McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 19 Delving Deeper Into Macroeconomics

19-2 Chapter Objectives Aggregate demand and supply Long-term equilibrium Shifts in aggregate supply Shifts in aggregate demand Basics of saving and investment Trade deficit

19-3 Aggregate Demand Aggregate demand is the sum of the quantity demanded from the different sectors of the economy: personal consumption (C), nonresidential investment (NR), residential investment (R), government consumption and investment (G), inventory investment (I), and net exports (NX). The equation for aggregate demand (AD) is: AD=C+NR+R+G+I+NX.

19-4 Aggregate Demand Curve The aggregate demand curve links the average price level of the whole economy with aggregate quantity demanded. The aggregate demand curve is downward-sloping. –Thus, a decline in the overall price level leads to an increase in the quantity demanded by consumers, businesses, and government.

19-5 Aggregate Demand Curve Lower aggregate prices leads to more aggregate demand, for the following reasons: –First is the wealth effect. Lower prices lead to an increase in the value of your assets. This higher wealth leads to more spending. –Second is the interest rate effect. Lower prices lead to lower interest rates, which increases consumption.

19-6 Aggregate Demand Curve –Third is the exchange rate effect. As interest rates fall, it become less appealing for foreigners to invest in the US. The demand for dollars falls, and the dollar depreciates relative to other currencies. This increases net exports and GDP.

19-7 Aggregate Demand Curve

19-8 Aggregate Supply Aggregate supply is the quantity of goods and services that the economy produces. The aggregate supply curve links the average price level of the economy with the quantity of goods and services produced. The short-run aggregate supply curve is upward- sloping. But, in the long term, aggregate supply is vertical, because when prices rise, so do wages and all the other costs of production.

19-9 Long-Term and Short-Term Aggregate Supply Short-term aggregate supply curve Q P Price level Q1Q1 GDP Long-term aggregate supply curve P1P1

19-10 Long-term Equilibrium The long-term aggregate equilibrium occurs at the point where long-run aggregate supply is equal to aggregate demand and the two lines cross. This point gives us an equilibrium aggregate price level, P, for the economy, and an equilibrium output, Q. Long-term aggregate supply is the same as potential GDP.

19-11 Aggregate Demand and Supply

19-12 Shifts in Aggregate Supply A reduction in aggregate supply (curve shifts to the left) causes equilibrium output to fall and the price level to rise. –Thus, inflation rises and growth slows. An increase in aggregate supply (curve shifts to the right) causes equilibrium output to increase and the price level to fall. –Thus, inflation is reduced and growth rises.

19-13 Shift in Aggregate Supply Aggregate demand curve Q P Price level Q1Q1 GDP Original aggregate supply curve P1P1 Aggregate supply after terrorist attack

19-14 Shifts in Aggregate Demand An increase in aggregate demand (curve shifts to the right) causes both the equilibrium level of output and the price level to rise. –Thus, both inflation and growth increase. –But this is only temporary. A decrease in aggregate demand (curve shifts down to left) causes both equilibrium output and the price level to fall. –Thus, both inflation and growth slow.

19-15 Shifts in Aggregate Demand Shifts in demand lead to only temporary changes in quantity. As prices and wages adjust, the economy moves along the long-term supply curve, with prices higher but output moving back to the starting point. Attempts by policymakers to stimulate the economy and boost output above its long- term equilibrium level may succeed temporarily.

19-16 Shifts in Aggregate Demand In the long run, however, the only outcome of government stimulation is to increase inflation. In other words, there is no sustainable way to drive unemployment down below its natural rate.

19-17 Shift in Aggregate Demand Original aggregate demand curve Q P Price level Q1Q1 GDP Short-term aggregate supply curve P1P1 Long-term aggregate supply curve New aggregate demand curve P2P2 Q2Q2 A B C

19-18 Saving and Investment Saving is the portion of income that is not consumed. It is available to invest in long-term assets. There are three types of savings: –Personal savings are what remains from household income after taxes and consumption spending are taken out. –Government savings are the excess of tax revenue over current spending – that is, the amount of money the government accumulates.

19-19 Saving and Investment –Business savings are the part of corporate profits that are not distributed in the form of stock dividends or some other payment to owners. National savings is the sum of personal savings, government savings, and business savings. Another source of potential funding of investment is flows of money from outside the US.

19-20 Sources and Uses of Savings

19-21 What Determines Savings? The personal savings rate in the United States has been falling. It was over 10% in the early 1980s, and now it is reportedly close to zero. –The personal savings rate is equal to personal savings as a percentage of disposable personal income. The personal savings rate in the US is much lower than in many other countries. This is also true of the national saving rate.

19-22 The US Personal Savings Rate

19-23 Does Saving Matter? In a closed economy (no global connections), savings are important, because they determine investment in the long run. But in a global economy, investments can be funded with overseas monies. The country is effectively borrowing the money from overseas. The question is whether this can be sustained.

19-24 Savings versus Investment

19-25 Trade Deficit The trade balance is the difference between exports of goods and services and imports of goods and services. If the trade balance is negative – that is, if imports exceed exports – we say that the country is running a trade deficit. The US trade deficit has increased significantly in recent years.

19-26 Goods and Services Trade Balance as Percent of GDP

19-27 Explanation for the Trade Deficit There are a number of possible explanations for the trade deficit: –First, it is our fault because: US manufacturers are unable to compete. US consumers are overspending, causing the deficit. Overspending by the federal government is the cause.

19-28 Explanation for the Trade Deficit –Second, it is their fault because: Foreign countries put up barriers that keep out US exports and subsidize their own exports. –Finally, it is no one’s fault because: The strength of the US economy allows us to import more goods. Other countries want to lend to the US.

19-29 Paying for Trade The US can pay for what we import in four ways: –Sell exports to foreigners. –Borrow money from foreign investors. –Sell assets such as stocks, bonds, and real estate to foreign investors. –Allow foreign companies to build factories in the US.