Microeconomics is the study of supply and demand in local markets, while macroeconomic studies supply and demand in the aggregate, the markets of the entire economy. Aggregate demand and aggregate supply affect the Gross Domestic Product (GDP), unemployment, price levels, inflation, and other macroeconomic variables. Therefore, to keep the economy at its potential output, central banks use monetary policies to influence aggregate demand. But to keep the economy optimized, it must be understood how changes in aggregate demand affect the economy.
The model most often used to model the macro economy in the short run is the aggregate demand-aggregate supply (AD-AS) model. Aggregate demand is the total demand for all final goods and services produced by the economy by all economic agents: consumers, firms, government, plus net foreign demand. Net exports equal the total demand for domestic production by people living outside of the country minus the total demand for foreign production by domestic economic agents.
The aggregate demand curve expresses the inverse relationship between aggregate price levels and real GDP. However, the aggregate demand curve is not the same as the demand curve for specific products or services, although they do seem similar. If the aggregate demand declines, then the demand for most products and services will also decline, but demand for some things may increase. Additionally, there is no substitution effect, since most products and services are affected, including possible substitutions. And while the demand curve for a specific product or service plots the quantity demanded vs. the price, the aggregate demand curve plots general price levels against real GDP.
Aggregate demand affects real GDP and price levels. There are several reactions that firms will take to respond to increased aggregate demand:
- hold output constant and increase prices;
- increase supply and hold prices constant, or both.
In the long run, the 1st option applies; in the short run, the 2nd option applies.
Aggregate demand is composed of 4 components: consumer consumption, business investment, government spending, and net exports.
Aggregate Demand = GDP (Y) = C + I + G + NX
Consumption is the household demand for goods and services, which is largest component of aggregate demand, equal to about 2/3 of output.
Disposable income is household income minus taxes. Thus, consumption depends on disposable income, expressed by the consumption function:
C = C (Y – T) = C0 + C1 (Y – T)
C0 specifies the level of autonomous consumption, which is consumption that does not depend on disposable income, since autonomous consumption is necessary for survival. C1 is the marginal propensity to consume, which is the percentage of disposable income spent for products and services, and, thus, not saved. Y represents real GDP or aggregate demand, while T represents taxes, so Y – T is disposable income.
A consumer will consume even if he has no income, since some consumption is necessary for survival. Without income, autonomous consumption is financed by savings or by borrowing against future income. Younger people tend to borrow more, while older people rely more on savings and pensions.
The marginal propensity to consume means that any increase in income will increase consumption, but only in proportion to the marginal propensity to consume, since it is usually less than 1. Likewise, any tax decreases will increase disposable income, and therefore, increase consumption by the marginal propensity to consume multiplied by the increase in disposable income.
The Marginal Propensity to Consume is Inversely Proportional to Wealth
The marginal propensity to consume is often graphed as a straight line, meaning that the percentage of income used for consumption does not change with increases in income (although both the straight-line and my curve are schematic). I disagree with this depiction, because the marginal utility of money declines with increasing income, reflecting the declining marginal utility of the things that it buys. Thus, as people become richer, they spend less of their money for consumption and more for investment. Autonomous consumption, in my opinion, is nothing more than a 100% marginal propensity to consume, reflecting the poor people's need to spend all their money to pay for essentials.
The government often gives tax breaks to stimulate consumption, which stimulates the economy, but some economists have questioned the effectiveness of these tax breaks. David Ricardo argued in his 1817 book, Principles of Political Economy and Taxation, that there is no difference between giving tax breaks, then borrowing the money, or increasing taxes now, since people will not spend the money from the tax breaks because they know that taxes will increase in the future, so they will not spend the money now, but save it for the later tax increase. I disagree with this Ricardian equivalence, that there is no difference in using debt or taxes to finance the government. If people did not spend money because they know they must repay it, then no one would ever borrow money, but since they do, this explanation is patently false. However, it is true that only some of the money from tax cuts is spent, and the amount spent is proportional to each person's propensity to consume, which is inversely proportional to their wealth.
