CHAPTER 9: Aggregate Demand

MACRO EQUILIBRIUM

  • Market equilibrium established where aggregate demand (AD) and aggregate supply (AS) intersect.

  • At equilibrium (E₁), output equals spending; producers maintain production level.

Desired Adjustment

  • Situations with excessive unemployment lead to production below full potential (QF).

  • Aggregate demand might need to shift (rightward) to ensure full employment.

Components of Aggregate Demand

  • Four components:

    • Consumption (C)

    • Investment (I)

    • Government Spending (G)

    • Net Exports (X - M)

  • Changes in these components can shift aggregate demand.

Consumption and Savings

  • Consumption function: $C = a + bYD$, where:

    • $C$: Current consumption

    • $a$: Autonomous consumption

    • $b$: Marginal propensity to consume (MPC)

    • $YD$: Disposable income

  • Economic factors influencing consumption include expectations, wealth effects, credit, and taxes.

Average and Marginal Propensities

  • Average propensity to consume (APC): $APC = C/YD$

  • Marginal propensity to consume (MPC): $MPC = \frac{ΔC}{ΔYD}$

  • Marginal propensity to save (MPS): $MPS = 1 - MPC$

Shifting of Aggregate Demand

  • Shifts in consumption function influence aggregate demand:

    • Upward shift = rightward shift in AD

    • Downward shift = leftward shift in AD

  • Factors include changes in expectations, credit availability, taxes, and wealth.

Investment Factors

  • Investment driven by expectations, interest rates, and technology advancements.

  • Changes in these factors lead to fluctuations in investment spending—more volatile than consumption.

Government Spending

  • Government spending is countercyclical, able to borrow to maintain spending during downturns.

  • Local/state spending often pro-cyclical due to tax receipt dependence.

Net Exports

  • Affected by foreign consumer behavior, income changes, and global economic conditions.

  • Volatile and can shift aggregate demand significantly.

Macro Failures and GDP Gaps

  • Two issues arise:

    1. Undesirable equilibrium not achieving full employment or price stability.

    2. Instability due to shifts in aggregate demand leading to cyclical unemployment or inflation.

  • GDP gaps:

    • Recessionary gap: when actual output falls below potential output (QF).

    • Inflationary gap: when actual output exceeds potential output, leading to inflation delays.

Key Concepts

  • Understanding the components and influences on aggregate demand is crucial for policy-making and managing economic cycles.

  • Aggregate Demand: The total quantity of output (real GDP) demanded at alternative price levels in a given time period

  • aggregate supply (AS) The total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period

  • equilibrium (macro) The combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

  • consumption Expenditure by consumers on final goods and services.

  • disposable income (DI) After-tax income of households; personal income less personal taxes.

  • saving That part of disposable income not spent on current consumption; disposable income less consumption.

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

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

  • marginal propensity to save (MPS) The fraction of each additional (marginal) dollar of disposable income not spent on consumption; 1 − MPC.

  • wealth effect A change in consumer spending caused by a change in the value of owned assets.

  • autonomous consumption Consumer spending not dependent on current income.

  • consumption function A mathematical relationship indicating the rate of desired consumer spending at various income levels.

  • dissaving Consumption expenditure in excess of disposable income; a negative saving flow.

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

  • full-employment GDP The value of total market output (real GDP) produced at full employment.

  • equilibrium GDP The value of total output (real GDP) produced at macro equilibrium (AS = AD).

  • recessionary GDP gap The amount by which equilibrium GDP falls short of full-employment GDP.

  • cyclical unemployment Unemployment attributable to a lack of job vacancies—that is, to an inadequate level of aggregate demand.

  • inflationary GDP gap The amount by which equilibrium GDP exceeds full-employment GDP.

  • demand-pull inflation An increase in the price level initiated by excessive aggregate demand.

  • business cycle Alternating periods of economic growth and contraction.

  • aggregate expenditure The rate of total expenditure desired at alternative levels of income,

  • recessionary gap The amount by which aggregate spending at full employment falls short of full-employment output.

  • expenditure equilibrium The rate of output at which desired spending equals the value of output.

  • inflationary gap The amount by which aggregate spending at full employment exceeds full-employment output.