Download fall 2013 ch. 9 revised

FRIEDRICH HAYEK (1899-1992)



Prominent classical (or
Neoliberal) economist
Winner of the 1974
Nobel in Economics
Argued for recovery
from Great Depression
with increased
PRIVATE investment
NOT government
spending
Aggregate Demand
Unit 3, Ch. 9
INTRODUCTION TO
CONSUMPTION
I’m just a poor college student…
WELCOME TO IMPOVERISHED U.!


Your campus job pays
$100 week after taxes.
Mom and Dad are
paying for tuition, room,
and yucky inconvenient
board, but it is up to you
to cover the rest.

Here are your expenses:









Textbooks ($20)
Economics Tutor ($20)
Ticket to 1 Movie ($10)
Cell phone bill ($20)
14 Packets EasyMac…cheap lunch &
dinner ($7)
7 Pop-Tarts…cheap
breakfast ($4)
3 Starbucks Lattes ($9)
Car Insurance ($40)
Essential Medication
($10)
DISCUSSION QUESTIONS
On only $100…


Needs?
Wants?
Living large…

If income>expenses

Spend more?

Save more?
CONSUMPTION SCHEDULE
Item
Textbooks
Weekly
Cost
20
Econ Tutor
20
Movie Tix
10
Cell Ph. Bill
20
Easy-Mac
7
Pop-Tarts
4
Lattes
9
Car Ins.
40
Essential
Meds
Total
Expenses
10
$140.00
$100
after tax
$150
after tax
$250
after tax
$1,000
after tax
Consumption
Spending
COLLEGE CONSUMPTION FUNCTION
Disposable
Income
AGGREGATE DEMAND (CH. 9)
Unit 3: Cyclical Instability
KEYNES’ KEY QUESTIONS



What goes into AD?
What determines
spending?
Is there enough AD to
meet preferred (full
employment rGDP?
FOCUS ON CONSUMPTION
GDP=C+I+G+(X-M)
CONSUMPTION


66% of GDP
Increases in
income increases
in spending at
every price level
FUN WITH FORMULAS…



Disposable Income Yd=
Personal Income-Taxes

Yd=Consumption +
Saving
Average Propensity to
Consume (APC) = Total
Consumption/Total
Disposable Income
Marginal Propensity
to Consume (MPC):
the fraction of each add’l
$ of Yd spent on
consumption

MPC=
C/

MPS=1-MPC
Yd
CONSUMPTION FUNCTION, WHAT’S YOUR
FUNCTION?

Consumption Results
from 2 Things:
Autonomous
Consumption
 Income Directed
Consumption


Examples from
College Consumption
Activity?
AUTONOMOUS CONSUMPTION


Consumption
regardless of income
Determinants:
Expectations
 Wealth Effects
 Credit
 Taxes


Examples of Each?
CONSUMPTION FUNCTION
C=a+b
Yd,
where
C=current
consumption
 a=autonomous
consumption
 b=marginal propensity
to consume
 Yd=disposable income

Key Insights

Tells you how much
consumption is in AD
at the price level

Tells you how much
the AD will shift when
incomes change

DEPICT THE CONSUMPTION FUNCTION
Dissaving: C>Yd
 Saving: C<Yd
 45 degree line:
C=Yd
 Slope: determined
by mpc

Illustrate a
change in “a”
 Illustrate a
change in “b”

CYCLICAL INSTABILITY AND THE CF


If consumer incomes
change OR autonomous
consumption changes,
the AD will shift,
causing macro
instability (business
cycles).
Changes in autonomous
consumption result
from:
Expectations
 Wealth
 Credit Conditions
 Tax Policy

INCREASED PERSONAL INCOME TAXES
Consumption Function
Macro Model
CONSUMPTION FUNCTION
PRACTICE
15 minutes
CALCULATE THE MPC & MPS
CONSUMPTION FUNCTION PRACTICE
A.
B.
C.
D.
E.
F.
3
2
1
2
3
2
1. Movement from A to B
2. Shift from CF 0 to CF1
3. Shift from CF0 to CF2
INVESTMENT, GOVERNMENT
SPENDING & NET EXPORTS
GDP=C+I+G+(X-M)
INVESTMENT
15% of GDP
 Includes new plant, equipment,
capital, change in inventories
 Determinants:

Expectations
 Interest Rates
 Technology & Innovation


Most VOLATILE spending
sector
CHANGES IN INVESTMENT

When investment
spending declines,
the AD will shift
left
Major shifts in I
determined by
interest rates &
expectations
Interest Rate

Planned Investment
Spending
GOVERNMENT SPENDING
1/3 Federal Spending
 2/3 State & Local
Spending

State and Local
Spending fall WITH
C and I (pro-cyclical)
 Federal Spending and
increase to
compensate for C and
I (counter-cyclical)

NET EXPORTS


Global recessions
serve to shrink
domestic AD (fewer
purchases of US
exports and imports)
Decreases in
consumption include
decreased imports
MACRO FAILURE…MIND THE
GAPS
Ch. 9, p. 181-184
KEY CONCERNS WITH MACRO
EQUILIBRIUM
1.
Macro Equilibrium may not yield Price
Stability OR Full Employment
2.
“Perfect” Macro Equilibrium may not last
PERFECT AD

