Aggregate Demand

1
Aggregate Demand

• Chapter 9

2
Keynes Questions

• What are the components of aggregate demand?
• What determines the level of spending for each
  component?
• Will there be enough demand to maintain full
  employment?

3
Response to a Recession
AS (Aggregate supply)
E1
PRICE LEVEL (average price)
AD2
AD1
QF
REAL OUTPUT (quantity per year)
4
Disposable IncomeConsumption and Saving

• By definition, all disposable income is either
  consumed (spent ) or saved (not spent).
• Disposable income Consumption Saving YD
  C S

5
U.S. Consumption and Income
7000
6000
5000
4000
CONSUMPTION (billions of dollars per year)
3000
2000
1000
0
1000
2000
3000
4000
5000
6000
7000
DISPOSABLE INCOME (billions of dollars per year)
6
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.

7
Average Propensity to Consumption

• The average propensity to consume (APC) is total
  consumption in a given period divided by total
  disposable income.

8
Average Propensity to Save

• Since disposable income is either consumed or
  saved.
• APS 1 APC

9
The Marginal Propensity to Consume

• The marginal propensity to consume (MPC) is the
  fraction of each additional (marginal) dollar of
  disposable income spent on consumption.
• It is the change in consumption divided by the
  change in disposable income.

10
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.
• It is the change in saving divided by the change
  in disposable income.

Or MPS 1 MPC
11
Two Types of Consumption

• Keynes distinguished two kinds of consumer
  spending.
• Autonomous Consumption
• Spending not influenced by current income,
• Determined by expectations, wealth, credit,
  taxes, and price levels.
• Income-Dependent Consumption
• Spending that is determined by current income.

12
The Non-income Determinants of Consumption

• 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 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.

13
The Non-income Determinants of Consumption

• Credit
• Availability allows people to spend more than
  their current income.
• The need to pay past debt may limit current
  consumption.
• Taxes
• Link between total and disposable income.
• Tax cuts give consumers more disposable income.
• Price levels
• Rising price levels reduce real value of money
  and may cause people to curtail spending.

14
Income-Dependent Consumption

• The consumption function is the mathematical
  relationship indicating the rate of desired
  consumer spending at various income levels.
• The consumption function provides a precise basis
  for predicting how changes in disposable income
  (YD) effect consumer spending (C).
• C a bYD

where C current consumption a autonomous
consumption b marginal propensity to
consume YD disposable income
15
Consumer Behavior

• We expect that even with an income level of zero,
  there will be some consumption.
• We expect consumption to rise with income based
  on the consumers MPC.
• Dissaving occurs when current consumption exceeds
  current income a negative saving flow.

16
The 45-Degree Line

• The 45-degree line represents all points where
  consumption and income are exactly equal.
• C YD

17
Consumption Function
400
C YD
350 300 250 200 150 100 50
50
100
150
200
250
300
350
400
450
18
The 45-Degree Line

• The 45-degree line represents all points where
  consumption and income are exactly equal.
• C YD
• Consumers increase their consumption as their
  incomes increase.
• The slope of the consumption function is the
  marginal propensity to consume.

19
Janas Consumption Function
20
Janas Consumption Function
400
C YD
50
100
150
200
250
300
350
400
450
21
Shifts of the Consumption Function

• Changing the a or b values in the consumption
  function (C a bYD) will alter the function to
  a new position.
• A change in the a variable will cause a parallel
  shift of the function.
• A change the value of (b) alters the consumers
  willingness to spend out of each additional
  dollar in income.

22
Shift in the Consumption Function
23
Shifts of Aggregate Demand

• Shifts in the consumption function are reflected
  in shifts of the aggregated demand curve.
• 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.

24
Shift Factors

• Shift factors include all of the non- income
  determinants of consumption.
• Changes in consumer confidence (expectations).
• Changes in wealth.
• Changes in credit conditions.
• Changes in tax policy.

25
AD Effects of Consumption Shifts
P1

Y0
Q1
Q2
26
Shift Factors

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

27
AD Effects of Investment
P1

Y0
Q1
Q2
28
Determinants of Investment

• 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 the lower the investment spending.
• More investment occurs at lower rates.
• Technology
• New technology changes the demand for investment
  goods.

29
Self-Adjustment or Instability

• Chapter 10

30
Leakages and Injections

• Total spending does not always match total output
  at the desired full-employmentprice-stability
  level.
• A leakage is income not spent directly on
  domestic output, but instead is diverted from the
  circular flow.
• An injection is an addition of spending to the
  circular flow of income.

31
Leakages and Injections
LEAKAGES
32
Self-Adjustment?

• Classical economists believed that flexible
  interest rates equalize injections and leakages
  and would lead to full employment.
• Keynes disagreed on the role of flexible interest
  rates in reaching full employment and argued that
  investment would fall in response to declining
  sales.

33
Flexible Prices

• Classical economists believed that a falling
  price level would prompt consumers to buy more
  output.
• Keynes disagreed on the role of flexible prices
  in reaching full employment and argued that
  declining retail prices were likely to prompt
  investment cutbacks.

