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Behavior of Aggregate DemandPowerPoint Presentation

Behavior of Aggregate Demand

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### ConsumptionBig but Stable

### The Keynesian Cross predicting how changes in income (

### Aggregate Expenditure at different price levels predicting how changes in income (

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)

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 + Saving

YD = C + S

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)

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.

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 predicting how changes in income (

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

$125 predicting how changes in income (

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

C = a predicting how changes in income (2 + bYD

C = a1 + bYD

CONSUMPTION (C) (dollars per year)

a2

a1

0

DISPOSABLE INCOME(dollars per year)

Shift in the Consumption FunctionIncreased confidence

Expenditure predicting how changes in income (

Price Level

Shift = f2 – f1

C2

f2

C1

P1

f1

AD2

AD1

Y0

Income

Q1

Q2

Real Output

AD Effects of Consumption ShiftsInvestment predicting how changes in income (Small 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.

11 predicting how changes in income (

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 DemandGovernment Spending predicting how changes in income (

- 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 predicting how changes in income (

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

GDP Gaps predicting how changes in income (

- 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 predicting how changes in income (

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

PRICE LEVEL predicting how changes in income (

AS

AD3

E3

P3

E1

P*

QE3

Q3

QF

Inflationary GDP GapDemand-pull inflation: (too much AD)

The Keynesian cross relates aggregate expenditure to total income (output).

At equilibrium, aggregate expenditure equals income (output).

Aggregate Expenditures predicting how changes in income (

- 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

Z predicting how changes in income (F

$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 ShortfallAggregate Expenditures includes Nonconsumer Spending predicting how changes in income (

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

Expenditure Equilibrium predicting how changes in income (

- 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 predicting how changes in income (

$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)

- When AE > Y, inventories depleting, signals expansion predicting how changes in income (
- When Y > AE, inventories increasing, signals contraction

Plots out Aggregate Demand

Wealth,

Int’l Trade and

Money Demand Effects

Aggregate Expenditures predicting how changes in income (

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

Changes to Autonomous Expenditure predicting how changes in income (

Autonomous spending

- Autonomous Consumption
- Investment
- Gov’t Spending
- Net Exports
Shifts Aggregate Expenditure Up or Down

Shifts Aggregate Demand Right or Left

AE + predicting how changes in income ( mpc (1-t) Y

Aggregate

Expenditures

AE

C = a + mpc (1-t) Y

G

I - di

NX

Y*

Y real output/Income

AE predicting how changes in income (0 + mpc (1-t) Y

Aggregate

Expenditures

AE1

AE 0

Y0 Y1

Y real output/Income

AE1 + mpc (1-t) Y

AE predicting how changes in income (1

AE 0

An increase in autonomous aggregate expenditures has a much

larger increase in real output/income.

Multiplier Effect

Y0 Y1

Multiplier Effect predicting how changes in income (

- 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 predicting how changes in income (

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 derived predicting how changes in income (

- 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))

Brass Tacks predicting how changes in income (

- 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 predicting how changes in income (

- Depends on the circular flow of income in the economy
- In a macroeconomic equilibrium aggregate expenditures equal national income

Circular Flow predicting how changes in income (

Draw on the Board

Injections versus Leakages

Equilibrium

Investment + Government Spending + Exports

= Savings + Taxes + Imports

Multiplier Decreases as Leakages Increase predicting how changes in income (

- 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.

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