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Macroeconomics
Unit 9
Aggregate Demand
Introduction
In this unit we examine the components of aggregate demand
closely. One of the key components is consumer
consumption.
Economists know that consumer consumption is dependent
upon the amount of income they receive; but some
consumption is not determined by current income.
Business investment, government spending, and net exports
are also explored in this unit.
Aggregate Demand
Aggregate demand (AD) is the total quantity of output (GDP)
demanded at alternative price levels in a given period, ceteris
paribus.
AD consists of four components:
• Consumption (C)
• Investment (I)
• Government Spending (G)
• Net Exports (X – IM)
Concept 1: Consumption
Consumption represents purchases by consumers on final
goods and services. Consumption is obtained from consumer
disposable income.
Disposable income must be either spent or saved. Therefore
the following formula applies:
Disposable Income (YD) = Consumption (C) + Saving (S)
Concept 1: Consumption
We often want to determine the proportion of total disposable
income spent on consumer goods and services.
The average propensity to consume (APC) is equal to total
consumption on consumer goods and services in a given time
period divided by total disposable income.
APC = total consumption / total disposable income
C / YD
=
Concept 1: Consumption
In 1999, total consumer consumption totaled $6,490 billion, and
total disposable income was $6,638 billion. Therefore the APC
=
$6,490 billion /$6,638 billion = .98
98 cents out of each dollar earned was spent on consumption
in 1999. In 2001 the U.S. APC was 1.001 indicating that
consumers actually spent more than they received from
income.
Concept 1: Consumption
Often we would like to know what consumers would do if they
received a change in their disposable income.
To determine this change, we calculate the marginal propensity
to consume (MPC).
The marginal propensity to consume is the fraction of each
additional dollar of disposable income spent on consumption. It
is calculated by taking the change in consumption and dividing
it by the change in disposable income.
Concept 1: Consumption
MPC = ΔC / ΔYD
To calculate MPC we need to know how consumers spend the
last dollar they receive.
If consumers spend 80 cents out of the last dollar, then MPC =
$0.80/$1.00 = .80.
Notice that the MPC is lower than the APC we previously
calculated. Consumers tend to save a greater percentage of
the last dollars earned.
Concept 1: Consumption
We are also concerned with how much consumers save from each
additional dollar they earn.
The marginal propensity to save (MPS) is the fraction of each
additional dollar of disposable income not spent on consumption.
MPS = ΔS / ΔYD or
MPS = 1 – MPC
If consumers save $0.20 out of the last dollar earned, what is the
MPS? The MPS = .20/1.00 = .20.
Concept 1: Consumption
We are also concerned with the average rate of consumer saving.
To determine this, we calculate the average propensity to save
(APS).
The APS = S / YD
or
APS = 1 – APC
Suppose disposable income is $6,698 billion and consumers saved
$208 billion. What is the APS? The APS = $208 billion/$6,698
billion = .031. Consumers save an average of $0.031 out of each
dollar of disposable income.
Concept 1: Consumption
Although calculating the MPC, MPS, APC, and APS is useful,
predicting them is even more important. What drives consumer
consumption?
Keynes believed that consumer consumption was driven be
current income and other non-income determinants.
The non-income determinants of consumption according to
Keynes are: expectations, wealth, credit, taxes, and price
levels. Consumption based upon one or more of these
determinants is called autonomous consumption.
Consumption
Concept 2: Non-Income Determinants
Expectations is concerned with consumers changing current
consumption based upon an anticipated future event.
Consumers will spend a portion of anticipated salary increases,
tax refunds, bonuses, often before they are received. If this is
occurring, autonomous consumption increases.
If consumers believe they may get their work hours cut, laid off,
or have their jobs eliminated, they will spend less and save
more. Autonomous consumption declines.
Consumption
Concept 2: Non-Income Determinants
Wealth is the amount of assets an
individual owns. This can affect their
consumption.
