Aggregate Demand and Aggregate Supply 21.1
21 c h a p t e r
WHAT IS AGGREGATE DEMAND?
Aggregate demand (AD) is the sum of the demand for all final goods and services in the economy. It can also be seen as the quantity of real gross domestic product demanded at different price levels. The four major components of aggregate demand are consumption (C), investment (I), government purchases (G), and net exports (X 2 M). Aggregate demand, then, is equal to C 1 I 1 G 1 (X 2 M).
CONSUMPTION (C )
Consumption is by far the largest component in aggregate demand. Expenditures for consumer goods and services typically absorb almost 70 percent of total economic activity, as measured by GDP. Understanding the determinants of consumption, then, is critical to an understanding of the forces leading to changes in aggregate demand, which in turn, change total output and income.
Does Higher Income Mean Greater Consumption?
The notion that the higher a nation's income, the more it spends on consumer items has been validated empirically. At the level of individuals, most of us spend more money when we have higher incomes.
But what matters most to us is not our total income but our after-tax or disposable income.
Moreover, other factors might explain consumption.
Some consumer goods are “lumpy”; that is, the expenditures for these goods must come in big amounts rather than in small dribbles. Thus, in years in which a consumer buys a new car, takes the family on a European trip, or has major surgery, consumption may be much greater in relation to income than in years in which the consumer does not buy such high-cost consumer goods or services. Interest rates also affect consumption because they affect savings. At higher real interest rates, people save more and consume less. At lower real interest rates, people save less and consume more.
The Average and Marginal Propensity to Consume
The typical household spends a large portion of its disposable income and saves the rest. The fraction of total disposable income that a household spends on consumption is called the average propensity to consume (APC). For example, a household that consumes $450 out of $500 disposable income has an APC of 0.9 ($450/$500). However, a household tends to behave differently with additional income than with income as a whole. How much increased consumption results from an increase in income?
That depends on the marginal propensity to consume (MPC), which is the additional consumption that results from an additional dollar of disposable income. For example, if a household’s consumption increases from $450 to $600 when disposable income increases from $500 to $700, what is that household’s marginal propensity to consume out of disposable income? First, we calculate the change in consumption: $600 2 $450 5 $150. Next, we calculate the change in income: $700 2 $500 5 $200.
The marginal propensity to consume, then, equals change in consumption divided by change in disposable income, which in this example is
MPC 5 Consumption/Disposable income 5
$150/$200 5 3/4 5 0.75 Thus, for each additional dollar in after-tax income over this range, this household consumes threefourths of the addition, or 75 cents.
INVESTMENT (I )
Because investment spending (purchases of investment goods) is an important component of aggregate demand, which in turn is a determinant of the level of GDP, changes in investment spending are often responsible for changes in the level of economic activity. If consumption is determined largely by the level of disposable income, what determines the level of investment expenditure? As you may recall, investment expenditure is the most unstable
438 CHAPTER TWENTY-ONE | Aggregate Demand and Aggregate Supply
The Determinants of Aggregate Demand
s e c t i o n
21.1
_ What is aggregate demand?
_ What is consumption?
_ What is investment?
_ What is government purchases?
_ What are net exports?
category of GDP; it is sensitive to changes in economic, social, and political variables. In 2001, investment was roughly 16 percent of GDP.
Many factors are important in determining the level of investment. Good business conditions “induce” firms to invest, because a healthy growth in demand for products in the future is likely based on current experience. We will consider the key variables that influence investment spending in the next section.
GOVERNMENT PURCHASES (G)
Government purchases, another component of aggregate demand, is spending by the federal, state, and local governments on the purchases of new goods and services produced. Most of the purchases at the federal level are for the military. In 2001, the federal government accounted for slightly more than 17 percent of total spending. Government purchases at the state and local levels include education, highways, and police protection. While volatile shifts in government purchases are less frequent than volatile shifts in investment spending, they do occasionally occur, often at the beginning or end of wars.
NET EXPORTS (X 2 M)
The interaction of the U.S. economy with the rest of the world is becoming increasingly important. Up to this point, for simplicity, we have not included the foreign sector. However, international trade must be incorporated into the framework. Models that include the effects of international trade are called open economy models.
Remember, exports are goods and services we sell to foreign customers, like movies, wheat, and Ford Mustangs; imports are goods and services we buy from foreign companies, like BMWs, French wine, and Sony TVs. Exports and imports can alter aggregate demand. Exports minus imports is what we call net exports. If exports are greater than imports, we have positive net exports (X > M). If imports are greater than exports, net exports are negative (X < M).