34
AD Shift
AS
F
P0
d
P1
b
AD0
AD0
QF 3,000
Q1
2,900
35
The Multiplier Process

• Keynes argued that things were likely to get
  worse once a spending shortfall emerged.

36
How?

• A Decline in Investment
• Expectations fall ? inventory of unsold goods
  (undesired inventory) accumulates ? businesses
  reduce prices, output, and investment ? lower
  wages and employment ? reduction in household
  disposable income ?decline in consumer spending

37
The Multiplier

• The multiplier is the multiple by which an
  initial change in aggregate spending will alter
  total expenditure after an infinite number of
  spending cycles.

38
The Multiplier

• The change in total spending equals the
  multiplier times the initial change in aggregate
  spending.
• A recessionary gap of 100 billion per year would
  decrease total spending by 400 billion per year
  (MPC 0.75).

39
The Multiplier
40
The Multiplier Process
41
The Multiplier Cycles
42
Multiplier Effects
AS
m
d
a
P0
b
AD0
c
AD1
AD2
QF 3000
2600
2900
43
Price and Output Effects

• As long as the aggregate supply curve is
  upward-sloping, the impact of a shift in
  aggregate demand is reflected in both output and
  price changes.
• The recessionary GDP gap equals the difference
  between equilibrium real GDP (QE) and
  full-employment real GDP (QF).
• The inadequate AD here leads to cyclical
  unemployment a short-run tradeoff between
  inflation and unemployment?

44
Recessionary GDP Gap
AS
AD2
m
a
P0
c
PE
AD0
Recessionary GDP gap
QE
QF
45
Increased Investment
AS
?C 300 billion
?I 100 billion
w
P6
r
P0
a
AD6
AD5
AD0
QE
QF
46
Demand-Pull Inflation
AS
?C 300 billion
?I 100 billion
w
P6
r
P0
a
AD6
AD5
AD0
QF
QE
47
Boom and Busts

• The basic conclusion of the Keynesian analysis is
  that
• The economy is vulnerable to abrupt changes in
  spending behavior, and
• The economy will not self-adjust to a desired
  macro equilibrium.
• Thats were the government comes in

48
Fiscal Policy

• Chapter 11

49
Policy Tools

• Fiscal Policy
• The use of government spending and taxation to
  try to influence levels of output, employment,
  and prices.
• GDP C I G (Ex - Im)

50
Purchases vs. Transfers

• Government purchases are part of aggregate
  demand, income transfers are not.
• Income transfers are payments to individuals for
  which no current goods or services are exchanged.

51
Fiscal Policy

• The federal government can alter aggregate demand
  by

• Purchasing more or fewer goods and services.
• Raising or lowering taxes.
• Changing the level of income transfer.

52
Fiscal Stimulus
53
Keynesian Strategy

• From a Keynesian perspective, the way out of
  recession is to get someone to spend more on
  goods and services.
• A fiscal stimulus results from tax cuts or
  spending hikes intended to increase (shift)
  aggregate demand.

54
Keynesian Strategy

• Two strategic policy questions must be answered
• By how much do we want to shift the AD curve to
  the right?
• How can we induce the desired shift?
• If GDP gap is 400 billion, why not just increase
  AD by that much?

55
The Naive Keynesian Model

• An increase in AD by 400 billion will achieve
  full employment in the naive Keynesian policy.
• An increase in aggregate demand by the amount of
  the GDP gap will achieve full employment only if
  the aggregate supply curve is horizontal.

56
The AD Shortfall
AD2
AD1
a
b
Price Level (average price)
PE
Recessionary GDP gap
QE 5.6
QF 6.0
Real GDP (trillions of dollars per year)
57
Price Level Changes

• Shifting (increasing) aggregate demand by the
  amount of the GDP gap will achieve full
  employment only if the price level does not rise.
• When the AD curve shifts to the right, the
  economy moves up the AS curve, not horizontally
  to the right.
• Both real output and prices change.

58
The AD Shortfall

• So long as the AS curve slopes upward, AD must
  increase by more than the size of the
  recessionary GDP gap to achieve full employment.

59
The AD Shortfall
Recessionary GDP gap
AD shortfall
60
More Government Spending

• Increased government spending is a form of fiscal
  stimulus.
• Every dollar of new government spending has a
  multiplied impact on aggregate demand.

61
Multiplier Effects
Direct impact of rise in government spending
200 billion
Indirect impact via increased consumption 600
billion
a
Price Level (average price)
b
Current price level
P1
AD2
AD3
AD1
5.8
Real GDP ( trillions per year)
5.6 QE
6.4
62
Tax Cuts

• By lowering taxes, the government increases the
  disposable income of the private sector.

63
Taxes Cuts

• By lowering taxes, the government increases the
  disposable income of the private sector.
• The amount consumption increases depends on the
  marginal propensity to consume.

64
Taxes and Consumption

• A dollar of tax cut is less stimulative than a
  dollar increase in government purchases.

