Aggregate Demand in Keynesian Analysis

12.1 Aggregate Demand in Keynesian Analysis

Learning Objectives

  • Explain definitions of real GDP, recessionary gaps, and inflationary gaps.

  • Recognize the Keynesian Aggregate Demand/Aggregate Supply (AD/AS) model.

  • Identify factors determining consumption and investment expenditures.

  • Analyze factors influencing government spending and net exports.

Keynesian Focus on Aggregate Demand

  • The Keynesian perspective emphasizes aggregate demand as a critical determinant of output.

  • Firms produce goods and services only if they anticipate sales.

  • Real GDP is responsive to the level of demand in the economy in contrast to potential GDP, which reflects available resources.

  • Figure 12.3 illustrates the Keynesian AD/AS model, displaying how the Short-Run Aggregate Supply (SRAS) curve behaves:

    • Horizontal below potential GDP, indicating that output can change without affecting prices when AD shifts.

    • Vertical at potential GDP, showing that at full employment, changes in AD will primarily influence price levels rather than output.

Recessionary and Inflationary Gaps

  • If AD falls while starting from potential output (Yp), the economy enters a recessionary gap (Y < Yp), leading to underemployment and reduced output.

  • Conversely, if AD increases excessively, it can create an inflationary gap, pushing output beyond potential GDP, resulting in inflation.

  • Keynes argued these gaps can persist over extended periods without intervention.

  • The government should intervene by:

    • Increasing spending during recessions to boost AD.

    • Decreasing spending during economic booms to control inflation.

Components of Aggregate Demand

  • Aggregate demand is defined as total planned expenditure on domestic goods and services, consisting of four principal components:

    1. Consumption Expenditure

    2. Investment Expenditure

    3. Government Spending

    4. Net Exports (the balance of exports and imports).

What Determines Consumption Expenditure?

  • Consumption expenditure refers to household spending on:

    • Durable Goods: Long-lasting items (e.g., automobiles).

    • Nondurable Goods: Items consumed quickly (e.g., groceries).

    • Services: Intangible goods (e.g., healthcare, entertainment).

  • Key Factors Influencing Consumption:

    1. Disposable Income: Income after taxes; a primary determinant of consumption.

    2. Expected Future Income: Consumer optimism can drive spending.

    3. Wealth: Rising household wealth can lower saving rates.

    • For instance, stock market gains can increase consumption but downturns can lead to increased savings.

What Determines Investment Expenditure?

  • Investment expenditure relates to spending on:

    • Producer’s Durable Equipment and Software

    • Nonresidential Structures (factories, offices)

    • Changes in Inventories

    • Residential Structures (homes, apartments).

  • Crucial factors include expectations of future profits and interest rates:

    • Expectations of Future Profits: Higher expected profits can boost investment.

    • Interest Rates: Lower rates encourage investment by reducing opportunity costs.

  • Historical Context: U.S. investment levels rose sharply during economic growth in the late 1990s but fell during the recession of 2001.

What Determines Government Spending?

  • Government spending affects AD and is crucial during economic downturns, where it can stimulate the economy through:

    • Federal, state, and local budgets that shape aggregate demand.

  • Key Insights:

    • Increased government expenditure raises AD, while tax adjustments can also influence consumption and investment patterns.

What Determines Net Exports?

  • Net exports (exports minus imports) contribute to aggregate demand:

    • Exports: Domestic goods sold abroad.

    • Imports: Foreign goods consumed domestically.

  • Fluctuations in net exports arise from:

    1. Relative Growth Rates: Economic conditions in importing countries affect demand.

    2. Relative Prices: Changes in competitiveness due to pricing or exchange rates can impact exports and imports.

Summary of Determinants of Aggregate Demand

  • Decreasing Aggregate Demand Factors:

    • Increase in taxes

    • Decreased income

    • Higher interest rates

    • Increased savings desire

    • Reduced wealth

    • Lower expectations of future income

  • Increasing Aggregate Demand Factors:

    • Decrease in taxes

    • Increased income

    • Lower interest rates

    • Reduced savings desire

    • Increased wealth

    • Higher expectations of future income

  • Investment Factors:

    • Decreasing investment: Falling expected returns, rising interest rates, decreased business confidence.

    • Increasing investment: Rising expected returns, declining interest rates, increased business confidence.

  • Government Spending:

    • Decrease: Reduction in government spending or tax increases.

    • Increase: Expansion of government spending or tax cuts.

  • Net Exports Factors:

    • Decrease in foreign demand, increase in U.S. goods prices.

    • Increase in foreign demand, decrease in U.S. goods prices.