Increases in wealth create greater
spending of current income. Autonomous
consumption increases.
Decreases in wealth causes spending of
current income to decline. Autonomous
consumption declines.
Consumption
Concept 2: Non-Income Determinants
Credit is the amount and availability of credit. It also can
affect consumption.
If credit is readily available, consumer spending of current
income increases causing an increase in autonomous
consumption.
If credit is not easily attainable or costly (high rates),
consumer spending of current income decreases and
autonomous consumption declines.
Consumption
Concept 2: Non-Income Determinants
Taxes are another non-income determinant. Decreases in
taxes increase consumer disposable income and consumer
spending. This would cause an increase in autonomous
consumption. Tax increases reduce consumer disposable
income and consumer spending, causing a decline in
autonomous consumption.
Price-levels are the final non-income determinant. If price
levels are increasing (inflation), the real value of money is
reduced, and consumer spending is reduced by the effects of
inflation. Autonomous consumption is reduced.
Consumption and the
Concept 3: Consumption Function
We have learned that consumer spending is influenced by
current income, and the non-income determinants of
consumption.
Therefore total consumption = non-income determinants of
consumption + income-dependent consumption, or total
consumption = autonomous consumption + income-dependent
consumption. The formula that represents this relationship is:
C = a + bYD
Consumption and the
Concept 3: Consumption Function
The equation C = a + bYD represents the consumption function.
The consumption function is a mathematical relationship
indicating the desired consumer spending at various income
levels.
•
•
•
•
C = current consumption
a = autonomous consumption
b = marginal propensity to consume
YD = disposable income
Consumption and the
Concept 3: Consumption Function
The consumption function is used to predict how changes in
disposable income (YD) will affect consumer spending. It also
shows the effect of changes in one or more non-income
determinants (autonomous consumption) on consumer
spending.
A consumption function can be graphically illustrated to show
the relationship between consumption and disposable income.
Concept 3: A Consumption Function
C = YD
Consumption
Spending
Saving
Dissaving
Disposable Income
Concept 3: A Consumption Function
The graph on the preceding page illustrates a consumption
function. The green dotted line represents the points at which
consumption is equal to disposable income – no saving or
dissaving occurs. This is called the 45 degree line
representing C = YD.
The red solid line represents the actual consumption.
Whenever the red line is below the green line savings occurs.
Once you reach the point at which the two lines intersect, any
additional spending is more than disposable income and
dissaving occurs (the green dotted line is below the red line of
the consumption function).
Concept 3: Consumption
and the Consumption Function
To graph the consumption function for a individual or for an
economy, we need to know the level of autonomous
consumption, the MPC, and the amount of disposable income.
If autonomous consumption = $100, and the MPC = .50, then
our equation is:
C = $100 + .50YD
Once we know different levels of disposable income, we can
graphically represent the consumption function.
Fred’s Consumption Function
Consumption = $100 + 0.50YD
Disposable
Income (YD)
Autonomous
Consumption
A
$ 0
100
$ 0
$100
B
100
100
50
150
C
200
100
100
200
D
300
100
150
250
E
400
100
200
300
+
IncomeDependent
Consumption
=
Total
Consumption
Fred’s Consumption Function
$400
C = YD
300
E
C
200
100
D
Dissaving
Saving
B
Consumption Function
C = $100 + 0.50YD
A
$50
100
150
200
250
300
350
400
450
Concept 3: Consumption and the
Consumption Function
A graph of a consumption function will contain a 45 degree line
which represents the point at which consumption (C) = disposable
income (YD). On the preceding graph, this line is the green dotted
line at a 45 degree angle.
Actual consumption may be above this line (dissaving) or below
the line (saving). Actual consumption is represented by the
consumption function equation and line. This line is shown as the
solid red line on the preceding graph.
The slope of the consumption function line will always equal the
MPC.
Concept 3: Consumption and the
Consumption Function
At point A, Fred has autonomous consumption of $100 and no
income. At point B Fred now has $100 in income, $100 in
autonomous consumption, and $50 in income dependent
consumption. Fred continues to dissave.
