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04/21/23 © 2004 Claudia Garcia - Szekely
1
Chapter 8
Aggregate Demand
2
“Only suppliers can supply us with goods and services; the demand side can’t will a
product or service into existence, no matter how
hard it tries. Society therefore advances
economically when it reduces tax and regulatory barriers to the creation of
goods and services”Supply Side View
3
Old fashioned voodoo economics- the belief in tax
cut magic- has been vanished from civilized
discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans and Republicans
Paul KrugmanNew York Times
The Keynesian Model
Developed within of the urgency to get the economy out of the Great Depression
4
• Concern is finding a short term solution to unemployment • Concern is NOT inflation
5
The Keynesian Model Is a Short Run (Unemployment)
model. Assumes that Aggregate Demand
determines the level of production. Focuses on how variables that affect
Aggregate Demand are interrelated. Develops tools for the government
to manage the amount of spending in the economy
Rest of World
InterestRent
ProfitsWages
Goods and Services
HouseholdsFirms
S
=300
C
I
T
G
G
Circular Flow Diagram
pay
to
NX
The Components of Aggregate Demand
8
9
National Income
The sum of the incomes that all individuals in the economy earned in the forms of wages, interest, rents, and profits.
– Excludes government transfer payments
– Income before paying taxes
10
Disposable Income
The sum of the incomes of all the individuals in the economy after all taxes have been deducted and all transfer payments have been added
DI = GDP - Taxes + Transfers = Y - T
11Time
12Disposable Income
Con
sum
pti
on
Consumer Spending and Disposable Income
What determines the level of Consumption?
Income Wealth Prices Expectations Real Interest
Rate
AutonomousComponent of consumption
Induced component of consumption
C=bY
C=a
Add these two components C = a + bY
As income increases,
consumption increases
The effect of these
components is “bunched” together
14
The Reaction of Consumption Spending to a Change in Income
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
B
A
$200
billion
$180 billion
1900
1700
1500
1360 1300
1180
1100
900
1900 1700 1500 1300 1100 900
1947
Real Disposable Income
Real
Con
sum
er
Sp
en
din
g
1963
0
MPC = DC/DYMPC = 180/200=0.9
This reaction is measured by the slope of the C function.
The slope is the Marginal
Propensity to Consume
MPC = DC/DY
15
MPC = 0.9 or 90%For each $1 increase in income,
consumption increases by 90 cents…
90% of the increase in income will be consumed.For each $1 decrease in income,
consumption decreases only by 90 cents…Only 90% of the decrease in income translates into a reduction in consumption.
When income drops, people use savings
(their own or borrowed)
The Consumption Function
Induced Consumption:As income increase
consumption increases.
Income Consumption0 ?
100 190150 235200 280250 325300 370350 415400 460450 505
Autonomous Consumption:
Value of Consumption when income is zero.
Determines the height of the Consumption Function
Disposable income Consumption Saving
0
1000 1,400
2000 2,200
3000
4000 3,800
5000 4,600
6000 5,400
1. Calculate the MPC2. Calculate the Intercept3. Write down the formula for the Consumption function4. What is the value of Consumption when Income is 10,0005. Calculate Savings6. At what value of Y is Consumption equal to Income? 7. Write down the formula for the Savings function
The Consumption Function
C = a + b YValue of C when Y is 0 MPC
19
How Important is Consumption?
Consumption is by far the largest component of aggregate demand.
Expenditures in consumer goods are 70% of GDP.
Understanding the determinants of consumption then, is critical.
20
Saving (S)
We will assume that income not
consumed is saved
Y - C = S
Consumption (C) Mirror Saving (S)
S = Y – CS = 0 - a
Intercept of Saving Function is – a
Value of C when Y = 0
When income is zero, saving = - a
Recall:Y - C = S
When Y = 0
C = a + (b x 0)C = a
C = a + b Y
22
The Saving Function
- a Intercept of Saving Function is – a
S = -a + ?S
23
A $200 increase in
income
Causes a $180Increase in C
3420
3240
MPC = C/Y
MPC = 180/200=0.9
3600 3800
C
S = Y – C
20 = 200 - 180
Recall:S = Y - C
The MPS= S/Y = 20/200 = 0.1 or 10%
The Slope of the Savings Function: MPS
Saving
380
360
The MPS = 20/200 = 10%
MPS = S/Y
A $200 increase
in income
Causes a $20Increase in S
3600 3800
25
The Marginal Propensity to Save
Is the proportion of an increase in income that is used to increase saving..
Is the proportion of an decrease in income by which saving decrease
Is a percentage or a number between o and 1.
