INTRODUCTION
The Great Depression was a springboard for
the Keynesian approach to economic policy.
 Keynes asked:

 What
are the components of aggregate demand?
determines the level of spending for each
component?
 Will there be enough demand to maintain full
employment?
 What
Chapter 9
AGGREGATE DEMAND
2
MACRO EQUILIBRIUM
MACRO EQUILIBRIUM
Aggregate demand and aggregate supply
confront each other in the marketplace to
determine macro equilibrium.
 Remember:


 Aggregate
demand is the total quantity of output
demanded at alternative price levels in a given time
period, ceteris paribus.
 Aggregate supply is the total quantity of output
producers are willing and able to supply at
alternative price levels in a given time period,
ceteris paribus.
I
Equilibrium is established where AS and AD
intersect.
Equilibrium (macro) is the combination of
price level and real output that is
compatible with both aggregate demand
and aggregate supply.
3
4
THE DESIRED ADJUSTMENT
THE DESIRED ADJUSTMENT
Macro equilibrium may or may not be at fullemployment.
 All economists recognize that short-run macro
failure of unemployment is possible.
possible
 A central macroeconomic debate is over
whether AS and AD will shift on their own to
reach full employment.

John Maynard Keynes asserted that high
unemployment was likely to be caused by
deficient aggregate demand.
 Keynes said that a market driven aggregate
demand curve might not shift when needed.

I
5
Government would have to intervene to
shift the AD curve rightward to reach full
employment.
6
IN ANALYZING AD, WE ASK:
ESCAPING A RECESSION
Who is buying the output of the economy?
 What factors influence their purchase
decisions?
PRICE LEVEL (avverage price)

AS (Aggregate supply)
E1
PE

AD2
Four Components of Aggregate Demand:
 Consumption
(C)
(I)
 Government spending (G)
 Net exports (X - IM)
AD1
 Investment
QE QF
REAL OUTPUT (quantity per year)
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7
CONSUMPTION
INCOME AND CONSUMPTION
Consumption expenditures are spending by
consumers on final goods and services.
 Consumer expenditures account for two-thirds
of total spending.
spending

Keynes believed that the amount consumers
decide to spend is determined by their
disposable income.
 Disposable income is the after-tax
after tax income of
consumers—personal income less personal
taxes.

9
INCOME AND CONSUMPTION
U.S. CONSUMPTION AND INCOME
By definition, all disposable income is either
consumed (spent) or saved (not spent).
CONSUMPTION (billions oof dollars per year)

10
Disposable income = Consumption + Saving
YD = C + S
$7000
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
6000
C = YD
5000
4000
3000
2000
1000
45°
0
$1000
Actual consumer spending
2000
3000
4000
5000
6000
7000
DISPOSABLE INCOME (billions of dollars per year)
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12
CONSUMPTION VS. SAVING

CONSUMPTION VS. SAVING
Keynes described the consumption-income
relationship in two ways:

 As
the ratio of total consumption to total disposable
income.
 As the relationship of changes in consumption to
changes in disposable income.
The average propensity to consume (APC) is
total consumption in a given period divided by
total disposable income.
APC =
Total consumption
C
=
Total disposable income YD
APS =
Total saving
S
=
Total disposable income YD
13
AVERAGE PROPENSITY TO SAVE

14
THE MARGINAL PROPENSITY TO CONSUME

By definition, disposable income is either
consumed (spent on consumption) or saved.
The marginal propensity to consume (MPC) is
the fraction of each additional (marginal) dollar
of disposable income spent on consumption.
APS = 1 – APC
15
THE MARGINAL PROPENSITY TO CONSUME

It is the change in consumption divided by the
change in disposable income.
MPC =
16
MARGINAL PROPENSITY TO SAVE

The marginal propensity to save (MPS) is the
fraction of each additional (marginal) dollar of
disposable income not spent on consumption.
MPS = 1 – MPC
Change iin Consumption
Ch
C
i
C
=
Change in Disposable Income YD
MPS =
17
Change in Saving
S
=
Change in Disposable Income YD
18
AUTONOMOUS CONSUMPTION
THE MPC AND MPS
Keynes noted that consumption is not
completely determined by current income.
 Some consumption is autonomous
(independent of income).
income)

 The
non-income determinants of consumption
include expectations, wealth, credit, taxes, and
price levels.
MPS = 0.20
MPC = 0.80
20
19
NON-INCOME: EXPECTATIONS
NON-INCOME: WEALTH
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.

The amount of wealth an individuals own
affects their willingness and ability to consume.
 The wealth effect is a change in consumer
spending caused by a change in the value of
owned assets.

21
22
NON-INCOME: CREDIT
NON-INCOME: TAXES
Availability of credit allows people to spend
more than their current income.
 The need to pay past debt may limit current
consumption.
consumption

Taxes are the link between total and disposable
income.
 Tax cuts give consumers more disposable
income.
income

23
24
NON-INCOME: PRICE LEVELS

INCOME-DEPENDENT CONSUMPTION
Rising price levels reduce real value of money
and may cause people to curtail spending.

