13e

Chapter 09:
Aggregate Demand

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

ADs Role in a Recession and

Recovery
In the Great Recession, spending
decreased across the board and
layoffs occurred in many industries.
AD declined. It shifted left away from
full-employment GDP as the country fell
into recession.
To escape from recession, AD must
increase. The AD curve must shift to the
right toward full-employment GDP.
9-2

ADs Role in a Recession and

Recovery
In this chapter we explore what is behind
the AD curve. Specifically, what causes
AD to shift?
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?
9-3

Learning Objectives
09-01. Know what the major components
of aggregate demand are.
09-02. Know what the consumption
function tells us.
09-03. Know the determinants of
investment spending.
09-04. Know how and why AD shifts
occur.
09-05. Know how and when macro failure
occurs.
9-4

Macro Equilibrium
In the macro model, AD and AS intersect.
This is macro equilibrium.

Macro equilibrium: the combination of

price level and real output that is
compatible with both AD and AS.
The rate of output equals the rate of
spending.
If there are no disturbances, the economy
gravitates to macro equilibrium.

9-5

Adjusting Macro Equilibrium

Macro equilibrium is
occurring where AD1
intersects AS. This is
insufficient to ensure full
employment.
QE < Q F .

The economy is producing

below capacity, so there
is high unemployment.
How can AD shift right to
AD2 and full employment?

9-6

Components of AD
The four components of AD are
Consumption (C).
Investment (I).
Government spending (G).
Net exports (X M).

9-7

Consumption (C)
Consumption (C): expenditure by
consumers on final goods and services.
Accounts for over two-thirds of total spending.
Consumers tend to spend most of their
disposable income (YD) that is, income
remaining after taxes. They save the rest.
Saving (S): Disposable income not spent as
consumption (C).
Disposable income = Consumption + Saving
YD = C + S
9-8

Marginal Propensity to
Consume
(MPC)

MPC: the fraction of each additional

(marginal) dollar of disposable
income spent on consumption.
MPC

Change in consumption

Change in disposable income

C
YD

9-9

AD Shift Factors
A change in consumption (C) causes AD to shift.
Thus AD will shift in response to changes in

Income.
Expectations (consumer confidence).
Wealth.
Credit conditions.
Tax policy.

In 2008-2009, home equity fell (wealth decrease)

and consumer confidence fell. AD shifted left,
resulting in the Great Recession.
Shifts in AD can be a cause of macro instability.
9-10

Investment
Investment: expenditures on new
plants, equipment, and structures, plus
changes in inventories.

Includes fixed investment and inventory

investment.
Favorable expectations of future sales are
necessary for investment spending.
Investment spending is inversely related to
interest rates, ceteris paribus.
Technological advances stimulate
investment spending.

9-11

The Investment Function

Investment spending
is inversely related to
the interest rate.
If expectations of
future sales improve,
the investment
function shifts right, as
will AD. Vice versa
applies.
Investment spending
is the most volatile
category of spending.
9-12

Government Spending
Because of balanced budget requirements,
state and local spending will decrease when
consumption and investment spending
decrease. This contributes to instability.
Because of deficit spending, federal spending
can be increased to counter spending
decreases in the other components.
This is the basis of Keynesian demand-side policy.

9-13

Net Exports (X M)
Economic downturns in other lands lead
to a decrease in U.S. exports (X), and
vice versa.
Economic downturns in the U.S. lead to
a decrease in U.S. imports (M), and vice
versa.
If X M decreases, AD shifts left.
If X M increases, AD shifts right.
9-14

Macro Failure

Panel (a) is where we want to be.

Panel (b) is when macro equilibrium occurs with high unemployment
(too little AD).
Panel (c) is when macro equilibrium occurs with too much inflation (too
much AD).

9-15

Macro Failure
Two concerns about macro equilibrium:
Macro equilibrium might not give us full
employment or price stability.
Even when macro equilibrium is perfectly
positioned, it might not last.

Equilibrium with cyclical unemployment (too

little AD) occurs with a recessionary GDP gap.
Equilibrium with demand-pull inflation (too
much AD) occurs with an inflationary GDP
gap.

9-16

 Recessionary GDP
gap: the amount by
which equilibrium
GDP falls short of fullemployment GDP.
At P*, too much would
be produced. There are
unsold inventories. We
cut back production
and lay off workers.
Equilibrium occurs at
P2 and QE, which is less
than QF.

Price level

Recessionary GDP Gap

AS
AD

P*
P2

Recessionary
GDP gap

Q2 QE QF Real GDP
9-17

 Inflationary GDP
gap: the amount by
which equilibrium GDP
exceeds fullemployment GDP.
At P*, not enough
would be produced.
With inventories
depleted, we begin to
strain capacity and
prices rise.
Equilibrium occurs at P3
and QE, which is greater
than QF.

Price level

Inflationary GDP Gap

AD

AS

P3
P*

Inflationary
GDP gap

Q3
QF QE
Real GDP
9-18

The Economy Tomorrow

Anticipating AD shifts.
How can policy makers tell what is
going to happen next?
The Index of Leading Indicators is a list of
10 gauges that are supposed to indicate
in what direction the economy is moving.
Included are equipment orders, consumer
confidence, and building permits.
9-19

The Economy Tomorrow

How is the index used?
When the index rises it is viewed as good news
for the economy (and vice versa).
Changes in the index are used to forecast
changes in GDP and turns in the business cycle.

The purpose of this index is to help predict

movements in GDP and the business cycle
in the economy tomorrow.

9-20

Index of Leading Indicators

Indicator
1. Average workweek

2. Unemployment claims

3. New orders

4. Delivery times

5. Equipment orders

6. Building permits
7. Stock prices

8. Money supply

9. Interest rates

Expected Impact
Hours worked per week typically
increase when greater output and
sales are expected.
Initial claims for unemployment
benefits reflect changes in industry
layoffs.
New orders for consumer goods
trigger increases in production and
employment.
The longer it takes to deliver ordered
goods, the greater the ratio of
demand to supply.
Orders for new equipment imply
increased production capacity and
higher anticipated sales.
A permit represents the first step in
housing construction.
Higher stock prices reflect
expectations of greater sales and
profits.
Faster growth of the money supply
implies a pickup in aggregate
demand.
Larger differences between long- and

9-21

Revisiting the Learning

Objectives
09-01. Know what the major
components of aggregate demand are.
The components are consumption (C), investment (I),
government spending (G), and net exports (X - M).
C is influenced by nonincome factors and by current
income, as indicated in the consumption function.
I depends on interest rates, expectations of future sales,
and innovation.
G depends on budgetary restraints and borrowing.
X M depends on market factors in the buying nation.

9-22

Revisiting the Learning

Objectives
09-02. Know what the consumption
function tells us.
It tells us that consumption spending (C) has
two components, one of which is autonomous
and the other is income-dependent.
The upward slope of the consumption function
is the marginal propensity to consume (MPC).

9-23

Revisiting the Learning

Objectives
09-03. Know the determinants of
investment spending.
Investment spending depends on interest
rates, expectations of future sales, and
innovation.

9-24

Revisiting the Learning

Objectives
09-04. Know how and why AD shifts
occur.
AD shifts right if any of the four
components increase:

C increases.
I increases.
G increases.
X M increases.

Vice versa applies for AD to shift left.

9-25

Revisiting the Learning

Objectives
09-05. Know how and when macro
failure occurs.
Macro failure occurs when the economy
fails to achieve full employment and price
stability.
Macro failure can be caused by
Too little aggregate demand (causing cyclical
unemployment).
Too much aggregate demand (causing
demand-pull inflation).
9-26