CHAPTER 9-AGGREGATE DEMAND

I. Introduction
A. Great Depression.

1. As many as 13 million Americans were out of work until the start of World War II.

2. The Great Depression was a springboard for the Keynesian approach to economic policy.

B. This chapter and the next two chapters focus on demand side of the macro economy by starting with the same questions Keynes posed:

1. What are the components of aggregate demand?

2. What determines the level of spending for each component?

3. Will there be enough demand to maintain full employment?

II. Macro Equilibrium
A. Aggregate Demand – The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

B. The Desire Adjustment (Figure 9.1, Page 175)

1. Aggregate Supply – The total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

2. Equilibrium (macro) – The combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

3. Equilibrium is established where AS and AD intersect.

4. This equilibrium may or may not be consistent with full-employment.

5. All economists recognize that short-run macro failure unemployment is possible.

6. A central macroeconomic debate is over whether or not the AS and AD curves will shift on their own.

7. John Maynard Keynes had a distinctive view of the macro failure unemployment. He believed:

• A deficient aggregate demand was likely to be the cause of high unemployment.

• A market driven aggregate demand curve might not shift when needed.

• There is an active role for government in the quest for full employment.

C. Components of aggregate demand.

1. In analyzing AD, we ask

• Who is buying the output of the economy?

• What factors influence their purchase decisions?

• What factors might change the level of spending, thereby shifting aggregate demand?

2. Four components of aggregate demand

• Consumption (C).

• Investment (I).

• Government spending (G).

• Net exports (X - IM).

III. Consumption
A. Consumption is the largest component of aggregate demand.

1. Consumption - Expenditure by consumers on final goods and services.

2. Consumer expenditures account for two-thirds of total spending.

B. Income and Consumption (Figure 9.2, Page 176)

1. The aggregate demand curve asserts that the real value of output depends on the price level.

2. Keynes argued that consumers simply decide how much to spend.

3. Price level, interest rates, wealth, etc. might influence consumer spending, but the most decisive influence is disposable income (DI).

4. Disposable Income – After-tax income of consumers; personal income less personal taxes.

5. By definition, all disposable income is either consumed (spent) or saved (not spent)

Formula:

Disposable Income (Y_D) = Consumption (C) + Savings (S)

C. Consumption vs. Saving

1. Keynes was interested in how consumers divide their disposable income between consumption and saving.

2. Saving – That part of disposable income not spent on current consumption; disposable income less consumption.

3. Two distinct decisions are involved:

• What fraction of total disposable income is spent on consumption?

• What fraction of added disposable income is spent on consumption?

4. Average Propensity to Consume (APC) – Total consumption in a given period divided by total disposable income.

5. Formula:

APC =	Total Consumption	=	C
	Total Disposable Income		YD

D. The Marginal Propensity to Consumer (Figure 9.3 and Table 9.1, Page 178)

1. Marginal propensity to consume (MPC) – The fraction of each additional (marginal) dollar of disposable income spent on consumption; the change in consumption divided by the change in disposable income.

2. Formula:

MPC =	Change in Consumption	=	ΔC
	Change in Disposable Income		ΔYD

E. Marginal Propensity to Save (MPS)

1. Marginal Propensity to Save (MPS) – The fraction of each additional (marginal) dollar of disposable income not spent on consumption; 1 – MPC.

2. Formula:

MPS = 1 - MPC
 

3. Disposable income is, by definition, either consumed (spent on consumption) or saved.

4. The Average Propensity to Save (APS) equals S/Y_D

IV. The Consumption Function
A. Autonomous consumption

1. Keynes first noted that consumption is not completely determined by current income. Some consumption is considered to be autonomous (independent of income)

2. These determinants include:

• Expectations -- 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.

• Wealth -- the amount of wealth an individual owns will affect their consumption.

• Credit -- availability of credit allows people to spend more than their current income. The need to pay past debt may limit current consumption.

• Taxes – taxes are the link between total and disposable income. If income tax rates go up, disposable income will decline and consumers will not be as able to buy the goods and services produced.

• Price levels - rising price levels reduce real value of money and may cause people to curtail spending.

B. Income-Dependent Consumption

1. In recognition of these many determinants of consumption, Keynes distinguished two kinds of consumer spending.

• Spending not influenced by current income, and

• Spending that is determined by current income

2. Formula:

Total Consumption = autonomous consumption + income = dependent consumption

3. These various determinants of consumption are summarized in the equation called the consumption function

4. Consumption Function – A mathematical relationship indicating the rate of desired consumer spending at various income levels.

