2. 1 Time As incomes rise, consumption increase.

3. 8/30/2015© 2004 Claudia Garcia - Szekely2 Chapter 8 Aggregate Demand

4. The Components of Aggregate Demand 4. Net Exports 2. Investment 3. Government Spending 1. Consumption

5. 4 Expenditures in consumer goods are 70% of GDP

6. GDP=Y Taxes Transfers

7. 6 Disposable Income Consumption

8. What determines the level of Consumption? Disposable Income Y d Wealth Prices Expectations C=bY d Add these two components C = a + bY d As income increases, consumption increases All other factors which affect Consumption C=a Autonomous from Y d Induced by changes in Y d

9. Slope:b Consumption has two components C = a + bY d Real Disposable Income Billions Consumption Billions 300500700900 425 575 875 1175 725 1025 11001300 C=bY d Induced by changes in Disposable Income Increase in Disposable income YdYd Increase in Consumption CC C = a + (  C/  Y d )Y d Slope  C/  Y d MPC  C/  Y d

10. Slope Consumption has two components Real Disposable Income Billions Consumption 300500700900 425 575 875 1175 725 1025 11001300 a: Intercept C = a + (  C/  Y d )Y d C = a Autonomous Consumption ( Independent from Disposable Income) responds to changes in wealth, prices and expectations C = a + MPCY d C = a + (  C/  Y d )Y d

11. MPC C = a + bY d Real Disposable Income Billions Consumption Billions 300500700900 425 575 875 1175 725 1025 11001300 C = a + 0.75Y d Choose any two points  Y d= 400  C=300 b MPC=  C/  Y d Calculating the slope MPC=300/400

12. Real Disposable Income Billions Consumption Billions 300500700900 425 575 875 1175 725 1025 11001300 a: Intercept C = a + 0.75 Y d 725 = a + 0.75(700) Value of Consumption when Disposable Income = 0 725 = a + 525 Choose any point 725-525= a 200= a 200 C =725 Y= 700 C = 200 + 0.75Y d

14. 13 S S = Y d – C S = 0 - a S = - a C= a C = a+ MPC*Y d When Disposable Income is zero: Income not consumed is saved When Disposable Income is zero: C = a+ MPC*Y d S = -a+ MPS*Y d

15. MPC for the US is 90% 14

16. MPC=0.9 Real Disposable Income Billions 300700 400 400+360=760 760+360=1120 11001500 C = a + 0.9Y d  Y d= 400  C=0.9*400  Y d= 400  C=0.9*400  Y d= 400 MPC=0.9  C=0.9*400 MPC=0.9 ?

17. MPS=0.1 300700 -a=-200 -200+30=-170 -170+40=-130 11001500  y d= 400  S=0.1*300  Y d= 400  S=0.1*400  Y d= 400 MPS=0.1  S=0.1*400 MPS=0.1 -130+40=-90 -90+40=-50  y d= 300 2000

18. Real Disposable Income Billions Consumption Billions 2000250030003500 2300 2750 3650 320 0 4100 4000

19. Same Intercept “a” different slope “MPC” 18 Y0Y0 Y1Y1 C0C0 C1C1 C0C0 C1C1 15003000 1400 2750 1100 2150 a Smaller MPC=0.7 a Larger MPC=0.9 Larger Increase in consumption Smaller Increase in consumption 1,350 1,050 1,500

20. Different intercept “a” same slope “MPC” 19 Y0Y0 Y1Y1 C0C0 C1C1 C0C0 C1C1 15003000 2250 3300 1100 2150 a Same MPC a* Same MPC same Increase in consumption Same Increase in consumption 1,050

21. 20

22. The Consumption Function C = a + MPC* YdYd Consumption responds to changes in wealth, prices and expectations Y d = GDP - Taxes + Transfers Consumption responds to changes in after tax income Changes in income: Movement Along the C line. Changes in wealth, prices and expectations: Shift C line Y d = NI- Taxes + Transfers

