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

McGraw-Hill/Irwin

©2008 The McGraw-Hill Companies, All Rights Reserved

Aggregate Demand

Chapter 9

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.

5

Some Quick

Review:

6

Macro Equilibrium

AS and AD combine to determine macro equilibrium.

Equilibrium is established where AS and AD intersect.

e

PR

ICE

LE

VE

L

REAL OUTPUT (quantity per year)QE

PE

Aggregatedemand

Aggregatesupply

E

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.

8

Escaping a Recession

AS (Aggregate supply)

AD1

E1

REAL OUTPUT (quantity per year)

PRIC

E LE

VEL

(ave

rage

pric

e)

AD2

QFQE

PE

9

…New Stuff…

10

1. Consumption

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

12

Building an AD Curve

13

Consumption

Consumption:

spending by consumers on final goods and services.

accounts for over two-thirds of total spending (GDP).

LO1

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

15

Income and Consumption

By definition, all disposable income is either:

consumed (spent ), or …

saved (not spent).

Disposable income = Consumption + Saving

LO1

YD = C + S

16

U.S. Consumption and Income

DISPOSABLE INCOME (billions of dollars per year)

$1000 2000 3000 4000

Actual consumer spending

6000

5000

4000

3000

2000

1000

0 5000 6000 7000

45°

$7000

19801982

19841986

19881990

19921994

19961998

1999

2000

CONS

UMPT

ION

(billi

ons

of d

olla

rs p

er y

ear)

C = YD

LO1

17

Income, Consumption, & AD

If we can model consumer spending…

…then we can predict consumer spending…

… and more effectively manipulate the AD curve.

18

Keynes described the consumption-income relationship in two ways:

1. AVERAGE propensity to consume:

- “APC"

2. MARGINAL propensity to consume:

- “MPC"


LO1

19


Average propensity to consume:- The “AVERAGE” rate of spending.

- A ratio of:

- total consumption to total disposable income:

LO1

Example:

20

Average Propensity to Save

Average Propensity to Save:

LO1

Example:

21

APC v. APS

So…

Since YD = C + S…

- or -

Example:

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

23

Marginal Propensity to Consume

Marginal Propensity to Consume:

MPC =Change in Consumption

Change in Disposable Income=

C

YD

LO1

8.10

8

200-210

192-200=

Y

C=MPC

D

Example:

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:

25

MPC vs. MPS

YD = C + S

So…

Example:

26

The MPC and MPS

MPS = 0.20 MPC = 0.80

LO1

27

ReviewIf 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 (Yd) 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)

28

Review 2If 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 (Yd) 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)

29

2. The Consumption Function

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

31


Keynes distinguished two kinds of consumer spending.

Autonomous:

Spending not influenced by current income,

Income-dependent:

Spending that is determined by current income.

LO1

32


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!)

33

Autonomous Consumption

Autonomous consumption:-consumption that occurs independent of income level.

Autonomous determinants of consumption include:

Expectations.

Wealth.

Credit.

(Taxes) ?!?

LO1

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

35

Wealth

An individual’s 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

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

38

Income-Dependent Consumption

Income-dependent consumption:This is delineated by one’s marginal propensity to consume (MPC):

MPC x Disposable Income

39


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 (YD) affect consumer spending (C) …

…and therefore, AD!LO1

43


C = a + bYD

where: C = current consumption a = autonomous consumption b = marginal propensity to consumeYD = disposable income

LO1

Income -dependent

consumption

Autonomous consumption

Total consumption

44


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

47

Consumer Behavior

Dissaving:

current consumption exceeds current income

a negative saving flow.

LO1

48

Justin’s Consumption Function

LO1

49

Justin’s Consumption Function

$400

$50 100 150 200 250 300 350 400 450

C = YD

Saving

DissavingConsumption Function

C = $50 + 0.75YD$125

A

CD

E

B

G

LO1

51

Application

Given C = 100 + .9YD

If YD = $1,400., then:

What is C ?

