Unit 3: Aggregate Supply &
Demand
Consumption Function
Development
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John Maynard Keynes originated idea
Measures economic performance of an economy
Focuses on the relationship b/w Consumption & Savings
Simplifications
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Private/closed economy (no int’l influence & gov’t ignored)
• C + Ig
Assume that all saving is personal
Depreciation & net foreign factor = 0
Reminder: w/ no gov’t or foreign trade,
GDP = NI = PI = DI (all the same!)
Consumption Function
Tools
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Theory assumes that the level of output & employment
depend directly on the level of aggregate expenditures
• Changes in output reflect changes in agg. spending
Consumption
• The most important determinant of consumer
spending is DI (income)
45° angle represents all points where consumer
spending equals DI (1:1)
• 45° line represents zero savings
• If DI increases, both consumption & savings will
increase
Consumption Function
Tools
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Consumption Schedule
• Historically, households spend a larger proportion
of small income than of a larger income
• Breakeven: C = DI
• total income level when H consume all income
• Dissavings occurs at low levels where consumption
exceeds income & households must borrow (credit
cards)
Consumption Function
Tools
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Non-income Determinants of Consumption & Saving
• Wealth
• Expectations
• Household Debt
• Taxation
Shifts & Stability
• Consumption & saving schedules will shift in
opposite directions
• UNLESS caused by a tax change
• Consumption & saving schedules are generally
stable unless deliberately shifted by gov’t action
Consumption Function
Consumption
1:1
Savings
$500
Break Even
Dissavings
45°
$500
DI
Savings Function
Savings
Savings
Dissavings
Break Even
DI
Marginal Propensity to
Consume & Save
• MPC: what effect a ∆ Income has on amount C
•
MPC = change in consumption
change in income
• MPS: what effect a ∆ Income has on amount S
•
MPS = change in saving
change in income
• MPC + MPS = 1
Marginal Propensity to
Consume & Save
• Calculate MPC/MPS
•
If disposable income changes from $10,000 to
$12,000 and consumption changes from $9,000
to $10,000:
• What is MPC?
• What is MPS?
•
Why do MPC & MPS always equal 1?
MPC & MPS
Level of
output &
income
(NNP=DI)
(1)
Consumption
(2)
Saving
(1)-(2)
(3)
MPC
Δ(2)/Δ(1)
(4)
MPS
Δ(3)/Δ(1)
(5)
$12,000 $12,100
-100
.90
.1
13,000
13,000
0
9/10
1/10
14,000
13,800
200
.8
.2
15,000
14,500
500
.7
.3
16,000
15,100
900
.6
.4
The Multiplier Effect
Why do cities want the Superbowl in their stadium?
An initial change in spending will set off a spending
chain that is magnified in the economy.
Example:
• A Seahawks fan spends $120 on dinner at John’s diner.
• John’s income has increased by $120.
• John spends $100 on a new bench from Carol’s furniture shop.
• Carol spends $80 on wood from Dan’s lumber yard.
• Dan spends $50 on lunch at Sharon’s restaurant…
The Multiplier Effect shows how spending is
magnified in the economy & doesn’t end at the initial
purchase/investment.
Multiplier
• Multiplier Effect
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Any increase in spending will result in an even
larger increase in GDP due to the fact that every
$ spent is spent again multiple times.
Increases in spending can come from either
government (G) or businesses (Ig)
• Any money spent is someone else’s income
& thus subject to spending.
• Contingent on MPC & MPS … WHY?
• Limiting factor of multiplier is MPS
• Multiplier = 1/MPS or 1/(1-MPC)
• Larger the MPC, larger the multiplier
Multiplier
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What is the multiplier if the MPC is equal to ¾?
• 1 / (1 - 0.75) = 4
•
What is the multiplier if the MPC is equal to 9/10?
• 1 / (1 - 0.9) = 10
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What is the multiplier if the MPS is 1/5?
• 1 / 0.2 = 5
Multiplier
• Multiplier Effect
•
Multiplier is used to calculate how any change
in spending will change total spending (AD) or
income (GDP)
• ∆ Spending x Multiplier = ∆ AD/GDP
George Bush, in an effort to increase GDP during a recession,
proposed a stimulus package which provided every American
family with $200 more of disposable income. The marginal
propensity to consume at that point in time was 0.75.
Calculate the multiplier and identify how much more spending this would
generate per family.
1/0.25 = 4
4 x 200 = $800
Multiplier
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Would the multiplier be larger or smaller if people saved
more of their additional income? (MPS = .25 vs. .3)
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What would happen to the multiplier if people saved all
of their income?
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Smaller ( 4 vs. 3.33)
It would be 1 & thus spending doesn’t multiply
(Multiplier = 1/1)
What would happen if people spent all of their income?
•
It would be infinite & thus spending would be replicated
for every transaction (Multiplier = 1/0)
Multiplier
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If the multiplier were 4, how much money would
the gov’t spend to increase aggregate demand by
$1 million?
