Behavior of aggregate demand
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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?.

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Behavior of aggregate demand

Behavior of Aggregate Demand

Increase/Decrease

Shift Right/Left

Recessionary/Inflationary Gaps


Major questions to address
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
Four Components of Aggregate Demand

  • Consumption (C)

  • Investment (I)

  • Government spending (G)

  • Net exports (X - IM)


Consumption big but stable

ConsumptionBig but Stable

Two Components

Autonomous Consumption

Income-Dependent (Induced) Consumption


Income and consumption
Income and Consumption

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

Disposable income = Consumption + Saving

YD = C + S


U s consumption and income

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)


The marginal propensity to consume
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
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

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


where:

C = current consumption

a = autonomous consumption (constant)

b = marginal propensity to consume (slope)

YD= disposable income


Autonomous consumption
Autonomous Consumption predicting how changes in income (

  • The non income determinants of consumption include

    • expectations,

    • wealth,

    • credit,

    • taxes,

    • and price levels.


Consumption function

$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


Shift in the consumption function

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 Function

Increased confidence


Ad effects of consumption shifts

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 Shifts


Investment small but volatile
Investment 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.


Investment demand

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 Demand


Government spending
Government 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
Net Exports predicting how changes in income (

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


Gdp gaps
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
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


Inflationary gdp gap

PRICE LEVEL predicting how changes in income (

AS

AD3

E3

P3

E1

P*

QE3

Q3

QF

Inflationary GDP Gap

Demand-pull inflation: (too much AD)


The keynesian cross

The Keynesian Cross predicting how changes in income (

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

At equilibrium, aggregate expenditure equals income (output).


Aggregate expenditures
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


The consumption shortfall

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 Shortfall


Aggregate expenditures includes nonconsumer spending
Aggregate 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
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 equilibrium1
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)



Aggregate expenditure at different price levels

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

Plots out Aggregate Demand

Wealth,

Int’l Trade and

Money Demand Effects


Aggregate expenditures1
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
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
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
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
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
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
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
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
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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