Chapter Determining Aggregate Demand (AD) zThis chapter -- looks at the components of Aggregate Expenditure. zExamines the major causes of Consumption (C), Investment (I), Government Expenditure Net of Taxes (G - T), and Net Exports (X - M).

“Unzipping” Aggregate Expenditure (AE) zCauses of AD I. Price Level (P) II. AE = C + I + (G – T) + (X – M) (a) C (i) (ii) (b) I (i) (ii) (c) (G – T) …

Causes of Consumption (C) zAggregate Income (Y), Y   C  zWealth, Wealth   C  zConsumer Confidence (CC), CC   C 

Applying the Causes to Aggregate Demand (AD) zAggregate Income (Y), appears on the graph, Y  C relationship affects the shape of the AD curve. zChanges in Wealth or Consumer Confidence make up autonomous consumption (consumption due to causes other than Y) -- shift the AD curve.

Consumer Confidence and the Economy zExample -- effect of a decrease in consumer confidence. zCC   C  zTherefore the AD curve shifts leftward. zIn the AD-AS model, this results in Y* , P* 

Causes of Investment (I): The Capital Market zInvestment (I) – primarily business purchases of new plant and equipment. Also includes new residential housing and changes in inventories (small). zLarge expenditures create the need for long-term borrowing. Borrowing is done from banks (or similar loaning institutions), or by companies issuing bonds or stock.

Investment and Capital Market Behavior zInvestment results from behavior in the (financial) capital market. zThe Capital Market -- The Demand and Supply for financial capital needed to finance purchases of plant and equipment and new residential housing (I).

The Demand For Financial Capital (D I ) -- Major Causes zNominal (Long-Term) Interest Rate (r) – cost of borrowing to finance investment. r   D I  zExpected Inflation Rate (  e )  e   D I  zBusiness Confidence (BC) BC   D I 

Formalizing the Demand for Financial Capital (D I ) zGraph D I against one of its causes -- the nominal interest rate (r). zInverse relationship implies that the curve is downward sloping. zChanges in r are described as a movement along the curve. zGraph is drawn assuming that other causes are constant (ceteris paribus).

Shifts in the Demand for Financial Capital zChanges in causes other than r are described as shifts of the D I curve. zChanges that increase the Demand for Financial Capital shift the D I curve rightward.  Changes that decrease the Demand for Financial Capital shift the D I curve leftward.

The Supply of Financial Capital (S I ) -- Major Causes zNominal Interest Rate (r) r   S I  zExpected Inflation Rate (  e )  e   S I  zTastes/Preferences Toward Saving (SAVE) SAVE   S I 

Other Causes -- Supply of Financial Capital zMonetary Policy -- affects banks ability to loan (more later). zForeigners’ willingness to buy US bonds or stock (Capital Flow). zNext Step -- Formalizing the above S I relationship

Formalizing the Supply of Financial Capital (S I ) zGraph S I versus one of its causes -- the nominal interest rate (r). zPositive relationship implies that the curve is upward sloping. zChanges in r are described as a movement along the curve. zGraph is drawn assuming that other causes are constant (ceteris paribus).

Shifts in the Supply of Financial Capital zChanges in causes other than r are described as shifts of the S I curve. zChanges that increase the Supply of Financial Capital shift the S I curve rightward. zChanges that decrease the Supply of Financial Capital shift the S I curve leftward.

Equilibrium in the Capital Market -- Determining I zInvestment (I*) occurs where the Demand for Financial Capital (D I ) equals the Supply of Financial Capital (S I ). zShifts in the Demand or Supply of Financial Capital, as a result, change Investment (I*) zBecause they change Investment, they also change Aggregate Demand (AD), and Y* and P* as a result.

Example 1 -- An Increase in Business Confidence (BC) zBC   D I  zD I curve shifts rightward  I*  zBecause investment increases, the AD curve shifts rightward. zIn the AD-AS model, this results in Y* , P* .

Example 2 -- An Increase in Foreign Capital Flows to US zCapital Flow   S I  zS I curve shifts rightward  I*  zBecause investment increases, the AD curve shifts rightward. zIn the AD-AS model, this results in Y* , P* .

Causes of (G - T) zGovernment Purchases of Goods and Services (G), Net Taxes (T), are policy variables. zBasically controlled by the government. zG, T changed for policy purposes (Fiscal Policy), other reasons as well (as in war example).

Causes of US Net Exports (NX) zGeneral Concepts -- NX = (X – M), must consider causes of both exports and imports. -- Assume for simplicity that the world consists of 2 countries, the US and the rest of the world.

Specific Causes of US Net Exports (NX = X - M) z World Output or Income (Y W ) Y W   X   NX  zUS Output or Income (Y) Y   M   NX  zBarriers to Trade (Tariffs, Quotas) zThe Exchange Rate (e) e   NX 

Introduction to Exchange Rates zExchange Rate (e) -- the amount of foreign currency needed to be exchanged for one (US) dollar. zAlso known as the “value of the dollar”. zConversion Ratio, in units of (foreign currency)/(US dollar).

Types of Exchange Rates zBilateral Exchange Rate -- exchange rate between the US and an individual country. zMultilateral (Trade Weighted) Exchange Rate -- weighted average of bilateral exchange rates expressed as an index (macro measure of exchange rate).

Using Exchange Rates as a Conversion Ratio zIn Both Examples: US exchange rate vs Japanese Yen = 100 (yen/$). zExample 1 -- Suppose that dinner for two people in the US costs $50. Find its price in terms of yen. ($50)(100 yen) = 5000 yen (1 $)

Example 2 -- The Exchange Rate as a Conversion Ratio zExample 2 -- Suppose that dinner for two people in Japan costs 6832 yen. Find its price in terms of US dollars ($). (6832 yen) (1 $) = $68.32 (100 yen) zNote: e = 100 (yen/$)

Exchange Rate Changes e   price of American goods and services to foreigners   price of foreign goods and services to Americans  e   price of American goods and services to foreigners   price of foreign goods and services to Americans 

The Exchange Rate and Net Exports e  (appreciating dollar, stronger dollar)  X , M   (X - M)  e  (depreciating dollar, weaker dollar)  X , M   (X - M) 

Exchange Rate Regimes zFixed (Pegged) Exchange Rates -- exchange rates are fixed by the government, unless changed by economic policy (e.g. US and China). zFloating Exchange Rates -- exchange rates are determined by natural forces in the foreign exchange market (e.g. US and Japan, US and European Union).

Return to Aggregate Demand -- An Example zExample -- effect of a decrease in world output or income (Y W ). zY W   X   (X - M)  zTherefore the AD curve shifts leftward. zIn the AD-AS model, this results in Y* , P* 

Aggregate Demand Changes and the Economy zLots of factors shift aggregate demand (AD), affect Y* and P*. zPoses challenges: economy subject to “buffeting winds,” blows the economy off course (either to where Y* Y F ). zRole of Economic Policy – “medicine” designed to move Y* closer to Y F.