This inverse proportionality explains why tax breaks to the poor stimulate the economy more than tax breaks to the rich, and if money is taken away from the poor and the middle class — such as by giving the lower classes a smaller tax break or none at all or by decreasing payments to the lower classes, such as decreasing healthcare expenditures, or by lowering Social Security or Medicare payments, which is often done to pay for the tax breaks to the wealthy — then the negative effect of higher taxes or lower payments will greatly exceed any positive effect of giving tax breaks to the wealthy. George W. Bush lowered taxes on the wealthy, but the economy still declined after his inauguration in 2001 until 2003, when debt financing greatly increased. Starting in 2004, credit requirements for loans were relaxed, so many poor and middle-class people were able to get loans to buy houses, or to use their home equity to easily get loans for other purchases, which fueled the boom in real estate and the general economy (thus illustrating the lower classes' higher marginal propensity to consume), only to end badly in 2007. The boom had to end, of course, because debt must be repaid, so consumption declines, and with the money multiplier effect, the economy declines even more. When debt is repaid, money flows from poorer debtors to richer creditors, causing the aggregate marginal propensity to consume to decline, and with it, the economy, as evinced by the 2007 - 2009 Great Recession. This further illustrates that the marginal propensity to consume declines with wealth.
On the other hand, both President Clinton and President Obama showed that the rich can be taxed heavily, and the economy can still grow robustly. In fact, under President Clinton, the economy boomed! These recent economic events demonstrate that the marginal propensity to consume is inversely proportional to the wealth of the buyer.
The real interest rate also affects consumption. Higher rates tend to lower consumption, as people save more and borrow less, while lower rates tend to increase consumption, as people borrow more and save less. However, because many other factors affect consumption, the link between real interest rates and consumption is tenuous at best. For instance, after the Great Recession of 2007 to 2009, interest rates were very low, but people saved more because they recognized the increased risk of not having sufficient savings when the economy downturns.
In economics, income is divided into 2 components: consumption and saving. What is not spent for consumption is saved, and vice versa. Saving is important to an economy, because it provides the source of funds for investments, which is the purchase of capital to produce goods and services. Just as investments is defined differently in economics, so if savings. When a consumer deposits money at a financial intermediary, it is generally used to lend out to other businesses so that they can invest in capital. The importance of saving is that it provides money for the purchase of capital; saving would be unimportant, or even detrimental to the economy, if it were not used for the purchase of capital, so economists make this assumption to simplify their models. Indeed, money cannot earn interest, if the borrowers did not think that they could earn a higher rate of return, which is done by investing in capital. However, this invites a broader definition of saving.
Saving is often thought of as putting money in the bank. However, in economics, savings is simply money used to buy capital goods and services instead of consumption goods and services. After all, if savings were not used to buy capital goods, it would have little economic value. But, considering this broader definition, it is also clear that much of the spending by businesses is also a form of saving. Some of the money for investments is borrowed, but much of business spending is financed by the revenues that the business earns by conducting its business. Yes, they are spending money, but they are spending it for capital goods, which yields the desired effect of saving. Therefore, in the economical sense, the saving of money by consumers is equivalent to businesses spending their earned income for capital goods and services!
Investment includes the demand for capital goods by firms, but also household demand for new housing, i.e. residential investments. Residential investments are included as an investment, because the purchase of a new house increases the demand for new capital goods and services concerned with housing. However, buying a house in the secondary market does not count as an investment, said since it simply transfers the demand for housing goods and services to another individual: there is no new demand. Domestic private investment (I) is the 3rd largest component of aggregate demand, typically 15% of GDP, but varies significantly from a low during busts to a high during booms. (Remember, that economists define investments as the purchase of new capital goods, used to produce products and services.)
Businesses will increase investments until the marginal product of capital equals marginal cost, i.e., the real interest rate plus depreciation:
MPk = r + δ
Investment is a negative function of the real interest rate, when one goes down, the other goes up. Net investment will depend on the real interest rate minus the depreciation rate of existing capital. Since the rate of depreciation is considered constant, investment becomes a simple function of the real interest rate r:
I = I (r)
As the real interest rate rises, the hurdle rate also rises, which is how much an investment must return for it to be profitable. Because capital projects involve risk, the project must earn an additional risk premium over what could be earned from safer investments, such as a savings account or US Treasuries.
