Aggregate Demand and
Output
in the Short Run
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 1
John Maynard Keynes
Most influential economist of the 20th century
Published The General Theory of
Employment, Interest, and Money in 1936
Keynes’ idea was that
A decline in aggregate spending may cause output
to fall below potential output for long periods of
time
 Government spending would increase aggregate
demand and restore full employment
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 2
Modeling Fluctuations
Goal of this chapter
To develop a model of how recessions and
expansions may arise from fluctuations in
aggregate spending following Keynes
Basic Keynesian model or the Keynesian
Cross
The diagram used to illustrate the theory
is not complete or entirely realistic model
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 3
Assumptions
Aggregate demand fluctuates
Total planned spending changes
In the short run, firms meet the demand for
their products at preset prices
Do not respond to every change in demand by
changing their prices
Set a price for some period and meet the demand
at that price
Produce just enough to satisfy their customers
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 4
Meet the Demand
Menu costs: The costs of changing prices
Firms do not change their prices
frequently
Or, in the short run
Firms will eventually change prices if
there is a large imbalance between sales
and potential output
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 5
Aggregate Demand
Aggregate demand (AD)
Total planned spending on final goods
and services
Four components
Consumer expenditure (C)
Investment (I)
Government purchases (G)
Net exports (NX)
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 6
Planned vs. Actual
Aggregate demand is planned spending
Planned may differ from actual for firms
When a firm sells either less or more of its
product than expected
For households, governments, and foreign
purchasers we can reasonably assume that
actual equals planned
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 7
Unplanned Investment
Suppose a firm’s actual sales are less then
expected
Warehouses fill up
Actual investment is greater than planned investment
The extra inventory becomes part of actual investment
I > Ip
Ip planned investment
I actual investment
If a firm sells more than expected
I < Ip
The firm planned on increasing inventories more than it
actually did
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 8
Definition of
Aggregate Demand
Aggregate demand equals the
economy’s total planned spending
AD = C + Ip + G + NX
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Slide 13 - 9
Consumption
C is nearly 2/3rds of AD
Many determinants of consumption spending
Prices, incomes, tastes, etc.
Disposable income
After-tax income is particularly important
National income (Y) minus net taxes (T)
As disposable income rises, consumption (C)
rises
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 10
Consumption Function
The relationship between consumption
spending and its determinants, such as
disposable (after-tax) income
C  C  c(Y  T )
 C constant term capturing factors other than
disposable income
c is the MPC (Marginal propensity to consume)
The amount by which consumption rises when disposable
income rises by $1
We assume that 0 < c < 1
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 11
Fig. 13.1
A Consumption Function
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Slide 13 - 12
Fig. 13.2
The U.S. Consumption Function,
1960-1999
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Slide 13 - 13
AD and Output
How is AD affected by changes in Y
Recall, Y is aggregate income
C depends on Y
C is a large part of AD
AD depends on Y
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 14
AD and Output
AD  C  I  G  NX
p
AD  [C  c(Y  T )]  I  G  NX
p
For now assume that Ip, G, NX, and T are
fixed, so that
IpI
G G
NX  NX
T T
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Slide 13 - 15
AD and Output
Substituting and rearranging,
AD  [C  c(Y  T )]  I  G  NX
AD  (C  cT  I  G  NX )  cY
Shows if Y increases by one unit, then
AD increases by c units
Positive relationship between Y and AD
c is the MPC
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 16
Autonomous AD
Autonomous aggregate demand
The portion of aggregate demand
that is determined outside the model
(C  cT  I  G  NX )
Induced aggregate demand
The portion of aggregate demand that
is determined within the model [cY]
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 17
SR Equilibrium Output
Short-run equilibrium output
The level of output at which output Y
equals aggregate demand AD
The level of output that prevails during
the period in which prices are
predetermined
Y = AD
Y – AD = 0
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 18
Numerical SR Equilibrium
Using Example 25.2 and Table 25.1
SR equilibrium occurs when Y = 4,800
If output Y was 4,000
Firms are not producing enough
Inventories are being depleted, I < Ip
Firms respond by increasing production
If output Y was 5,000
Firms are producing too enough
Inventories are piling up, I > Ip
Firms respond by decreasing production
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Fig. 13.3
Determination of Short-Run
Equilibrium Output (Keynesian
Cross)
Slide 13 - 19
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Slide 13 - 20
AD and Gaps
Using Example 25.2 and adding the
assumption that potential output also
equals 4,800,
We can see how a fall in AD can lead to a
recession
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Slide 13 - 21
Fig. 13.4
A Decline in Spending
Leads to a Recession
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Slide 13 - 22
The Multiplier
Income-expenditure multiplier
The effect of a one-unit increase in
autonomous aggregate demand on shortrun equilibrium output
An initial change in spending
leads to a larger change in short-run
equilibrium output
Simplified form:
1
1 MPC
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Slide 13 - 23
Stabilization
The Keynesian model says that recessions are
caused by insufficient aggregate spending
Implying that policymakers must find ways to
increase aggregate demand
Stabilization policies
Government policies that are used to affect
aggregate demand, with the objective of
eliminating output gaps
Monetary policy
Fiscal policy
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Slide 13 - 24
Government Policy
Monetary policy
Decisions on the size of the money supply
Fiscal policy
Decisions about the government’s budget
Government spending
Government revenues
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 25
Government Purchases
and AD
Keynes thought that changes in G
would be the most effective tool for
reducing output gaps
Increased government purchases can
eliminate a recessionary gap
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Fig. 13.5
An Increase in Government
Purchases Eliminates a
Recessionary Gap
Slide 13 - 26
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Slide 13 - 27
Fig. 13.6
U.S. Military Expenditures as a Share
of GDP,
1940-1999
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 28
Taxes, Transfers and AD
Fiscal policymakers also determine the
level of
Tax collections
Payments from the private sector to the
government
Transfer payments
Payments from the government to the private
sector (e.g., welfare, social security payments)
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 29
Taxes, Transfers, and AD
Using taxes and/or transfers affects AD
indirectly by changing disposable
income
Increase in disposable income
Decrease taxes
Increase transfers
Decrease in disposable income
Increase taxes
Decrease transfers
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 30
Qualifications of
Fiscal Policy
 The real world is more complicated than the basic
Keynesian model
 1. Fiscal policy may affect potential output Y* as well
as AD
 Investments in public capital increase growth and potential
output Y*
Roads, airports, schools, etc.
 Taxes and transfers affect incentives
People save less with higher taxes on saving
Tax break on new investment encourages firms to make
more investment
 Policymakers should take both the demand side and
supply side effects into account
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 31
Qualifications of
Fiscal Policy
2. Fiscal policy is not always flexible enough to be
useful for stabilization
 Changes in government spending or taxes are slow
usually a lengthy legislative process ensues
Budget changes proposed by the president must be
submitted to Congress 18 or more months before they go
into effect
 Policymakers may have goals other than stabilizing AD
Adequate national defense
Income support for the poor
Reelection
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 13 - 32
Automatic Stabilizers
Automatic stabilizers
Provisions in the law that imply automatic
increases in government spending or
decreases in taxes when real output
declines
“Recession aid” flows out when the
unemployment rate reaches a certain amount
Transfer payments increase and tax revenues
decline during a recession
Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.