Macro Presentation 9 Top 5 Revised

7/30/2019 Macro Presentation 9 Top 5 Revised

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Macroeconomics

Unit 9

Aggregate Demand


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Introduction

In this unit we examine the components of aggregate demandclosely. One of the key components is consumerconsumption.

Economists know that consumer consumption is dependentupon the amount of income they receive; but someconsumption is not determined by current income.

Business investment, government spending, and net exportsare also explored in this unit.


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Aggregate Demand

Aggregate demand (AD) is the total quantity of output (GDP)demanded at alternative price levels in a given period, ceterisparibus.

AD consists of four components: Consumption (C)

Investment (I)

Government Spending (G)

Net Exports (X IM)


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Concept 1: Consumption

Consumption represents purchases by consumers on finalgoods and services. Consumption is obtained from consumerdisposable income.

Disposable income must be either spent or saved. Thereforethe following formula applies:

Disposable Income (YD) = Consumption (C) + Saving (S)


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We often want to determine the proportion of total disposableincome 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 timeperiod divided by total disposable income.

APC = total consumption / total disposable income =

C / YD


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In 1999, total consumer consumption totaled $6,490 billion, andtotal 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 consumptionin 1999. In 2001 the U.S. APC was 1.001 indicating thatconsumers actually spent more than they received from

income.


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Often we would like to know what consumers would do if theyreceived a change in their disposable income.

To determine this change, we calculate the marginal propensityto consume (MPC).

The marginal propensity to consume is the fraction of eachadditional dollar of disposable income spent on consumption. Itis calculated by taking the change in consumption and dividing

it by the change in disposable income.


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MPC =C /YD

To calculate MPC we need to know how consumers spend thelast 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 ofthe last dollars earned.


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We are also concerned with how much consumers save from eachadditional dollar they earn.

The marginal propensity to save (MPS) is the fraction of each

additional dollar of disposable income not spent on consumption.

MPS =S /YD or MPS = 1 MPC

If consumers save $0.20 out of the last dollar earned, what is theMPS? The MPS = .20/1.00 = .20.


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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/$6,698billion = .031. Consumers save an average of $0.031 out of each

dollar of disposable income.


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Although calculating the MPC, MPS, APC, and APS is useful,predicting them is even more important. What drives consumerconsumption?

Keynes believed that consumer consumption was driven becurrent income and other non-income determinants.

The non-income determinants of consumption according to

Keynes are: expectations, wealth, credit, taxes, and pricelevels. Consumption based upon one or more of thesedeterminants is called autonomous consumption.


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ConsumptionConcept 2: Non-Income Determinants

Expectations is concerned with consumers changing currentconsumption 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 isoccurring, 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 savemore. Autonomous consumption declines.


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Wealth is the amount of assets anindividual owns. This can affect theirconsumption.

Increases in wealth create greaterspending of current income. Autonomousconsumption increases.

Decreases in wealth causes spending ofcurrent income to decline. Autonomousconsumption declines.


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Credit is the amount and availability of credit. It also canaffect consumption.

If credit is readily available, consumer spending of currentincome increases causing an increase in autonomous

consumption.

If credit is not easily attainable or costly (high rates),consumer spending of current income decreases andautonomous consumption declines.


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Taxes are another non-income determinant. Decreases intaxes increase consumer disposable income and consumerspending. This would cause an increase in autonomousconsumption. Tax increases reduce consumer disposableincome and consumer spending, causing a decline in

autonomous consumption.

Price-levels are the final non-income determinant. If pricelevels are increasing (inflation), the real value of money isreduced, and consumer spending is reduced by the effects of

inflation. Autonomous consumption is reduced.


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Consumption and theConcept 3: Consumption Function

We have learned that consumer spending is influenced bycurrent income, and the non-income determinants ofconsumption.

Therefore total consumption = non-income determinants ofconsumption + income-dependent consumption, or totalconsumption = autonomous consumption + income-dependentconsumption. The formula that represents this relationship is:

C = a + bYD


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The equation C = a + bYD represents the consumption function.