23. 22 C = 200+0.75Y 5,00010,00019,000 25,000 C=3,950 C=7,700 C=14,450 C=18,950 Given the Consumption function, Find the value of consumption for each of these values of Y: Y C = 200+0.75*25,000 C = 200+0.75*19,000 C = 200+0.75*10,000 C = 200+0.75*5,000

24. Movement along the Consumption Function Changes in Disposable Income ONLY! 5,00010,00019,000 25,000 3,950 7,700 14,450 18,950 YdYd C

25. 24 C0C0 S0S0 1200 1300 2080 -880 2170 -870 Move UP Along C Move UP Along S Consumption Increase Savings Increase Movement along  C=MPC*  Y d  S=MPS*  Y d

26. 25 Smaller intercept Higher intercept C1C1 C0C0 S1S1 S0S0 a = 300 -a = -300 a = 200 -a = -200 Shifts in Consumption

27. Shifts in the consumption function 1.Changes in wealth: stocks, bonds, consumer durables, homes. When stock prices go down, consumer wealth drops. Consumers feel poorer (even though incomes may be the same!) decrease purchases. A downward shift in the Consumption Line: a smaller intercept. An upward shift in the Savings Line: a larger intercept.

28. Shifts in the consumption function 2.Changes in consumer expectations: Pessimistic expectations about future: employment, incomes, wealth. Consumers slow down purchases (even though incomes are the same!) A downward shift in the Consumption Line: a smaller intercept. An upward shift in the Savings Line: a larger intercept.

29. Shifts in Consumption 3.Overall Prices of goods and services When prices rise (an increase in the CPI) consumers lose buying power. This drop in the purchasing power of saved dollars make consumers feel poorer: slow down purchases. Real Wealth Decrease A downward shift in the Consumption Line: a smaller intercept. An upward shift in the Savings Line: a larger intercept.

30. Factors that shift the consumption function Changes in wealth value of stocks, bonds, consumer durables, homes. Changes in consumer expectations Pessimistic expectations decrease autonomous consumption. Changes in Prices Affect the purchasing power of assets. Shift Consumption line Interest Rates are NOT in the list! Statistical studies: interest rates have no effect on Consumption Interest rates do not shift C Interest rates affect INVESTMENT: New home purchases

31. 30 Smaller intercept Higher intercept C1C1 C0C0 S1S1 S0S0 Wealth Expectations Prices a = 300 -a = -300 a = 200 -a = -200

32. 31 Larger intercept Lower intercept C1C1 C0C0 S1S1 S0S0 Wealth Expectations Prices

33. 32 Write the equation for this consumption function 6008001000120014001600 600 700 800 900 1000 1200 1100 700 1000 900 1300 300 200 MPC =200/300 = 2/3 To get the equation, we choose any two points: C = 33.33 + 2/3 Y We know that C = 700 when Y =1,000. 700 = a + 2/3 (1,000) solve for a = 700 – 2,000/3 = 700 – 666.67 = 33.33 To calculate the intercept (a), use the MPC and the consumption function: C = a + 2/3 Y d

34. 33 Y= S= 0 C= Y What is the value of Y such that C=Y? C = 33.34 + 2/3 * Y Set C =Y: 33.34 + 2/3*Y = Y Solve for Y = 100 Set S =0: -33.34 + 1/3*Y = 0 Solve for Y = 100 S = -33.34 + 1/3*Y -33.34 Y= 100 What is the value of Y such that Saving = 0? C 33.34 S Y Y

35. Disposable incomeConsumptionSaving 0 10001,400 20002,200 3000 40003,800 50004,600 60005,400 1.Calculate the MPC 2.Calculate the Intercept 3.Write down the formula for the Consumption function. 4.Fill in the missing Consumption Values 5.What is the value of Consumption when Income is 10,000 6.Fill in the value of Savings in the table 7.At what value of Y is Consumption equal to Income? 8.Write down the formula for the Savings function

