Aggregate Spending Model: Keynesian Approach relating Total Spending to Income
In Classical View
To be in equilibrium
total supply and total demand must be equal.
Production must equal purchases
BUT: what forces operate to achieve this?
Market forces will determine a price level
Potential Problems with Macroequilibrium
Undesirable: The equilibrium may be more or less than our full employment capacity.
Unstable: Aggregate Demand and Supply can be moving due to other factors, like external shocks or expectations.
Macro- equilibrium and the price mechanism: Does it work?
Total Demand and Supply depend somewhat on the price level.
BUT not in the simple way as SAY’s law suggests.
The production of a good does result in an equal amount of income
BUT it does not necessarily result in an equal amount of spending.
Demand Side approaches to policy
Fiscal : Change taxes and spending - to affect total demand. Most directly Keynesian
Monetary : focus on the money supply and interest rates to affect demand.
Aggregate Spending Model
So– important to study the relationship of Spending and Income.
Keynesian model of spending
Components of Total Spending:Keynes’ concerns
Consumption depends on income, but people do not spend all of their income.
Investment: Depends on expectations more than income from production.
Government : up to us
Exports - Imports (depends on global effects: later)
Why production does not necessarily => spending
the amount people save will reduce the amount of spending on consumption
If all of savings became investment (purchases of capital goods) , this would even out
Exports may not = Imports (later)
Government : up to us
Why production does not necessarily => spending
Flow: Production -> income ->spending -> production
But we will have
Leakages : amount of income that are not spent
Injections : spending that is does not determined by income
Total spending = C +I+G+Xn
Issues in the Keynesian Model
Disequilibrium: Total Spending and Output may not be equal if Leakages not equal to Injections.
Equilibrium can be at less than potential output.
Fiscal Policy: Gov’t spending and taxation can be used to affect Spending
GETTING THE TERMS STRAIGHT
Aggregate = Total
Expenditure = Spending
Output = real GDP
Income (expressed as Y)
Identities and Conditions
Always the case
Total Spending = C + I(actual)+ G + Xn
Output (=GDP) = Income
Only true in Expenditure Equilibrium
Total Spending = Output
OUTPUT must = INCOME
OUTPUT = Spending ???
Preview of DISEQUILIBRIUM
How can output be different from Spending?
All parts of Expenditure are included
Government spending (G)
Net exports (X - IM)
Purchases by households
Cost of Credit (interest rate)
Income ß key connection
Why is it so important in our model?
Strongest determinant of consumption
Linked to output (since we get our incomes from production)
Can use to predict how changes in income affect consumer spending.
Consumption has two components:
Autonomous : a
Depending on income:
MPC x Y
MPC = marginal propensity to consume
Y = Income (disposable)
If GDP is $2,000 billion; the MPC is .75 and the autonomous consumption is $100bil., what is consumption?
Y= _________ a= _________
C = _______ + _______________
To find consumption for each level of income (or output, since output = income) we can use the equation:
C = A + (MPC) x Y disposable
In this situation :
C = $100 billion + (.75) x Y
Draw a graph of the level of consumption at different levels of income.
Shows how consumption increases as income increases
At the rate of consumers’ MPC = Slope of the Consumption Function
Change in C caused by change in Income
Note that the consumption function is already written in the form of an equation for a line.
Change in Consumption due to other factors not related to income
Several factors affect consumption even if income stays the same:
Consumer expectations (confidence)
People who anticipate a pay raise often increase spending before extra income is received.
People who expect to be laid off tend to save more and spend less.
Measure of "consumer confidence" used as a leading indicator
Changes in Wealth
Changes in the values of important assets – stocks, houses
Changes in total savings or debt
Can change the amount consumers spend
The stock market boom of 1996-1999 increased the value of household wealth AND increased expectations of future income.
Effect added 1 point to the percentage consumed out of income in 1997 and 1998.
The reverse occurred in 2001 when stock values fell
Change in wealth also changes the amount saved.
In 1998, Americans spent more money than they received in after-tax income.
Negative personal savings rate for the first time since 1959.
This left Americans with a large amount of debt –
Made the 2001 fall in consumption worse?