The consumption function equation determines the dollar
amount of Fred’s income dependent spending. Since Fred’s
MPC = .50, Fred will spend half of his income.
At point C, Fred’s income finally equals his autonomous and
income dependent consumption. At points D and E, Fred’s
income exceeds his total spending and he is saving.
Aggregate Consumption Function
The aggregate model of the consumption function is essentially
identical to the simple consumer model presented.
Shifts of the consumption function can occur when a change
occurs in one of the autonomous consumption determinants
(expectations, wealth, credit, taxes, price levels). For example,
significant positive returns in the stock market can increase
consumer wealth which would cause autonomous consumption
to increase. This would cause the consumption function to shift
upwards.
CONSUMPTION (C) (dollars per year)
Shift in the Consumption Function
0
DISPOSABLE INCOME(dollars per year)
Movement along the Consumption Function
Movement along the consumption function occurs when there
is a change in income or a change in the MPC.
A decline in income causes a leftward movement along the
consumption function (from point A to B on the next slide).
A decline in MPC also causes a leftward movement along the
consumption function.
Movements along the Consumption Function
CONSUMPTION
(billions of dollars per
year)
A
B
0
DISPOSABLE INCOME (billions of dollars per year)
Consumption Function
You should notice that when the consumption function shifts,
there is a change in autonomous consumption. Overall
consumption has changed as a result of a change in nonincome dependent consumption.
The point at which the line representing the consumption
function intersects the Y axis changes when autonomous
consumption changes.
When the line shifts up it indicates an increase in autonomous
or non-income dependent consumption. When the line shifts
down it indicates a decrease in autonomous or non-income
dependent consumption.
Consumption Function
When there is movement along the consumption function, the
level of autonomous consumption does not change.
Overall consumption has changed as a result of a change in
income-dependent consumption.
Movement along the consumption function line indicates a
change in income. Movement to the right occurs when income
increases and movement to the left occurs when income
decreases.
Consumption and AD
The consumption function and aggregate demand curves will
move together.
A downward shift of the consumption function implies a leftward
shift of the AD curve. Demand/consumption have fallen.
An upward shift of the consumption function implies a rightward
shift of the AD curve. Demand/consumption have risen.
AD Effects of Consumption Shifts
Spending
Price Level
AD
AD
AD shifts to the right
indicating increased
output
Consumption function
shifts up indicating an
increase in autonomous
consumption
Income
Real Output
Concept 4: Investment
A change in consumer spending is not the only factor that
affects aggregate demand.
The other factors (investment, government services, and net
exports) can offset changes in consumer spending.
Investment accounts for about 18% of output and consists of
expenditures on new plant, equipment, business software,
inventory, new residential construction.
There are also determinants of investment.
Concept 4: Determinants of Investment
• Expectations – The expectations of business owners and
management for future growth and sales of their products.
Future sales, future economic factors, future trends.
• Interest Rates – The current and expected rates of interest
for loans. Businesses need to borrow to expand – if rates
are low this is favorable. At higher rates of interest business
investment declines.
Concept 4: Determinants of Investment
• Technology and Innovation
– The impact of improved
technology and innovation on
the ability to manufacture
goods at a lower cost.
Improving technology can
improve profits and increase
investment in other
improvements.
Concept 4: Determinants of Investment
A change in any of the determinants of investment will cause a
shift in the investment function (investment demand curve). For
example, if factor costs increase, the investment demand curve
will shift to the left. If improved economic conditions are
expected, the investment demand curve will shift to the right.
If investment spending declines, the aggregate demand curve
will shift to the left. As investment spending increases, the
aggregate demand curve shifts to the right. Historically there
have been wide swings in the amount of investment spending;
it is much more volatile than consumer spending.
