FRIEDRICH HAYEK 1899 1992 Prominent classical or Neoliberal

FRIEDRICH HAYEK (1899 -1992) Prominent classical (or Neoliberal) economist Winner of the 1974 Nobel in Economics Argued for recovery from Great Depression with increased PRIVATE investment NOT government spending

Aggregate Demand Unit 3, Ch. 9

INTRODUCTION TO CONSUMPTION I’m just a poor college student…

WELCOME TO IMPOVERISHED U. ! Your campus job pays $100 week after taxes. Mom and Dad are paying for tuition, room, and yucky inconvenient board, but it is up to you to cover the rest. Here are your expenses: � � � � � Textbooks ($20) Economics Tutor ($20) Ticket to 1 Movie ($10) Cell phone bill ($20) 14 Packets Easy. Mac…cheap lunch & dinner ($7) 7 Pop-Tarts…cheap breakfast ($4) 3 Starbucks Lattes ($9) Car Insurance ($40) Essential Medication ($10)

DISCUSSION QUESTIONS On only $100… Needs? Living large… If income>expenses � Spend Wants? � Save more?

CONSUMPTION SCHEDULE Item Weekly Cost Textbooks 20 Econ Tutor 20 Movie Tix 10 Cell Ph. Bill 20 Easy-Mac 7 Pop-Tarts 4 Lattes 9 Car Ins. 40 Essential Meds Total Expenses 10 $140. 00 $100 after $150 after $250 after $1, 000 tax tax after tax

Consumption Spending COLLEGE CONSUMPTION FUNCTION Disposable Income

AGGREGATE DEMAND (CH. 9) Unit 3: Cyclical Instability

KEYNES’ KEY QUESTIONS What goes into AD? What determines spending? Is there enough AD to meet preferred (full employment r. GDP?

FOCUS ON CONSUMPTION GDP=C+I+G+(X-M)

CONSUMPTION 66% of GDP Increases in income increases in spending at every price level

FUN WITH FORMULAS… Disposable Income Yd= Personal Income-Taxes Yd=Consumption + Saving Average Propensity to Consume (APC) = Total Consumption/Total Disposable Income Marginal Propensity to Consume (MPC): the fraction of each add’l $ of Yd spent on consumption MPC= MPS=1 -MPC C/ Yd

CONSUMPTION FUNCTION, WHAT’S YOUR FUNCTION? Consumption Results from 2 Things: � Autonomous Consumption � Income Directed Consumption Examples from College Consumption Activity?

AUTONOMOUS CONSUMPTION Consumption regardless of income Determinants: � Expectations � Wealth Effects � Credit � Taxes Examples of Each?

CONSUMPTION FUNCTION C=a+b Yd, where � C=current consumption � a=autonomous consumption � b=marginal propensity to consume � Yd=disposable income Key Insights � Tells you how much consumption is in AD at the price level � Tells you how much the AD will shift when incomes change

DEPICT THE CONSUMPTION FUNCTION Dissaving: C>Yd Saving: C<Yd 45 degree line: C=Yd Slope: determined by mpc Illustrate a change in “a” Illustrate a change in “b”

CYCLICAL INSTABILITY AND THE CF If consumer incomes change OR autonomous consumption changes, the AD will shift, causing macro instability (business cycles). Changes in autonomous consumption result from: Expectations � Wealth � Credit Conditions � Tax Policy �

INCREASED PERSONAL INCOME TAXES Consumption Function Macro Model

CONSUMPTION FUNCTION PRACTICE 15 minutes

CALCULATE THE MPC & MPS

CONSUMPTION FUNCTION PRACTICE A. B. C. D. E. F. 3 2 1 2 3 2 1. Movement from A to B 2. Shift from CF 0 to CF 1 3. Shift from CF 0 to CF 2

INVESTMENT, GOVERNMENT SPENDING &NET EXPORTS GDP=C+I+G+(X-M)

INVESTMENT 15% of GDP Includes new plant, equipment, capital, change in inventories Determinants: � Expectations � Interest Rates � Technology & Innovation Most VOLATILE spending sector

When investment spending declines, the AD will shift left Major shifts in I determined by interest rates & expectations Interest Rate CHANGES IN INVESTMENT Planned Investment Spending

GOVERNMENT SPENDING 1/3 Federal Spending 2/3 State & Local Spending State and Local Spending fall WITH C and I (pro-cyclical) Federal Spending and increase to compensate for C and I (counter-cyclical)

NET EXPORTS Global recessions serve to shrink domestic AD (fewer purchases of US exports and imports) Decreases in consumption include decreased imports

