Aggregate Demand
Background information:
Why do we have economic fluctuations?
Why do we periods when economic productivity, employment and income rise? Or why do we
have economic “bad-times” or recessions when producers can’t sell their goods, cut back
production, lay off workers and income falls? What causes short run fluctuations?
One theory is that the amount of goods and services produced (and therefore the level of
employment) directly depends on the level of spending by all sectors of the economy
(aggregate demand). Say that consumers stop buying and businesses stop investing, reducing
the aggregate demand for goods and services. When our total spending reduces, producers cut
back on output and lay of workers. When workers are fearful of being laid off or do lose their
jobs, they cut back on their spending, perpetuating a cycle of declining real incomes and rising
unemployment.
Let’s get to the nuts and bolts of this theory. In order to understand why economic fluctuations
occur, we must first examine the factors that influence aggregate demand. Recall that:
Aggregate Demand = Consumption + Investment + Government Spending + Net Exports.
C: What factors affect consumption?
I: What factors cause business investment to rise & fall?
Once we establish these basic relationships, then we can understand how and why economic
fluctuations occur.
Learning outcomes
Learning Outcomes:
1. What is Aggregate Demand?
a. What is the relationship between price level and real GDP according to the
Aggregate Demand Curve?
b. Why is the Aggregate Demand curve downward sloping?
c. What factors shift the aggregate demand curve?
2. What factors affect consumption?
a. In particular, how do changes in income affect the level of consumption and
savings?
b. What other factors affect consumption?
3. What factors affect investment?
c. In particular, how does the cost of borrowing funds (real interest rates) affect
business investment?
d. What other factors affect investment?
4. What are the effects of changes in consumption and investment on the economy
(aggregate output as measured by real GDP)?
Prior Knowledge: Match the following terms with the appropriate definitions
Terms for defining GDP
Definition
Aggregate Demand
(note: Interest rate = cost of borrowing)
Interest rate adjusted for inflation
Investment
Amount of income households have left over after paying
their personal taxes; we can consume or save (DI = C + S )
Disposable Income
Determines how large the change in real GDP will be due to
an initial change in spending
Multiplier = change in real GDP/ initial change in spending
Average Propensity to
Measures the total spending by firms on capital equipment,
Consume
all construction (including private homes) and inventory
changes
Marginal Propensity to
Reflects an inverse relationship between real interest rates
Consume
and investment
Marginal Propensity to Save The fraction of any change in income consumed
MPC= Change in consumption / change income
Real Interest Rates
The fraction of any change in income saved
MPS = change in savings/change in income
Investment Demand Curve
The fraction of total income that is consumed (APC=
Consumption / income)
Expected Rate of Return
The profits that businesses hope to realize by borrowing
funds for investment
Spending Multiplier
Total demand for the nation’s goods and services at a given
(Multiplier Effect)
price level at a given period of time
Learning Outcome 1: Aggregate Demand
What is aggregate demand and the components of aggregate demand?
Define Aggregate Demand:
What is the difference between Aggregate Demand and demand for a product?
What is the key difference between demand for a product and aggregate demand (AD)?
A) Micro graph shows the quantity of ONE good/service demanded at various prices
B) Macro graph shows the total quantity of ALL FINAL goods/services demanded at various
PRICE LEVELS
Components of Aggregate Demand:
(C) Consumption: household spending on goods and services during a period of time; a
function of income and marginal propensity to consume (MPC)
(I) Investment: Gross Domestic Private Investment, the total spending by firms on capital
equipment. The level of investment is a function of national output and the interest rate.
(G) Government Spending: Government spending on goods and services
(X-M) Net Exports: Net exports measures the total income earned from the sale exports to
foreigners minus the amount spent by a nation’s households, firms and government on imports
Key questions for Learning Outcome 1: Aggregate Demand
A. What is the relationship between price level and real GDP?
B. Why is the Aggregate Demand downward slowing?
a. Wealth Effect:
b. Interest Rate Effect:
c. Net Export Effect:
C. What shifts aggregate demand? Any factor that affects consumption and investment
(see learning outcomes 2 and 3)
Learning Outcome 2: What factors affect consumption?
a. In particular, how do changes in income affect the level of consumption and
savings?
b. What other factors affect consumption
What factors affect consumption?
National Income
Level of national income is the primary
determinant of consumption;
1. direct relationship national income
(Y) and consumption (C)
2.
Non-income determinants of
consumption
1. Wealth
2. Real interest rates
3. Household debt and expectations
of future income
4. Consumer confidence
Learning Outcome 2: What factors affect consumption?
a. In particular, how do changes in income affect the level of consumption and
savings?
b. What other factors affect consumption?
Task 1: (See Think Wonder) Key conceptual questions to consider
1. How do changes in disposable income determine the amount households consume and
save?