If interest rates fall, it is cheaper to borrow to buy now
Consumption will increase in the current period
Fall in interest rates for auto purchases in 2002
Availability of credit
If it is easier to get a loan or buy on credit, consumers will buy more
If consumer income tax increases, disposable income decreases at the same level of output (national income)
Therefore, consumption decreases.
Taxes can change independent of income.
If the price level increases, there is no reason that real income changes
Aggregate demand model : increase prices have wealth, credit , trade effects.
In this model, we ignore the price effects. To see price effects, use AS/AD model
Autonomous part of consumption
These factors change the amount of consumption not related to income
This is the "autonomous" part of the consumption equation
Any change in the autonomous part will shift the consumption line up or down by the change in consumption
Shift Caused by a Change in ‘autonomous factors’
Shift in Consumption Function also shifts of Aggregate Demand
An upward shift of the consumption function
- > Means more spending at each price level
= a rightward shift of the aggregate demand curve.
Shifts of Aggregate Demand
Total spending = C + I + G + Xn
To find the total amount of spending, we must
Add Investment, Gov’t spending, and (exports – imports)
Spending on (production of) new capital (plant, equipment, and structures)
Changes in inventories is not spending.
While much of savings is directed into investment,
Investment is not the same as savings
Investment is determined by factors other than income.
Investment Determined by.
Expected Rate of returnFuture sales
Future sales price
Cost of investment
Changes in Technology
Difference between desired and optimal capital stock.
Access to funds.
Adding Investment to Consumption
Taxes receipts change when output/income changes
State, local government spending are generally limited to taxes
Federal government can spend more or less than taxes
Net effect: spending not determined by income
Govt spending : business cycle
State/local: since taxes will decrease when income decreases
and spending is limited by taxes
State/local spending tends to be pro-cyclical
Ex. current state budget cuts may lower spending during growth recession
Government spending related to business cycle
Federal govt can run a deficit
While taxes fall during a recession (raising disposable income)
certain federal govt expenditures increase during a recession
So – tends to be counter cyclical
Export sales depend primarily on
depend on exchange rate
may increase or decrease with income.
Conclusion: Net Exports (exports- imports) depend little if at all on income.
Net Exports usually negative
During most recent period
Exports have been less than imports
Net exports have been negative
=> Trade deficit
Will Spending be at the correct level?
We want the macroeconomic equilibrium to be at full employment.
Spending must be at the right level for this to occur.
This is the critical question asked by the Keynesian model.
What if full employment output/income were $3,000?
The level of spending is less than required if
the amount of desired spending
that would exist at the full employment level of output
is not enough to sustain the economy.
Measuring the Recessionary Gap
the amount by which total spending at full-employment
falls short of full-employment output.
If economy has full employment output at $3,000?
At an output of $3,000 bil.
C+I+G+Xn = 2750
Not all output would be sold
Inventories would be increasing
producers may react to the spending short-fall by
cutting back on production
laying off workers.
Result: Macro Failure
The economy cannot sustain output at the full employment level
The economy moves to an Equilibrium at a lower level of output
à Unemployment equilibrium
back to the Aggregate
Supply and Demand model
This situation is the same as
Where the equilibrium in the AS/AD model is below full employment level
This difference is called the Real GDP Gap
Equilibrium below Full Employment
Relation to Business Cycle
Recessionary gaps are a primary cause of cyclical unemployment.
(the unemployment due to a lack of jobs)
In a boom, we may get to full employment,
But if aggregate expenditure falls,
the economy will move to a lower equilibrium output.
A Decline in some part of Total Expenditure:
What if equilibrium is above full employment level?
an inflationary gap would exist.
total spending at full-employment is more than full-employment output.
Therefore, even if the economy could move to equilibrium, it would cause inflation.
if full employment Y is at 1250
Doomed to Macro Failure?
Keynes believed macro failure was likely in a market-driven economy.No reason to expect that total spending would = total output at full employment.
Leakages (savings, imports, taxes) not tied to Injections (Investment, exports, govt spending)
Spending not simply related to prices,
Doomed to Macro Failure?
If Demanders want to spend less than full-employment output at current price levels à cyclical unemployment
If total spending exceeds the amount of output à demand-pull inflation