Aggregate Demand - Aggregate

Supply Equilibrium

The Fixed-Price Keynesian Model: An Economy Below

Full – Employment

Focus on the Demand Side

Factors that Affect AD

Consumption ≈ 68% of gdp– INCOME– Wealth Price– Interest Rates Price– Expectations

• Future Income• Future Prices

– Demographics– Taxes

Investment ≈ 17% of gdp– Interest Rates Price– Technology– Cost of Capital Goods– Capacity Utilization– Expectations!!!

AD = C + I + G + NXGovernment Spending

≈ 18% of gdpNet Exports ≈ - 3% of gdp

– Foreign Income– Domestic INCOME– Foreign Prices– Domestic Prices– Exchange Rates

– Foreign Interest Rates– Domestic Interest Rates

– Government Policy– Tariffs, Quotas, etc.– Gov’t Procurement

Consumption and Disposable Income 1947-2002

Simple Consumption FunctionIgnore depreciation, taxes, etc. for the time beingThen DI = Y = Aggregate Income = Real GDP

C = a + bY is a straight line with slope b.

a is autonomous autonomous consumptionconsumption.

The slope, b, is the marginal marginal propensity to consumepropensity to consume (MPCMPC).

0 < MPC < 1. MPC is C/Y, the amount by

which consumption changes for each dollar change in Y

C

Aggregate Income Y

a

C

Y

MPC = C/Y = b

Saving Function and

Autonomous Shifts in

Consumption and in Saving

Investment Spending (I)• Capital goods have a long life.• Capital goods take time to build.• Capital goods involve large expenditure.• The present value of a capital good

depends on the income it generates over a long time horizon.– Businesses must form expectations

about future conditions and profitability.– Investment is inherently risky.

• Investment expenditure tends to be erraticerratic.

Investment as a Function of Current IncomeInvestment depends more on expectations of the future than on what’s happening now.

The Aggregate Expenditures FunctionAE = C + I + G + NXG + NX

Real GDP (Output)

Agg

rega

te p

lan

ned

expe

ndit

ure

400

500

600

700

0 300 400 500 600 700

45o line: AE = Y

Total Expenditure

Reduce Output,Reduce Employment

Increase Output,increase Employment

Movement to EquilibriumMovement to Equilibrium

Equilibrium Real GDP: mpc = .75(1)

RealGDP(Y)

(2)

Consumption(C)

(3)Planned

Investment(I)

(4)Gov’t

Spending(G)

(5)Net

Exports(NX)

(6)Aggregate

Expenditures(AE)

(7)Unplanned Change in Inventories

(8)Change in Real

GDP

0 100 25 0 0 125 -125 Up

100 175 25 0 0 200 -100 Up

Equilibrium Real GDP: mpc = .75(1)

RealGDP(Y)

(2)

Consumption(C)

(3)Planned

Investment(I)

(4)Gov’t

Spending(G)

(5)Net

Exports(NX)

(6)Aggregate

Expenditures(AE)

(7)Unplanned Change in Inventories

(8)Change in Real

GDP

0 100 25 0 0 125 -125 Up

100 175 25 0 0 200 -100 Up

200 250 25 0 0 275 -75 Up

300 325 25 0 0 350 -50 Up

Equilibrium Real GDP: mpc = .75(1)

RealGDP(Y)

(2)

Consumption(C)

(3)Planned

Investment(I)

(4)Gov’t

Spending(G)

(5)Net

Exports(NX)

(6)Aggregate

Expenditures(AE)

(7)Unplanned Change in Inventories

(8)Change in Real

GDP

0 100 25 0 0 125 -125 Up

100 175 25 0 0 200 -100 Up

200 250 25 0 0 275 -75 Up

300 325 25 0 0 350 -50 Up

400 400 25 0 0 425 -25 Up

500 475 25 0 0 500 0 No chg

Equilibrium Real GDP: mpc = .75(1)

RealGDP(Y)

(2)

Consumption(C)

(3)Planned

Investment(I)

(4)Gov’t

Spending(G)

(5)Net

Exports(NX)

(6)Aggregate

Expenditures(AE)

(7)Unplanned Change in Inventories

(8)Change in Real

GDP

0 100 25 0 0 125 -125 Up

100 175 25 0 0 200 -100 Up

200 250 25 0 0 275 -75 Up

300 325 25 0 0 350 -50 Up

400 400 25 0 0 425 -25 Up

500 475 25 0 0 500 0 No chg

700 625 25 0 0 650 50 Down

Equilibrium Real GDP: mpc = .75(1)

RealGDP(Y)

(2)

Consumption(C)

(3)Planned

Investment(I)

(4)Gov’t

Spending(G)

(5)Net

Exports(NX)

(6)Aggregate

Expenditures(AE)

(7)Unplanned Change in Inventories

(8)Change in Real

GDP

0 100 25 0 0 125 -125 Up

100 175 25 0 0 200 -100 Up

200 250 25 0 0 275 -75 Up

300 325 25 0 0 350 -50 Up

400 400 25 0 0 425 -25 Up

500 475 25 0 0 500 0 No chg

600 550 25 0 0 575 25 Down

700 625 25 0 0 650 50 Down

Equilibrium Real GDP: mpc = .75(1)

RealGDP(Y)

(2)

Consumption(C)

(3)Planned

Investment(I)

(4)Gov’t

Spending(G)

(5)Net

Exports(NX)

(6)Aggregate

Expenditures(AE)