The consumption function is a mathematical relationshipindicating the desired consumer spending at various incomelevels.

C = current consumption

a = autonomous consumption

b = marginal propensity to consume

YD = disposable income


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The consumption function is used to predict how changes indisposable income (YD) will affect consumer spending. It alsoshows the effect of changes in one or more non-incomedeterminants (autonomous consumption) on consumerspending.

A consumption function can be graphically illustrated to showthe relationship between consumption and disposable income.


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Concept 3: A Consumption Function

C = YD

Saving

Dissaving

Disposable Income

Consumption

Spending


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Concept 3: A Consumption Function

The graph on the preceding page illustrates a consumptionfunction. The green dotted line represents the points at whichconsumption is equal to disposable income no saving ordissaving occurs. This is called the 45 degree linerepresenting 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, anyadditional spending is more than disposable income and

dissaving occurs (the green dotted line is below the red line ofthe consumption function).


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Concept 3: Consumptionand the Consumption Function

To graph the consumption function for a individual or for aneconomy, we need to know the level of autonomousconsumption, 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 cangraphically represent the consumption function.


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Freds Consumption Function

Consumption = $100 + 0.50YD

DisposableIncome (YD)

AutonomousConsumption

+ Income-Dependent

Consumption

= TotalConsumption

A $ 0 100 $ 0 $100

B 100 100 50 150

C 200 100 100 200

D 300 100 150 250

E 400 100 200 300


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Freds 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


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Concept 3: Consumption and theConsumption Function

A graph of a consumption function will contain a 45 degree linewhich represents the point at which consumption (C) = disposableincome (YD). On the preceding graph, this line is the green dottedline at a 45 degree angle.

Actual consumption may be above this line (dissaving) or belowthe line (saving). Actual consumption is represented by theconsumption function equation and line. This line is shown as thesolid red line on the preceding graph.

The slope of the consumption function line will always equal theMPC.


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Concept 3: Consumption and theConsumption Function

At point A, Fred has autonomous consumption of $100 and noincome. At point B Fred now has $100 in income, $100 inautonomous consumption, and $50 in income dependentconsumption. Fred continues to dissave.

The consumption function equation determines the dollaramount of Freds income dependent spending. Since FredsMPC = .50, Fred will spend half of his income.

At point C, Freds income finally equals his autonomous andincome dependent consumption. At points D and E, Fredsincome exceeds his total spending and he is saving.


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Aggregate Consumption Function

The aggregate model of the consumption function is essentiallyidentical 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 increaseconsumer wealth which would cause autonomous consumptionto increase. This would cause the consumption function to shift

upwards.


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Shift in the Consumption Function

CONS

UMPTION

(C)(dollarsperyear

)

DISPOSABLE INCOME(dollars per year)0


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Movement along the Consumption Function

Movement along the consumption function occurs when thereis 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 theconsumption function.


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Movements along the Consumption Function

CONSU

MPTION

(billionso

fdollarsper

year)

DISPOSABLE INCOME (billions of dollars per year)

0

B

A


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Consumption Function

You should notice that when the consumption function shifts,there is a change in autonomous consumption. Overallconsumption has changed as a result of a change in non-income dependent consumption.

The point at which the line representing the consumptionfunction intersects the Y axis changes when autonomousconsumption changes.

When the line shifts up it indicates an increase in autonomousor non-income dependent consumption. When the line shifts

down it indicates a decrease in autonomous or non-incomedependent consumption.


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Consumption Function

When there is movement along the consumption function, thelevel 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 achange in income. Movement to the right occurs when incomeincreases and movement to the left occurs when incomedecreases.


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Consumption and AD

The consumption function and aggregate demand curves willmove 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 rightwardshift of the AD curve. Demand/consumption have risen.


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AD Effects of Consumption Shifts

Spending

Income

Price Level

Consumption functionshifts up indicating anincrease in autonomous

consumption

AD AD

Real Output

AD shifts to the rightindicating increasedoutput


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Concept 4: Investment

A change in consumer spending is not the only factor thataffects aggregate demand.