• $250,000
( spending x 4 = 1,000,000 )
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If the gov’t needed to cut AD by $2 million and the
multiplier were 4, how much would gov’t
spending have to be reduced?
• $500,000
( spending x 4 = 2,000,000 )
Multiplier
•
How does the multiplier explain why changes in
investment spending cause large fluctuations in
GDP?
• Because increases in investment cause
endogenous increases in consumption, the
ultimate increase in GDP is larger than the
initial investment
• i.e. minor injections/leakages cause even greater
growth of GDP ($1 M injection can yield growth
of $5 M)
MPS/MPC & Multiplier
• If disposable income changes from $15,000 to $19,000
and saving changes from $10,000 to $11,000:
• MPS: .25
• MPC: .75
• The MULTIPLIER: 4
MPS/MPC & Multiplier
• If disposable income changes from $15,000 to $16,000
and consumption changes from $10,000 to $10,750:
• MPS: .25
• MPC: .75
• The MULTIPLIER: 4
Interest Rates & Investment Demand
• What is investment?
• Investment decisions made using cost/benefit
analysis.
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Benefit = expected rate of return (r)
Cost = interest rates – the “cost” of money (i)
• make sure i is adjusted for inflation
Rules:
• If expected return ≥ real interest – INVEST
• If expected return < real interest – DO NOT
Interest Rates & Investment Demand
Why is the ID downward
sloping?
Shifts in Investment Demand
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Cost of Production
• Lower costs shift ID 
Higher shifts ID 
Business Taxes
• Lower business taxes shift ID 
Higher shifts ID 
•
Technological Change
• New technology shifts ID 
•
Stock of Capital
• Low on capital shifts ID 
High shifts ID 
Expectations
• Positive expectations shifts ID 
Negative shifts ID 
•
Interest Rates & Investment Demand
The real interest rate is 2%. What is
investment at that level?
investment
Investment Schedule
If real interest rate was 2%, we would
assume that businesses are investing $2T
at all levels of output.
$2 T
Ig
$1.8
Ig0
The amount invested is very
unstable/volatile, however, and
investment can & does occur irregularly.
GDP = DI
Aggregate Expenditures Model
• Measures Aggregate Demand/Expenditures against real
GDP
• POLICY GOAL IS TO MOVE IT UP (increase GDP)
• Leakages (withdrawal of spending from
income/expenditure stream)
 imports, taxes, savings
• Injections (addition of spending to the
income/expenditure stream)
 spending (G or Ig), investment, net exports
• Must equal each other: S( savings) + M ( imports) + T ( taxes) =
I ( investments) + X ( exports) + G( government purchases)
Aggregate Expenditures Model
1:1
AD/AE
C + Ig
C
45°
Equilibrium GDP is the
intersection of ____ & ____.
GDP (NI, NO)
International Trade &
Equilibrium Output
• Xn & Aggregate Expenditures
• Closed economy:
• AE = C + Ig
• Open economy:
• AE = C + Ig + Xn
• Measuring AE for domestic goods (X – M)
Government Purchases &
Equilibrium GDP
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A mixed economy – adding gov’t spending & taxes.
Government spending is subject to the multiplier.
• Balanced Budget Multiplier: a change in G is more
powerful than a tax change of the same size \
• (spend & tax at same amount will yield growth)
Taxes are leakages
• Lump Sum: tax that provides equal amounts of
revenue at each level of GDP
•
a tax increase shifts AE downward only by the
amount of the tax times the MPC
Aggregate Expenditures Model
1:1
AD/AE
U. S.
C + Ig + G + Xn
C + Ig + G
C + Ig + G + (Xn)
C + Ig
C
45°
GDP (NI, NO)
Government Purchases &
Equilibrium GDP
• Recessionary Gap:
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The amount by which AE at full employment GDP
falls short of those required to achieve full
employment GDP
• Inflationary Gap
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The amount by which an economy’s AE at full
employment exceeds those just necessary to achieve
full employment
Aggregate Expenditures Model
1:1
C + Ig
AD/AE
C
45°
GDP (NI, NO)
AE Model
AD Curve
AE1 (at P1)
AE2 (at P2)
Price Level
AD/AE
1:1
P2
P1
AD
45°
3500
4000
GDP
Thus, GDP is less at P2 (higher price
level) than P1
0
3500
4000
GDP
Aggregate Demand
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Shows the amounts of real GDP that buyers desire to
purchase at each price level.
If the price level:
• Increases (inflation), then Real GDP demanded ___
• Decreases (deflation), then Real GDP demanded ___
Price
Level
AD = C + I + G + Xn
Real domestic output (GDPR)
Aggregate Demand
Why downward slope?
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Real-Balances Effect:
•  price level reduces purchasing power – GDP 
•
Interest Rate Effect:
•  price level leads lenders need to charge higher
interest rates – GDP 
•
Foreign Purchases Effect:
•  price level reduces foreign D of U.S. goods &
increases U.S. D of foreign goods – GDP  (due to –Xn)
Determinants of Aggregate Demand
An increase in spending shifts AD right & decrease in spending
shifts AD left.
