Chap009  4 (2010)
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Chap009 4 (2010)

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Chap009  4 (2010) Chap009 4 (2010) Presentation Transcript

  • Aggregate Demand
    • By working through the demand side of the macro economy we’ll better understand business cycles and their causes
      • What are the components of aggregate demand?
      • What determines the level of spending for each?
      • Will there be enough to maintain full employment?
  • Macro Equilibrium
    • The forces of aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium
    • Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply
  • The Desired Adjustment
    • All economists recognize that short-run macro failure is possible
    • The debate is over whether the economy will self-adjust to full employment
    • If not, government might have to step in and adjust AD to reach full employment
  • Escaping a Recession AS (Aggregate supply) AD 1 E 1 AD 2 Q F REAL OUTPUT PRICE LEVEL Q E P E
  • Components of Aggregate Demand
    • The four components of aggregate demand are
      • Consumption ( C )
      • Investment ( I )
      • Government spending ( G )
      • Net exports ( X – M )
  • Consumption
    • Consumption: Expenditure by consumers on final goods and services
    • Consumer expenditures account for over two-thirds of total spending in the U.S.
  • Income and Consumption
    • Most consumers spend most of whatever income they have
    • Disposable income ( DI ): After-tax income of consumers
  • U.S. Consumption and Income DISPOSABLE INCOME (billions of dollars per year) $1000 2000 3000 4000 6000 5000 4000 3000 2000 1000 0 5000 6000 7000 $7000 CONSUMPTION (billions of dollars per year) Actual consumer spending 45° 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 1999 2000 C = Y D
  • Consumption vs. Saving
    • All disposable income is either consumed (spent) or saved (not spent)
    • Saving: That part of disposable income not spent on current consumption
  • Consumption vs. Saving
    • To determine effect on AD, need to consider fractions of DI consumed and saved
      • In terms of averages - the ratios of total consumption and saving to total disposable income
      • In terms of marginal decisions - relationship of changes in consumption and saving to changes in disposable income
  • Consumption vs. Saving
    • The proportion of total disposable income spent on consumer goods and services is the average propensity to consume (APC)
  • Consumption vs. Saving
    • The proportion of total disposable income saved is the average propensity to save (APS)
  • Consumption vs. Saving
    • Marginal propensity to consume (MPC): The fraction of each additional (marginal) dollar of disposable income spent on consumption
  • Consumption vs. Saving
    • Marginal propensity to save (MPS): The fraction of each additional (marginal) dollar of disposable income not spent on consumption
  • MPC and MPS MPS = 0.20 MPC = 0.80
  • The Consumption Function
    • It is useful to know what drives consumption in order to help predict consumer behavior
    • Keynes distinguished two kinds of consumer spending
      • Spending that is not influenced by current income (autonomous)
      • Spending that is determined by current income
  • Autonomous Consumption
    • Consumption that is independent of income is influenced by non -income determinants:
      • Expectations – people get a raise, spend it in advance, expect economy to be poor, save.
      • Wealth – affects willingness to spend
      • Credit – need to pay past debt affects spending
      • Taxes – tax cuts give consumers more disposable income to spend
  • Income-Dependent Consumption
    • Consumption function: A mathematical relationship indicating the rate of desired consumer spending at various income levels
    income -dependent consumption autonomous consumption Total consumption  
    • The consumption function provides a basis for predicting how changes in income effect consumer spending
    Income-Dependent Consumption
  • Income-Dependent Consumption
    • The consumption function tells us:
      • How much consumption will be included in aggregate demand at the prevailing price level
      • How the consumption component of AD will change (shift) when incomes change
  • One Consumer’s Behavior
    • Even with an income level of zero there will be some consumption
    • Consumption will rise with income based on the consumer’s MPC
    • Dissaving: Consumption expenditure in excess of disposable income; a negative saving flow
  • A Consumption Function
  • The 45-Degree Line
    • In a graph of the consumption function, the 45-degree line represents all points where consumption and income are exactly equal, or
    • C = Y D
    • The slope of the consumption function is the marginal propensity to consume
  • A Consumption Function $400 $50 100 150 200 250 300 350 400 450 C = Y D Saving Dissaving Consumption Function C = $50 + 0.75Y D $125 A C D E B G
  • The Aggregate Consumption Function
    • Repeated studies suggest that in the aggregate consumers increase consumption as income increases
    • The consumption function summarizes this behavior
  • Shifts of the Consumption Function
    • A change in the a or b parameters will move the consumption function to a new position
    • A change in a will cause a parallel shift up or down of the function
    • A change in b alters the slope of the function
  • Shift in the Consumption Function Decreased confidence a 1 C = a 1 + bY D C = a 2 + bY D a 2 CONSUMPTION ( C ) DISPOSABLE INCOME 0
  • Shifts of Aggregate Demand
    • Shifts in the consumption function are reflected in shifts of the aggregate demand curve
      • A downward shift of the consumption function implies a leftward shift in aggregate demand
      • An upward shift of the consumption function implies a rightward shift in aggregate demand
  • AD Effects of Consumption Shifts Y 0 Q 2 Q 1 P 1 f 2 f 1 C 1 AD 1 Shift = f 1 – f 2 Expenditure Income C 2 Price Level Real Output AD 2
  • AD Shift Factors
    • The AD curve will shift in response to
      • Changes in income
      • Changes in expectations (consumer confidence)
      • Changes in wealth
      • Changes in credit conditions
      • Changes in tax policy
  • Shifts and Cycles
    • Shifts in aggregate demand can cause macro instability.