5. Formula:

C = a + bY_D

• where C = current consumption,

• a = autonomous consumption

• b = marginal propensity to consume,

• Y_D = disposable income

6. The consumption function provides a precise basis for predicting how changes in income (Y_D ) will affect consumer spending C.

C. One Consumer’s Behavior (Figure 9.4, Page 181)

1. We expect that even with an income level of zero, there will be some consumption. This is the autonomous consumption.

2. We also expect consumption to rise with income based on the consumers MPC.

3. Dissaving occurs when current consumption exceeds current income.

4. Dissaving – Consumption expenditure in excess of disposable income; a negative saving flow.

5. The 45-degree line.

• 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.

6. In the News: “Livin’ Large”
   According to the article 40% of Americans admit to living beyond their means; young adults are most likely to overspend.

D. The Aggregate Consumption Function

1. Figure 9.2 suggests that actual consumer spending lies below the 45-degree line, indicating that most consumers save something.

2. Figure 9.2 suggest the MPC is approximately 0.90.

E. Shifts of the Consumption Functions (Figures 9.5 and 9.6, Page 182)

1. In the function C = a + bY_D a change in either of the values of a or b will change the dimensions of the function.

2. A change in the variable ‘a’ will cause the function to shift parallel

• For example, an increase in consumer confidence will increase autonomous consumption, shifting the consumption function up.

• A decrease in consumer confidence will decrease autonomous consumption, shifting the consumption function down.

3. In The News: “Consumer Confidence Drops to Seven-Year Low”
   In October 2001, consumer confidence fell to its lower level in seven years. Apparently consumers were worried about their jobs after the terrorist attacks and the economic recession that began earlier in the year.

4. Shifts of Aggregate Demand (Figure 9.7, Page 184)

• Shifts in AD reflect shifts of the consumption function.

• An upward shift of the consumption function implies a rightward shift of the aggregate demand curve.

• A downward shift of the consumption function implies a reduction (a leftward shift) in aggregate demand.

F. Shift Factors (Figure 9.7, Page 184)

1. Anything that changes the value of autonomous consumption will shift the consumption function. The shift factors include a:

• Change in consumer confidence (expectations)

• Change in wealth

• Change in credit conditions

• Change in tax policy

2. In The News: “Falling Stocks Smash Nest Eggs”
   The more than $2 trillion dollar decline in stock values between March and December 2000 caused a fall-off in the ‘wealth effect.’ Interviews with consumers suggests that spending may decline.

V. Investment
A. A number of factors are important in determining the amount of investment which occurs in an economy.

1. Investment – Expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories.

2. Investment represents an injection into the circular flow that may offset the leakage caused by consumer saving.

B. Determinants of Investment

1. Expectations play a critical role in investment decisions.

2. Interest Rates. Businesses often 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.

3. Technology and innovation. New technology changes the demand for investment goods.

C. Shifts of Investment

1. Altered expectations. (Figure 9.8, Page 186)
   Experience shows that investor’s expectations are not as stable as l1 in figure 9.8. The relationship could shift to I2 if there are better expectations, as for example with a tax break. Or, the relationship could shift to I3 with worse expectations, as for example after the September 11, 2001 terrorist attacks.

2. Empirical Instability. (Figure 9.9, Page 187) Investment spending is volatile as shown in the historical data for 1988 through 1992.

3. In The News: “Manufacturing-Output Slump Continues while Businesses Again Trim Inventories”
   In 2001, the US Commerce Department reported a drop in business inventories when industrial production fell.

VI. Government and Net Export Spending
A. Government spending (Figure 9.11, Page 191)

1. The Government sector (federal, state, and local) currently spends over $1.5 trillion a year on goods and services

2. Government spending decisions are made independently of current income.

B. Net exports – The level of export sales are not very sensitive to changes to American income.

C. World View: “Canada Forecasts Slower 2001 Growth, Citing U.S. Spillover”
The slowing US economy caused a lowering in the forecast of Canadian growth in 2001 to 3 percent. Inflation was also expected to ease.