Interest Rate (percent per year)
Investment Demand And Interest Rates
11
10
9
8
7
6
5
4
3
2
1
0
Better expectations cause a shift rightward
Movement up the existing curve
is caused by an increase in interest rates
I2
Initial expectations
11
Worse expectations The curve shifts left
100
200
300
I3
400
500
Planned Investment Spending (billions of dollars per year)
Government Spending
The level of government spending can have an impact on
aggregate demand.
Increases in government spending can shift the aggregate
demand curve to the right.
Federal government spending is less dependent upon tax
collections. Deficit spending is often used to supplement
spending programs.
Net Exports
Exports depend upon the needs and demand of foreign
consumers and businesses.
Economic factors affecting other countries affect the amount of
exports we can sell. Declines in exports cause a leftward shift
of the AD curve.
Strong demands for imported goods can be weakened by a
drop in consumer confidence. If imports are preferred over
domestically produced items aggregate demand can shift to the
left.
Concept 5: Macro Failure
When the economy is at the equilibrium price and quantity, the
economy may not be at its optimal level of output.
According to Keynes at equilibrium we may not be at a full
employment level of output and price stability may not exist.
Even if the equilibrium point gives us full employment and price
stability, it will likely change.
Concept 5: AD & AS at Full Employment
Macro Success: (perfect AD)
QF indicates output at full employment
Price
Level
AS
AD1
E1
P*
QF
Real GDP
Concept 5: Insufficient AD - Unemployment
The GDP gap
Equilibrium is below full employment output
Price
Level
P*
P2
AS
AD2
F2
E2
Q2 QE2
recessionary
GDP gap
QF
Real GDP
Concept 5: Macro Failure
Recessionary GDP Gap – The amount of which equilibrium
GDP (QE) falls short of full-employment GDP (QF). This is
defined as a macro economic failure.
Graphically, the distance between the quantity produced at full
employment and the quantity at which AD and AS intersect
(see the previous graph – the distance between QE and QF.
Full employment GDP – The value of total output (real GDP)
produced at full employment. Full employment GDP is the
major goal of economic policy.
Concept 5: Too Much AD
Inflationary gap exists between QF and QE3
Demand-pull inflation: (too much AD)
Equilibrium is above full employment output
Price
Level
AS
AD3
E3
P3
P*
Inflationary GDP gap
Real GDP
QF QE3
Q3
Concept 5: Macro Failure
Inflationary GDP Gap – The amount by which equilibrium
GDP exceeds full employment GDP. Graphically, the distance
between full employment GDP and the intersection of AD and
AS. In the preceding graph, the distance between QF and QE.
Therefore, if AD is too high or too low the economy will not
reach its goals of full employment and price stability. The
recessionary or inflationary gaps must be closed by using
economic policies to increase or decrease AD and/or AS.
Concept 5: Macro Failure
How do you tell from a graph what kind of a gap exists?
1.
Look first for the quantity associated where AD and AS
meet. This point is often referred to as QE.
2.
Look for the designated point for full employment output,
usually labeled QF.
3.
Is QF above QE? If yes, you have a recessionary GDP
gap. If no, you have an inflationary GDP gap. If QF
represents the point at which AD and AS intersect, you are
at full employment at macro equilibrium.
Too little, too much, just right
QR represents output during a recessionary gap while
QI represents output during an inflationary gap. QF is
the output level at full employment.
Price
Level
AS
P*
QR QF QI Real GDP
Summary
•
•
•
•
•
•
•
•
•
•
Components of AD.
APC, APS, MPC, MPS.
Autonomous consumption.
Non-income determinants of autonomous consumption (5).
Income dependent consumption.
Consumption function – C = a + bYD
45 degree line.
Dissaving.
Shifts in the consumption function.
Shifts in AD.
Summary
•
•
•
•
•
Investment and AD.
Determinants of Investment (3).
Causes of investment shifts.
Macro failure.
Graphs of full employment GDP, equilibrium GDP,
recessionary GDP gap, inflationary GDP gap.