Aggregate expenditures & aggregate demand

Chapters 10 and 11

Aggregate Expenditures approach

• Simplifications– Closed private economy– GDP=DI– No exports, Gov’t– Aggregate expenditures doesn’t impact price

INVESTMENT DEMAND & SCHEDULE

Exp

ecte

d r

ate

of

retu

rn,

r, a

nd

real

in

tere

st r

ate,

i (

per

cen

ts)

Inve

stm

ent

(bil

lio

ns

of

do

lla

rs)

Investment(billions of dollars)

20

8

20

Real Domestic Product, GDP(billions of dollars)

I D

Ig

InvestmentDemandCurve

InvestmentSchedule

2020

Pri

vate

sp

end

ing

, C +

I g

(bill

ion

s o

f d

olla

rs)

o45

o

C

C + Ig

Ig = $20 Billion

Equilibrium

Real domestic product, GDP (billions of dollars)

370 390 410 430 450 470 490 510 530 550

(C + I g = GDP)

EQUILIBRIUM GDP

C =$450 Billion

$530

510

490

470

450

430

410

390

370

CHANGES IN EQUILIBRIUM GDPAND THE MULTIPLIER

Pri

vate

sp

end

ing

(b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

510

490

470

450

430

430 450 470 490 510

(C + Ig ) 0

(C + Ig ) 1

Equilibrium GDPat Ig0 level of investment

Equilibrium GDPat Ig1 level of investment

Increasesin the levelof C + Ig

CHANGES IN EQUILIBRIUM GDPAND THE MULTIPLIER

Pri

vate

sp

end

ing

(b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

510

490

470

450

430

430 450 470 490 510

Equilibrium GDPat Ig2 level of investment

(C + Ig ) 0

(C + Ig ) 2

Decreasesin the levelof C + Ig

INTERNATIONAL TRADE AND AGGREGATE EXPENDITURES

Pri

vate

sp

end

ing

(b

illi

on

s o

f d

oll

ars)

o45o

Real domestic product, GDP (billions of dollars)

510

490

470

450

430

430 450 470 490 510

Aggregate Expenditureswith Negative Net Exports

C + Ig C + Ig + Xn2

Net

Exp

ort

s, X

n

(bil

lio

ns

of

do

lla

rs)

+5

0

-5

430 450 470 490 510 Real GDP

ADDING THE PUBLIC SECTOR

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

470 550

C

C + Ig + Xn

C + Ig + Xn + GGovernmentSpending of$20 Billion

Government Purchases and Equilibrium GDP

ADDING THE PUBLIC SECTORLump-Sum Tax and Equilibrium GDP

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

490 550

C + Ig + Xn + G

Ca + Ig + Xn + G

$15 Billion Decreasein Consumption froma $20 Billion Increasein Taxes

FULL-EMPLOYMENT GDP

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

490 510 530

AE0

Recessionary Gap

AE1

530

510

490

Recessionary Gap= $5 Billion

Full Employment

FULL-EMPLOYMENT GDP

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

490 510 530

AE0

Inflationary Gap

AE2

530

510

490

Inflationary Gap= $5 Billion

Full Employment

PROBLEMS WITH AGGREGATE EXPENDITURES APPROACH

• Does Not Show Price-Level Changes• Ignores Premature Demand-Pull Inflation• Limited Real GDP to the Full-Employment

Level• Does not Deal with Cost-Push Inflation• Does not Allow for “Self-correction”

Defined: •Amounts of Real Output•Buyers Collectively Desire •At Each Possible Price Level

AGGREGATE DEMAND

Aggregate Demand CurveDown Sloping Due To:

•Real-Balances Effect•Interest-Rate Effect•Foreign Purchases Effect

Graphically…

AGGREGATE DEMAND CURVE

Pri

ce le

vel

Real domestic output, GDP

AD

Shifts in Aggregate Demand Caused by Non-Price Level Factors

• Factors that Shift the Curve

Change in Consumer Spending

• Consumer Wealth• Consumer

Expectations• Household

Indebtedness• Taxes

Change in Investment Spending

• Interest Rates• Profit Expectations• Business Taxes• Technology• Degree of Excess

Capacity

Change in Government Spending

• Desire to add or deduct from government supported programs.

Net Export Spending

• Increased exports----Increased AD

• Based on

• 1- national income abroad

• 2-exchange rates

AGGREGATE SUPPLYDefined: •Levels of Real Domestic Output•At Each Possible Price Level•Long-run Supply Curve

•Wages and Resource Prices Match Price Level

•Short-run Supply Curve•Wages and Resource Prices Do Not Match Price Level

AGGREGATE SUPPLY

Pric

e le

vel

Real domestic output, GDPQ

PLong Run

ASLR

Long-runAggregate

Supply

Qf

Full-Employment

AGGREGATE SUPPLY

Pric

e le

vel

Real domestic output, GDPQ

PShort Run

ASAggregate

SupplyShort-run

Qf

Full-Employment

Shifts in Aggregate Supply Caused by Non-Price Level Factors

• Factors that Shift the Curve

Change in Input Prices

• Domestic Resource Availability

• Prices of Imported Goods

• Market Power

Change in Productivity

• Effect of Training Programs

• Technology Gains

Change in Legal-Institutional Environments

• Business Taxes• Business Subsidies• Government

Regulation

Pric

e Le

vel

Real Domestic Output, GDP

Q

P AS

AD510

502514

EQUILIBRIUM AND CHANGESIN EQUILIBRIUM

92

100a b

EquilibriumReal Output

Pric

e Le

vel

Real Domestic Output, GDP

Q

P ASAD1

INCREASES IN AD: DEMAND-PULL INFLATION

P2

P1

AD2

Qf Q1 Q2

Pric

e Le

vel

Real Domestic Output, GDP

Q

P ASAD1

DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT

P1

AD2

QfQ1

a

c

b

Ratchet Effect

• At full employment• AD declines

– GDP declines but price does not– “sticky” prices

• Wage contracts• Efficiency wages• Min. wage• Menu cost• Fear price wars

Pric

e Le

vel

Real Domestic Output, GDP

Q

P AS1

AD1

DECREASES IN AS: COST-PUSH INFLATION

P2

QfQ1

a

b

AS2

P1

Pric

e Le

vel

Real Domestic Output, GDPQ

P AS1

AD1

INCREASES IN AS: FULL EMPLOYMENT

P1

Q2Q1

a

b

AS2

P2

…With Price-Level Stability

AD2

P3

Q3