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Chapter 09:Aggregate Demand

  Copyright © 2013 by The McGraw-Hill Companies, Inc !ll rights reser"e# McGraw-Hill$Irwin

13e

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AD’s Role in a Recession and

Recovery• In the Great Recession, spending

decreased across the board and

layofs occurred in many industries. – AD declined. It shited let away rom

ullemployment GD! as the country ellinto recession.

 – "o escape rom recession, AD mustincrease. "he AD curve must shit to theright toward ullemployment GD!.

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AD’s Role in a Recession and

Recovery• In this chapter we e#plore what is behind

the AD curve. $peci%cally, what causes

AD to shit& – 'hat are the components o aggregate

demand&

 – 'hat determines the level o spending or

each component& – 'ill there be enough demand to maintain

ull employment&

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(earning )b*ectives

• ++-. now what the ma*or componentso aggregate demand are.

• ++/. now what the consumptionunction tells us.

• ++0. now the determinants oinvestment spending.

• ++1. now how and why AD shitsoccur.

• ++2. now how and when macro ailureoccurs.

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3acro 45uilibrium

• In the macro model, AD and A$ intersect. – "his is macro equilibrium.

• Macro equilibrium: the combination oprice level and real output that iscompatible with both AD and A$. – "he rate o output e5uals the rate o

spending. – I there are no disturbances, the economy

gravitates to macro e5uilibrium.

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Ad*usting 3acro 45uilibrium

• 3acro e5uilibrium isoccurring where AD- intersects A$. "his is

insu6cient to ensure ullemployment. – QE 7QF.

•  "he economy is producingbelow capacity, so thereis high unemployment.

• 8ow can AD shit right toAD/ and ull employment&

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9omponents o AD

• "he our components o AD are

 – 9onsumption :C;.

 – Investment :I;. – Government spending :G;.

 –

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9onsumption :C;• Consumption (C): e#penditure by

consumers on %nal goods and services.

 – Accounts or over twothirds o total spending.

 – 9onsumers tend to spend most o theirdisposable income :  D; = that is, income

remaining ater ta#es. "hey save the rest.

 – !a"ing (S): Disposable income not spent as

consumption :9;.

Disposable income = Consumption + SavingY D = C  + S 

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3arginal !ropensity to9onsume

:3!9;• M#C: the raction o each additional

:marginal; dollar o disposable

income spent on consumption.

MPC = Change in consumption = ΔC 

 Change in disposable income  ΔY 

D

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AD $hit >actors

• A change in consumption :C; causes AD to shit. – "hus AD will shit in response to changes in

• Income.

• 4#pectations :consumer con%dence;.• 'ealth.

• 9redit conditions.

• "a# policy.

• In /++?/++, home e5uity ell :wealth decrease;and consumer con%dence ell. AD shited let,resulting in the Great Recession.

• $hits in AD can be a cause o macro instability.

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Investment

• $n"estment: e#penditures on newplants, e5uipment, and structures, pluschanges in inventories.

 – Includes %#ed investment and inventoryinvestment. – >avorable e#pectations o uture sales are

necessary or investment spending. – Investment spending is inversely related to

interest rates, ceteris paribus. – "echnological advances stimulate

investment spending.

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 "he Investment >unction

• Investment spendingis inversely related tothe interest rate.

• I e#pectations outure sales improve,the investmentunction shits right, aswill AD. @ice versa

applies.• Investment spending

is the most volatilecategory o spending.

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Government $pending

• ecause o balanced budget re5uirements,state and local spending will decrease whenconsumption and investment spending

decrease. "his contributes to instability.• ecause o de%cit spending, ederal spending

can be increased to counter spendingdecreases in the other components.

 – "his is the basis o eynesian demandside policy.

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3acro >ailure

!anel :a; is where we want to be.!anel :b; is when macro e5uilibrium occurs with high unemployment:too little AD;.

