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Aggregate Demand
Chapter 9
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
Chapter 9 – Aggregate Demand
1. Consumption.
2. The Consumption Function.
3. Investment.
4. Government & Net Export Spending.
5. Macro Failure.
6. Anticipating AD Shifts.
2
Some Quick
Review:
5
Macro Equilibrium
PRICE LEVEL
AS and AD combine to determine
macro equilibrium.
Equilibrium is established where AS
and AD intersect.
PE
Aggregate
supply
e
E
Aggregate
demand
QE
REAL OUTPUT (quantity per year)
6
The Desired Adjustment
Any particular macro equilibrium
point may be undesirable.
All economists agree that short-run
unemployment is possible.
Will the economy self-adjust ?
If not, government might have to step
in to increase AD to reach full
employment.
7
PRICE LEVEL (average price)
Escaping a Recession
AS (Aggregate supply)
E1
PE
AD2
AD1
QE QF
REAL OUTPUT (quantity per year)
8
…New Stuff…
9
1. Consumption
10
Four Components of Aggregate
Demand
To adjust AD, we need to understand AD
and how various factors will affect it.
The Four Components of Aggregate Demand
are:
Consumption (C)
Investment (I)
Government spending (G)
Net exports (X - M)
If we can increase the spending of any one of
these components, we increase AD.
LO1
11
Building an AD Curve
12
Consumption
Consumption:
spending by
consumers on final
goods and services.
accounts for over
two-thirds of total
spending (GDP).
LO1
13
Income and Consumption
Consumers tend to spend most of
their disposable incomes.
(Disposable income:
- the after-tax income of consumers:
- personal income less personal taxes.)
LO1
14
Income and Consumption
By definition, all disposable income
is either:
consumed (spent ), or …
saved (not spent).
Disposable income = Consumption + Saving
YD = C + S
LO1
15
CONSUMPTION (billions of dollars per year)
U.S. Consumption and Income
$7000
2000
6000
5000
4000
1988
3000
2000
1000
45°
0
1999
1998
C = YD
$1000
1994
1992
1990
1996
1986
1984
1982
1980
Actual consumer spending
2000
3000
4000
5000
6000
7000
DISPOSABLE INCOME (billions of dollars per year)
LO1
16
Income, Consumption, & AD
If we can model consumer spending…
…then we can predict consumer
spending…
… and more effectively manipulate
the AD curve.
17
Income, Consumption, & AD
Keynes described the consumptionincome relationship in two ways:
1. AVERAGE propensity to consume:
- “APC"
2. MARGINAL propensity to consume:
- “MPC"
LO1
18
Income, Consumption, & AD
Average propensity to consume:
- The “AVERAGE” rate of spending.
- A ratio of:
- total consumption to total disposable income:
Total consumptio n
C
APC =
=
Total disposable income YD
Example:
LO1
C 192
APC =
=
 .96
YD 200
19
Average Propensity to Save
Average Propensity to Save:
Total saving
S
APS =
=
Total disposable income YD
S
8

 .04
Example: APS =
YD
200
LO1
20
APC v. APS
So…
Since YD = C + S…
APS APC = 1
- or -
Example:
APS = 1 - APC
APS = 1 - .96  .04
21
Marginal Propensity to Consume
2. Marginal propensity to consume:
- The ratio of:
- changes in consumption to changes in
disposable income.
- The fraction of each additional
(marginal) dollar of disposable income
spent on consumption.
LO1
22
Marginal Propensity to Consume
Marginal Propensity to Consume:
Change in Consumption
C
MPC =
=
Change in Disposable Income YD
Example:
C
200 - 192 8
MPC =
=

 .8
YD 210 - 200 10
LO1
23
Marginal Propensity to Save
Marginal propensity to save:
the fraction of each additional
(marginal) dollar of disposable income
not spent on consumption.
S
MPS =
YD
Example:
LO1
10  8
2
MPS =

 .2
210  200 10
24
MPC vs. MPS
YD = C + S
So…
MPS  MPC = 1
Example:
MPS = 1 - MPC
MPS = 1 - .8  .2
25
The MPC and MPS
MPS = 0.20
LO1
MPC = 0.80
26
Review
If the MPC is .90 and the APC is .95:
1. What is the APS? .05
2. What is the MPS? .1
3. What is the level of spending if
disposable income (Yd) is $600?
$570
4. How much would be saved from an
additional $100 of disposable income.
$10
5. What are the four components of AD?
C, I, G, (X-M)
27
Review 2
If the MPC is .85 and the APC is .98:
1. What is the APS? .02
2. What is the MPS? .15
3. What is the level of spending if
disposable income (Yd) is $1200? $1176
4. How much would be saved from an
additional $100 of disposable income.
$15
5. What are the four components of AD?
C, I, G, (X-M)
28
2. The Consumption
Function
29
The Consumption Function
The consumption function:
a mathematical relationship that helps
predict consumer behavior.
Based in part on the concept of
marginal propensity to consume.
LO1
30
The Consumption Function
Keynes distinguished two kinds of
consumer spending.
Autonomous:
Spending not influenced by current income,
Income-dependent:
Spending that is determined by current
income.
LO1
31
The Consumption Function
These two determinants of
consumption are summarized in an
equation called the consumption
function.
Total
consumption