What is the savings level?

If C = $1,000., then:What is YD ?

What is the savings level?

What is the slope of this consumption function?

Graphically, what is the Y intercept?

$1,360

$40

$1,000

$0.00

52

Application

2. Suppose the MPC in an economy is 0.7. The APC is initially 0.8 and disposable income is $10 billion. If disposable income increases to $14 billion, what is the new level of consumption?

A). $10.8 billion. C). $8 billion.

B). $11.2 billion. D). $12.8 billion.

53

Shifts of the Consumption Function

Changing the a or b values in the consumption function (C = a + bYD) will shift the function to a new position.

A change in the a variable will cause a parallel shift of the function.

Caused by changes in expectations, wealth, or credit.

LO1

54

Shift in the Consumption Function

a1

C = a1 + bYD

C = a2 + bYD

a2CONS

UMPT

ION

(C) (

dolla

rs p

er y

ear)

DISPOSABLE INCOME(dollars per year)0

Decreased confidence

LO1

55

Shifts of Aggregate Demand

Shifts in the consumption function:

are reflected in shifts of AD:

Consumption function ↑ = AD to the right:

Consumption function ↓ = AD to the left:

LO2

57

AD Effects of Consumption Shifts

Y0

f2

f1

Q2 Q1

P1

C1

AD1

Shift = f1 – f2

Expenditure

Income

C2

Price Level

Real Output

AD2

LO2

***The AD curve will shift if:

- autonomous consumption changes, or…

- consumer incomes change.

61

Shifts and Cycles

AD shifts may originate from consumer behavior.

AD shifts = macro instability.

LO2

63

3. Investment

64

Investment

Investment:expenditures on (production of) new plant, equipment, and structures (capital), …

in a given time period, …

plus changes in business inventories.

LO1

65

Determinants of Investment

The following factors determine the amount of investment that occurs in an economy:

Interest rates.

Expectations.

Technology and innovation.

LO1

66

Interest Rates

Businesses typically borrow money to invest in new plants or equipment.

The higher the interest rate, the costlier it is to invest and the lower the investment spending.

LO1

67

Investment Demand

11

Inte

rest

Rat

e (p

erce

nt p

er y

ear)

Planned Investment Spending (billions of dollars per year)

100 200 300 400 500

10

9

8

7

6

54

3

2

1

0

11

B

A

LO1

68

Expectations

Expectations: play a critical role in investment decisions.

are determined by business confidence in future sales.

Confidence ↑ = AD shift to the right.

LO1

69

Investment Demand

11

Inte

rest

Rat

e (p

erce

nt p

er y

ear)


100 200 300 400 500

10

9

8

7

6

54

3

2

1

0

C

I2

I3

11

Better expectations

B

A

Initial expectations

Worse expectations

LO1

70

Technology and Innovation

New technology changes the demand for investment goods:

Technological advances and corresponding cost reductions stimulate new investment spending.

LO1

71

Investment Demand

11

Inte

rest

Rat

e (p

erce

nt p

er y

ear)


100 200 300 400 500

10

9

8

7

6

54

3

2

1

0

I2

11

Investment demand givenavailability of new technology

B

A

Initial Investment Demand

LO1

72

AD Shifts

So….The AD curve shifts:

to the left when investment spending declines.

to the right when investment spending increases.

LO2

73

AD Effects of Consumption Shifts

Q2 Q1

AD1

Price Level

Real Output

AD2

LO2

The AD curve shifts:

to the left when investment spending declines.

to the right when investment spending increases.

74

Investment Instability

Investment spending fluctuates more than consumption.

Abrupt changes in investment were the cause of the 2001 recession.

LO2

75

Volatile Investment Spending

LO2

76

4. Government Spending and Net Export Spending

77

Government Spending

State-local government spending is slightly pro-cyclical:

If consumption and investment spending decline,

- state/local government tax receipts fall,

- State/local spending subsequently falls,

- aggravating the leftward shift of the AD curve.