Meets Goals

Problem
RECESSIONARY GAP

Causes: Too little AD
PL too low
 rGDP too low


Effect: cyclical
unemployment
INFLATIONARY GAP

Causes:Too much AD
PL too high
 rGDP too high


Effect: demand pull
inflation
THE KEYNESIAN CROSS
Ch. 9: Appendix
MACRO MODEL

Great Depression Reality: lots of slack in
economy (horizontal range of AS) price level is
not an issue
PL
AD1
AD2
AS
Qe

Focus:
Qf
rGDP
RG
Aggregate Demand (sum of C+I+G+(X-M))
 Real GDP


Adjusted for inflation
KEYNES’ AGGREGATE EXPENDITURES MODEL

Directly Relates Aggregate Expenditures (Total
Spending) to Nominal Income
Y Axis: Aggregate Expenditure (AE as sum of
C+I+G+(X-M))
 X Axis: Nominal Income/Output (Y)



NOT adjusted for inflation
Shows “layers” of spending

Constant spending
Investment
 Government Spending
 Net Exports


Increasing spending—with increased income

Consumption (based on consumption function, C=a+bYd)
LAYERS OF SPENDING?

Yum!
AGGREGATE EXPENDITURE
At Income
(output) of
Consumers
Desire to
Spend
$ 500
$ 475
150
200
50
$ 875
1000
850
150
200
50
1250
1500
1225
150
200
50
1625
2000
1600
150
200
50
2000
2500
1975
150
200
50
2375
3000
2350
150
200
50
2750
3500
2725
150
200
50
3125
+
Investors
Desire to
Spend
+
Governments
Desire to
Spend
+
Net Export
Spending
=
Aggregate
Expenditure
EXPENDITURE (billions of dollars per year)
AGGREGATE EXPENDITURE
3500
Y = AE
YF
g
3000
f
2500
e
2000
c
1500
1000
Aggregate expenditure
= C + I + G + (X – M)
d
Consumer spending
= $100 + 0.75(Y)
b
a
500
$500
$1000
$1500
$2000
$2500
$3000
$3500
INCOME (OUTPUT) (billions of dollars per year)
Investment spending = $150
Government spending = $200
Net exports = $50
EXPENDITURE EQUILIBRIUM

Equilibrium is the point where aggregate
expenditure and 45 degree lines meet.
EXPENDITURE EQUILIBRIUM
$3500
AE = Y
Expenditure
3000
2500
Equilibrium
2000
E
1500
1000
500
45°
0
YE
$500
1000
1500
2000
2500
3000
Income (Output) (billions of dollars per year)
EXPENDITURE EQUILIBRIUM
At Income Consumers + Investors + Governments + Net Export = Aggregate
Desire to
Desire to
(output) of Desire to
Spending
Expenditure
Spend
Spend
Spend
$ 500
$ 475
150
200
50
$ 875
1000
850
150
200
50
1250
1500
1225
150
200
50
1625
2000
1600
150
200
50
2000
2500
1975
150
200
50
2375
3000
2350
150
200
50
2750
3500
2725
150
200
50
3125
RECESSIONARY GAP

The recessionary gap is the amount by which
aggregate spending at full employment falls short
of full-employment output.
KEYNESIAN AGGREGATE EXPENDITURES MODEL

Focus:
Aggregate Expenditure (AE as sum of C+I+G+(X-M))
 Nominal Income/Output (Y)


NOT adjusted for inflation
AE
AE=Y
B
RG
AE1
A
Ye
Yf
Y
A SINGLE EQUILIBRIUM

At equilibrium, aggregate expenditure equals
income (output).
Benefits of macro equilibrium to
producers:
Have no incentive to change the rate
of output
Are selling all they produce.
TWO PATHS TO THE SAME CONCLUSION

Both the Keynesian cross and the AD/AS
framework lead to the same conclusion about
macro instability.
Keynsian Cross (AE Model) focuses on total
spending, the product of output and prices.
 AD/AD explains macro instability with prices and
real output.


Ultimate conclusion?

Spending matters!
AP MACRO COOK OFF
LAYERS OF SPENDING…

Cook Off Rules
Groups of 2
 Due Fri, Mar. 15th
 Creatively Depict AE
 Must Be Edible
2 points for participation
 5 points for winner!


Class Vote Based on
• Accuracy
• Creativity
• Taste
PRACTICE WITH AGGREGATE
EXPENDITURES…
15 minutes
SHOW WHAT YOU KNOW
Show the Macro Model with equilibrium that
meets policy goals
 Describe a scenario that would cause a change in
autonomous consumption

Show the change in the Consumption Function
 Show the ensuing change in the Macro Model & the
Aggregate Expenditure Model

Identify how the change in autonomous
consumption will create either an Inflationary or
Recessionary Gap
 Describe a potential policy response that could
correct the Cyclical Instability created

SHOW WHAT YOU KNOW
Show the Macro Model with equilibrium that
meets policy goals
 Describe a scenario that would cause a change in
autonomous consumption

Show the change in the Consumption Function
 Show the ensuing change in the Macro Model & the
Aggregate Expenditure Model

Identify how the change in autonomous
consumption will create either an Inflationary or
Recessionary Gap
 Describe a potential policy response that could
correct the Cyclical Instability created

Consumption Function
MY EXAMPLE…
People are worried about a
lengthy government shutdown…
Macro Model
Aggregate Expenditures Function
Consumption Function
YOUR EXAMPLE…
Macro Model
Aggregate Expenditures Function