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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.
slide10
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
Autonomous Consumption
  • The non income determinants of consumption include
    • expectations,
    • wealth,
    • credit,
    • taxes,
    • and price levels.
consumption function

$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

shift in the consumption function

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

ad effects of consumption shifts

Expenditure

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
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 demand

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

inflationary gdp gap

PRICE LEVEL

AS

AD3

E3

P3

E1

P*

QE3

Q3

QF

Inflationary GDP Gap

Demand-pull inflation: (too much AD)

the keynesian cross

The Keynesian Cross

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

At equilibrium, aggregate expenditure equals income (output).

aggregate expenditures
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 shortfall

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
aggregate expenditures includes nonconsumer spending
Aggregate Expenditures includes Nonconsumer Spending
  • Investors, governments, and net export buyers add to consumer spending to equal aggregate expenditure.
expenditure equilibrium
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 equilibrium1
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)

slide28
When AE > Y, inventories depleting, signals expansion
  • When Y > AE, inventories increasing, signals contraction
aggregate expenditure at different price levels

Aggregate Expenditure at different price levels

Plots out Aggregate Demand

Wealth,

Int’l Trade and

Money Demand Effects

aggregate expenditures1
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

changes to autonomous expenditure
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

slide32

AE + mpc (1-t) Y

Aggregate

Expenditures

AE

C = a + mpc (1-t) Y

G

I - di

NX

Y*

Y real output/Income

slide33

AE0 + mpc (1-t) Y

Aggregate

Expenditures

AE1

AE 0

Y0 Y1

Y real output/Income

AE1 + mpc (1-t) Y

slide34

AE1

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
  • 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

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

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
  • 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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