homes (40+% of the total
investment spending) (an explanation of
why the current financial crisis is being
compounded by Housing)
Expected Rates of Return
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How does business make investment
decisions?
• Cost / Benefit Analysis
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How does business determine the benefits?
• Expected rate of return (Marginal Benefit > Marginal
Cost)
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How does business count the cost?
• Interest costs
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How does business determine the amount of
investment they undertake?
• Compare expected rate of return to interest cost
 If expected return > interest cost, then invest
 If expected return < interest cost, then do not invest
Real v. Nominal Interest Rate
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What’s the difference?
• Nominal is the observable rate of interest. Real
subtracts out the rate of inflation and is only known
after the fact.
Businesses and banks attempt to anticipate
upcoming inflation rates. Remember if inflation is
5% per year and the bank makes no allowance for
the 5%, they are being paid back with dollars that
are worth 5% less.
• How do you compute the real interest rate?
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Nominal Interest Rate minus Rate of Inflation
= Real Interest Rate
• What then, determines the cost of an investment
decision?
 The Real Interest Rate
The Investment Demand Curve
Changes in rate cause
changes in In. Factors
other than interest rates
may shift the entire ID
curve
I
N
T
E
R
5%

E
S
T
3%
R
A
T
E
ID

$2
trillion
$3
trillion
IG
Shifts in Investment Demand
I
N
T
E
R
E
S
T
r%
When investment demand
shifts, different levels of gross
private investment occur even
while interest rate remains
constant

4%
R
A
T
E
ID1
ID
$2.5
trillion
$3.25
trillion
QUANTITY OF $ INVESTED
IG
What Causes Shifts in Investment
Demand
• Interest Rates
• Expected Rate of Return
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Cost of Production
Business Taxes
Technological Change
Stock of Capital
Expectations
Degree of Excess Capacity.
Understanding Aggregate Supply
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The aggregate supply curve depicts the
relationship between the level of prices
and the total quantity of final goods and
services that firms are willing and able to
supply.
• To determine both the price level and real
GDP, we need to combine both aggregate
demand and aggregate supply.
CHANGES IN SHORT RUN
AGGREGATE SUPPLY (SRAS)
Price level
P
SRAS1
SRAS3
SRAS2
In
Decrease
Aggregate
Supply
Increase In
Aggregate
Supply
Q
Real domestic output, GDP
DETERMINANTS OF AGGREGATE SUPPLY
(What shifts AS)
1. Change in Input Prices
Domestic Resource Availability
• Land
• Labor
• Capital
• Entrepreneurial Ability
•Per unit production costs increase
•Per unit cost = total input cost
total output
Prices of Imported Goods, for example
Negative supply shocks (like oil price
increases in the 70s)
DETERMINANTS OF AGGREGATE SUPPLY
(contd)
2. Change in Productivity
Productivity
=
Real Output
Input
3. Change in Legal-Institutional
Environment
• Business Taxes and Subsidies
• Government Regulation
Negative Supply Shocks
(decreases AS)
Original Keynesian AD/AS Model
Price Level
AS
P1
AD1
AD2
Q2
Q1
Real Domestic Output/GDP
(New)Keynesian (AS/AD)
AS
Price Level
The new Keynesian
graph reflects an
“intermediate”
range to reflect
increasing price
levels while GDP
P1
increases.
LRAS/Full
Employment
AD
Q
Real Domestic Output/GDP
EQUILIBRIUM: REAL OUTPUT
AND THE PRICE LEVEL
Price Level
P
LRAS SRAS
AD
Equilibrium in the
Intermediate Range
Economy tends to return
to equilibrium (or Full
Employment) as AD
increases
Pe
P1
AD1
Q1
Qe
Real Domestic Output, GDP
Q
How to Increase AD!
Where is the best place for
the U.S. economy
Price Level
P
LRAS
SRAS
Point Pe, Qe,
represents a fully
employed economy;
i.e. about a 5% rate of
Unemployment;
3.5% Real GDP growth;
and an Inflation rate of
2-3%.
Pe
AD
Qe
Real Domestic Output, GDP
Q
Capital Goods
Growth Illustrated on PPC
Also Increased LRAS on AD/AS
Graph
.
.
PPC
Consumer Goods
PPC1
Capital Goods
Growth Illustrated on PPC
Also Increased LRAS on AD/AS
Graph
.
.
PPC
Consumer Goods
PPC1
Classical Economic Theory
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We will review several economic
theories in detail in Chapter 16.
The next few slides introduce the
Classical approach to economics and
the graphs that explain this theory.
One of the major tenets of this
approach is that the government should
NOT intervene in the economy. The
economy is self regulating and will
correct itself.
Full Employment
THE LONG RUN AGGREGATE SUPPLY
(LRAS) REPRESENTS FULL EMPLOYMENT.
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PL
LRAS
SRAS
P
AD
YF
THE MOST
IMPORTANT
GRAPH IN
MACROECONOMICS
(at least for the
AP test.)
GDPR
YF refers to Full Employment
Recessionary Gap

A recessionary gap exists when
equilibrium occurs below full employment
output.
SRAS
LRAS
PL
P
AD
Y
YF
GDPR
Inflationary Gap

An inflationary gap exists when equilibrium
occurs at a point above full employment.
PL
LRAS
SRAS
P
AD
YF Y
GDPR
Increase in AD
LRAS
PL
SRAS

P

P1
AD1
AD

Y
YF
GDPR
Price level increases, GDP increases and unemployment
decreases
Decrease in AD
LRAS
PL
SRAS

P

P1
AD
AD1

YF
Y
GDPR
The decrease in AD causes the price level to decrease,
The GDP to decrease and unemployment to increase.
Increase in SRAS
SRAS
LRAS
PL
SRAS1

P

P1
AD

Y
YF
GDPR
Price level decreases, GDP increases and unemployment
decreases
Decrease in SRAS
SRAS1
LRAS
PL
SRAS

P

P1
AD

Y1
YF
GDPR
Increase in input costs causes SRAS to decrease. GDP
decreases, unemployment increases and Price increases
ECONOMIC GROWTH
LRAS1
PL
SRAS
LRAS
SRAS1
P
AD1

Y
AD
YF
GDPR
Economic growth occurs as an economy is able to produce
more goods and increase the Real GDP. In the graph above,
growth occurs as both AD and SRAS increase simultaneously
and this enables price level to remain stable.
Capital Goods
Growth Illustrated on PPC
Also Increased LRAS on AD/AS
Graph
.
.
PPC
Consumer Goods
PPC1