The amount invested may also depend on other factors, such as the rate that firms would be willing to invest per unit of time, since some projects, such as building new factories, would take considerable time.
Taxes on profits will also lower investments proportionate to the tax rate. Hence, the decision to invest will depend on whether the marginal product of capital multiplied by the tax-free rate at least equals the real interest rate minus the depreciation rate.
(1 – Tax Rate) MPk = r + δ
Government Purchases and Net Exports
Government purchases represent the government demand for goods and services and are a major component of aggregate demand. Economists treat this component as a constant, since government purchases depend on political decisions, which are not predictable, but historically, government purchases have composed around 20% of aggregate demand.
Because aggregate demand is defined as the demand for all goods and services provided by the economy, it does not include imported goods and services, but it does include exports. Imports must be subtracted because they would otherwise be included in the other components of aggregate demand, since some of the income received by consumers, businesses, and governments is spent for imported goods and services.
Net exports are the smallest component of aggregate demand. For the United States, it is usually less than 5%. The main factor affecting net exports is the foreign exchange rate. The foreign exchange rate tends toward a purchasing power parity, where the equivalent amount of currencies will buy comparable products and services in different countries; otherwise, arbitrage of products and services in different countries will cause the respective currencies to move toward purchasing power parity. Although, the nominal exchange rate changes frequently in response to the supply and demand for the currencies, prices tend to be sticky, because there are usually costs associated with changing prices of products and because arbitrage takes considerable time to equalize any differences in purchasing power of the 2 currencies.
The downward sloping aggregate demand curve, often depicted schematically as a straight line, plots a general price level of the economy to real GDP. The demand for real GDP is the aggregate demand.
Aggregate demand increases with lower prices for the same reasons that demand for most products and services increases with lower prices. Products and services become more affordable and consumers enjoy higher surplus because of the lower prices. Additionally, exports become cheaper with respect to imports, thus causing more consumption of domestic goods over foreign goods.
Note, however, that aggregate demand differs from demand for individual products or services, because there is no substitution effect. Aggregate demand is the demand for all products and services offered by the economy, so there is no substitution, except in limited cases where foreign products may offer better value.
Shifts in the Aggregate Demand Curve
Factors that shift the AD curve to the right include:
- increased consumer and business confidence
- increases in government purchases
- lower taxes, especially on the poor and middle classes
- increases in the money supply
- greater demand for exports, which is often caused by a depreciation in the exchange rate of domestic currency relative to foreign currencies
- optimistic expectations
- a greater portion of the national income going to the lower and middle classes
An increase in the money supply also shifts aggregate demand to the rate by reducing the interest rate, thereby stimulating consumer consumption and business investment. Leftward shifts in the AD curve are caused by the inverse of the above factors.
Another major factor that shifts the aggregate demand curve is a redistribution of wealth between the wealthy and the non-wealthy. As stated above, poorer people have a greater marginal propensity to consume, so when they receive more the nation's income, that will increase aggregate demand. On the other hand, when more of the nation's income goes to the wealthy, this decreases aggregate demand. The great recession has demonstrated this. When loan requirements were relaxed during the 2004 to 2007 boom, the poor and the middle class received more money, which they readily spent. Money flowed from richer creditors to poorer debtors, increasing the aggregate marginal propensity to consume. Loan requirements were relaxed because banks were transferring their credit default risk for such loans to buyers of mortgage-backed securities; meanwhile, the banks were earning origination and loan processing fees, so they were incentivized to provide as many loans as possible, which is why many borrowers did not even have to prove that they had the income to repay the loan. When the real estate bubble burst in 2007, loan requirements became much more stringent, causing aggregate demand to drop precipitously. Nonetheless, the money didn't just disappear. Instead of buying products and services, the debtors had to repay their loans, so now the money was flowing from debtors to creditors, and since creditors are generally richer than debtors, the aggregate marginal propensity to consume is much less, so aggregate demand falls.
Changes in demographics can also shift the AD curve, albeit over a longer time. The young and the old tend to spend more of their income, while middle-aged adults tend to save and invest more.