Behavior of Aggregate Demand

1. Behavior of Aggregate Demand Increase/Decrease Shift Right/Left Recessionary/Inflationary Gaps

2. Major Questions to Address • 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?

3. Four Components of Aggregate Demand • Consumption (C) • Investment (I) • Government spending (G) • Net exports (X - IM)

4. ConsumptionBig but Stable Two Components Autonomous Consumption Income-Dependent (Induced) Consumption

5. Income and Consumption • By definition, all disposable income is either consumed (spent ) or saved (not spent). Disposable income = Consumption + Saving YD = C + S

6. 2000 1999 C = YD 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 Actual consumer spending 45° U.S. Consumption and Income $7000 6000 5000 4000 CONSUMPTION (billions of dollars per year) 3000 2000 1000 0 $1000 2000 3000 4000 5000 6000 7000 DISPOSABLE INCOME (billions of dollars per year)

7. The Marginal Propensity to Consume • The marginal propensity to consume(MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.

8. Marginal Propensity to Save • The marginal propensity to save (MPS) is the fraction of each additional (marginal) dollar of disposable income not spent on consumption. MPS = 1 – MPC

9. The Consumption Function • The consumption function is a mathematical relationship that helps to predict consumer behavior.

10. The consumption function provides a precise basis for predicting how changes in income (YD) effect consumer spending (C). C = a + bYD where: C = current consumption a = autonomous consumption (constant) b = marginal propensity to consume (slope) YD= disposable income

11. Autonomous Consumption • The non income determinants of consumption include • expectations, • wealth, • credit, • taxes, • and price levels.

12. $125 Consumption Function $400 C = YD E Saving D C Dissaving Consumption Function C = $50 + 0.75YD B G A $50 100 150 200 250 300 350 400 450

13. C = a2 + bYD C = a1 + bYD CONSUMPTION (C) (dollars per year) a2 a1 0 DISPOSABLE INCOME(dollars per year) Shift in the Consumption Function Increased confidence

14. Expenditure Price Level Shift = f2 – f1 C2 f2 C1 P1 f1 AD2 AD1 Y0 Income Q1 Q2 Real Output AD Effects of Consumption Shifts

15. InvestmentSmall but Volatile • Investment are expenditures on new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories. • investment depends on: • Expectations. • Interest rates. • Technology and innovation.

16. 11 10 Better expectations 9 C A 8 7 B 6 I2 Interest Rate (percent per year) 5 Initial expectations 4 11 3 Worse expectations I3 2 1 0 100 200 300 400 500 Planned Investment Spending (billions of dollars per year) Investment Demand

17. Government Spending • The government sector (federal, state, and local) currently spends over $2 trillion a year on goods and services. • Government spending decisions are made independently of current income.

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

19. GDP Gaps • 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.

20. Recessionary GDP Gap 130 AD AS 120 110 100 E 90 Recessionary GDP gap 80 70 65 60 9 10 11 12 13 3 4 5 6 7 8 Full-employment GDP REAL GDP Equilibrium GDP

21. PRICE LEVEL AS AD3 E3 P3 E1 P* QE3 Q3 QF Inflationary GDP Gap Demand-pull inflation: (too much AD)

22. The Keynesian Cross The Keynesian cross relates aggregate expenditure to total income (output). At equilibrium, aggregate expenditure equals income (output).

23. Aggregate Expenditures • Aggregate expenditures are the rate of total expenditure desired at alternative levels of income, ceteris paribus, at a given price level • Aggregate expenditures is the sum of C, I, G, and NX, at a given price level

24. ZF $3000 2350 CF Total output 2000 Output not purchased by consumers Expenditure 1500 1000 Consumption function (C)= $100 + 0.75YD 500 YF 45° 0 1000 2000 3000 Income (Output) The Consumption Shortfall

25. Aggregate Expenditures includes Nonconsumer Spending • Investors, governments, and net export buyers add to consumer spending to equal aggregate expenditure.