    • Aggregate demand shifts may originate from consumer behavior.
    LO2
  • Government Spending
    • The federal government is not constrained by tax receipts so it has counter -cyclical power
    • The federal government can increase spending to counteract declines in consumption and investment spending
  • Net Exports
    • Net exports can be both uncertain and unstable, also affecting aggregate demand
      • Exports react to foreign demand, which is affected by foreign incomes, expectations, wealth, etc.
      • Imports are affected by the same factors affecting domestic consumption and investment demand
  • The AD Curve Revisited
    • The four components of spending come together to determine aggregate demand
    • By adding up the intended spending of these market participants we can see how much output will be demanded at the current price level
  • Building an AD Curve Q G Q I Q X-M C I G X-M d Q C Q 0 P 0 AD Price Level Real GDP
  • Macro Failure
    • There are two chief concerns about macro equilibrium:
      • The market’s macro-equilibrium might not give us full employment or price stability
      • Even if macro-equilibrium were at full employment and price stability, it might not last
  • Undesired Equilibrium
    • Market participants make independent spending decisions
    • There is no reason to expect that the sum of their expenditures will generate exactly the right amount of aggregate demand
  • Recessionary GDP Gap
    • Equilibrium may not occur at full-employment
      • Equilibrium GDP: The value of total output (real GDP) produced at macro equilibrium ( AS=AD )
    • Recessionary GDP gap: The amount by which equilibrium GDP falls short of full-employment GDP
  • Recessionary GDP Gap
    • The recessionary GDP gap represents unused productive capacity, lost GDP, and unemployed workers
    • Cyclical unemployment: Unemployment attributable to a lack of job vacancies; that is, to inadequate aggregate
  • Macro Failures Macro Success: (perfect AD) PRICE LEVEL REAL GDP AD 1 AS P* E 1 Q F
  • Macro Failures Cyclical Unemployment: (too little AD) recessionary GDP gap PRICE LEVEL REAL GDP AS P* E 1 Q F AD 2 E 2 Q 2 P 2 Q E2
  • A Recessionary GDP Gap
  • A Recessionary GDP Gap
  • Inflationary GDP Gap
    • Equilibrium GDP might exceed its full-employment/price stability capacity
    • Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP
  • Inflationary GDP Gap
      • An inflationary GDP gap leads to demand-pull inflation
      • Demand-pull inflation: An increase in the price level initiated by excessive aggregate demand
  • Macro Failures Demand-pull inflation: (too much AD) inflationary GDP gap PRICE LEVEL AS P* E 1 Q F AD 3 E 3 P 3 Q 3 Q E3
  • Unstable Equilibrium
    • GDP gaps are clearly troublesome, since goal is to produce at full employment
    • Recurrent shifts of aggregate demand could cause a business cycle
    • Business cycle: Alternating periods of economic growth and contraction
  • Macro Failures
    • If aggregate demand is too little, too great, or too unstable, the economy will not reach and maintain the goals of full employment and price stability
  • Self-Adjustment?
    • The critical question is whether undesirable outcomes will persist
      • Classical economists asserted that markets self-adjust so that macro failures would be temporary
      • Keynes didn’t think that was likely to happen
  • The Leading Economic Indicators
    • Policymakers use the Index of Leading Indicators to forecast changes in GDP
    • Average workweek
    • Unemployment claims
    • New orders
    • Delivery times
    • Equipment orders
    • Building permits
    • Stock prices
    • Money supply
    • Interest rates
    • Consumer confidence