Chapter 9: Aggregate Demand and Macroeconomic Equilibrium Notes

Foundational Macroeconomic Concepts

• Macro Equilibrium: This is defined as the specific combination of price level and real output that is compatible with both aggregate demand and aggregate supply. It is the point where the intentions of buyers and sellers coincide.
• Aggregate Demand ($AD$): The total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus.
• Aggregate Supply ($AS$): The total quantity of output (real GDP) that producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.
• The Four Components of Aggregate Demand: Aggregate demand is the sum of spending from four distinct sectors:
  • Consumption ($C$): Spending by households.
  • Investment ($I$): Spending by businesses on capital and inventories.
  • Government Spending ($G$): Spending by federal, state, and local governments.
  • Net Exports ($X - M$): The difference between exports ($X$) and imports ($M$).

Income, Consumption, and Saving

• Consumption: Expenditure by consumers on final goods and services.
• Disposable Income ($Y_D$): The after-tax income of households; it represents the actual amount of money consumers have available to spend or save.
• Saving ($S$): That part of disposable income not spent on current consumption. The fundamental relationship is expressed as:
  • $\text{Disposable Income} = \text{Consumption} + \text{Saving}$
• Consumption and Income Relationship: Consumption typically rises as income rises. Observations of U.S. data (1980–2000) indicate that consumers spend almost every extra dollar they receive.
• Propensities to Consume and Save:
  • Average Propensity to Consume ($APC$): The total consumption in a given period divided by total disposable income:
    • $APC = \frac{C}{Y_D}$
  • Marginal Propensity to Consume ($MPC$): 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:
    • $MPC = \frac{\Delta C}{\Delta Y_D}$
  • Marginal Propensity to Save ($MPS$): The fraction of each additional (marginal) dollar of disposable income not spent on consumption. Since every extra dollar is either spent or saved:
    • $MPS = 1 - MPC$
    • Example: If $MPC = 0.80$, then $80$ cents of an extra dollar are spent and $20$ cents are saved ($MPS = 0.20$).
• Dissaving: When consumer spending exceeds disposable income, consumer saving is negative. Dissaving is financed by using credit or tapping into prior savings.

The Consumption Function

• Keynesian Distinction: John Maynard Keynes distinguished between two types of consumer spending:
  • Autonomous Consumption ($a$): Spending that is not influenced by current income. This represents the level of spending that would occur even if disposable income were zero.
  • Income-Dependent Consumption: Spending that is determined by the current level of disposable income.
• Determinants of Autonomous Spending: The level of "$a$" depends on:
  • Expectations (consumer confidence).
  • Wealth effects (changes in the value of assets like stocks or homes).
  • Availability and cost of credit.
  • Tax policies.
• Mathematical Formula: The consumption function is expressed as:
  • $C = a + bY_D$
  • Where $C$ is current consumption, $a$ is autonomous consumption, $b$ is the marginal propensity to consume ($MPC$), and $Y_D$ is disposable income.
• Illustrative Example: A college student spends $50$ when they have no income. When they earn $100$ per week, their spending increases to $125$.
  • Autonomous consumption ($a$) = $50$.
  • Change in income ($\Delta Y_D$) = $100$.
  • Change in consumption ($\Delta C$) = $125 - 50 = 75$.
  • $MPC$ ($b$) = $\frac{75}{100} = 0.75$.
  • Consumption Function: $C = 50 + 0.75 Y_D$.
• Graphical Representation:
  • On a graph with Consumption ($C$) on the y-axis and Disposable Income ($Y_D$) on the x-axis, a $45$-degree line represents points where $C = Y_D$.
  • When the consumption function is above the $45$-degree line, dissaving occurs.
  • When the consumption function is below the $45$-degree line, saving occurs.
  • The slope of the consumption function is equal to the $MPC$.
• Shifts and Changes:
  • A change in "$a$" (autonomous consumption) shifts the entire consumption function up or down.
  • A change in "$b$" ($MPC$) alters the slope of the consumption function.
  • An upward shift in the consumption function increases aggregate demand (shifts $AD$ rightward); a downward shift decreases aggregate demand (shifts $AD$ leftward).

Investment Spending

• Definition: Expenditures on the production of new plants, equipment, and structures (capital) in a given time period, plus changes in business inventories.
• Determinants of Investment:
  • Expectations: Business outlook on future sales and profits.
  • Interest Rates: The cost of borrowing to finance capital projects.
  • Technology and Innovation: New developments that necessitate capital upgrades.
• Investment Demand Curve:
  • A change in interest rates leads to a movement along the existing investment demand curve.
  • A change in expectations or technology shifts the investment demand curve.
• Volatility: Investment is significantly more volatile than consumption spending, making it a frequent driver of shifts in the aggregate demand curve.
  • Decline in investment shifts $AD$ left.
  • Increase in investment shifts $AD$ right.

Government Spending and Net Exports

• Government Spending ($G$):
  • The total government sector spends nearly $15$ trillion on goods and services.
  • State and Local Level: Accounts for approximately $2/3$ of all government spending. These governments cannot deficit spend and operate "pro-cyclically" (spending increases when the economy expands/tax receipts rise, and declines when the economy slumps).
  • Federal Level: The federal government can borrow money and engage in deficit spending. It can consciously change its spending to help reverse undesirable shifts in $AD$.
• Net Exports ($X - M$):
  • Economic downturns in foreign countries lead to a decrease in U.S. exports ($X$).
  • Economic downturns in the U.S. lead to a decrease in U.S. imports ($M$).
  • Decreases in net exports shift $AD$ left; increases shift $AD$ right.

Macro Failure and Productivity Gaps

• Macro Failure: Occurs when the market equilibrium does not align with social goals. There are two primary concerns:
  • Undesirability: The equilibrium price level or output level may not provide full employment or price stability.
  • Instability: Even a desirable equilibrium may be temporary because market participants change behavior abruptly.
• Equilibrium Disparities:
  • Aggregate Demand too small: Leads to cyclical unemployment.
  • Aggregate Demand too great: Leads to demand-pull inflation.
• Recessionary GDP Gap: The amount by which equilibrium GDP ($Q_E$) falls short of full-employment GDP ($Q_F$).
  • Formula: $\text{Recessionary Gap} = Q_F - Q_E$
  • This represents unused productive capacity and results in cyclical unemployment.
• Inflationary GDP Gap: The amount by which equilibrium GDP exceeds full-employment GDP.
  • This can result in Demand-Pull Inflation, which is an increase in the price level initiated by excessive aggregate demand.
• Business Cycle: Defined as alternating periods of economic growth and contraction, often caused by recurrent shifts in aggregate demand.

Self-Adjustment and Policy

• Macro Self-Adjustment: The theory that if markets self-adjust, macro failures are only temporary. This requires that shortfalls in one component of $AD$ (e.g., Investment) be offset by spending in another component (e.g., Consumption).
• Predicting Failures: Policymakers use various tools to foresee shifts in $AD$.
• Index of Leading Economic Indicators (LEI): A list of $10$ gauges designed to indicate the direction of the economy. While not perfect, the LEI has a strong track record of predicting economic shifts.