26. Expenditure Equilibrium • Equilibrium is the point where aggregate expenditure and 45 degree lines meet. • Recall that real GDP can be calculated as the value of final goods and services, or as the payments to all inputs in its production. • In essence real output = income

27. Expenditure Equilibrium $3500 AE = Y 3000 2500 Equilibrium 2000 E Expenditure 1500 Aggregate expenditure 1000 500 YE 45° 0 $500 1000 1500 2000 2500 3000 Income (Output) (billions of dollars per year)

28. When AE > Y, inventories depleting, signals expansion • When Y > AE, inventories increasing, signals contraction

29. Aggregate Expenditure at different price levels Plots out Aggregate Demand Wealth, Int’l Trade and Money Demand Effects

30. Aggregate Expenditures C + I + G + NX YD= Y – tY = (1-t)Y C = a + mpcYD = a + mpc (1-t)Y I = I – di G = G NX = NX AE=a + I – di + G + NX + mpc (1-t)Y AE = AE + mpc (1-t)Y

31. Changes to Autonomous Expenditure Autonomous spending • Autonomous Consumption • Investment • Gov’t Spending • Net Exports Shifts Aggregate Expenditure Up or Down Shifts Aggregate Demand Right or Left

32. AE + mpc (1-t) Y Aggregate Expenditures AE C = a + mpc (1-t) Y G I - di NX Y* Y real output/Income

33. AE0 + mpc (1-t) Y Aggregate Expenditures AE1 AE 0 Y0 Y1 Y real output/Income AE1 + mpc (1-t) Y

34. AE1 AE 0 An increase in autonomous aggregate expenditures has a much larger increase in real output/income. Multiplier Effect Y0 Y1

35. Multiplier Effect • An increase in autonomous expenditures increases income by a like amount • With the increase in income, there is an increase in induced consumption. • The increase in consumption, again increases income. • The increase in consumption diminishes at each step due to savings and taxes.

36. Deriving the Multiplier ΔY =ΔAE + mpc(1-t)ΔAE + mpc(1-t)[mpc(1-t)ΔAE] +mpc(1-t)[mpc(1-t)mpc(1-t)ΔAE] +…… ΔY =ΔAE{1 + mpc(1-t)+ [mpc(1-t)]2 + [mpc(1-t)]3 +……+ [mpc(1-t)] } M = ΔY / ΔAE = 1 + mpc(1-t)+ [mpc(1-t)]2 + [mpc(1-t)]3 +……+ [mpc(1-t)]

37. Multiplier derived • M = 1 + mpc(1-t)+ [mpc(1-t)]2 + [mpc(1-t)]3 +……+ [mpc(1-t)] • M [mpc(1-t)]=mpc(1-t)+ [mpc(1-t)]2 + [mpc(1-t)]3 +……+ [mpc(1-t)] c) Subtract equation b from a, and we get M - M [mpc(1-t)]= 1 or M (1 - mpc(1-t)) = 1 d) M = 1 / (1 - mpc(1-t))

38. Brass Tacks • Suppose mpc=0.9, and t=0.15, then how much would a $100 increase in autonomous expenditure raise real income? • M = 1 / (1 – 0.9(1 – 0.15)) = 1 / (1 – 0.9*0.85) = 1 / (1 – 0.765) = 1 / 0.235 = 4.26 • ΔY = 4.26 * $100 = $426

39. Size of Multiplier • Depends on the circular flow of income in the economy • In a macroeconomic equilibrium aggregate expenditures equal national income

40. Circular Flow Draw on the Board Injections versus Leakages Equilibrium Investment + Government Spending + Exports = Savings + Taxes + Imports

41. Multiplier Decreases as Leakages Increase • With each increase in income that motivates the multiplier, • consumers save some portion, • the government taxes another portion, • and consumers may purchase imports • With each leakage, the less the consumer spends on domestic products, lowering the amount of additional income in the next round of the multiplier.