Behavior of Aggregate Demand

Increase/Decrease

Shift Right/Left

Recessionary/Inflationary Gaps

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?

Four Components of Aggregate Demand

• Consumption (C)

• Investment (I)

• Government spending (G)

• Net exports (X - IM)

ConsumptionBig but Stable

Two Components– Autonomous Consumption

– Income-Dependent (Induced) Consumption

Income and Consumption

• By definition, all disposable income is either consumed (spent ) or saved (not spent).

Disposable income = Consumption + SavingYD = C + S

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

198019811982198319841985198619871988198919901991199219931994199519961997

19981999

2000

CONS

UMPT

ION

(billi

ons

of d

olla

rs p

er y

ear)

C = YD

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.

MPC =Change in Consumption

Change in Disposable Income=

C

YD

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

The Consumption Function

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

• 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

Autonomous Consumption

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

Consumption Function$400

$125

$50 100 150 200 250 300 350 400 450

C = YD

Saving

DissavingConsumption Function

C = $50 + 0.75YD

A

C

D

E

B

G

Shift in the Consumption Function

a2

C = a2 + bYD

C = a1 + bYD

a1CONS

UMPT

ION

(C) (

dolla

rs p

er y

ear)

DISPOSABLE INCOME(dollars per year)0

Increased confidence

AD Effects of Consumption Shifts

Y0

f1

f2

Q1 Q2

P1

C2

AD2

Shift = f2 – f1

Expenditure

Income

C1

Price Level

Real Output

AD1

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.

Investment Demand11

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

C

I2

I3

11

Better expectations

B

A

Initial expectations

Worse expectations

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.

Net Exports

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

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.

Recessionary GDP Gap

130

120

110

100

90

80

706560

REAL GDP

3 4 5 6 7 8

Equilibrium GDPFull-employment GDP

9 10

E

AD AS

11 12

RecessionaryGDP gap

13

Inflationary GDP Gap

PRICE LEVEL

Demand-pull inflation: (too much AD)

AS

P*E1

QF

AD3

E3P3

Q3QE3

The Keynesian Cross

The Keynesian cross relates aggregate expenditure to total income

(output).

At equilibrium, aggregate expenditure equals income (output).

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

The Consumption ShortfallE

xpe

ndi

ture

Income (Output)

$3000

1000 2000

ZF

CFTotal output Output not

purchased by consumers

2350

2000

1500

1000

500

0

YF45°

Consumption function(C)= $100 + 0.75YD

3000

Aggregate Expenditures includes Nonconsumer Spending

• Investors, governments, and net export buyers add to consumer spending to equal aggregate expenditure.

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

Expenditure Equilibrium

Income (Output) (billions of dollars per year)

Exp

endi

ture

AE = Y

$500 1000 1500 2000 2500 3000

$3500

3000

2500

2000

1500

1000

500

0

Equilibrium

45°

Aggregate expenditureE

YE

• When AE > Y, inventories depleting, signals expansion

• When Y > AE, inventories increasing, signals contraction

Aggregate Expenditure at different price levels

Plots out Aggregate Demand

•Wealth,

•Int’l Trade and

•Money Demand Effects

Aggregate Expenditures

C + I + G + NXYD= Y – tY = (1-t)YC = a + mpcYD = a + mpc (1-t)YI = I – diG = GNX = NX AE=a + I – di + G + NX + mpc (1-t)YAE = AE + mpc (1-t)Y

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

Aggregate Expenditures AE C = a + mpc (1-t) Y

G

I - di

NX

Y real output/Income

AE + mpc (1-t) Y

Y*

Aggregate Expenditures

AE1

AE 0

Y real

output/Income

AE0 + mpc (1-t) Y

Y0 Y1

AE1 + mpc (1-t) Y

AE1

AE 0

Y0 Y1

An increase in autonomous aggregate expenditures has a much larger increase in real output/income.Multiplier Effect

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.

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)]

Multiplier deriveda) M = 1 + mpc(1-t)+ [mpc(1-t)]2 + [mpc(1-t)]3 +……+ [mpc(1-t)]

b) 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 getM - M [mpc(1-t)] = 1 or M (1 - mpc(1-t)) = 1

d) M = 1 / (1 - mpc(1-t))

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

Size of Multiplier

• Depends on the circular flow of income in the economy

• In a macroeconomic equilibrium aggregate expenditures equal national income

Circular Flow

Draw on the Board

Injections versus Leakages

Equilibrium

Investment + Government Spending + Exports

= Savings + Taxes + Imports

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.