LO1

78

Government Spending

The federal government can “deficit spend:

it has counter-cyclical power.

can increase spending to counteract declines in consumption and investment spending.

LO1

79

Net Exports

Net exports can be both uncertain and unstable, creating further shifts of aggregate demand.

LO1

80

So…The four components of spending (C+I+G+(X-M)) come together to determine aggregate demand.

By adding up the intended spending of these market participants we can see how much output will be demanded at the current price level.

LO1

81

Building an AD Curve

82

Review

1. Suppose a consumption function is given as C = $175 + 0.85YD. The marginal propensity to save is:

2. If an increase in disposable income causes consumption to increase from $4,000 to $10,000 and causes saving to increase from $2,000 to $4,000 it can be inferred that the MPC equals:

3. Suppose the consumption function is C = $300 + 0.9YD. If disposable income is $400, consumption is:

What is the level of savings?

83

ReviewWhat are the 3 determinants of investment spending?

What is the major difference between Federal v. state/local spending (demand) during a recession?

84

Application

2. Suppose the MPC in an economy is 0.7. The APC is initially 0.8 and disposable income is $10 billion. If disposable income increases to $14 billion, what is the new level of consumption?

A). $10.8 billion. C). $8 billion.

B). $11.2 billion. D). $12.8 billion.

85

5. Macro Failure

86

Macro Failure - REVIEW

There are two chief concerns about macro equilibrium:

Undesirability:The market’s macro-equilibrium might not give us full employment or price stability.

Instability:Even if the market’s macro-equilibrium were at full employment and price stability, it might not last.

LO3

88

Recessionary GDP Gap

(REVIEW): Keynes worried that equilibrium GDP may not occur at full-employment GDP.

Equilibrium GDP: is the value of total output (real GDP) produced at macro equilibrium (AS=AD).

Full-employment GDP: is the value of total output (real GDP) produced at full employment.

LO3

89

Macro Failures

PRICE LEVEL

REAL GDP

Macro Success: (perfect AD)

AD1

AS

P*E1

QF

LO3

90

Macro Failures – Recessionary GDP Gap

PRICE LEVEL

REAL GDP

Cyclical Unemployment: (too little AD)

AS

P*E1

QF

AD2

E2P2

QE2

recessionary GDP gap

LO3

91

Recessionary GDP Gap

Recessionary GDP gap: the amount by which equilibrium GDP falls short of full-employment GDP.

The GDP gap represents

unused productive capacity,

lost GDP, and …

unemployed workers.

LO3

94

A Recessionary GDP Gap

LO3

95

Inflationary GDP Gap

Inflationary GDP gap:

the amount by which equilibrium GDP exceeds full-employment GDP.

leads to demand-pull inflation:

an increase in the price level initiated by excessive aggregate demand.

LO3

97

Macro Failures - Inflationary GDP Gap

PRICE LEVEL

Demand-pull inflation: (too much AD)

AS

P*E1

QF

AD3

E3P3

QE3

inflationary GDP gap

LO3

99

Unstable Equilibrium

Recurrent shifts of aggregate demand cause business cycles:

alternating periods of economic growth and contraction.

LO3

101

Self-Adjustment?

The critical question is whether undesirable outcomes will persist.

Classical economists asserted that markets self-adjust so that macro failures would be temporary.

Keynes didn’t think that was likely to happen.

102

6. Anticipating AD Shifts

103

Looking for AD Shifts

Average workweek.Unemployment claims.Delivery times.Credit.Materials prices.Equipment orders.

Stock prices.

Money supply.

New orders.

Building permits.

Inventories.

Policymakers use the Index of Leading Indicators to forecast changes in GDP:

104

Looking for AD Shifts

McGraw-Hill/Irwin

©2008 The McGraw-Hill Companies, All Rights Reserved

Aggregate Demand

End of Chapter 9