65
The Tax Cut Multiplier
First round of spending
Second round of spending
Third round of spending
66
Increased Transfers

• Increasing transfer payments stimulates the
  economy.
• The initial fiscal stimulus of increased transfer
  payments is

67
Fiscal Restraint

• There are times when the economy is expanding too
  fast and fiscal restraint is more appropriate.
• Fiscal restraint is using spending cuts, tax
  hikes, or reduced transfers intended to lower
  (shift) aggregate demand.

68
Excess Aggregate Demand
Inflationary GDP gap
Excess AD
69
Time Lags

• It takes time to recognize that a problem exists
  and then formulate policy to address the problem.
• The very nature of the macro problems could
  change if the economy is hit with other internal
  or external shocks.

70
Deficits, Surpluses, and Debt

• Chapter 12

71
Indebtedness of the Worlds Governments
72
Budget Deficits and Surpluses

• Deficit spending is the use of borrowed funds to
  finance government expenditures that exceed tax
  revenues in a given time period.
• Budget surplus is an excess of government
  revenues over government expenditures in a given
  time period.

73
Keynesian View

• Budget deficits and surpluses are a routine
  feature of counter-cyclical fiscal policy.
• The goal of macro policy is not to balance the
  budget but to balance the economy at
  full-employment.

74
Non Discretionary vs. Discretionary Spending

• To a large extent, current revenues and
  expenditures are the result of decisions made in
  prior years and are non-discretionary.
• Discretionary fiscal spending includes those
  elements of the federal budget not determined by
  past legislative or executive commitments.

75
Non Discretionary vs. Discretionary Spending

• Since most of the budget is not controllable,
  fiscal restraint or fiscal stimulus are less
  effective.

• Fiscal restraint tax hikes or spending cuts
  intended to reduce (shift) aggregate demand.
• Fiscal stimulus tax cuts or spending hikes
  intended to increase (shift) aggregate demand.

76
Automatic Stabilizers

• Most of the uncontrollable line items in the
  federal budget change with economic conditions.
• Policies that stimulate or depress the economy
  when necessary without any deliberate policy
  change.
• They are designed to reduce the lags associated
  with stabilization policy.
• Examples
• income tax (progressive)
• unemployment insurance
• welfare

77
Time and Fiscal Policy

• Long variable lags
• inside lag the time between the shock and the
  policy response
• takes time to recognize shock
• takes time to implement policy, especially
  fiscal policy
• outside lag the time it takes for policy to
  affect economy

If conditions change before policys impact is
felt, then policy may end up destabilizing the
economy.
78
Deficits

• To isolate effects of fiscal policy, the deficit
  is broken down into cyclical and structural
  components.

79
Cyclical Deficits

• The size of the federal deficit or surplus is
  sensitive to expansion and contraction of the
  macro economy.
• Actual budget deficits and surpluses may arise
  from economic conditions as well as policy.

80
Cyclical Deficits

• The cyclical deficit is that portion of the
  budget deficit attributable to unemployment or
  inflation.

• The cyclical deficit widens when GDP growth slows
  or inflation decreases.
• The cyclical deficit shrinks when GDP growth
  accelerates or inflation increases.

81
Structural Deficits

• The structural deficit is federal revenues at
  full-employment minus expenditures at full
  employment under prevailing fiscal policy.
• Fiscal stimulus is measured by the increase in
  the structural deficit (or shrinkage in the
  structural surplus).
• Fiscal restraint is measured by the decrease in
  the structural deficit (or increase in the
  structural surplus).

82
Economic Effects of Deficits

• Crowding-out is the reduction in private-sector
  borrowing (and spending) caused by increased
  government borrowing.
• Crowding out implies less private-sector output.
• Crowding out reminds us that there is an
  opportunity cost to government spending.
• Rising interest rates are both a symptom and a
  cause of crowding out.

83
Crowding Out
b
g2
Increase in government spending . . .
g1
a
c
Crowds out private spending
h2
h1
84
Economic Effects of Surpluses

• Crowding in is the increase in private sector
  borrowing (and spending) caused by decreased
  government borrowing.
• The economic effects of budget surpluses are the
  mirror image of those for deficits.
• There are four potential uses for a budget
  surplus
• Cut taxes.
• Increase income transfers.
• Spend it on goods and services.
• Pay off old debt (save it).

85
The Accumulation of Debt

• When the government borrows funds it issues
  bonds.
• The national debt is the accumulated debt of the
  government.
• The national debt is a stock of IOUs created by
  annual deficit flows.

86
Liabilities Assets

• National debt represents a liability as well as
  an asset in the form of bonds.
• Liability An obligation to make future payment
  debt.
• Asset Anything having exchange value in the
  marketplace wealth.

87
Burden of the Debt

• Refinancing
• the issuance of new debt in payment of debt
  issued earlier..
• Debt service
• the interest required to be paid each year on
  outstanding debt.
• Interest payments restrict the governments
  ability to balance the budget or fund other
  public sector activities.
• Both represent opportunity costs

88
External Debt

• No Crowding Out
• External financing allows us to get more
  public-sector goods without cutting back on
  private-sector production.
• As long as foreigners are willing to hold our
  bonds, external financing imposes no real cost.
• Repayment
• Foreigners may not be willing to hold bonds
  forever.
• External debt must be paid with exports of real
  goods and services.

89
External Financing