VIII. Macro Failure
A. Keynes analysis of spending behavior led him to conclude that macro failure was likely in a market-driven economy. He had two chief concerns:

1. The market’s macro-equilibrium might not give us full employment or price stability.

2. Even if the market’s macro equilibrium were perfectly positioned, it might not last.

B. Undesired Equilibrium

1. Macro Success (Figure 9.10a, Page 189)

• There is both full employment and price stability

• But there is no reason to expect that market participants, making independent decisions will generate exactly this aggregate demand.

2. Recessionary GDP Gap (Figure 9.10b, Page 189)

• Full-employment GDP – The value of total output (real GDP) produced at full employment.

• Equilibrium GDP - The value of total output (real GDP) produced at macro equilibrium.

• Recessionary GDP gap – The amount of which equilibrium GDP falls short of full-employment GDP.

• If the spending plans of consumers, investors, government and export buyers don’t generate enough aggregate demand at current prices, then there will be a recessionary gap, a breeding ground for cyclical unemployment.

• Cyclical Unemployment – Unemployment attributable to a lack of job vacancies, i.e., to an inadequate level of aggregate demand.

3. Inflationary GDP Gap.

• If market participants demand more output at current prices than the economy can produce then there will be an inflationary GDP gap, a breeding ground for demand-pull inflation.

• Demand-pull Inflation – An increase in the price level initiated by excessive aggregate demand.

C. Unstable Equilibrium

1. Even if market participants generate the perfect amount of aggregate demand, changes in spending behavior, often abrupt, can push the AD curve out of its ‘perfect’ position.

2. The result will be undesirable outcomes. (Figure 9.11, Page 191)

3. Recurrent shifts can cause a business cycle.

4. Business cycle – Alternating periods of economic growth and contraction.

D. Macro Failures
If aggregate demand is too little, too great, or too unstable, the economy will not reach and maintain its goals.

E. Self-Adjustment?

1. If markets self-adjust, as classical economists asserted, then macro failures would be temporary.

2. Keynes didn’t think it likely that offsetting shifts would occur.

The Economy Tomorrow

Looking for AD Shifts

1. Policymakers need a way to peer into the future. One of the most widely used crystal balls is the Index of Leading Indicators.

2. The Leading Economic Indicators (Table 9.2, Page 192)
   There are eleven factors believed to predict economic activity. They are reported each month by the Conference Board.

3. Although they have a good track record, the Indicators aren’t a perfect crystal ball.

COMMON STUDENT ERRORS

Students often believe the following statements are true. The correct answer is explained after the incorrect statement is presented.

1. The economy can spend no more than its income. The economy can spend more than its income by drawing down inventories of both public and private goods or by consuming capital (allowing it to depreciate) without replacing it. If the economy consumers more than its income, it will actually dissave and experience negative investment.
    

2. When a person invests in stocks, investment expenditures increase. Investment expenditure refers to purchases of new capital goods (buildings and equipment, etc.), inventories, or residential structures. A purchase of stock represents a transfer of ownership from one person to another. Sometimes such purchases are called “financial investments,” but they do not represent economic investment. You should note for the student that the term investment is used differently in economics than in a finance or accounting course.
    

3. The aggregate expenditure curve is the same as the aggregate demand curve. The aggregate expenditure curve and aggregate demand curves are two quite different concepts. They have different units on the axes; aggregate expenditure represents the intended expenditures at each income level; aggregate demand represents quantity demanded at each average price level for all goods and services.
    

4. The marginal propensity to consume is consumption divided by income. There is a big difference between total consumption and a change in consumption. While the average propensity to consume involves total consumption and total income, the marginal propensity to consume involves changes in consumption and changes in income.
    

5. Dissaving is the difference between the 45-degree line and aggregate expenditure curves. Both saving and dissaving are defined as the difference between disposable income and consumption. Thus, it is the difference between the 45-degree line and the consumption function that measures savings. The 45-degree line shows the points at which expenditures equals income. So, when consumption expenditures equals income (the consumption function intersects the 45-degree line)), there is zero savings. When consumption expenditures exceed income (the consumption function is above the 45-degree line), there will be dissaving.
    

6. Aggregate expenditure rises when people buy more imports. Students often think of imports as expenditures and therefore believe that increased spending on imports will have the same effect on the economy as an increase in consumption. Expenditures on imports, however, do not generate domestic income. If imports increase, they do so at the expense of purchases of U.S. goods, meaning fewer jobs in the United States. Because employment declines, there is less income with which to purchase goods; consumption falls and so does aggregate spending.