36. Disposable incomeConsumptionSaving 0600 -600 10001,400-400 20002,200-200 30003,0000 40003,800200 50004,600400 60005,400 600 1.Calculate the MPC =800 /1000 2.Calculate the Intercept = 600 3.Write down the formula for the Consumption function = 600 +0.8 Y 5.What is the value of Consumption when Income is 10,000 = 600 + 0.8*10,000 7.At what value of Y is Consumption equal to Income? At 3,000 8.Write down the formula for the Savings function = -600 + 0.2Y

37. 36 Using C function from previous slide, fill in the missing values/labels Y= S= 0 C= Y What is the value of Y such that C=Y? What is the value of Y such that Saving = 0?

38. 37 Event Consumption Purchases Increase? Decrease? Remain the Same? Consumption line shifts Movement Along the Consumption Line Saving Increase? Decrease? Remain the Same? Savings line shifts Movement Along the Savings Line Up? Down? No shift? Up? Down? No movement along? Up? Down? No shift? Up? Down? No movement along? 1 A cut in taxes which increases Disposable Income. 2 Stock prices collapse 3 The CPI (overall prices) increase 4 A decrease in transfer payments from the government to consumers which decreases Disposable Income 5 Home prices increase 6 Profits increase 7 Consumers decide to save more 8 Consumers become pessimistic 9 Decrease in interest rates 10 Employer announces major layoffs of employees 11 Massive layoffs of employees. Shift up Shift down Down Along Up along Down Along Shift down No Change Down Along Up along Shift up Shift down Up along Shift up Down Along

39. 38 Investment Includes…  Residential Construction – Consumer purchases of new houses and condominiums.  Non-residential Construction – Factories, Office buildings.  Firms’ purchases of equipment – software, tools, etc.  Changes in Inventories: unsold goods are included as investment.

40. 8/30/2015© 2004 Claudia Garcia - Szekely39 Chapter 7 Investment “Growth Policy: Encouraging Capital Formation”

41. 40 Po Goods and Services Purchased AD = C + I + G + NX GDPo Aggregate Demand Price Level Real GDP P1 GDP1

42. Aggregate DemandAggregate Expenditures Goods and Services Purchased at different Price Levels AD = C + I + G + NX Price Level AD=C + I + G + NX Goods and Services Purchased at different Income Levels AE = C + I + G + NX C + I + G + NX Income Po AD=C + I + G + NX C + I + G + NX Y0Y0

43. S0S0 1200 1300 2080 -880 2170 -870 Move Up Along C Move Up Along S Disposable Income Increase: Savings Increase Consumption Increase Savings Consumption

44. Downward shift in Consumption Upward shift in Savings

45. 44 1.Interest Rates : – Business borrow to finance investment. – Consumers borrow to purchase new homes. As interest rates drop, more investment projects become profitable and investment increases.

46. 2.Tax Incentives 3.Technical Change – Create incentive to invest as firms rush to adopt new technologies (Microchip, Internet, Faster Computers, bio - fuels) – Open business opportunities to take advantage of these new technologies (Internet Cafes) 4.Expectations – High sustained level of sales and expectations of growing economy boost investment 45

47. 46 5.Political Stability and the rule of law – Business cannot be conducted without a guarantee that property rights and contracts will be respected. (Danger of communist take over, public unrest, will negatively affect investment) Dictatorship Democracy Monarchy Theocracy Kleptocracy Political Stability can be achieved with many types of Government

48. 47 3. Government Spending Expenditures by federal, state and local governments. – Include final, intermediate and capital goods purchased by the government. – Exclude transfer payments (social security, unemployment benefits, etc) Government expenditures are determined by the budget process: The president, Congress and the Senate.