The impact of net exports (X 2 M) on aggregate demand is similar to the impact of government purchases on aggregate demand. Suppose the United States has no trade surplus and no trade deficit—zero net exports. What happens if foreign consumers start buying more U.S. goods and services while U.S. consumers continue to buy imports at roughly the same rate? The result would be positive net exports (X > M) and greater demand for U.S. goods and services—a higher level of aggregate demand. What if a country has a trade deficit? Assuming, again, that the economy initially had zero net exports, a trade deficit, or negative net exports
(X < M), would lower U.S. aggregate demand, ceteris paribus.
The Determinants of Aggregate Demand 439
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The aggregate demand curve reflects the total amount of real goods and services that all groups together want to purchase in a given period. In other words, it indicates the quantities of real gross domestic product demanded at different price levels.
Note that this is different from the demand curve for a particular good presented in Chapter 4, which looked at the relationship between the relative price of a good and the quantity demanded.
HOW IS THE QUANTITY OF REAL GDP DEMANDED AFFECTED BY THE PRICE LEVEL?
The aggregate demand curve slopes downward, which means that there is an inverse (or opposite) relationship between the price level and real gross domestic product (RGDP) demanded. Exhibit 1 illustrates this relationship, where the quantity of RGDP demanded is measured on the horizontal axis and the overall price level is measured on the vertical axis. As we move from point A to point B on the aggregate demand curve, we see that an increase in the price level causes RGDP demanded to fall. Conversely, if a reduction in the price level occurs, a movement from B to A, RGDP demanded increases. Why do purchasers in the economy demand less real output when the price level rises and more real output when the price level falls?
WHY IS THE AGGREGATE DEMAND CURVE NEGATIVELY SLOPED?
Three complementary explanations exist for the negative slope of the aggregate demand curve: the real wealth effect, the interest rate effect, and the open economy effect.
The Real Wealth Effect
If you had $1,000 in cash stashed under your bed while the economy suffered a serious bout of inflation, the purchasing power of your cash would be
440 CHAPTER TWENTY-ONE | Aggregate Demand and Aggregate Supply
1. Aggregate demand is the sum of the demand for all final goods and services in the economy. It can also be seen as the quantity of real GDP demanded at different price levels.
2. The four major components of aggregate demand are consumption (C), investment (I), government purchases (G), and net exports (X 2 M). Aggregate demand, then, is equal to C 1 I 1 G 1 (X 2 M).
3. Empirical evidence suggests that consumption increases directly with any increase in income.
4. The additional consumption spending stemming from an additional dollar of disposable income is called the marginal propensity to consume (MPC).
5. Changes in investment spending are often responsible for changes in the level of economic activity.
6. Government purchases are made up of federal, state, and local purchases of goods and services.
7. Trade deficits lower aggregate demand, other things equal; trade surpluses increase aggregate demand, other things equal.
1. What are the major components of aggregate demand?
2. If consumption is a direct function of disposable income, how would an increase in personal taxes or a decrease in transfer payments affect consumption?
3. Would you spend more or less on additional consumption if your marginal propensity to consume increased?
4. What would an increase in exports do to aggregate demand, other things equal? An increase in imports? An increase in both imports and exports, where the change in exports was greater in magnitude?
s e c t i o n c h e c k
The Aggregate Demand Curve
21.2
_ How is the aggregate demand curve different from the demand curve for a particular good?
_ Why is the aggregate demand curve downward sloping?
eroded by the extent of the inflation. That is, an increase in the price level reduces real wealth and would consequently decrease your planned purchases of goods and services, lowering the quantity of RGDP demanded.
In the event that the price level falls, the reverse would hold true. A falling price level would increase the real value of your cash assets, increasing your purchasing power and increasing RGDP demanded.
The connection can be summarized as follows:
yPrice level k vReal wealth k vPurchasing power
k vRGDP demanded
and
vPrice level k yReal wealth k yPurchasing power
k yRGDP demanded
The Interest Rate Effect
If the price level falls, households and firms will need to hold less money to conduct their day-to-day activities. Firms will need to hold less money for inputs like wages and taxes; households will need to hold less money for purchases like food, rent, and clothing. At a lower price level, households and firms will shift their “excess” money into interestearning assets like bonds or savings accounts. This will increase the supply of funds to the loanable funds market, leading to lower interest rates. As interest rates fall, households and firms will borrow more and buy more goods and services—thus, the quantity of RGDP demanded will increase. In sum:
v Price Level k Households and firms reduce their holdings of money k Supply of loanable funds increases k Interest rates fall k Households and firms are encouraged to borrow k RDP demanded increases
If the price level rises, households and firms will need to hold more money to buy goods and service and conduct their daily activities. Households and firms will need to borrow money, and this increased demand for loanable funds results in higher interest rates. At higher interest rates, consumers may give up plans to buy new cars or houses, and firms may delay investments in plant and equipment. In sum:
yPrice Level k Households and firms increase their holdings of money k Demand for loanable funds increases k Interest rates rise k Households and firms are discouraged from borrowing k RDP demanded decreases
The Open Economy Effect
Many goods and services are bought and sold in global markets. If the prices of goods and services in the domestic market rise relative to those in global markets due to a higher domestic price level, consumers and businesses will buy more from foreign producers and less from domestic producers.