Autonomous
consumption

Income dependent
consumption
(***Informal, “theoretical” equation: not the mathematical equation!)
LO1
32
Autonomous Consumption
Autonomous consumption:
-consumption that occurs independent
of income level.
Autonomous determinants of
consumption include:
Expectations.
Wealth.
Credit.
(Taxes) ?!?
LO1
33
Expectations
Examples:
People who anticipate a
pay raise often increase
spending before extra
income is received.
People who expect to be
laid off tend to save more
and spend less.
LO1
34
Wealth
An individual’s wealth affects his
willingness and ability to consume.
The wealth effect:
a change in consumer spending…
…caused by…
a change in the value of owned assets.
LO1
35
Credit
Availability of credit allows people to
spend more than their current income.
The cost of credit
fluctuates.
The need to pay past
debt may limit current
consumption.
LO1
36
Income-Dependent Consumption
Income-dependent consumption:
This is delineated by one’s marginal
propensity to consume (MPC):
MPC x Disposable Income
38
The Consumption Function
The consumption function:
The mathematical relationship indicating
the (desired) rate of consumer spending
at various income levels.
It combines autonomous and incomedependent consumption into one formula.
It provides a precise basis for predicting
how changes in income (YD) affect
consumer spending (C) …
…and therefore, AD!
LO1
39
The Consumption Function
Total
consumption

