Chapter 9: Aggregate Spending, part I

We continue to study the AD/AS model of the macro economy. In this chapter we focus solely on the AD curve to get a better understanding of why the AD might shift, leading to business cycles.

Recall that macro equilibrium is the level of price and output where AD and AS intersect. A desirable macro equilibrium is one where real GDP is at its full employment level.

Note that if AD is too low (AD1), real GDP is too low, and unemployment will be too high.
If AD is too high (AD2), real GDP is too high, unemployment is too low, and prices are too high.

How do we get stuck at AD1 or AD2? How can we get back to full employment?
To answer these questions, we take a closer look at four components of aggregate demand:


In part one we focus on consumption.

Consumption (C)

Consumption is the largest component of AD. Recall that consumer spending accounts for 2/3 of GDP in the United States.

Keynes argued that the most important determinant of consumption is disposable income, or income leftover after taxes. Consumers do one of two things with their disposable income: They save it or they spend it:

Disposable income = consumption + saving
or
Yd = C + S

When consumers receive additional disposable income (like a bonus at work) they must decide how much of that addition to save, and how much to spend. The fraction of each dollar of disposable income that is spent is called the marginal propensity to consume (MPC):

For example, suppose I receive an extra $1000 in disposable income for designing an online course and I spend $750 and save $250 of that extra income. My MPC is

Of course, anything I do not consume, I save so that my marginal propensity to save (MPS) is

1 - MPC = 1 - .75 = .25

The MPC is an essential part of our model of consumer behavior.

Disposable income is not the only factor affected consumption decisions. Other factors include:


If we want to model consumer behavior, it can be complicated to look at all of these factors at once, so lets put them in two categories (1) spending that is affected by current income and (2) spending not influenced by current income
Using these two categories, we get the equation

C = a + b(Yd)

where,

C = current consumption
a = autonomous consumption (consumption not influenced by current income)
b = marginal propensity to consumer
Yd = disposable income

The equation above is a model of consumer spending behavior, known as the consumption function.
We can use this equation to predict how changes in income will affect consumer spending.


Example. Recall that I consumer $750 out of an additional $1000 in income, for an MPC = .75. Now suppose my autonomous consumption is $50. This gives me a consumption function of

C = $50 + .75Yd
I can now calculate my consumption spending for various levels of income:
 
Consumption, C
Disposable Income, Yd
A
$125
$100
B
200
200
C
275
300
D
350
400
E
425
500

We can draw a picture of the consumption function using the table above.

In addition to the consumption function, I have also draw a 45-degree line. At point B, where the 2 lines intersect, represents that level of disposable income where C = Yd = 200. At an income of less than 200, C > Yd, or I am dissaving. At an income greater than 200, C < Yd, so I am saving.

The consumption function will shift up or down with any changes in the economy that impact consumer confidence, wealth, credit, and taxes. For example, suppose credit card companies cut back on issuing credit cards to college students. This means that college students will be consuming less at every income level because they will not be able to finance purchases with their own credit card. As a result, the aggregate consumption function will shift down:

This would also affect aggregate demand as well: a downward shift in the consumption function implies a decrease (shift left) in aggregate demand.

The table below summarizes how factors will affect the consumption function and aggregate demand:
shift factor
consumption function
aggregate demand
increase in consumer confidence
increase (shift up)
increase (shift right)
increase in wealth
increase (shift up)
increase (shift right)
increase in credit
increase (shift up)
increase (shift right)
increase in cost of credit
decrease (shift down)
decrease (shift left)
increase in taxes
decrease (shift down)
decrease (shift left)

In part two of chapter 9, we continue looking the 3 remaining components of aggregate demand: investment, government spending, and net exports.

FYI: Related Links

Surveys of Consumers An ongoing survey by the University of Michigan used to gauge consumer confidence.

The Wealth Effect An article on Policy.com discussing whether stock market gains of the 1990s fueled rising consumer spending.