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Chap009 4 (2010)


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Chap009 4 (2010)

  1. 1. Aggregate Demand <ul><li>By working through the demand side of the macro economy we’ll better understand business cycles and their causes </li></ul><ul><ul><li>What are the components of aggregate demand? </li></ul></ul><ul><ul><li>What determines the level of spending for each? </li></ul></ul><ul><ul><li>Will there be enough to maintain full employment? </li></ul></ul>
  2. 2. Macro Equilibrium <ul><li>The forces of aggregate demand and aggregate supply confront each other in the marketplace to determine macro equilibrium </li></ul><ul><li>Equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply </li></ul>
  3. 3. The Desired Adjustment <ul><li>All economists recognize that short-run macro failure is possible </li></ul><ul><li>The debate is over whether the economy will self-adjust to full employment </li></ul><ul><li>If not, government might have to step in and adjust AD to reach full employment </li></ul>
  4. 4. Escaping a Recession AS (Aggregate supply) AD 1 E 1 AD 2 Q F REAL OUTPUT PRICE LEVEL Q E P E
  5. 5. Components of Aggregate Demand <ul><li>The four components of aggregate demand are </li></ul><ul><ul><li>Consumption ( C ) </li></ul></ul><ul><ul><li>Investment ( I ) </li></ul></ul><ul><ul><li>Government spending ( G ) </li></ul></ul><ul><ul><li>Net exports ( X – M ) </li></ul></ul>
  6. 6. Consumption <ul><li>Consumption: Expenditure by consumers on final goods and services </li></ul><ul><li>Consumer expenditures account for over two-thirds of total spending in the U.S. </li></ul>
  7. 7. Income and Consumption <ul><li>Most consumers spend most of whatever income they have </li></ul><ul><li>Disposable income ( DI ): After-tax income of consumers </li></ul>
  8. 8. 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
  9. 9. Consumption vs. Saving <ul><li>All disposable income is either consumed (spent) or saved (not spent) </li></ul><ul><li>Saving: That part of disposable income not spent on current consumption </li></ul>
  10. 10. Consumption vs. Saving <ul><li>To determine effect on AD, need to consider fractions of DI consumed and saved </li></ul><ul><ul><li>In terms of averages - the ratios of total consumption and saving to total disposable income </li></ul></ul><ul><ul><li>In terms of marginal decisions - relationship of changes in consumption and saving to changes in disposable income </li></ul></ul>
  11. 11. Consumption vs. Saving <ul><li>The proportion of total disposable income spent on consumer goods and services is the average propensity to consume (APC) </li></ul>
  12. 12. Consumption vs. Saving <ul><li>The proportion of total disposable income saved is the average propensity to save (APS) </li></ul>
  13. 13. Consumption vs. Saving <ul><li>Marginal propensity to consume (MPC): The fraction of each additional (marginal) dollar of disposable income spent on consumption </li></ul>
  14. 14. Consumption vs. Saving <ul><li>Marginal propensity to save (MPS): The fraction of each additional (marginal) dollar of disposable income not spent on consumption </li></ul>
  15. 15. MPC and MPS MPS = 0.20 MPC = 0.80
  16. 16. The Consumption Function <ul><li>It is useful to know what drives consumption in order to help predict consumer behavior </li></ul><ul><li>Keynes distinguished two kinds of consumer spending </li></ul><ul><ul><li>Spending that is not influenced by current income (autonomous) </li></ul></ul><ul><ul><li>Spending that is determined by current income </li></ul></ul>
  17. 17. Autonomous Consumption <ul><li>Consumption that is independent of income is influenced by non -income determinants: </li></ul><ul><ul><li>Expectations – people get a raise, spend it in advance, expect economy to be poor, save. </li></ul></ul><ul><ul><li>Wealth – affects willingness to spend </li></ul></ul><ul><ul><li>Credit – need to pay past debt affects spending </li></ul></ul><ul><ul><li>Taxes – tax cuts give consumers more disposable income to spend </li></ul></ul>
  18. 18. Income-Dependent Consumption <ul><li>Consumption function: A mathematical relationship indicating the rate of desired consumer spending at various income levels </li></ul>income -dependent consumption autonomous consumption Total consumption  
  19. 19. <ul><li>The consumption function provides a basis for predicting how changes in income effect consumer spending </li></ul>Income-Dependent Consumption
  20. 20. Income-Dependent Consumption <ul><li>The consumption function tells us: </li></ul><ul><ul><li>How much consumption will be included in aggregate demand at the prevailing price level </li></ul></ul><ul><ul><li>How the consumption component of AD will change (shift) when incomes change </li></ul></ul>
  21. 21. One Consumer’s Behavior <ul><li>Even with an income level of zero there will be some consumption </li></ul><ul><li>Consumption will rise with income based on the consumer’s MPC </li></ul><ul><li>Dissaving: Consumption expenditure in excess of disposable income; a negative saving flow </li></ul>
  22. 22. A Consumption Function
  23. 23. The 45-Degree Line <ul><li>In a graph of the consumption function, the 45-degree line represents all points where consumption and income are exactly equal, or </li></ul><ul><li>C = Y D </li></ul><ul><li>The slope of the consumption function is the marginal propensity to consume </li></ul>
  24. 24. 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
