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McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Aggregate Demand Chapter 9

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  • McGraw-Hill/Irwin 2008 The McGraw-Hill Companies, All Rights Reserved Aggregate Demand Chapter 9
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  • 2 Chapter 9 Aggregate Demand 1. Consumption. 2. The Consumption Function. 3. Investment. 4. Government & Net Export Spending. 5. Macro Failure. 6. Anticipating AD Shifts.
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  • 3 *************************** Note to self: This used to be Section 1. It transitions from Chapter 8 into this Chapter. Just talk this section through with an AD/AS graph on the board.
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  • 4 1. Macro Equilibrium & AD
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  • 5 Some Quick Review:
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  • 6 Macro Equilibrium AS and AD combine to determine macro equilibrium. Equilibrium is established where AS and AD intersect. e PRICE LEVEL REAL OUTPUT (quantity per year) QEQE PEPE Aggregate demand Aggregate supply E
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  • 7 The Desired Adjustment Any particular macro equilibrium point may be undesirable. All economists agree that short-run unemployment is possible. Will the economy self-adjust ? If not, government might have to step in to increase AD to reach full employment.
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  • 8 Escaping a Recession AS (Aggregate supply) AD 1 E1E1 REAL OUTPUT (quantity per year) PRICE LEVEL (average price) AD 2 QFQF QEQE PEPE
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  • 9 New Stuff
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  • 10 1. Consumption
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  • 11 Four Components of Aggregate Demand To adjust AD, we need to understand AD and how various factors will affect it. The Four Components of Aggregate Demand are: Consumption (C) Investment (I) Government spending (G) Net exports (X - M) If we can increase the spending of any one of these components, we increase AD. LO1
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  • 12 Building an AD Curve
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  • 13 Consumption Consumption: spending by consumers on final goods and services. accounts for over two-thirds of total spending (GDP). LO1
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  • 14 Income and Consumption Consumers tend to spend most of their disposable incomes. (Disposable income: - the after-tax income of consumers: - personal income less personal taxes.) LO1
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  • 15 Income and Consumption By definition, all disposable income is either: consumed (spent ), or saved (not spent). Disposable income = Consumption + Saving LO1 Y D = C + S
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  • 16 U.S. Consumption and Income DISPOSABLE INCOME (billions of dollars per year) $1000200030004000 Actual consumer spending 6000 5000 4000 3000 2000 1000 0 500060007000 45 $7000 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 1999 2000 CONSUMPTION (billions of dollars per year) C = Y D LO1
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  • 17 Income, Consumption, & AD If we can model consumer spending then we can predict consumer spending and more effectively manipulate the AD curve.
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  • 18 Keynes described the consumption- income relationship in two ways: 1.AVERAGE propensity to consume: - APC" 2.MARGINAL propensity to consume: - MPC" Income, Consumption, & AD LO1
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  • 19 Income, Consumption, & AD Average propensity to consume: -The AVERAGE rate of spending. -A ratio of: - total consumption to total disposable income: LO1 Example:
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  • 20 Average Propensity to Save Average Propensity to Save: LO1 Example:
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  • 21 APC v. APS So Since Y D = C + S - or - Example:
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  • 22 Marginal Propensity to Consume 2. Marginal propensity to consume: -The ratio of: -changes in consumption to changes in disposable income. - The fraction of each additional (marginal) dollar of disposable income spent on consumption. LO1
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  • 23 Marginal Propensity to Consume Marginal Propensity to Consume: LO1 Example:
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  • 24 Marginal Propensity to Save Marginal propensity to save: the fraction of each additional (marginal) dollar of disposable income not spent on consumption. LO1 Example:
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  • 25 MPC vs. MPS Y D = C + S So Example:
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  • 26 The MPC and MPS MPS = 0.20MPC = 0.80 LO1
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  • 27 Review If the MPC is.90 and the APC is.95: 1. What is the APS? 2. What is the MPS? 3. What is the level of spending if disposable income (Y d ) is $600? 4. How much would be saved from an additional $100 of disposable income. 5. What are the four components of AD?.05.1 $570 $10 C, I, G, (X-M)
