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AD’s Role in a Recession and Recovery

AD’s 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.

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AD’s Role in a Recession and Recovery

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  1. AD’s 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.

  2. AD’s 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?

  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.

  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.

  5. 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

  6. Average Propensity to Consume(APC) • APC: total consumption in a given time period divided by total disposable income. • In 2010 U.S. consumers had an APC of 0.942. They saved only 6 cents out of each dollar of disposable income. • APC can be greater than 1 if credit is used to finance current consumption. APC = Total consumption = C Total disposable income YD

  7. Marginal Propensity to Consume(MPC) • MPC: the fraction of each additional (marginal) dollar of disposable income spent on consumption. • MPC is not as high as APC since consumers do not respond to the next dollar earned in the same way as past dollars. As income rises, more saving can occur. MPC = Change in consumption = ΔC Change in disposable income ΔYD

  8. Marginal Propensity to Save (MPS) • MPS: the fraction of each additional (marginal) dollar of disposable income not spent on consumption – that is, saved. • Since added disposable income is either spent or saved, the MPC + MPC = 1 always. MPS = 1 - MPC

  9. The Consumption Function • The two determinants of consumption are • Autonomous consumption. • Income-dependent consumption.

  10. The Consumption Function • Autonomous consumption: consumer spending not dependent on current income. • people consume even if they have no income… • … by borrowing or drawing down savings. • They expect future income changes. • They perceive greater wealth and increase spending, and vice versa. • There is availability of credit. • Tax increases and rebates alter their disposable income. • Income-dependent consumption: consumer spending that increases as income increases, and vice versa.

  11. The Consumption Function • Together they make up the consumption function: • The consumption function allows us to predict how much the consumption component of AD will change when incomes change. C = a + bYD where C = current consumption a = autonomous consumption b = marginal propensity to consume YD = disposable income

  12. 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.

  13. 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.

  14. 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.

  15. 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.

  16. 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.

  17. 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).

  18. 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.

  19. Recessionary GDP Gap • Recessionary GDP gap: the amount by which equilibrium GDP falls short of full-employment 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 thanQF. AS Price level AD P* Recessionary GDP gap P2 Q2 QF QE Real GDP

  20. Inflationary GDP Gap • Inflationary GDP gap: the amount by which equilibrium GDP exceeds full-employment 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 thanQF. AD AS Price level P3 P* Inflationary GDP gap QE Q3 QF Real GDP

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