Price
Level
AD1
AD2
AD = C + I + G + Xn
Real domestic output (GDP)
Determinants of Aggregate Demand
1. Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Taxes (Decrease in income taxes…)
2. Change in Investment Spending
Real Interest Rates (Price of borrowing $...)
Rate of Return:
Future Business Expectations (High expectations…)
Productivity and Technology (New robots…)
Business Taxes (Higher corporate taxes…)
Determinants of Aggregate Demand
3. Change in Government Spending
(War…)
(Decrease in defense spending…)
4. Change in Net Exports (X-M)
Exchange Rates
(If the us dollar depreciates relative to the euro…)
National Income Abroad
AD = GDP = C + I + G + Xn
Aggregate Supply
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•
Shows the level of real GDP that firms will produce at
each price level.
Three ranges:
Price
Level
D
Classical
C
A
B
Keynesian
Q1
Q2
Q3
GDPR
Cost-Push Inflation vs. Demand
Pull Inflation
•
Outcome on price level is the same, but GDP differs.
AS
Price
Level
AD
D Classical
C
A
B
Keynesian
Q1 Q2
Q3
GDPR
SRAS & LRAS
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AS differentiates b/w short-run & long-run
• SRAS: immediately after change in PL (input costs
haven’t yet adjusted to change in PL)
• LRAS: measures potential output / NRU; point at which
input prices have adjusted to change in PL
Actual GDP = SRAS
Potential GDP = LRAS
SRAS & LRAS
The LRAS & SRAS curves also indicate our PPF & can be
used to identify GDP gaps.
LRAS
Price
Level
SRAS
Consumer Goods
•
C
P1
A
B
Capital Goods
500
550
600
GDPR
Determinants of Aggregate Supply
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Firms are able to produce more or less at every price level.
• per-unit production costs change for reasons outside
changes in real GDP
• SRAS shifters mostly
AS3 AS1
Price
Level
Q1
Q2
Q3
AS2
GDPR
Determinants of Aggregate Supply
1. Inputs
• Costs of Domestic Resources
Factors of Production
• Cost of Imported Resources
Exchange rate value
• Market Power
Competition
Determinants of Aggregate Supply
2. Legal-Institutional Environment
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•
Business taxes & subsidies
Gov’t regulation:
Anti-trust laws
Labor laws
Environmental laws
3. Productivity
worker education
management skill
technology
Equilibrium Price Level & Real Output
•
Shifts in SRAS/AD will reveal inflationary/recessionary
gaps.
Price
Level
Recessionary Inflationary
Gap
Gap
LRAS
GDPR
Fiscal Policy
• The use of government spending (the BUDGET)
& revenue collection (TAXES) to influence the
economy
• Fiscal year
o October 1- September 30
• Federal Budget:
o Revenues = Spending… Balanced Budget
o Revenues > Spending… Budget Surplus
o Revenues < Spending… Budget Deficit
National Debt
Federal Debt = accumulated deficits - accumulated surpluses
$17.3 T
Types of Fiscal Policy
T
O
O
L
S
Contractionary: works to fight inflation but can
lead to a fall in GDP.
1. Raise taxes: take money out of circulation
2. Reduce gov’t spending: cuts back on funding
social programs & business contracts
Results in…
• Budget surplus
Resolves inflationary / recessionary gap.
Republicans would prefer which option?
Types of Fiscal Policy
Expansionary: works to fight deflation,
unemployment, & recessions. Used to raise the
level of output in the economy.
T 1. Reduce taxes: gives consumers more to spend
O
& less to pay the gov’t
O
2. Increase gov’t spending: gov’t spends money
L
on social programs & business contracts
S
Results in…
• Budget deficit
Resolves inflationary / recessionary gap
Republicans would prefer which option?
Demand Side Economics
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Focuses on changing AD
Gov’t or consumer spending to help the economy.
Policy used traditionally by Democrats
John Maynard Keynes (1883-1946)
o Gov’t should depend more on public works to fix
unemployment.
o Gov’t should decrease spending to fix inflation.
Supply Side Economics:
• Focuses on changing AS
• Stresses influence of taxation on the economy,
especially businesses
• Gov’t should cut taxes on personal & corporate
income
• Gov’t should reduce regulations to decrease the
costs of production
• John Baptiste Say
o Says Law: supply creates it’s own demand?
o If you make a product, people will get paid and have
money to spend and therefore purchase more goods
• Reaganomics
Nondiscretionary/Automatic
Fiscal Policy
• Built-in Stabilizers: automatic changes in G &
T as the economy changes
• Don’t require new legislation – already
embodied in law
• e.g. unemployment compensation, food
stamps, SS, Medicare
• Progressive Tax System
• Recession: as incomes drop, ppl pay less of
their income in taxes – more to spend
• Inflation: as incomes rise, ppl pay more of
their income in taxes – less to spend