The other factors (investment, government services, and netexports) can offset changes in consumer spending.

Investment accounts for about 18% of output and consists ofexpenditures on new plant, equipment, business software,inventory, new residential construction.

There are also determinants of investment.


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Concept 4: Determinants of Investment

Expectations The expectations of business owners andmanagement for future growth and sales of their products.Future sales, future economic factors, future trends.

Interest Rates The current and expected rates of interestfor loans. Businesses need to borrow to expand if ratesare low this is favorable. At higher rates of interest businessinvestment declines.


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Technology and Innovation The impact of improvedtechnology and innovation onthe ability to manufacturegoods at a lower cost.

Improving technology canimprove profits and increaseinvestment in otherimprovements.


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A change in any of the determinants of investment will cause ashift in the investment function (investment demand curve). Forexample, if factor costs increase, the investment demand curvewill shift to the left. If improved economic conditions areexpected, the investment demand curve will shift to the right.

If investment spending declines, the aggregate demand curvewill shift to the left. As investment spending increases, theaggregate 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


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Investment Demand And Interest Rates

11

InterestRate(p

ercentperyear)

Planned Investment Spending (billions of dollars per year)

100 200 300 400 500

10

9

8

7

6

54

3

2

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


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Government Spending

The level of government spending can have an impact onaggregate demand.

Increases in government spending can shift the aggregatedemand curve to the right.

Federal government spending is less dependent upon taxcollections. Deficit spending is often used to supplementspending programs.


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Net Exports

Exports depend upon the needs and demand of foreign

consumers and businesses.

Economic factors affecting other countries affect the amount ofexports we can sell. Declines in exports cause a leftward shiftof the AD curve.

Strong demands for imported goods can be weakened by adrop in consumer confidence. If imports are preferred overdomestically produced items aggregate demand can shift to the

left.


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Concept 5: Macro Failure

When the economy is at the equilibrium price and quantity, theeconomy may not be at its optimal level of output.

According to Keynes at equilibrium we may not be at a fullemployment level of output and price stability may not exist.

Even if the equilibrium point gives us full employment and pricestability, it will likely change.

Concept 5: AD & AS at Full Employment


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Concept 5: AD & AS at Full Employment

PriceLevel

Real GDP

Macro Success: (perfect AD)

QF indicates output at full employment

AD1

AS

P*E1

QF

Concept 5: Insufficient AD - Unemployment


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Concept 5: Insufficient AD Unemployment

PriceLevel

Real GDP

The GDP gapEquilibrium is below full employment output

AS

P*F2

QF

AD2

E2

Q2

P2

QE2

recessionaryGDP gap

C 5 M F il


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Recessionary GDP Gap The amount of which equilibriumGDP (QE) falls short of full-employment GDP (QF). This isdefined as a macro economic failure.

Graphically, the distance between the quantity produced at fullemployment 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 themajor goal of economic policy.

Concept 5: Too Much AD


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Inflationary 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

C t 5 M F il


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Inflationary GDP Gap The amount by which equilibriumGDP exceeds full employment GDP. Graphically, the distancebetween full employment GDP and the intersection of AD andAS. In the preceding graph, the distance between QF and QE.

Therefore, if AD is too high or too low the economy will notreach its goals of full employment and price stability. Therecessionary or inflationary gaps must be closed by usingeconomic policies to increase or decrease AD and/or AS.

C t 5 M r F il r


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How do you tell from a graph what kind of a gap exists?

1. Look first for the quantity associated where AD and ASmeet. 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 GDPgap. If no, you have an inflationary GDP gap. If QF

represents the point at which AD and AS intersect, you areat full employment at macro equilibrium.

Too little, too much, just right


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PriceLevel

Real GDP

AS

P*

QFQR QI

QR represents output during a recessionary gap whileQI represents output during an inflationary gap. QF isthe output level at full employment.

Summary


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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


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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.

Macro Presentation 9 Top 5 Revised

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