Unit III: Aggregate DemandAggregate Demand The Consumer Confidence IndexThe Consumer Confidence Index MultiplierMultiplier Crowding Out EffectCrowding Out Effect ECONOMICS What does it mean to me? READ Krugman Sec 4, Mod 16 Mankiw Ch 33 DO Morton Unit 3

READ Mankiw, Chapter 33, 34 Krugman Sec 4, Mod 16 Morton Unit 3

Module Income and Expenditure KRUGMAN'S MACROECONOMICS for AP* 16 Margaret Ray and David Anderson Use a Picture of a retiree here

What you will learn in this Module : The nature of the multiplier, which shows how initial changes in spending lead to further changes The meaning of the aggregate consumption function, which shows how current disposable income affects consumer spending How expected future income and aggregate wealth affect consumer spending The determinants of investment spending Why investment spending is considered a leading indicator of the future state of the economy Krugman, Sec 4 Mod 16

GROSS DOMESTIC PRODUCT---GDP The value of the TOTAL of final goods and services produced within the boundaries of the US whether by Americans or foreigners.

Module Aggregate Demand: Introduction and Determinants KRUGMAN'S MACROECONOMICS for AP* 17 Margaret Ray and David Anderson

AGGREGATE DEMAND What is AGGREGATE DEMAND? …a schedule or curve showing the sum of the demand for all goods and services in the economy…… It can also be seen as the quantity of real GDP demanded at different price levels. It reflects the summation of desired expenditures by domestic consumers, businesses, government, and foreign buyers on newly produced goods and services.

Aggregate Demand Curve The Aggregate Demand Curve is downsloping, which indicates an inverse relationship between the price level and the amount of real domestic output purchased. AD 0 Real Gross Domestic Product PRICE LEVELPRICE LEVEL

The Aggregate Demand Curve *Krugman

Aggregate Demand Curve Horizontal axis Vertical axis Relationship between price level and real GDP demanded Aggregate Demand Krugman, Sec 4, Mod 17

What you will learn in this Module : How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy How the wealth effect and interest rate effect explain the aggregate demand curve’s downward slope What factors can shift the aggregate demand curve Krugman, Sec 4, Mod 17

Why is the Aggregate Demand Curve Downward Sloping? The effect of price level on C, I, and X - M Not the Law of Demand Wealth Effect Interest Rate Effect p p’p’ Y’Y Krugman, Sec 4, Mod 17

Aggregate Demand p p YY’ Y p’

Shifts of the Aggregate Demand Curve Changes in  Expectations  Any part of the GDP equation  Wealth  Stock of physical capital *Krugman

Shifts of the Aggregate Demand Curve ∆C, ∆I, ∆G, ∆X - ∆M ∆Expectations ∆Wealth ∆Existing Stock of Capital ∆Fiscal Policy ∆Monetary Policy

Shifts of the Aggregate Demand Curve *Krugman

There are 3 reasons why the aggregate demand curve is negatively sloped: 1) Pigou’s REAL WEALTH EFFECT. 2) Keynes’s INTEREST RATE EFFECT. 3) Mundell-Fleming’s EXCHANGE-RATE EFFECT (also called the OPEN ECONOMY EFFECT or the FOREIGN PURCHASES EFFECT)

A higher price level reduces the real value or purchasing power of the total financial assets of the public. REAL WEALTH EFFECT When the purchasing power of your money is reduced, it is called the REAL WEALTH EFFECT. It holds true for any asset of fixed dollar amount. The wealth effect was emphasized by Arthur Pigou ( ) and is sometimes called the Pigou Effect.

Suppose that you were a retired person living on a pension (fixed-income) during a period of high inflation. The costs you incur continue to rise in price but your income remains the same.

The reverse would be true if the price level were to fall. A decline in the price level will increase the real value or purchasing power of a household’s wealth and increase consumption spending. In summary: Price Level => Real Wealth => Purchasing Power => RGDP demanded

INTEREST RATE EFFECT The INTEREST RATE EFFECT also causes aggregate demand to have a negative slope. This will increase demand for money. Consumers will wish to hold more dollars in order to purchase those items they want to buy. When interest rates increase, most goods and services will have a higher price tag. As price level increases, so do interest rates.

the aggregate demand curve assumes the money supply is fixed. To put it another way, the aggregate demand curve assumes the money supply is fixed. A higher interest rate will cause…….. The increase in demand drives up the price paid to use money (interest rate). A higher price level increases the demand for money. When the price level increases, people need more money for their purchases.

Other repercussions such as: Delayed expansion by businesses. Delayed replacement of worn parts in businesses. Delayed purchases of boats, cars, or homes by consumers.