!anel :c; is when macro e5uilibrium occurs with too much inCation :toomuch AD;.

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3acro >ailure

• "wo concerns about macro e5uilibrium – 3acro e5uilibrium might not give us ull

employment or price stability.

 – 4ven when macro e5uilibrium is perectlypositioned, it might not last.

• 45uilibrium with cyclical unemployment :toolittle AD; occurs with a recessionary GD! gap.

• 45uilibrium with demandpull inCation :toomuch AD; occurs with an inCationary GD!gap.

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Recessionary GD! Gap

• %ecessionar& 'D#gap: the amount bywhich e5uilibriumGD! alls short o ull

employment GD!. – At #, too much would

be produced. "here areunsold inventories. 'ecut bacE production

and lay of worEers. – 45uilibrium occurs at

# andQE, which is less

than QF.

   P  r   i  c  e

   l  e  v  e   l

Real GDPQF

P*

 AS

 AD

QE

P2

Recessionary

GDP gap

Q2

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InCationary GD! Gap

• $n*ationar& 'D#gap: the amount bywhich e5uilibrium GD!e#ceeds ull

employment GD!. – At #, not enoughwould be produced.'ith inventoriesdepleted, we begin tostrain capacity and

prices rise. – 45uilibrium occurs at #+ 

and QE, which is greaterthan QF.

   P  r   i  c  e

   l  e  v  e   l

Real GDP

QF

P*

 AS AD

QE

P3

InflationaryGDP gap

Q3

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 "he 4conomy "omorrow

• Anticipating AD shits.

• 8ow can policy maEers tell what is

going to happen ne#t& – "he Inde# o (eading Indicators is a list o

-+ gauges that are supposed to indicatein what direction the economy is moving.

 – Included are e5uipment orders, consumercon%dence, and building permits.

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 "he 4conomy "omorrow

• 8ow is the inde# used&

 – 'hen the inde# rises it is viewed as good newsor the economy :and vice versa;.

 – 9hanges in the inde# are used to orecastchanges in GD! and turns in the business cycle.

• "he purpose o this inde# is to help predict

movements in GD! and the business cyclein the economy tomorrow.

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Inde# o (eading Indicators$ndicator E,pected $mpact

  -. Average worEweeE 8ours worEed per weeE typicallyincrease when greater output andsales are e#pected.

  /. Bnemployment claims Initial claims or unemploymentbene%ts reCect changes in industry

layofs.  0.

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Revisiting the (earning

)b*ectives• ++-. now what the ma*or

components o aggregate demand are. – "he components are consumption :C;, investment :I;,

government spending :G;, and net e#ports : X  - M;.

 – C is inCuenced by nonincome actors and by currentincome, as indicated in the consumption unction.

 – I depends on interest rates, e#pectations o uture sales,and innovation.

 – G depends on budgetary restraints and borrowing.

 –  X  . M depends on marEet actors in the buying nation.

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Revisiting the (earning

)b*ectives• ++/. now what the consumption

unction tells us.

 – It tells us that consumption spending :9; hastwo components, one o which is autonomousand the other is incomedependent.

 – "he upward slope o the consumption unction

is the marginal propensity to consume :3!9;.

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Revisiting the (earning

)b*ectives• ++0. now the determinants o

investment spending.

 – Investment spending depends on interestrates, e#pectations o uture sales, andinnovation.

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Revisiting the (earning

)b*ectives• ++1. now how and why AD shits

occur.

 – AD shits right i any o the ourcomponents increase

• C increases.

• I increases.

• G increases.• X  . M increases.

 – @ice versa applies or AD to shit let.

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Revisiting the (earning

)b*ectives• ++2. now how and when macro

ailure occurs. –

3acro ailure occurs when the economyails to achieve ull employment and pricestability.

 – 3acro ailure can be caused by• "oo little aggregate demand :causing cyclical

unemployment;.

• "oo much aggregate demand :causingdemandpull inCation;.