Because real GDP is a measure of domestic output, the reduction in the willingness of consumers to
The Aggregate Demand Curve 441
0 PL1
PL2
RGDP2 RGDP1
Price Level
AD
RGDP
A B
SECTION 21.2
EXHIBIT 1
The aggregate demand curve slopes downward, reflecting an inverse relationship between the overall price level and the quantity of real GDP demanded. When the price level increases, the quantity of RGDP demanded decreases; when the price level decreases, the quantity of RGDP demanded increases.
buy from domestic producers leads to a lower real GDP demanded at the higher domestic price level.
And if domestic prices of goods and services fall relative to foreign prices, consumers and businesses will buy more from domestic producers and less from foreign producers, increasing real GDP demanded.
This relationship can be shown as follows:
yPrice level k vDemand for domestic goods
vPrice level k yDemand for domestic goods
SHIFTS VERSUS MOVEMENTS ALONG THE AGGREGATE DEMAND CURVE
Like the supply and demand curves described in Chapter 4, the aggregate demand curve can experience both shifts and movements. In the previous section, we discussed three factors—the real wealth effect, the interest rate effect, and the open economy effect—that result in the downward slope of the aggregate demand curve. Each of these factors, then, generates a movement along the aggregate demand curve, in reaction to changes in the general price level. In this section, we will discuss some of the many factors that can cause the aggregate demand curve to shift to the right or left.
The whole aggregate demand curve can shift to the right or left, as seen in Exhibit 1. Put simply, if some non–price level determinant causes total spending to increase, the aggregate demand curve will shift to the right. If a non–price level determinant causes the level of total spending to decline, the aggregate demand curve will shift to the left.
Let’s look at some specific factors that could cause the aggregate demand curve to shift.
AGGREGATE DEMAND CURVE SHIFTERS
Anything that changes the amount of total spending in the economy (holding price levels constant) will affect the aggregate demand curve. An increase in any component of GDP (C, I, G, and X 2 M) will cause the aggregate demand curve to shift rightward. Conversely, decreases in C, I, G, or (X 2 M) will shift aggregate demand leftward.
442 CHAPTER TWENTY-ONE | Aggregate Demand and Aggregate Supply
1. An aggregate demand curve shows the inverse relationship between the amounts of real goods and services (RGDP) that are demanded at each possible price level.
2. The aggregate demand curve is downward sloping because of the real wealth effect, the interest rate effect, and the open economy effect.
1. Why is the aggregate demand curve downward sloping?
2. How does an increased price level reduce the quantities of investment goods and consumer durables demanded?
3. What is the real wealth effect, and how does it imply a downward-sloping aggregate demand curve?
4. What is the interest rate effect, and how does it imply a downward-sloping aggregate demand curve?
5. What is the open economy effect, and how does it imply a downward-sloping aggregate demand curve?
Shifts in the Aggregate Demand Curve
21.3
_ What is the difference between a movement along and a shift in the aggregate demand curve?
_ What variables shift the aggregate demand curve to the right?
_ What variables shift the aggregate demand curve to the left?
Changing Consumption (C)
A whole host of changes could alter consumption patterns. For example, an increase in consumer confidence, an increase in wealth, or a tax cut can increase consumption and shift the aggregate demand curve to the right. An increase in population will also increase the aggregate demand because more consumers will be spending more money on goods and services.
Of course, the aggregate demand curve could shift to the left due to decreases in consumption demand.
For example, if consumers sensed that the economy was headed for a recession or if the government imposed a tax increase, the result would be a leftward shift of the aggregate demand curve. Because consuming less is saving more, an increase in saving, ceteris paribus, will shift aggregate demand to the left. Consumer debt can also cause some consumers to put off additional spending. In fact, some economists believe that part of the 1990–1992 recession was due to consumer debt that had built up
Shifts in the Aggregate Demand Curve 443
Price Level RGDP
0 AD3 AD1 AD2
Decrease Increase Left Right
SECTION 21.3
An increase in aggregate demand shifts the curve to the right (from AD1 to AD2...
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