26
MPS = 1 - MPC
If the MPC = 90%, you will consume 90% of any increase in income…
If you consume 90% of any increase in income, you save the rest: 10%
MPC + MPS = 100%MPC = 0.9 then MPS = 0.1MPC + MPS = 1
27
The Saving Function
S = -a + (1- b) Y
Value of Saving when Y(Income) is
0
1 – MPC
Disposable income Consumption Saving
0
1000 1,400
2000 2,200
3000
4000 3,800
5000 4,600
6000 5,400
1. Calculate the MPC2. Calculate the Intercept3. Write down the formula for the Consumption function4. What is the value of Consumption when Income is 10,0005. Calculate Savings: S = Y - C6. Write down the formula for the Savings function7. At what value of Y is Consumption equal to Income?
Disposable income Consumption Saving
0 600 -600
1000 1,400 -400
2000 2,200 -200
3000 0
4000 3,800 200
5000 4,600 400
6000 5,400 600
1. Calculate the MPC =800 /1002. Calculate the Intercept = 6003. Write down the formula for the Consumption function = 600 +0.8 Y4. What is the value of Consumption when Income is 10,000 = 600 + 0.8*10,0005. Calculate Savings6. At what value of Y is Consumption equal to Income? At 3,0007. Write down the formula for the Savings function = -600 + 0.2Y
30
04/21/23 © 2004 Claudia Garcia - Szekely
31
Events that cause a movement along the Consumption
Function
Changes in incomes ONLY!
32
Factors that shift the consumption function
1. Changes in wealth Example: value of stocks, bonds, consumer
durables, homes.
When stock prices go down, consumer wealth decreases in value.
Consumers feel poorer and slow down purchases
A downward shift in the Consumption Line
Factors that shift the consumption function
1. Changes in wealth When stock prices go UP, consumer
wealth increases in value. Consumers feel richer and increase
purchases
An upward shift in the Consumption Line
34
Factors that shift the consumption function
2. Changes in consumer expectation:
Pessimistic expectations about future: employment, incomes, wealth.
Consumers slow down purchasesA downward shift in the Consumption Line
35
Factors that shift the consumption function
2. Changes in consumer expectation:
Optimistic expectations about future: employment, incomes, wealth.
Consumers increase purchasesAn upward shift in the Consumption Line
36
Factors that shift the consumption function
3. Prices When overall prices rise (an increase in
the CPI) consumer’s wealth lose buying power.
This drop in the purchasing power of saved dollars make consumers feel poorer and they slow down purchases.
A downward shift in the Consumption Line
Factors that shift the consumption function
3. Prices When overall prices fall (a decrease in
the CPI) consumer’s wealth gains buying power.
This increase in the purchasing power of saved dollars make consumers feel richer and they increase purchases.
An upward shift in the Consumption Line
Factors that shift the consumption function
Changes in wealth value of stocks, bonds, consumer
durables, homes.
Changes in consumer expectations
Pessimistic expectations decrease autonomous consumption.
Prices Affect the purchasing power of assets.
Shift Consumption
line
Interest Rates are NOT in the
list!
Statistical studies: interest rates have no effect on Consumption
We will assume that changes in interest rates do not shift C
39
40
Investment
The acquisition of capital goods
41
Investment Includes… Residential Construction
– consumer purchases of new houses and condominiums.
Non-residential construction– Equipment, software, buildings,
tools, etc. Changes in Inventories: unsold
goods are included as investment.
42
Investment Includes…
Residential Construction– consumer purchases of new houses
and condominiums. Higher interest rates reduce home purchases.
43
Investment Includes…
Non-residential construction Equipment, software, tools, etc.
44
Determinants of Investment Interest Rates:
– Business borrow to finance investment. As interest rates drop, more investment projects become profitable and investment increases.
Tax Incentives: – If directly tied to capital formation will increase
investment. Technical Change:
– New technology creates a boom in investment as firms rush to adopt the new technology (Microchip)
– New technologies open new business opportunities: Firms build new factories, stores, offices and equipment to take advantage of these opportunities (Internet Cafes)
Expectations about the strength of demand: – high sustained level of sales and expectations of growing
economy boost investment
Political Stability and the rule of law:– Business cannot be conducted without a guarantee that
property rights and laws will be respected. (News communist take over will negatively affect investment)
45
Inventories are of two kinds:– Planned (desired) inventories.
• Firms build up inventories to be able to fulfill future orders.
– Unplanned (unwanted) inventories.• Firms end up with unsold inventories
because sales decreased unexpectedly.
Investment Also Includes Inventories
46
InvestmentFirms control how much to
spend in Investment goodsFirms control how much they
want to hold in inventories
Firms control Planned Investment
47
Investment does not change with current income
Income / GDP
Inve
stm
en
t S
pen
din
g Total PLANNED Expenditures on Capital goods and desired inventories
Investment
48
Investment Firms have NO control over how much ends up
as inventories. These changes in inventories depend on actual demand:– If demand dropped below what firms expected,
inventories rise– If demand was as expected, inventories do not change– If demand increases from expected inventories fall.
