1. 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?

2. READ Mankiw, Chapter 33, 34 Krugman 27, 28, 29 Morton Unit 3

3. 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.

4. 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.

5. 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

6. The Aggregate Demand Curve *Krugman

7. Shifts of the Aggregate Demand Curve Changes in Expectations Wealth Stock of physical capital *Krugman

8. Shifts of the Aggregate Demand Curve *Krugman

9. There are 3 reasons why the aggregate demand curve is negatively sloped: 1) Pigous REAL WEALTH EFFECT. 2) Keyness INTEREST RATE EFFECT. 3) Mundell-Flemings EXCHANGE-RATE EFFECT (also called the OPEN ECONOMY EFFECT or the FOREIGN PURCHASES EFFECT)

10. 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 (1877-1959) and is sometimes called the Pigou Effect.

11. 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.

12. 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 households wealth and increase consumption spending. In summary: Price Level => Real Wealth => Purchasing Power => RGDP demanded

13. 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.

14. 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.

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

16. The Interest Rate Effect was emphasized by the only economist to have a branch of economics named after him: John Maynard Keynes (1883-1946). It is sometimes called the Keynes Effect.

17. 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.

18. 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

19. 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.

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

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

22. 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).

23. 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. 1 2 3 GDP 2 GDP 1 GDP 3 P1P1 P3P3 P2P2 AD

24. Real Domestic Output, GDP AggregateAggregate GDP 2 GDP 1 GDP 3 ExpendituresExpenditures 45 0 2 1 3 (C a + I g + X n + G) 1 at P 1 Additionally, aggregate expenditures schedule will rise when the price level declines and fall 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

25. 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 45 0 2 2 1 3 P2P2 P1P1 P3P3 Compare the GDP at each level.

26. 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.

27. 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

28. 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

29. 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

30. Shifts of Aggregate Demand: Short-Run Effects *Krugman

31. 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.

32. 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.

33. Long-Run Macroeconomic Equilibrium *Krugman

34. THE MULTIPLIER EFFECT

35. 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.

36. 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.

37. 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... 2.... but the multiplier effect can amplify the shift in aggregate demand. Copyright © 2004 South-Western *Mankiw

38. 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.

39. 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.

40. The Multiplier

41. THE CROWDING OUT EFFECT

42. 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.

43. 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.

44. 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 3.... which increases the equilibrium interest rate... 2.... the increase in spending increases money demand... MD2D2 Quantity of Output 0 Price Level Aggregate demand, AD 1 (b) The Shift in Aggregate Demand 4.... 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

45. 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.

46. Quantity of Output 0 4 7 2….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

47. 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.

48. 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

49. 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