1. The Aggregate Economy Price Level AD AS RGDP LRAS FEQ1 PL1

2. The Aggregate Economy Economic well being is determined by the level of Real GDP The level of RGDP is determined by current levels of aggregate demand (AD) and aggregate supply (AS). Since spending levels are more easily changed than production levels most macroeconomic policy focuses on aggregate demand.

3. Price Level RGDP AD r1r1 Q1Q1 Q2Q2 Down Sloping Nature of AD r2r2 A B

4. Aggregate Demand slopes downward for reasons different than the demand curve for a single product Aggregate Demand Wealth Effect Interest Rate Effect Product Demand Income Effect Substitution Effect Aggregate Demand differs from the demand curve for an individual item in that an increase in overall price level does NOT diminish my purchasing power because overall income is tied to overall price levels in the macroeconomy

5. The Aggregate Demand The level of total spending in an economy is the most important determinant of GDP. –Aggregate demand is the total spending by all four sectors of our economy. AD = Consumption + Investment + Government + Net Exports = GDP –Aggregate demand is determined by current price level and the current level of spending (Consumption, Investment, Government, Net Exports)

6. Aggregate Demand (AD) Real GDP Price Level AD A change in Price Level moves the economy along the AD curve. A change in C, I, G or NX moves the location of the curve. AD AD 2

7. Consumption is a determinant of AD --A change in C causes a shift in the AD Curve Consumption (C) –spending by households on goods and services Determinants of Consumption –Disposable income –Taxes –Wealth (accumulated savings) –Expectations of prices or income

8. Disposable Income (DI) or (Y d ) Disposable income is the income available after taxes. –All income can either be spent or saved. –The higher your income the more you spend and save and vice versa. Taxes come out of personal income and thus affect your disposable income –Personal income – taxes = disposable income = spending + saving –An increase in taxes reduces both spending and saving and vice versa.

9. Disposable Income and Autonomous Consumption There is a constant level of Consumption across all levels of disposable income. If income falls to zero Consumption does not become zero. Savings become negative because households either use past savings or borrow.

10. Wealth Wealth is the accumulation of savings. It can take the form of financial assets or real assets. (Changes in stock or real estate prices will affect your wealth & your spending habits). The greater your present wealth the less you have to save, increasing consumption.

11. Expectations of Future Income or Prices If you expect a raise in the near future you will spend more now and vice versa. If you think prices will rise in the near future you will spend more now and vice versa.

12. Debt Debt is what is owed on previous spending. The more I owe the less I can spend now. Debt accumulation is seen as an increase in consumption and a decrease in savings. Debt reduction is seen as a decrease in consumption and an increase in savings.

13. Investment Investment (I) –Spending by businesses on capital Machinery, factories, technology, inventories Investment Demand (I) is the quantity businesses want to spend within a given time period. –Determinants of Investment Interest rates Future level of GDP Productive capacity

14. Determinants of Investment Demand 1.Interest rates – this is the cost of borrowing or forgoing savings –If interest rates are high it would be more profitable to save and less profitable to borrow to spend (Investment decreases) –If interest rates are low it would be more profitable to borrow to spend and less profitable to save (Investment increases)

15. Affect of Interest Rates on Investment Demand I d Quantity of Investment Real Interest Rate i1i1 Q1Q1 i2i2 Q2Q2 A B

16. 2.Expected future level of GDP –If businesses expect GDP to decrease in the future they will spend less today 3.Stock of productive capital on hand –If businesses have productive capital sitting idle they will decrease their spending today A change in investment causes the AD curve to shift right or left Determinants of Investment Demand

17. Real Interest Rate Quantity of Investment I d1 i1i1 I d2 Q1Q1 Q2Q2 Affect of a Decrease in Profit Expectations or an Increase in Productive Capacity

18. Cost of Production Any change in the cost of inputs will change businesses’ profit expectations and their investment demand. Cost of inputs increases therefore investment demand decreases (shifts left). Cost of inputs decreases therefore investment demand increases (shifts right). The major costs of inputs are wages and oil.

19. Business Taxes Increases in businesses taxes reduces businesses’ profits and therefore their investment demand. Business taxes include corporate income tax, capital gains tax, excise tax. Increases in taxes shift the investment demand curve left; decreases shift the curve right.

20. Technological Change An increase in technology allows businesses to produce at a lower cost and therefore increases their profits and their investment demand. An increase in technology shifts the investment demand right; a decrease shifts the curve left.

21. Expectations of Future Profit An expected future increase in demand for their product will lead to larger profits and therefore leads to an immediate increase in investment demand. An increase in expected future profit shifts the investment curve to the right; a decrease shifts the curve to the left.

22. Stock of Capital on Hand If companies have capital equipment (factories, tools, etc.) on hand that are not being utilized there is no reason to purchase more (investment demand decreases). If companies are maximizing their use of capital equipment then they will purchase more (investment demand shifts right).

23. Volatility of Investment Investment demand is much more unstable than Consumption. It changes often and to a large degree, due to the following: –The durability of capital goods. –Innovation occurs irregularly. –Profits vary considerably. –Business expectations are easily changed.

24. Adding Government Government policies can have a powerful influence on aggregate demand Government influences AD through fiscal and monetary policy Fiscal Policy has two main components –Government spending – government purchases of goods and services and government transfer payments –A change in government spending has a direct effect because it is a component of AD. A decrease in spending shifts the curve left, an increase in spending shifts the curve right –Tax policy –A change in tax policy influences the economy indirectly though changes in consumers’ disposable income. A decrease in taxes increases Consumption and shifts AD right and vice versa.

25. Taxes Taxes are leakages They reduce AD, but any change in taxes results in a change in savings and spending AD decreases by less than the change in taxes PL RGDP $450b AD 1 AD 2 A reduction in taxes of $600 reduces Consumption and AD by $450.

26. Adding Government Monetary Policy involves the use of changes in the money supply and consequently changes in the interest rate to affect overall spending levels –An increase in the money supply gives households and firms more money, which they are then more willing to loan out. This decreases interest rates increasing consumption and investment spending –The opposite is also true. RGDP AD 1 PL AD 2 An increase in Government spending or an increase in the money supply increases AD

27. Net Exports Net Exports (exports – imports) Determinants of Net Exports: Income abroad (if foreign income is up our exports go up) Exchange rates (if the dollar appreciates our exports go down) Tariffs (if we place a tariff on imports our imports go down) Net Exports (NX) goes up If exports go up or if imports go down Net Exports (NX) goes down if exports go down or if imports go up. An increase in NX leads to an increase in AD A decrease in NX leads to a decrease in AD