Firms DO NOT control Actual
Investment
49
Expenditures by federal, state and local governments.– Include final, intermediate and capital
goods purchased by the government.– Exclude transfer payments (social
security, unemployment benefits, etc)
Government expenditures are determined by the budget process: The president, Congress and the Senate.
Government expenditures are not a function of current income.
Government Spending does not change with current income
Income / GDP
Gove
rnm
en
t S
pen
din
gTotal PLANNED Expenditures by all levels of government as dictated by the budget
G
Have two components:1. Exports: Sales of US goods to other
countries. Incomes abroad: as other countries grow,
they increase purchases of U.S. goods. Relative prices: if prices in U.S. rise faster
than prices abroad, U.S. goods become relatively more expensive for foreigners and purchases of U.S. goods drop.
Exchange rates (see discussion next).
Have two components:2. Imports: Purchases of foreign goods
by Americans. Incomes in the US: As the U.S.
economy grows Americans purchase more goods from abroad.
Relative prices: as prices in the U.S. fall relative to prices abroad, Americans find foreign goods cheaper and purchase more from abroad.
Exchange rates (See discussion below).
National Incomes:– When US incomes rise, imports increase and vice versa.
GDP of other countries:– When GDP abroad increases, US exports rise as foreigners
buy more American goods. Relative Prices:
– When prices in the US rise, American goods become more expensive and exports drop as foreigners buy fewer American goods.
– When prices in the US rise, foreign goods become cheaper and imports increase as Americans more foreign goods.
Exchange Rates
54
Net Exports do not change with current income
Income / GDP
Net
exp
ort
s
NX
55
U$1
1DM 0.5 DMU.S. Prices are
lower to GermansU.S. Exports increase
when the dollar becomes weaker.
Weaker dollar
One Dollar buys less DM’s
56
1DM
1U$ 2 U$
Foreign Prices are higher to
AmericansU.S. Imports decrease when the dollar becomes weaker.
Weaker dollar
One DM buys more Dollars
57
U$1
1DM 2 DMU.S. Prices are
higher to ForeignersU.S. Exports decrease when
the dollar becomes stronger.
Stronger dollar
One Dollar buys more
DM’s
58
1DM
1U$ 0.5 U$Foreign Prices are
lower to AmericansU.S. Imports increase when
the dollar becomes stronger.
Stronger dollar
One DM buys less Dollars
04/21/23 © 2004 Claudia Garcia - Szekely
59
The Effect of Changes in Exchange Rates
More on Strong Dollar
60
1. Determine the effect on Aggregate Demand. Identify the component of AD which is affected (C,
I, G, X or M) and explain how it is affected.
a)Prices in the US Increase (decrease) relative to prices abroad.
b)The U.S. dollar becomes weaker (stronger)c) Home prices collapse (increase) d)Stock prices collapse (increase)e) Interest rates Increase (decrease)f) A zero-emissions engine is developed.g)Government announces an Increase
(decrease) in the number of troops deployed abroad.
h)As the economy recovers (enters into a recession) incomes increase (drop).
Questions to Prepare for Quiz
2. Use the table in the next slide to answer the following:
a) Calculate the MPC and the intercept of the consumption line.
b) Write the consumption function: C = intercept (a) + slope (MPC)* Y
c) If Income is 5700 what is the value of consumption? How much is saved?
d) If autonomous consumption increases by 300 what is the new consumption function? Does this increase represent a shift? Or a Movement along the Consumption line? Does this increase imply an increase or a decrease in saving?
Output Consumption Investment Net Exports
1000 800 500 100
1500 1200 500 100
2000 1600 500 100
2500 2000 500 100
3000 2400 500 100
3500 2800 500 100
4000 3200 500 100
63
C = 100+0.9Y
5,000 10,000 19,000 25,000
4,600
9,100
17,200
22,600
64
I+G+NX
5,000 10,000 19,000 25,000
I =1,000G = 500NX = 300
1,800
65
AE = 100 + 0.9Y +1,800AE = 1,900 + 0.9 Y
5,000 10,000 19,000 25,000
4,600 +1,800= 6,400
9,100 +1,800 = 10,900
17,200 +1,800= 19,000
22,600 +1,800 = 24,400
AE = 100 + 0.9Y +1,800AE = 1,900 + 0.9 Y
5,000 10,000 19,000 25,000
6,400
10,900
19,000
24,400
Sold
Produced
Produced 5,000Sold 6,400
Inventories fallFirms increase Production
Produced 10,000Sold10,900
Inventories fallFirms increase Production
Produced 19,000Sold19,000
Inventories do not changeFirms do not change Production
Produced 25,000Sold 24,400
Inventories riseFirms decrease Production