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  • 28 Review 2 If the MPC is.85 and the APC is.98: 1. What is the APS? 2. What is the MPS? 3. What is the level of spending if disposable income (Y d ) is $1200? 4. How much would be saved from an additional $100 of disposable income. 5. What are the four components of AD?.02.15 $1176 $15 C, I, G, (X-M)
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  • 29 2. The Consumption Function
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  • 30 The Consumption Function The consumption function: a mathematical relationship that helps predict consumer behavior. Based in part on the concept of marginal propensity to consume. LO1
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  • 31 The Consumption Function Keynes distinguished two kinds of consumer spending. Autonomous: Spending not influenced by current income, Income-dependent: Spending that is determined by current income. LO1
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  • 32 The Consumption Function These two determinants of consumption are summarized in an equation called the consumption function. Income - dependent consumption Autonomous consumption Total consumption LO1 (*** Informal, theoretical equation: not the mathematical equation! )
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  • 33 Autonomous Consumption Autonomous consumption: -consumption that occurs independent of income level. Autonomous determinants of consumption include: Expectations. Wealth. Credit. (Taxes) ?!? LO1
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  • 34 Expectations Examples: People who anticipate a pay raise often increase spending before extra income is received. People who expect to be laid off tend to save more and spend less. LO1
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  • 35 Wealth An individuals wealth affects his willingness and ability to consume. The wealth effect: a change in consumer spending caused by a change in the value of owned assets. LO1
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  • 36 Credit The cost of credit fluctuates. The need to pay past debt may limit current consumption. Availability of credit allows people to spend more than their current income. LO1
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  • 37 Taxes Taxes are the link between total and disposable income. Tax cuts give consumers more disposable income to spend. LO1
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  • 38 Income-Dependent Consumption Income-dependent consumption: This is delineated by ones marginal propensity to consume (MPC): MPC x Disposable Income
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  • 39 The Consumption Function The consumption function: The mathematical relationship indicating the (desired) rate of consumer spending at various income levels. It combines autonomous and income- dependent consumption into one formula. It provides a precise basis for predicting how changes in income (Y D ) affect consumer spending (C) and therefore, AD! LO1
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  • 40 The Consumption Function The consumption function tells us: How much consumption will be included in aggregate demand at the prevailing price level. How the consumption component of AD will change (shift) when incomes change. LO1
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  • 41 Review What are/is: The 4 components of AD? APC? APS? The mathematical relationship of APC to APS? MPC? MPS? The mathematical relationship of MPC to MPS? The two types of consumption?
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  • 42 Autonomous Consumption Determinants of Autonomous consumption: Expectations. Wealth. Credit. Taxes. LO1
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  • 43 The Consumption Function C = a + bY D where: C = current consumption a = autonomous consumption b = marginal propensity to consume Y D = disposable income LO1 Income - dependent consumption Autonomous consumption Total consumption
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  • 44 The Consumption Function
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  • 45 The 45-Degree Line The 45-degree line represents all points where consumption and income are exactly equal. C = Y D LO1
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  • 46 Consumer Behavior Even with an income level of zero: there will be some consumption (autonomous). Consumption will rise with income based on the MPC. Slope = MPC. LO1
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  • 47 Consumer Behavior Dissaving: current consumption exceeds current income a negative saving flow. LO1
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  • 48 Justins Consumption Function LO1
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  • 49 Justins Consumption Function $400 $50100150200250300350400450 C = Y D Saving Dissaving Consumption Function C = $50 + 0.75Y D $125 A C D E B G LO1
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  • 50 The Aggregate Consumption Function Repeated studies suggest that consumers increase their consumptions as their incomes increase. LO1
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  • 51 Application Given C = 100 +.9Y D If Y D = $1,400., then: What is C ? What is the savings