49. 1.U.S. GDP/National Income 2.GDP/Income in other countries 1. U.S Prices rise relative to prices abroad

50. 49 U $1 1Euro 0.5 Euro U.S. Goods are cheaper to Germans U.S. Exports increase when the dollar becomes weaker. Weaker dollar One Dollar buys fewer Euros Germans now pay

51. 50 1Euro 1U$ 2 U$ Foreign goods are more expensive to Americans U.S. Imports decrease when the dollar becomes weaker. Weaker dollar One Euro buys more Dollars Americans now pay

52. WEAKER DOLLAR INCREASE EXPORTS AND DECREASE IMPORTS 51

53. Aggregate Expenditures =AE I = 1000 AE = C+I+G+NX AE G = 500 NX= 300 Y = 5,000 C = 100 + 0.9Y C = 9,100 I = 1000 G = 500 NX= 300 Y = 10,000 C = 17,200 I = 1000 G = 500 NX= 300 Y = 19,000 AE = 10,900 AE = 19,000 C = 4600 AE = 6,400 C = 22,600 I = 1000 G = 500 NX= 300 Y = 25,000 AE = 24,400 AE = C + I + G + NX Income (Y)

54. 53 Identify the component of AE which is affected (C, I, G, X or M) explain how it is affected (increase, decrease). Determine the effect on Aggregate Expenditures (AE increase, decrease). a)Prices in the US decrease relative to prices abroad. b)The U.S. dollar becomes stronger c)Home prices increase d)Stock prices decrease e)Interest rates decrease f)A zero-emissions engine is developed. g)Government announces a decrease in the number of troops deployed abroad. h)U.S GDP increase Class Work

55. 8/30/2015© 2004 Claudia Garcia - Szekely54 The Effect of Changes in Exchange Rates More on Strong Dollar

56. Which component of AE is affected? a)Prices Increase b)Wealth Increase c)Interest rates Increase d)Technological Improvement e)Government spending Increase f)Taxes Increase g)Transfers Increase Review

57. AE component affected Shift? Movement Along? AE Shifts Equilibrium Y AD Prices Increase Prices Decrease NX Increase NX Decrease Exports Increase Exports Decrease Imports increase Imports Decrease Wealth Increase Wealth Decrease

58. AE component affected Shift? Movement Along? AE Shifts Equilibrium Y AD Prices Increase C drops due to wealth effect: consumers feel poorC shifts downdowndecreases Movement up along Prices Decrease C increases due to wealth effect: consumers feel richC shifts upupincreases Movement down along NX IncreaseNX increaseNX shifts upupincreases shifts right NX DecreaseNX decreaseNX shifts downdowndecreases shifts left Exports IncreaseNX increaseNX shifts upupincreases shifts right Exports DecreaseNX decreaseNX shifts downdowndecreases shifts left Imports increaseNX decreaseNX shifts downdowndecreases shifts left Imports DecreaseNX increaseNX shifts upupincreases shifts right Wealth Increase C increases due to wealth effectC shifts upupincreases shifts right Wealth Decrease C drops due to wealth effectC shifts downdowndecreases shifts left

59. AE component affected Shift? Movement Along? AE Shifts Equilibrium YAD Interest rates increase Interest rates Decrease Technological Improvement Government Spending Increase Government Spending Decrease Taxes Increase Taxes Decrease Transfers Increase Transfers Decrease

60. AE component affected Shift? Movement Along? AE Shifts Equilibrium YAD Interest rates increaseInvestment dropsI shifts downdowndecrease shifts left Interest rates DecreaseInvestment IncreasesI shifts upupincrease shifts right Technological ImprovementInvestment increasesI shifts upupincrease shifts right Government Spending IncreaseG increasesG shifts upupincrease shifts right Government Spending DecreaseG dropsG shifts downdowndecrease shifts left Taxes Increase C dropsC shifts downdowndecrease shifts left Taxes Decrease C increasesC shifts upupincrease shifts right Transfers Increase C increasesC shifts upupincrease shifts right Transfers Decrease C dropsC shifts downdowndecrease shifts left

61. 60 AE component affected Shift? Movement Along? AE Shifts Relative US Prices Increase Relative US Prices Decrease Dollar weaker Dollar Stronger