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.

ConsumptionConcept 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.

ConsumptionConcept 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.

ConsumptionConcept 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.

ConsumptionConcept 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 theConcept 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

Saving

Dissaving

Disposable Income

Co

nsu

mp

tio

n

Sp

end

ing

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: Consumptionand 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

Fred’s Consumption Function

$400

$50 100 150 200 250 300 350 400 450

C = YD

SavingDissaving

Consumption FunctionC = $100 + 0.50YD

A

C D

E

B

300

200

100

Concept 3: Consumption and theConsumption 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 theConsumption 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.

Shift in the Consumption FunctionC

ON

SUM

PTIO

N (C

) (do

llars

per

yea

r)

DISPOSABLE INCOME(dollars per year)0

Increased confidence

Greater wealth

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 FunctionC

ON

SUM

PTIO

N(b

illio

ns o

f dol

lars

per

ye

ar)

DISPOSABLE INCOME (billions of dollars per year)0

Movement along the curveB

A

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 non-income 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

Income

Price Level

Consumption function shifts up indicating an increase in autonomous consumption

AD AD

Real Output

AD shifts to the right indicating increased 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.

Investment Demand And Interest Rates

11

Inte

rest

Rat

e (p

erce

nt p

er y

ear

)

Planned Investment Spending (billions of dollars per year)

100 200 300 400 500

109876

5432

1

0

I2

I3

11

Movement up the existing curveis caused by an increase in interest rates

Initial expectations

Worse expectations - The curve shifts left

Better expectations cause a shift rightward

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

Price Level

Real GDP

Macro Success: (perfect AD)QF indicates output at full employment

AD1

AS

P*E1

QF

Concept 5: Insufficient AD - Unemployment

Price Level

Real GDP

The GDP gapEquilibrium is below full employment output

AS

P*F2

QF

AD2

E2

Q2

P2

QE2

recessionary GDP gap

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 ADInflationary gap exists between QF and QE3

PriceLevel

Demand-pull inflation: (too much AD)Equilibrium is above full employment output

AS

P*

QF

AD3

E3P3

Q3QE3

Inflationary GDP gap

Real GDP

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

Price Level

Real GDP

AS

P*

QFQRQI

QR represents output during a recessionary gap while QI represents output during an inflationary gap. QF is the output level at full employment.

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.