MACRO FAILURE…MIND THEGAPS Ch. 9, p. 181 -184

KEY CONCERNS WITH MACRO EQUILIBRIUM 1. Macro Equilibrium may not yield Price Stability OR Full Employment 2. “Perfect” Macro Equilibrium may not last

PERFECT AD Meets Goals Problem

RECESSIONARY GAP Causes: Too little AD � PL too low � r. GDP too low Effect: cyclical unemployment

INFLATIONARY GAP Causes: Too much AD � PL too high � r. GDP too high Effect: demand pull inflation

THE KEYNESIAN CROSS Ch. 9: Appendix

MACRO MODEL Great Depression Reality: lots of slack in economy (horizontal range of AS) price level is not an issue PL AD 1 AD 2 AS Qe Focus: � Aggregate Qf r. GDP RG Demand (sum of C+I+G+(X-M)) � Real GDP Adjusted for inflation

KEYNES’ AGGREGATE EXPENDITURES MODEL Directly Relates Aggregate Expenditures (Total Spending) to Nominal Income �Y Axis: Aggregate Expenditure (AE as sum of C+I+G+(X-M)) � X Axis: Nominal Income/Output (Y) NOT adjusted for inflation Shows “layers” of spending � Constant spending Investment Government Spending Net Exports � Increasing spending—with increased income Consumption (based on consumption function, C=a+b. Yd)

LAYERS OF SPENDING? Yum!

AGGREGATE EXPENDITURE

EXPENDITURE (billions of dollars per year) AGGREGATE EXPENDITURE 3500 Y = AE YF g 3000 Aggregate expenditure = C + I + G + (X – M) f 2500 e 2000 c 1500 1000 d Consumer spending = $100 + 0. 75(Y) b a 500 $1000 $1500 $2000 $2500 $3000 $3500 INCOME (OUTPUT) (billions of dollars per year) Investment spending = $150 Government spending = $200 Net exports = $50

EXPENDITURE EQUILIBRIUM Equilibrium is the point where aggregate expenditure and 45 degree lines meet.

EXPENDITURE EQUILIBRIUM $3500 AE = Y Expenditure 3000 2500 Equilibrium 2000 1500 1000 itu d n e re E p ex e t ga re Agg 500 45° 0 YE $500 1000 1500 2000 2500 3000 Income (Output) (billions of dollars per year)

EXPENDITURE EQUILIBRIUM At Income (output) of Consumers Investors Governments + + + Net Export = Aggregate Desire to Spending Expenditure Spend $ 500 $ 475 150 200 50 $ 875 1000 850 150 200 50 1250 1500 1225 150 200 50 1625 2000 1600 150 2000 2500 1975 150 200 50 2375 3000 2350 150 200 50 2750 3500 2725 150 200 50 3125

RECESSIONARY GAP The recessionary gap is the amount by which aggregate spending at full employment falls short of full-employment output.

KEYNESIAN AGGREGATE EXPENDITURES MODEL Focus: � Aggregate Expenditure (AE as sum of C+I+G+(X-M)) � Nominal Income/Output (Y) NOT adjusted for inflation AE AE=Y B RG A Ye Yf AE 1 in p u AE t f i h , s G G R R ad e e e h s t t o s f l To c mount o oint B in diture p n a the sect at e expe v r (inte. Achie Yf. t ) of A brium a ili equ Y

A SINGLE EQUILIBRIUM At equilibrium, aggregate expenditure equals income (output). Benefits of macro equilibrium to producers: Have no incentive to change the rate of output Are selling all they produce.

TWO PATHS TO THE SAME CONCLUSION Both the Keynesian cross and the AD/AS framework lead to the same conclusion about macro instability. � Keynsian Cross (AE Model) focuses on total spending, the product of output and prices. � AD/AD explains macro instability with prices and real output. Ultimate conclusion? � Spending matters!

AP MACRO COOK OFF LAYERS OF SPENDING… Cook Off Rules Groups of 2 � Due Fri, Mar. 15 th � Creatively Depict AE � Must Be Edible � 2 points for participation � 5 points for winner! � Class Vote Based on • Accuracy • Creativity • Taste

PRACTICE WITH AGGREGATE EXPENDITURES… 15 minutes

SHOW WHAT YOU KNOW Show the Macro Model with equilibrium that meets policy goals Describe a scenario that would cause a change in autonomous consumption � Show the change in the Consumption Function � Show the ensuing change in the Macro Model & the Aggregate Expenditure Model Identify how the change in autonomous consumption will create either an Inflationary or Recessionary Gap Describe a potential policy response that could correct the Cyclical Instability created