Keynes distinguished two kinds of consumer
spending.
 Spending
not influenced by current income, and
 Spending that is determined by current income.
income
25

26
INCOME-DEPENDENT CONSUMPTION
INCOME-DEPENDENT CONSUMPTION
These determinants of consumption are
summarized in the equation called the
consumption function.

The consumption function is the mathematical
relationship indicating the rate of desired
consumer spending at various income levels.
Total Consumption = Autonomous Consumption
+ Income Dependant Consumption

The consumption function is a mathematical
relationship that helps to predict consumer
behavior.
27
INCOME-DEPENDENT CONSUMPTION

28
ONE CONSUMER’S BEHAVIOR
The consumption function provides a precise
basis for predicting how changes in income (YD)
effect consumer spending (C).
C = a + bYD
where:
C = current consumption
a = autonomous consumption
b = marginal propensity to consume
YD = disposable income
29
We expect that even with an income level of
zero, there will be some consumption.
 This is the autonomous consumption.
 We
W expectt consumption
ti tto rise
i with
ith income
i
based on the consumer’s MPC.
 Dissaving occurs when current consumption
exceeds current income – a negative saving
flow.

30
THE 45-DEGREE LINE
JUSTIN’S CONSUMPTION FUNCTION
The 45-degree line represents all points where
consumption and income are exactly equal.
 The slope of the consumption function equals
the marginal propensity to consume.
consume

Consumption = $50 + 0.75YD
Disposable
Income (YD)
C = YD
Autonomous
Consumption
+
Income-Dependent
Consumption
=
Total
Consumption
A
$ 0
50
$ 0
B
100
50
75
$ 50
125
C
200
50
150
200
D
300
50
225
275
E
400
50
300
350
F
500
50
375
425
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32
SHIFTS OF THE CONSUMPTION FUNCTION
JUSTIN’S CONSUMPTION FUNCTION
Repeated studies suggest that consumers
increase their consumptions as their incomes
increase
 A change in the values of a or b in the
consumption function (C = a + bYD) will shift
the function to a new position.
 A change in the variable a will cause a parallel
shift of the function.

$400
C = YD
E
D
Saving
C
Dissaving
Consumption Function
C = $50 + 0.75YD
B
$125
G
A
$50
100
150
200
250
300
350
400
450
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33
SHIFTS OF THE CONSUMPTION FUNCTION
I
An increase in consumer confidence will
increase autonomous consumption, shifting
the consumption function up.
CONSUMPTION (C) (doollars per year)

SHIFT IN THE CONSUMPTION FUNCTION
A decrease in consumer confidence will
decrease autonomous consumption,
shifting the consumption function down.
C = a2 + bYD
C = a1 + bYD
a2
a1
0
35
DISPOSABLE INCOME(dollars per year)
36
SHIFTS VS. MOVEMENTS
Incomes declined and consumer confidence
fell during the 2001 recession.
CONSUM
MPTION
(billions of dolllars per year)

SHIFTS VS. MOVEMENTS
 Declining
income prompted a movement along the
consumption function.
 Falling consumer confidence shifted the function
downward.
C = a1 + bYD
f
Cf
g
Cg
C = a2 + bYD
Shift
a1
h
Ch
a2
0
Y2
Y1
DISPOSABLE INCOME (billions of dollars per year)
37
SHIFTS OF AGGREGATE DEMAND

38
AD EFFECTS OF CONSUMPTION SHIFTS
Shifts in the consumption function are
reflected in shifts of the aggregated demand
curve.
Expenditure
Price Level
C2
A
downward shift of the consumption function
implies a reduction (a leftward shift) in aggregate
demand.
 An upward shift of the consumption function
implies an increase (a rightward shift) of the
aggregate demand.
Shift = f2 – f1
f2
C1
f1
P1
AD1
Y0
Income
Q1
AD2
Q2 Real Output
39
SHIFT FACTORS

40
SHIFTS AND CYCLES
Shift factors include all of the non income
determinants of consumption.
Shifts in aggregate demand can cause macro
instability.
 Aggregate demand shifts may originate from
consumer behavior.
behavior

 Changes
in consumer confidence (expectations).
in wealth.
wealth
 Changes in credit conditions.
 Changes in tax policy.
 Changes
 If
consumer spending increases abruptly, demand
pull inflation will follow.
 If consumer spending slows abruptly, a recession
may occur.
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42
INVESTMENT
DETERMINANTS
Investment are expenditures on (production of)
new plant, equipment, and structures (capital)
in a given time period, plus changes in
business inventories.
 The following factors determine the amount of
investment that occurs in an economy:


Expectations: Favorable expectations for future
sales are a necessary condition for investment
spending.
 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 thus the lower the investment spending.
 More investment occurs at lower rates.
 Expectations.
 Interest
rates.
and innovation.
 Technology

43
Interest Rate (perrcent per year)
0
Predictions about investment spending assume
that investor expectations are stable.
 This is often not the case.