(7)Unplanned Change in Inventories

(8)Change in Real

GDP

0 100 25 0 0 125 -125 Up

100 175 25 0 0 200 -100 Up

200 250 25 0 0 275 -75 Up

300 325 25 0 0 350 -50 Up

400 400 25 0 0 425 -25 Up

500 475 25 0 0 500 0 No chg

600 550 25 0 0 575 25 Down

700 625 25 0 0 650 50 Down

Equilibrium Output (Y) & Spending (AE)and

Autonomous Spending Multiplier

Polish your algebraPolish your algebraY = C + I = {100 + .75 Y} + 25

Y = 125 + . 75 Y

Y - .75 Y = (1 - .75)Y = (1 – mpc) Y = 125

.25 Y = 125

= Autonomous Spending

Y = (1/.25) 125 = 4 x 125 = 500In general,

Y = Autonomous Spending/(1 – mpc)

= Autonomous Spending/mps

=AutonomousSpend/{marginal propensity to leak}

Spending Multiplier

• The spending multiplier measures the change in equilibrium income (real GDP) produced by change in autonomous expenditures:

ΔY/ΔI

By how many dollars does real GDP change for every dollar change in autonomous

expenditures?

MPS

1

leakages

1Multiplier

Multiplier at Work

Introduce Government Spending: mpc = .75(1)

RealGDP(Y)

(2)

Tax(T)

(3)Disposable

Income(Yd)

(4)ConsumptionC=100+.75 Yd

(C)

(5)Planned

Investment(I)

(6)Gov’t

Spending(G)

(7)Aggregate

Expenditure(AE)

(8)Change in Real GDP

0 0 0 100 25 50 175 Up

100 0 100 175 25 50 250 Up

200 0 200 250 25 50 325 Up

300 0 300 325 25 50 400 Up

400 0 400 400 25 50 475 Up

500 0 500 475 25 50 550 UP

Introduce Government Spending: mpc = .75(1)

RealGDP(Y)

(2)

Tax(T)

(3)Disposable

Income(Yd)

(4)ConsumptionC=100+.75 Yd

(C)

(5)Planned

Investment(I)

(6)Gov’t

Spending(G)

(7)Aggregate

Expenditure(AE)

(8)Change in Real GDP

0 0 0 100 25 50 175 Up

100 0 100 175 25 50 250 Up

200 0 200 250 25 50 325 Up

300 0 300 325 25 50 400 Up

400 0 400 400 25 50 475 Up

500 0 500 475 25 50 550 UP

600 0 600 550 25 50 625 UP

Introduce Government Spending: mpc = .75(1)

RealGDP(Y)

(2)

Tax(T)

(3)Disposable

Income(Yd)

(4)ConsumptionC=100+.75 Yd

(C)

(5)Planned

Investment(I)

(6)Gov’t

Spending(G)

(7)Aggregate

Expenditure(AE)

(8)Change in Real GDP

0 0 0 100 25 50 175 Up

100 0 100 175 25 50 250 Up

200 0 200 250 25 50 325 Up

300 0 300 325 25 50 400 Up

400 0 400 400 25 50 475 Up

500 0 500 475 25 50 550 UP

600 0 600 550 25 50 625 UP

700 0 700 625 25 50 700 No Change

Now add a tax (leakage): mpc = .75(1)

RealGDP(Y)

(2)

Tax(T)

(3)Disposable

Income(Yd)

(4)ConsumptionC=100+.75 Yd

(C)

(5)Planned

Investment(I)

(6)Gov’t

Spending(G)

(7)Aggregate

Expenditure(AE)

(8)Change in Real GDP

200 50 150 212.50 25 50 287.50 Up

300 50 250 287.50 25 50 362.5 Up

400 50 350 362.50 25 50 437.50 Up

500 50 450 437.50 25 50 512.50 UP

700 50 650 587.50 25 50 662.50 DOWN

Now add a tax (leakage): mpc = .75(1)

RealGDP(Y)

(2)

Tax(T)

(3)Disposable

Income(Yd)

(4)ConsumptionC=100+.75 Yd

(C)

(5)Planned

Investment(I)

(6)Gov’t

Spending(G)

(7)Aggregate

Expenditure(AE)

(8)Change in Real GDP

200 50 150 212.50 25 50 287.50 Up

300 50 250 287.50 25 50 362.5 Up

400 50 350 362.50 25 50 437.50 Up

500 50 450 437.50 25 50 512.50 UP

600 50 550 512.50 25 50 587.50 DOWN

700 50 650 587.50 25 50 662.50 DOWN

Now add a tax (leakage): mpc = .75(1)

RealGDP(Y)

(2)

Tax(T)

(3)Disposable

Income(Yd)

(4)ConsumptionC=100+.75 Yd

(C)

(5)Planned

Investment(I)

(6)Gov’t

Spending(G)

(7)Aggregate

Expenditure(AE)

(8)Change in Real GDP

200 50 150 212.50 25 50 287.50 Up

300 50 250 287.50 25 50 362.5 Up

400 50 350 362.50 25 50 437.50 Up

500 50 450 437.50 25 50 512.50 UP

550 50 500 475.00 25 50 550.00 NO Change

600 50 550 512.50 25 50 587.50 DOWN

700 50 650 587.50 25 50 662.50 DOWN

Government Spending Multiplier:

ΔY/ΔG = 1/(1 – mpc) = 1/mps

= 1/(1 - .75) = 1/.25 = 4 in our example

Tax Multiplier:

Y = C + I + G = a + mpc (Y – T) + I + G

(1 – mpc) Y = a + I + G – mpc T

Y = {1/(1-mpc)}{a + I + G – mpc T}

When tax is increased

ΔY = {1/(1-mpc)}{ - mpc ΔT}

ΔY/ ΔT = {- mpc/mps} ΔT

= - .75/.25 = - .75 x 4 = - 3 in our example