2. How do following factors determine consumption and saving levels? (Shifts the
consumption and savings schedules)
a. Wealth= Assets – Liabilities (debt)
b. Real Interest Rate
c. Level of household debt & Expectations of future income,
d. Consumer confidence
Key Math Formulas
Average Propensity to Consume (APC)
APC = Consumption (C) / Income
Average Propensity to Save (APS)
APS = Savings (S) / Income
Marginal Propensity to Consume (MPC)
MPC = Change in Consumption / Change in Income (MPC = Δ Consumption/ Δ Income)
Marginal Propensity to Save
MPS = Change in Savings / Change in Income (MPS = Δ Savings/ Δ Income)
Key Tables and Graphs
See Think Wonder: How do changes in disposable income determine the amount households
consume and save?
Verify your interpretations of the table above by examining this diagram:
Task 2: Check your understanding
Morton p. 111-112
Learning Outcome 3: Investment
1. What factors affect investment?
a. In particular, how does the cost of borrowing funds (real interest rates) affect
business investment?
b. What other factors affect investment?
Task 1: Key Conceptual Questions (See Think Wonder)
1. How do changes in real interest rates affect investment?
2. Why do businesses hope to equate the expected rate of return on investment with real
interest rates?
3. Why is investment spending unstable and why is this important to know?
Task 2: Check your understanding
1. Examine the investment demand curve above and answer the following questions.
2. Apply your understanding to the loanable funds market which exams the relationship
between REAL interest rates (always real, not nominal for loanable funds market) and quantity
of loanable funds.
At higher interest rates, the amount of
investment in the economy declines.
Why?
1. firms & households have an
incentive to save, greater return
on their savings
2. cost of borrowing to finance
investments goes up
3. fewer investments in capital
with expected rate of return
equal to or greater than the real
interest rate
Loanable Funds Market
Reflect:
a. Why do businesses hope to equate the expected rate of return on investment
with real interest rates?
c. What other factors affect investment? Explain how the following factors affect
investment:
Factors affecting
If this increases, the
If this decreases, the impact on
investment
impact on investment
investment
Business confidence &
Demand for investment  Demand for investment: _________
expectations of future
AD shifts to the right
AD shifts to the _________
prices
Technology
Business taxes
Inventory
Degree of excess capacity
(stock of capital available)
Learning Outcome 4: Multiplier
1. What are the effects of changes in consumption and investment on the economy
(aggregate output as measured by real GDP)?
Task 1: Key Conceptual Questions
1. How do changes in spending (consumption, investment or govt. spending) affect
real GDP?
2. How is the multiplier related to MPS and MPC? Explain the relationship.
Key Math Formulas
Marginal Propensity to Consume (MPC)
MPC = Change in Consumption / Change in Income (MPC = Δ Consumption/ Δ Income)
Marginal Propensity to Save
MPS = Change in Savings / Change in Income (MPS = Δ Savings/ Δ Income)
MPC + MPS = 1
Multiplier: Change in Real GDP / Initial Change in Spending (Δ Real GDP/ Δ initial Spending)
Change in Real GDP = Δ Initial Spending * Multiplier
Investment Multiplier: 1/MPS or Multiplier = 1/ (1-MPC)
Government Spending Multiplier: 1/ MPS or Multiplier = 1/ (1-MPC)
Tax Multiplier= -MPC/ (1-MPC) = -MPC/MPS (remember, always negative!)
Task 2: Apply what you know: Morton p. 113-117
C. Check your understanding
answers to key terms
Terms for defining GDP
1. Aggregate Demand
2. Investment
3. Disposable Income
4. Average Propensity
to Consume
5. Marginal Propensity
to Consume
6. Marginal Propensity
to Save
7. Real Interest Rates
8. Investment Demand
Curve
9. Expected Rate of
Return
10. Spending Multiplier
(Multiplier Effect)
Definition
Total demand for the nation’s goods and services at a
given price level at a given period of time
Measures the total spending by firms on capital
equipment, all construction (including private homes) and
inventory changes
Amount of income households have left over after paying
their personal taxes; we can consume or save (DI = C + S )
The fraction of total income that is consumed (APC=
Consumption / income)
The fraction of any change in income consumed
MPC= Change in consumption / change income
The fraction of any change in income saved
MPS = change in savings/change in income
(note: Interest rate = cost of borrowing)
Interest rate adjusted for inflation
Reflects an inverse relationship between real interest
rates and investment
The profits that businesses hope to realize by borrowing
funds for investment
Determines how large the change in real GDP will be due
to an initial change in spending
Multiplier = change in real GDP/ initial change in spending
Points to notice about National Income & Consumption
1. households increase their spending as disposable income rises
2. spend a larger proportion of a small DI than of a large DI (large DI= proportionally less
consumption and more savings)
a. APC falls at higher levels of income even though total consumption increases
with income
b. APS increases as income increases
3. the fraction of any change in income consumed (MPC) is constant
4. APC + APS = 1; MPC + MPS = 1 because households can only do two things with their
disposable income: consume or save
5.