Better expectations
C
A
44
SHIFTS OF INVESTMENT
INVESTMENT DEMAND
11
10
9
8
7
6
5
4
3
2
1
New technology changes the demand for
investment goods.
B
I2
Initial expectations
11
Worse expectations
100
200
300
400
I3
500
Planned Investment Spending (billions of dollars per year)
46
45
ALTERED EXPECTATIONS

EMPIRICAL INSTABILITY
Business expectations are determined by
business confidence in future sales.
Investment spending fluctuates more than
consumption.
 Abrupt changes in investment were the cause
of the 1990-91
1990 91 recession.
recession

 An
upsurge in confidence shifts the aggregate
demand curve to the right.
 When investment spending declines, aggregate
demand shifts to the left.
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48
GOVERNMENT SPENDING
Change from Prior Quarter (percent)
VOLATILE INVESTMENT SPENDING
The government sector (federal, state, and
local) currently spends over $2 trillion a year on
goods and services.
 Government spending decisions are made
independently of current income.

+7
+6
+5
+4
+3
+2
+1
0
–1
–2
–3
–4
–5
C
Consumption
ti
Investment
1
2 3
1988
4
1
2 3
1989
4
1
2 3 4 1 2 3
1990
1991
Calendar Quarter
4
1
2 3
1992
4
50
49
NET EXPORTS

MACRO FAILURE
Net exports can be both uncertain and
unstable, creating further shifts of aggregate
demand.

Keynes had two chief concerns about macro
equilibrium:
 The
market’s macro-equilibrium might not give us
full employment or price stability.
 Even if the market’s macro-equilibrium were at full
employment and price stability, it might not last.
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52
UNDESIRED EQUILIBRIUM
RECESSIONARY GDP GAP
Market participants make independent
spending decisions.
 There’s no reason to expect that the sum of
their expenditures will generate exactly the
right amount of aggregate demand.


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
(AS=AD).
AD).
 Full-employment GDP is the value of total output
(real GDP) produced at full employment.
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54
RECESSIONARY GDP GAP

RECESSIONARY GDP GAP
A recessionary GDP gap is the amount by which
equilibrium GDP falls short of full-employment
GDP.

Recessionary GDP gaps lead to cyclical
unemployment.
G
I
The gap represents unused productive
capacity, lost GDP, and unemployed
workers.
Cyclical
y
unemployment
p y
is the unemployment
p y
attributable to a lack of job vacancies; that is,
to inadequate aggregate demand.
55
MACRO FAILURES
56
MACRO FAILURES
Macro Success: (perfect AD)
PRICE
LEVEL
Cyclical Unemployment: (too little AD)
PRICE
LEVEL
AS
AS
AD2
AD1
E1
P*
E1
P*
P2
QF
REAL GDP
E2
Q2 QE2
recessionary
GDP gap
QF
REAL GDP
57
58
INFLATIONARY GDP GAP
INFLATIONARY GDP GAP
The economy might exceed its fullemployment/price stability capacity causing an
inflationary GDP gap.
 An inflationary GDP gap is the amount by which
equilibrium GDP exceeds full-employment GDP.


59
Inflationary GDP gaps lead to demand-pull
inflation.
G
Demand-pull
p
inflation is an increase in the
price level initiated by excessive aggregate
demand.
60
MACRO FAILURES
MACRO FAILURES
Macro Success: (perfect AD)
PRICE
LEVEL
Demand-pull inflation: (too much AD)
PRICE
LEVEL
AS
AS
AD3
AD1
E3
P3
E1
P*
QF
E1
P*
REAL GDP
QF
QE3
Q3
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62
UNSTABLE EQUILIBRIUM
MACRO FAILURES
The goal is to produce at full employment BUT…
 Equilibrium GDP may be greater or less than
full-employment GDP.
 Recurrent
R
t shifts
hift off aggregate
gg g t demand
d
d could
ld
cause a business cycle.
 The business cycle is alternating periods of
economic growth and contraction.


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.
 The critical question is whether undesirable
outcomes will persist.
 Classical
economists asserted that markets selfadjust so that macro failures would be temporary.
 Keynes didn’t think that was likely to happen.
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64
LOOKING FOR AD SHIFTS
Policymakers use the Index of Leading Indicators to
forecast changes in GDP.

Examples of leading indicators are:






Average Workweek
Unemployment Claims
Delivery Times
Credit
Materials Prices
Equipment Orders





Stock Prices
Money Supply
New orders
Building Permits
Inventories
End of Chapter 9
AGGREGATE SPENDING
65