Lecture 16: Aggregate Demand PDF

Introduction to Economics ECON 10770 Dr Kevin Denny Lecture 16: Aggregate Demand ©McGraw-Hill Education, 2024  What Is Aggregate Demand? Reading: Chapter 19 “Aggregate demand is the amount firms and households plan to spend at each level of income” Macro level...

Introduction to Economics ECON 10770 Dr Kevin Denny Lecture 16: Aggregate Demand ©McGraw-Hill Education, 2024  What Is Aggregate Demand? Reading: Chapter 19 “Aggregate demand is the amount firms and households plan to spend at each level of income” Macro level – for the entire economy In contrast, first part of module looked at demand for an individual or household ©McGraw-Hill Education, 2024  Simplifying Assumptions Needed because aggregate demand is difficult to model For now: ASSUME no government and no trade ASSUME prices and wages are fixed ©McGraw-Hill Education, 2024  Likely Consequences of Assumptions Some workers cannot find jobs Some machinery not used Actual output less than potential output Focus is on short run ©McGraw-Hill Education, 2024  Potential and Actual Output Book uses concepts of potential and actual output Potential output = economy’s output if all factors were fully employed &all markets are in LR equilibrium Actual output = economy’s output during a period – Could be lower than potential output but should not be much higher Output gap = Potential-Actual ©McGraw-Hill Education, 2024  Are Wages Fixed? Wages are sometimes “sticky” – Do not drop immediately in recessions – After recessions, firms are often slow to raise wages – Public sector wage changes often scheduled in agreements with unions Drop in public sector wages in Ireland at start of Great Recession was unusual People seem to mind nominal wage cuts more than real ones ©McGraw-Hill Education, 2024  Back to Aggregate Demand Investment = firms’ desired or planned additions to physical capital and inventories Consumption = households’ demand for goods and services AD = C + I No G, NX for now ©McGraw-Hill Education, 2024  Consumption Households allocate income (Y) between consumption (C) and saving (S) Thus, consumption depends on income (and saving) In linear form: C = A + c*Y A = Autonomous consumption c = marginal propensity to consume Consumption function invented by J M Keynes ©McGraw-Hill Education, 2024  Consumption Function Consumption function shows desired aggregate consumption at each level of aggregate income. Consumption With zero income, C = A + c* Y desired consumption is a (“autonomous consumption”). c The marginal 1 propensity to A consume (the slope of the function) is c – i.e. 0 for each additional €1 of Income income, c cents are ©McGraw-Hill Education, 2024 consumed.  Saving In our simple model, any income that is not consumed is saved: Y = C + S Consumption function: C = A + c*Y If Y = C + S, then C = Y – S Y – S = A + c*Y Y = S + A + c*Y Y – (A + c*Y) = S S = -A + (1-c)*Y ©McGraw-Hill Education, 2024 Saving The Saving Function The saving function shows desired saving at each income level. Because all income is S = -A + (1-c)*Y either saved or spent on consumption, the saving 0 function can be derived Income from the consumption function or vice versa. MPS=1-MPC =1-c ©McGraw-Hill Education, 2024  Investment How do firms decide how much to invest? Too complicated for Introduction to Economics! Just assume a level of investment I – Does not depend on income or anything else. – Book calls this “autonomous” ©McGraw-Hill Education, 2024 Aggregate demand Aggregate Demand Schedule AD = C + I Aggregate demand is what households plan to spend on C consumption and what firms plan to spend on investment. The AD function is the vertical addition of C and I. Income AD = (A + I) + c*Y ©McGraw-Hill Education, 2024  Move along or Shift AD? Just like D (and S), we need to be able to distinguish movements along AD from shifting the entire AD curve Movement along: change in income (Y) Shift: change in something else ©McGraw-Hill Education, 2024  Activity 19.1: Name that Shift / Movement Does the following result in a shift in, a shift out, or a movement along the AD? 1. Irish increase their saving rate in response to Brexit 2. Irish government gives each household €50 3. 2017 Women’s Rugby World Cup creates investment boom in Irish construction ©McGraw-Hill Education, 2024  Equilibrium Output How does the macro economy reach an equilibrium? Equilibrium is when aggregate demand equals output, i.e. Y = AD Different from micro equilibrium of supply = demand We ignore supply constraints ©McGraw-Hill Education, 2024  Equilibrium Output 45o line The 45o line shows the (Desired) Spending points at which E AD desired spending equals output or income. Given the AD schedule, equilibrium is thus at E. Output, Income This is the point at which planned spending equals ©McGraw-Hill Education, 2024 actual output and  What If Actual Output is below AD? 45o line Suppose income is Y1. (Desired) Spending E At that level of AD income, AD = F. F However, output is only B. B Firms hire more workers, so income and output go up. Y1 Y* This continues until Output, Income income is Y* ©McGraw-Hill Education, 2024  What If Actual Output is above AD? 45o line H Suppose income is Y2. (Desired) Spending V At that level of AD income, AD = V. E However, output is H. Firms reduce output and workers, so income and output go down. Y* Y2 This continues until Output, Income income is Y* ©McGraw-Hill Education, 2024  Equilibrium, Saving, and Investment Saving function: S = -A + (1-c)*Y Y=C+S We assume I is fixed In equilibrium, Y = AD = C + I In equilibrium, I = S ©McGraw-Hill Education, 2024  I = S in Equilibrium An equivalent view S, I of S equilibrium is seen by equating planned investment (I) to E I planned saving (S), again giving us equilibrium at E. Output, Income This approach (I=S) gives same equilibrium as earlier approach where AD = Y. ©McGraw-Hill Education, 2024  Equilibrium Algebra In equilibrium Y = AD = C + I Y = [A + c* Y] + I Y = [A + I] + c* Y Or … Y – c *Y = A + I (1 – c ) * Y = A + I Y* = [A + I] / (1 – c ) Can also show I = -A + (1 – c)* Y* = S ©McGraw-Hill Education, 2024 Consumption function revisited In the Keynesian model used here current consumption depends on current income  Time doesn’t enter the model In more realistic models, consumption depends on more long run income, “permanent income” (Milton Friedman) People “smooth” consumption over time So consumption responses to short run changes in income are smaller ©McGraw-Hill Education, 2014 Evidence for Nigeria ©McGraw-Hill Education, 2014 USA Korea ©McGraw-Hill Education, 2014  Expectations for This Lecture Understand AD, consumption function, savings function Explain AD what causes shifts vs. movements along AD Comprehend equilibrium in macro demand ©McGraw-Hill Education, 2024