The Interest Rate Effect was emphasized by the only economist to have a branch of economics named after him: John Maynard Keynes ( ). It is sometimes called the Keynes Effect.

If the demand for money increases and the FEDERAL RESERVE SYSTEM does not alter the money supply, then interest rates will rise. At higher interest rates, the opportunity cost of borrowing rises, and fewer interest- sensitive investments will be profitable, reducing the quantity of investment goods demanded.

Price level Money demanded (money supply unchanged) Interest rate Investments RGDP demanded The net effect of the higher interest rate is fewer investment goods demanded and, as a result, a lower RGDP demanded. In summary: and

OPEN ECONOMY EFFECT FOREIGN PURCHASES EFFECT The third reason for a negatively sloped aggregate demand curve is the OPEN ECONOMY EFFECT, also called the FOREIGN PURCHASES EFFECT of changes in the price level. A higher domestic price level causes the price of goods and services to rise relative to the Global markets. This lowers the real GDP demanded at the higher price level. Consumers tend to buy fewer domestic goods and more foreign goods.

In summary: Price level Demand for domestic goods RGDP demanded and

Price level changes affects the level of aggregate spending, which, in turn, affects the amount of real GDP demanded in the economy.

Real Domestic Output, GDP Price LevelPrice Level AD 2 AD 1 AD 3 Change in aggregate demand Change in aggregate demand, which is caused by changes in one or more of the determinants of aggregate demand (consumer spending, investment spending, government spending, net export spending). AD 0 Real Gross Domestic Product PRICE LEVELPRICE LEVEL Change in the quantity of real output demanded real wealth effect, interest rate effect, foreign market effect Change in the quantity of real output demanded, caused by changes in the price level (real wealth effect, interest rate effect, foreign market effect).

To be more specific, an increase in the price level, other things equal, will decrease the quantity of real GDP demanded. Real Domestic Output, GDP Price LevelPrice Level By the same token, a decrease in the price level, other things equal, will increase the quantity of real GDP demanded GDP 2 GDP 1 GDP 3 P1P1 P3P3 P2P2 AD

Real Domestic Output, GDP AggregateAggregate GDP 2 GDP 1 GDP 3 ExpendituresExpenditures (C a + I g + X n + G) 1 at P 1 Additionally, aggregate expenditures schedule will rise (to P 3 ) when the price level declines and fall (to P 2 ) when the price level increases. (C a + I g + X n + G) 3 at P 3 (C a + I g + X n + G) 2 at P 2 We will discuss this in greater detail when we get to Aggregate Supply.

Real Domestic Output, GDP Price LevelPrice Level 1 3 GDP 2 GDP 1 GDP 3 P1P1 P3P3 P2P2 AD Real Domestic Output, GDP AggregateAggregate GDP 2 GDP 1 GDP 3 ExpendituresExpenditures P2P2 P1P1 P3P3 Compare the GDP at each level.

With respect the U.S. exports, a $30 pair of U.S.-made blue jeans now might be brought for 2880 yen compared to 3600 yen. In terms of U.S. imports, a Japanese watch might now cost $225 rather than $180. This increase in NET EXPORTS translates into a rightward shift in U.S. aggregate demand. Under these circumstances, U.S. exports will rise and imports will fall. This increase in NET EXPORTS translates into a rightward shift in U.S. aggregate demand.

A B In other words, it indicates the quantities of real gross domestic product demanded at different price levels. aggregate demand curve The aggregate demand curve reflects the total amounts of goods and services that all groups together want to purchase in a given time period. AD PL 1 PL 0 RGDP 1 RGDP 0 Real Gross Domestic Product PRICE LEVELPRICE LEVEL

A B In other words, when price level decreases ( ), the quantity of RGDP increases ( ); when price level increases ( ), the quantity of RGDP decreases ( ). The aggregate demand curve slopes downward to reflect an inverse relationship between overall PRICE LEVEL and the quantity of REAL GROSS DOMESTIC PRODUCT. AD PL 1 PL 0 RGDP 1 RGDP 0 Real Gross Domestic Product PRICE LEVELPRICE LEVEL Notice that as we move from point A to point B, price level increases as RGDP decreases

But what are some of the factors that cause the curve to shift to the right or left?? AD 0 Real Gross Domestic Product PRICE LEVELPRICE LEVEL AD 2 AD 1

Shifts of Aggregate Demand: Short-Run Effects *Krugman

AD 0 Real Gross Domestic Product PRICE LEVELPRICE LEVEL AD 1 An increase in any component of GDP (C, I, G, X - M) can cause the aggregate demand curve to shift to the right.