  25. 25. The Aggregate Consumption Function <ul><li>Repeated studies suggest that in the aggregate consumers increase consumption as income increases </li></ul><ul><li>The consumption function summarizes this behavior </li></ul>
  26. 26. Shifts of the Consumption Function <ul><li>A change in the a or b parameters will move the consumption function to a new position </li></ul><ul><li>A change in a will cause a parallel shift up or down of the function </li></ul><ul><li>A change in b alters the slope of the function </li></ul>
  27. 27. 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
  28. 28. Shifts of Aggregate Demand <ul><li>Shifts in the consumption function are reflected in shifts of the aggregate demand curve </li></ul><ul><ul><li>A downward shift of the consumption function implies a leftward shift in aggregate demand </li></ul></ul><ul><ul><li>An upward shift of the consumption function implies a rightward shift in aggregate demand </li></ul></ul>
  29. 29. 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
  30. 30. AD Shift Factors <ul><li>The AD curve will shift in response to </li></ul><ul><ul><li>Changes in income </li></ul></ul><ul><ul><li>Changes in expectations (consumer confidence) </li></ul></ul><ul><ul><li>Changes in wealth </li></ul></ul><ul><ul><li>Changes in credit conditions </li></ul></ul><ul><ul><li>Changes in tax policy </li></ul></ul>
  31. 31. Shifts and Cycles <ul><li>Shifts in aggregate demand can cause macro instability. </li></ul><ul><li>Aggregate demand shifts may originate from consumer behavior. </li></ul>LO2
  32. 32. Government Spending <ul><li>The federal government is not constrained by tax receipts so it has counter -cyclical power </li></ul><ul><li>The federal government can increase spending to counteract declines in consumption and investment spending </li></ul>
  33. 33. Net Exports <ul><li>Net exports can be both uncertain and unstable, also affecting aggregate demand </li></ul><ul><ul><li>Exports react to foreign demand, which is affected by foreign incomes, expectations, wealth, etc. </li></ul></ul><ul><ul><li>Imports are affected by the same factors affecting domestic consumption and investment demand </li></ul></ul>
  34. 34. The AD Curve Revisited <ul><li>The four components of spending come together to determine aggregate demand </li></ul><ul><li>By adding up the intended spending of these market participants we can see how much output will be demanded at the current price level </li></ul>
  35. 35. 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
  36. 36. Macro Failure <ul><li>There are two chief concerns about macro equilibrium: </li></ul><ul><ul><li>The market’s macro-equilibrium might not give us full employment or price stability </li></ul></ul><ul><ul><li>Even if macro-equilibrium were at full employment and price stability, it might not last </li></ul></ul>
  37. 37. Undesired Equilibrium <ul><li>Market participants make independent spending decisions </li></ul><ul><li>There is no reason to expect that the sum of their expenditures will generate exactly the right amount of aggregate demand </li></ul>
  38. 38. Recessionary GDP Gap <ul><li>Equilibrium may not occur at full-employment </li></ul><ul><ul><li>Equilibrium GDP: The value of total output (real GDP) produced at macro equilibrium ( AS=AD ) </li></ul></ul><ul><li>Recessionary GDP gap: The amount by which equilibrium GDP falls short of full-employment GDP </li></ul>
  39. 39. Recessionary GDP Gap <ul><li>The recessionary GDP gap represents unused productive capacity, lost GDP, and unemployed workers </li></ul><ul><li>Cyclical unemployment: Unemployment attributable to a lack of job vacancies; that is, to inadequate aggregate </li></ul>
  40. 40. Macro Failures Macro Success: (perfect AD) PRICE LEVEL REAL GDP AD 1 AS P* E 1 Q F
  41. 41. 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
  42. 42. A Recessionary GDP Gap
  43. 43. A Recessionary GDP Gap
  44. 44. Inflationary GDP Gap <ul><li>Equilibrium GDP might exceed its full-employment/price stability capacity </li></ul><ul><li>Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP </li></ul>
  45. 45. Inflationary GDP Gap <ul><ul><li>An inflationary GDP gap leads to demand-pull inflation </li></ul></ul><ul><ul><li>Demand-pull inflation: An increase in the price level initiated by excessive aggregate demand </li></ul></ul>
  46. 46. 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
  47. 47. Unstable Equilibrium <ul><li>GDP gaps are clearly troublesome, since goal is to produce at full employment </li></ul><ul><li>Recurrent shifts of aggregate demand could cause a business cycle </li></ul><ul><li>Business cycle: Alternating periods of economic growth and contraction </li></ul>
  48. 48. Macro Failures <ul><li>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 </li></ul>
  49. 49. Self-Adjustment? <ul><li>The critical question is whether undesirable outcomes will persist </li></ul><ul><ul><li>Classical economists asserted that markets self-adjust so that macro failures would be temporary </li></ul></ul><ul><ul><li>Keynes didn’t think that was likely to happen </li></ul></ul>
  50. 50. The Leading Economic Indicators <ul><li>Policymakers use the Index of Leading Indicators to forecast changes in GDP </li></ul><ul><li>Average workweek </li></ul><ul><li>Unemployment claims </li></ul><ul><li>New orders </li></ul><ul><li>Delivery times </li></ul><ul><li>Equipment orders </li></ul><ul><li>Building permits </li></ul><ul><li>Stock prices </li></ul><ul><li>Money supply </li></ul><ul><li>Interest rates </li></ul><ul><li>Consumer confidence </li></ul>