Autonomous
consumption

Income dependent
consumption
C = a + bYD
where:
C = current consumption
a = autonomous consumption
b = marginal propensity to consume
YD = disposable income
LO1
43
The Consumption Function
44
Consumer Behavior
Even with an income level of zero:
there will be some consumption
(autonomous).
Consumption will rise with income
based on the MPC.
Slope = MPC.
LO1
46
Consumer Behavior
Dissaving:
current
consumption
exceeds
current income
a negative
saving flow.
LO1
47
Justin’s Consumption Function
Consumption = $50 + 0.75YD
LO1
Disposable
Income (YD)
Autonomous
Consumption
A
$ 0
50
$ 0
$ 50
B
100
50
75
125
C
200
50
150
200
D
300
50
225
275
E
400
50
300
350
F
500
50
375
425
+
Income-Dependent
Consumption
=
Total
Consumption
48
Justin’s Consumption Function
$400
C = YD
E
D
Saving
C
Dissaving
B
$125
G
A
$50
LO1
Consumption Function
C = $50 + 0.75YD
100
150
200
250
300
350
400
450
49
Application
Given C = 100 + .9YD
If YD = $1,400., then:
What is C ?
$1,360
What is the savings level?
$40
If C = $1,000., then:
What is YD ?
$1,000
What is the savings level?
$0.00
What is the slope of this consumption
function?
Graphically, what is the Y intercept?
51
Application
2. Suppose the MPC in an economy is 0.7. The APC is initially 0.8
and disposable income is $10 billion. If disposable income
increases to $14 billion, what is the new level of consumption?
A). $10.8 billion.
C). $8 billion.
B). $11.2 billion.
D). $12.8 billion.
52
Shifts of the Consumption
Function
Changing the a or b values in the
consumption function (C = a + bYD)
will shift the function to a new
position.
A change in the a variable will cause
a parallel shift of the function.
Caused by changes in expectations,
wealth, or credit.
LO1
53
CONSUMPTION (C) (dollars per year)
Shift in the Consumption Function
C = a1 + bYD
C = a2 + bYD
a1
a2
0
LO1
DISPOSABLE INCOME(dollars per year)
54
Shifts of Aggregate Demand
Shifts in the consumption function:
are reflected in shifts of AD:
Consumption function ↑ = AD to the right:
Consumption function ↓ = AD to the left:
LO2
55
AD Effects of Consumption Shifts
Expenditure
Price Level
C1
Shift = f1 – f2
f1
C2
f2
P1
AD1
AD2
Y0
Income
Q2
Q1 Real Output
***The AD curve will shift if:
- autonomous consumption changes, or…
LO2
- consumer incomes change.
57
Shifts and Cycles
AD shifts may originate from
consumer behavior.
AD shifts = macro instability.
LO2
61
3. Investment
63
Investment
Investment:
expenditures on (production of) new plant,
equipment, and structures (capital), …
in a given time period, …
plus changes in business inventories.
LO1
64
Determinants of Investment
The following factors determine the
amount of investment that occurs in
an economy:
Interest rates.
Expectations.
Technology and innovation.
LO1
65
Interest Rates
Businesses typically borrow money
to invest in new plants or equipment.
The higher the interest rate, the
costlier it is to invest and the lower
the investment spending.
LO1
66
Interest Rate (percent per year)
Investment Demand
11
10
9
8
7
6
5
4
3
2
1
0
A
B
11
100
200
300
400
500
Planned Investment Spending (billions of dollars per year)
LO1
67
Expectations
Expectations:
play a critical role in investment
decisions.
are determined by business confidence
in future sales.
Confidence ↑ = AD shift to the right.
LO1
68
Interest Rate (percent per year)
Investment Demand
11
10
9
8
7
6
5
4
3
2
1
0
Better expectations
C
A
B
I2
Initial expectations
11
Worse expectations
100
200
300
400
I3
500
Planned Investment Spending (billions of dollars per year)
LO1
69
Technology and Innovation
New technology changes the
demand for investment goods:
Technological advances and
corresponding cost reductions
stimulate new investment spending.
LO1
70
Interest Rate (percent per year)
Investment Demand
11
10
9
8
7
6
5
4
3
2
1
0
Investment demand given
availability of new technology
A
B
I2
Initial Investment Demand
11
100
200
300
400
500
Planned Investment Spending (billions of dollars per year)
LO1
71
AD Shifts
So….
The AD curve shifts:
to the left when investment spending
declines.
to the right when investment spending
increases.
LO2
72
AD Effects of Consumption Shifts
Price Level
The AD curve shifts:
to the left when
investment spending
declines.
to the right when
investment spending
increases.
LO2
AD2
Q2
AD1
Q1 Real Output
73
Investment Instability
Investment spending fluctuates more
than consumption.
Abrupt changes in investment were
the cause of the 2001 recession.
LO2
74
Volatile Investment Spending
LO2
75
4. Government
Spending and Net
Export Spending
76
Government Spending
State-local government spending is
slightly pro-cyclical:
If consumption and investment
spending decline,
- state/local government tax receipts fall,
- State/local spending subsequently falls,
- aggravating the leftward shift of the
AD curve.
LO1
77
Government Spending
The federal government can “deficit
spend:
it has counter-cyclical power.
can increase spending to counteract
declines in consumption and investment
spending.
LO1
78
Net Exports
Net exports can be both uncertain
and unstable, creating further shifts
of aggregate demand.
LO1
79
So…
The four components of spending
(C+I+G+(X-M)) 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.
LO1
80
Building an AD Curve
81
Review
1. Suppose a consumption function is given as
C = $175 + 0.85YD. The marginal propensity to
save is:
2. If an increase in disposable income causes
consumption to increase from $4,000 to $10,000
and causes saving to increase from $2,000 to
$4,000 it can be inferred that the MPC equals:
3. Suppose the consumption function is C = $300 +
0.9YD. If disposable income is $400, consumption
is:
What is the level of savings?
82
Review
What are the 3 determinants of investment
spending?
What is the major difference between
Federal v. state/local spending (demand)
during a recession?
83
Application
2. Suppose the MPC in an economy is 0.7. The APC is initially 0.8
and disposable income is $10 billion. If disposable income
increases to $14 billion, what is the new level of consumption?
A). $10.8 billion.
C). $8 billion.
B). $11.2 billion.
D). $12.8 billion.
84
5. Macro Failure
85
Macro Failure - REVIEW
There are two chief concerns about
macro equilibrium:
Undesirability:
The market’s macro-equilibrium might not
give us full employment or price stability.
Instability:
Even if the market’s macro-equilibrium were
at full employment and price stability, it
might not last.
LO3
86
Recessionary GDP Gap
(REVIEW): Keynes worried that
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.
LO3
88
Macro Failures
Macro Success: (perfect AD)
PRICE
LEVEL
AS
AD1
E1
P*
QF
LO3
REAL GDP
89
Macro Failures – Recessionary GDP Gap
Cyclical Unemployment: (too little AD)
PRICE
LEVEL
AS
AD2
E1
P*
P2
E2
QE2
LO3
recessionary
GDP gap
QF
REAL GDP
90
Recessionary GDP Gap
Recessionary GDP gap:
the amount by which equilibrium GDP
falls short of full-employment GDP.
The GDP gap represents
unused productive capacity,
lost GDP, and …
unemployed workers.
LO3
91
A Recessionary GDP Gap
LO3
94
Inflationary GDP Gap
Inflationary GDP gap:
the amount by which equilibrium GDP
exceeds full-employment GDP.
leads to demand-pull inflation:
an increase in the price level initiated by
excessive aggregate demand.
LO3
95
Macro Failures - Inflationary GDP Gap
Demand-pull inflation: (too much AD)
PRICE
LEVEL
AS
AD3
E3
P3
E1
P*
inflationary
GDP gap
QF
LO3
QE3
97
Unstable Equilibrium
Recurrent shifts of aggregate
demand cause business cycles:
alternating periods of economic growth
and contraction.
LO3
99
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.
101
6. Anticipating AD
Shifts
102
Looking for AD Shifts
Policymakers use the Index of
Leading Indicators to forecast
changes in GDP:
Average workweek.
Unemployment
claims.
Delivery times.
Credit.
Materials prices.
Equipment orders.
Stock prices.
Money supply.
New orders.
Building permits.
Inventories.
103
Looking for AD Shifts
104
Aggregate Demand
End of Chapter 9
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved