13e
Chapter 09:
Aggregate Demand
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
AD’s Role in a Recession and Recovery
• In the Great Recession, spending decreased
across the board and layoffs occurred in
many industries.
– AD declined. It shifted left away from fullemployment GDP as the country fell into
recession.
– To escape from recession, AD must increase.
The AD curve must shift to the right toward fullemployment GDP.
9-2
AD’s Role in a Recession and Recovery
• In this chapter we explore what is behind
the AD curve. Specifically, what causes AD to
shift?
– What are the components of aggregate demand?
– What determines the level of spending for each
component?
– Will there be enough demand to maintain full
employment?
9-3
Learning Objectives
• 09-01. Know what the major components of
aggregate demand are.
• 09-02. Know what the consumption function
tells us.
• 09-03. Know the determinants of investment
spending.
• 09-04. Know how and why AD shifts occur.
• 09-05. Know how and when macro failure
occurs.
9-4
Macro Equilibrium
• In the macro model, AD and AS intersect.
– This is macro equilibrium.
• Macro equilibrium: the combination of
price level and real output that is
compatible with both AD and AS.
– The rate of output equals the rate of spending.
– If there are no disturbances, the economy
gravitates to macro equilibrium.
9-5
Consumption (C)
• Consumption (C): expenditure by consumers
on final goods and services.
– Accounts for over two-thirds of total spending.
– Consumers tend to spend most of their disposable
income (YD) – that is, income remaining after
taxes. They save the rest.
– Saving (S): Disposable income not spent as
consumption (C).
Disposable income = Consumption + Saving
YD = C + S
9-6
Average Propensity to Consume
(APC)
• APC: total consumption in a given time period
divided by total disposable income.
APC =
Total consumption
Total disposable income
=
C
YD
• In 2010 U.S. consumers had an APC of 0.942.
They saved only 6 cents out of each dollar of
disposable income.
• APC can be greater than 1 if credit is used to
finance current consumption.
9-7
Marginal Propensity to Consume
(MPC)
• MPC: the fraction of each additional (marginal)
dollar of disposable income spent on
consumption.
MPC
=
Change in consumption
=
Change in disposable income
ΔC
ΔYD
• MPC is not as high as APC since consumers do
not respond to the next dollar earned in the
same way as past dollars. As income rises,
more saving can occur.
9-8
Marginal Propensity to Save (MPS)
• MPS: the fraction of each additional
(marginal) dollar of disposable income not
spent on consumption – that is, saved.
MPS = 1 - MPC
• Since added disposable income is either
spent or saved, the MPC + MPC = 1 always.
9-9
The Consumption Function
• The two determinants of consumption are
– Autonomous consumption.
– Income-dependent consumption.
9-10
The Consumption Function
• Autonomous consumption: consumer spending not
dependent on current income.
– people consume even if they have no income…
• … by borrowing or drawing down savings.
• They expect future income changes.
• They perceive greater wealth and increase spending,
and vice versa.
• There is availability of credit.
• Tax increases and rebates alter their disposable
income.
• Income-dependent consumption: consumer spending
that increases as income increases, and vice versa.
9-11
The Consumption Function
• Together they make up the consumption function:
C = a + bYD
where C = current consumption
a = autonomous consumption
b = marginal propensity to consume
YD = disposable income
• The consumption function allows us to predict how
much the consumption component of AD will change
when incomes change.
9-12
AD Shift Factors
• A change in consumption (C) causes AD to shift.
– Thus AD will shift in response to changes in
•
•
•
•
•
Income.
Expectations (consumer confidence).
Wealth.
Credit conditions.
Tax policy.
• In 2008-2009, home equity fell (wealth decrease) and
consumer confidence fell. AD shifted left, resulting in the
Great Recession.
• Shifts in AD can be a cause of macro instability.
9-13
Investment
• Investment: expenditures on new plants,
equipment, and structures, plus changes in
inventories.
– Includes fixed investment and inventory
investment.
– Favorable expectations of future sales are necessary
for investment spending.
– Investment spending is inversely related to interest
rates, ceteris paribus.
– Technological advances stimulate investment
spending.
9-14
The Investment Function
• Investment spending is
inversely related to the
interest rate.
• If expectations of future
sales improve, the
investment function shifts
right, as will AD. Vice versa
applies.
• Investment spending is the
most volatile category of
spending.
9-15
Government Spending
• Because of balanced budget requirements,
state and local spending will decrease when
consumption and investment spending
decrease. This contributes to instability.
• Because of deficit spending, federal spending
can be increased to counter spending
decreases in the other components.
– This is the basis of Keynesian demand-side policy.
9-16
Net Exports (X – M)
• Economic downturns in other lands lead to
a decrease in U.S. exports (X), and vice
versa.
• Economic downturns in the U.S. lead to a
decrease in U.S. imports (M), and vice versa.
• If X – M decreases, AD shifts left.
• If X – M increases, AD shifts right.
9-17
Macro Failure
Panel (a) is where we want to be.
Panel (b) is when macro equilibrium occurs with high unemployment (too little AD).
Panel (c) is when macro equilibrium occurs with too much inflation (too much AD).
9-18
Macro Failure
• Two concerns about macro equilibrium:
– Macro equilibrium might not give us full
employment or price stability.
– Even when macro equilibrium is perfectly
positioned, it might not last.
• Equilibrium with cyclical unemployment (too
little AD) occurs with a recessionary GDP gap.
• Equilibrium with demand-pull inflation (too
much AD) occurs with an inflationary GDP gap.
9-19
• Recessionary GDP gap:
the amount by which
equilibrium GDP falls
short of full-employment
GDP.
– At P*, too much would be
produced. There are unsold
inventories. We cut back
production and lay off
workers.
– Equilibrium occurs at P2
and QE, which is less than
QF.
Price level
Recessionary GDP Gap
AS
AD
P*
P2
Recessionary
GDP gap
Q2 QE QF Real GDP
9-20
• Inflationary GDP gap: the
amount by which
equilibrium GDP exceeds
full-employment GDP.
– At P*, not enough would be
produced. With inventories
depleted, we begin to strain
capacity and prices rise.
– Equilibrium occurs at P3 and
QE, which is greater than QF.
Price level
Inflationary GDP Gap
AD
AS
P3
P*
Inflationary
GDP gap
Q3
QF QE
Real GDP
9-21