AD 0 Real Gross Domestic Product PRICE LEVELPRICE LEVEL AD 2 Conversely, decreases in C, I, G, or (X - M) will shift the aggregate demand curve to the left.

Long-Run Macroeconomic Equilibrium *Krugman

THE MULTIPLIER EFFECT

Marginal Propensity to Consume (MPC) Marginal Propensity to Save (MPS) MPC = ∆ Consumer Spending ∆ Disposable Income MPS = ∆ Saving ∆ Disposable Income MPC + MPS = 1 MPC = 1 - MPS MPS = 1 - MPC The Multiplier: An Informal Introduction Krugman Sec 4, Mod 16

The Multiplier Effect Government purchases are said to have a multiplier effect on aggregate demand. –Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

The Multiplier Effect The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Autonomous Change in Aggregate Spending (AAS) Multiplier ∆Y = 1_________ (1 - MPC) X ∆AAS Multiplier = ∆Y_____ ∆AAS = 1_________ (1 - MPC) The Multiplier: An Informal Introduction

Figure 4 The Multiplier Effect Quantity of Output Price Level 0 Aggregate demand,AD 1 $20 billion AD 2 AD 3 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion but the multiplier effect can amplify the shift in aggregate demand. Copyright © 2004 South-Western *Mankiw

A Formula for the Spending Multiplier The formula for the multiplier is: Multiplier = 1/(1 - MPC) An important number in this formula is the marginal propensity to consume (MPC). –It is the fraction of extra income that a household consumes rather than saves.

A Formula for the Spending Multiplier If the MPC is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

The Multiplier *Krugman

Current Disposable Income and Consumer Spending Relationship between Disposable Income and Consumer Spending Consumption Function (equation showing how an individual household’s consumer spending varies with the household’s current disposable income) (c = a + MPC x yd) Autonomous Consumer Spending (A) (the amount of spending a household would spend if it had no disposable income Aggregate Consumption Function C = A + MPC X DI Krugman, Sec 4, Mod 16

Shifts of the Aggregate Consumption Function Changes in Expected Future Disposable Income (consumer expectations) Permanent Income Hypothesis (Milton Friedman argued that consumer spending depends mainly on the income people expect to have over the long-term, not just their current income) Changes in Aggregate Wealth (wealth has an effect on consumer spending) Life-cycle Hypothesis (consumers plan their spending over their lifetime, not just the current DI) Krugman, Sec 4, Mod 16

Planned Investment Investment Spending Krugman, Sec 4, Mod 16

The Interest Rate and Investment Spending A decrease in the real interest rate will result in more gross private investment r r’ I I’ Krugman, Sec 4, Mod 16

eve Expected Future Real GDP, Production Capacity, and Investment Spending An increase in either expected future real GDP or production capacity will result in more investment at the same interest rate r I I’ Krugman, Sec 4, Mod 16

THE CROWDING OUT EFFECT

The Crowding-Out Effect Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending.

The Crowding-Out Effect This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect Quantity of Money Quantity fixed by the Fed 0 Interest Rate r Money demand,MD Money supply (a) The Money Market which increases the equilibrium interest rate the increase in spending increases money demand... MD2D2 Quantity of Output 0 Price Level Aggregate demand, AD 1 (b) The Shift in Aggregate Demand which in turn partly offsets the initial increase in aggregate demand. AD 2 AD 3 1. When an increase in government purchases increases aggregate demand... r2r2 $20 billion Copyright © 2004 South-Western *Mankiw

The Crowding-Out Effect When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

Quantity of Output ….the increase in spending increases money demand…. 1…When an increase in government purchases increases aggregate demand… Interest Rate SmSm Quantity of money fixed by the Fed MD 1 MD 2 r1r1 r2r2 AD 1 AD 2 3…which increases the equilibrium interest rate…. 4…which in turn partly offsets the initial increase in demand. AD 3

The increase in the interest rate tends to reduce the quantity of goods and services demanded, especially in the investment sector. This CROWDING OUT of investment will offset the expansion of Aggregate Demand and the AD curve will shift only to AD 3.

Macroeconomic Policy  Fiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending.  Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending. *Krugman

Compiled by: Virginia H. Meachum, Economics Teacher Coral Springs High School Sources: Principles, Problems, and Policies, by Campbell McConnell & Stanley Brue Economics, by Krugman, Wells Principles of Economics, by N. Gregory Mankiw Notes by Florida Council on Economic Education and FAU Center for Economic Education Notes by Foundation for Teaching Economics