2. 9/19/2015© 2004 Claudia Garcia - Szekely1 Chapter 8 Aggregate Demand

3. 2 “Only suppliers can supply us with goods and services; the demand side can’t will a product or service into existence, no matter how hard it tries. Society therefore advances economically when it reduces tax and regulatory barriers to the creation of goods and services” Supply Side View

4. 3 Old fashioned voodoo economics- the belief in tax cut magic- has been vanished from civilized discourse. The supply- side cult has shrunk to the point that it contains only cranks, charlatans and Republicans Paul Krugman New York Times

5. The Keynesian Model Developed within of the urgency to get the economy out of the Great Depression 4 Concern is finding a short term solution to unemployment Concern is NOT inflation

6. 5 The Keynesian Model  Is a Short Run (Unemployment) model.  Assumes that Aggregate Demand determines the level of production.  Focuses on how variables that affect Aggregate Demand are interrelated.  Develops tools for the government to manage the amount of spending in the economy

7. Rest of World Interest Rent Profits Wages Goods and Services Households Firms S =300 C I T G G Circular Flow Diagram pay to NX

8. The Components of Aggregate Demand

9. 8

10. 9 National Income The sum of the incomes that all individuals in the economy earned in the forms of wages, interest, rents, and profits. – Excludes government transfer payments – Income before paying taxes

11. 10 Disposable Income The sum of the incomes of all the individuals in the economy after all taxes have been deducted and all transfer payments have been added DI = GDP - Taxes + Transfers = Y - T

12. 11 Time

13. 12 Disposable Income Consumption Consumer Spending and Disposable Income

14. What determines the level of Consumption?  Income  Wealth  Prices  Expectations  Real Interest Rate Autonomous Component of consumption Induced component of consumption C=bY C=a Add these two components C = a + bY As income increases, consumption increases The effect of these components is “bunched” together

15. 14 The Reaction of Consumption Spending to a Change in Income Copyright © 2006 South-Western/Thomson Learning. All rights reserved. B A $200 billion $180 billion 1900 1700 1500 1360 1300 1180 1100 900 19001700150013001100900 1947 Real Disposable Income Real Consumer Spending 1963 0 MPC = DC/DY MPC = 180/200=0.9 This reaction is measured by the slope of the C function. The slope is the Marginal Propensity to Consume MPC = DC/DY

16. 15 MPC = 0.9 or 90% For each $1 increase in income, consumption increases by 90 cents… 90% of the increase in income will be consumed. For each $1 decrease in income, consumption decreases only by 90 cents… Only 90% of the decrease in income translates into a reduction in consumption. When income drops, people use savings (their own or borrowed)

17. The Consumption Function Induced Consumption : As income increase consumption increases. Autonomous Consumption : Value of Consumption when income is zero. Determines the height of the Consumption Function

18. 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.What is the value of Consumption when Income is 10,000 5.Calculate Savings 6.At what value of Y is Consumption equal to Income? 7.Write down the formula for the Savings function

19. The Consumption Function C = a + b Y Value of C when Y is 0 MPC

20. 19 How Important is Consumption?  Consumption is by far the largest component of aggregate demand.  Expenditures in consumer goods are 70% of GDP.  Understanding the determinants of consumption then, is critical.

21. 20 Saving (S) We will assume that income not consumed is saved Y - C = S

22. Consumption (C) Mirror Saving (S) S = Y – C S = 0 - a Intercept of Saving Function is – a Value of C when Y = 0 When income is zero, saving = - a Recall: Y - C = S Recall: Y - C = S When Y = 0 C = a + (b x 0 ) C = a C = a + b Y

23. 22 The Saving Function - a Intercept of Saving Function is – a S = -a + ? S

24. 23 A $200 increase in income Causes a $180 Increase in C 3420 3240 MPC =  C/  Y MPC = 180/200=0.9 36003800 C  S =  Y –  C 20 = 200 - 180  S =  Y –  C 20 = 200 - 180 Recall: S = Y - C Recall: S = Y - C The MPS=  S/  Y = 20/200 = 0.1 or 10%

25. The Slope of the Savings Function: MPS Saving 380 360 The MPS = 20/200 = 10% MPS =  S/  Y A $200 increase in income Causes a $20 Increase in S 36003800

26. 25 The Marginal Propensity to Save  Is the proportion of an increase in income that is used to increase saving..  Is the proportion of an decrease in income by which saving decrease  Is a percentage or a number between o and 1.

27. 26 MPS = 1 - MPC  If the MPC = 90%, you will consume 90% of any increase in income…  If you consume 90% of any increase in income, you save the rest: 10% MPC + MPS = 100% MPC = 0.9 then MPS = 0.1 MPC + MPS = 1

28. 27 The Saving Function S = -a + (1- b) Y Value of Saving when Y(Income) is 0 1 – MPC

29. 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.What is the value of Consumption when Income is 10,000 5.Calculate Savings: S = Y - C 6.Write down the formula for the Savings function 7.At what value of Y is Consumption equal to Income?

30. Disposable incomeConsumptionSaving 0600 -600 10001,400-400 20002,200-200 30000 40003,800200 50004,600400 60005,400 600 1.Calculate the MPC =800 /100 2.Calculate the Intercept = 600 3.Write down the formula for the Consumption function = 600 +0.8 Y 4.What is the value of Consumption when Income is 10,000 = 600 + 0.8*10,000 5.Calculate Savings 6.At what value of Y is Consumption equal to Income? At 3,000 7.Write down the formula for the Savings function = -600 + 0.2Y

31. 30

32. 9/19/2015© 2004 Claudia Garcia - Szekely31 Events that cause a movement along the Consumption Function Changes in incomes ONLY!

33. 32 Factors that shift the consumption function 1.Changes in wealth Example: value of stocks, bonds, consumer durables, homes. When stock prices go down, consumer wealth decreases in value. Consumers feel poorer and slow down purchases A downward shift in the Consumption Line

34. Factors that shift the consumption function 1.Changes in wealth When stock prices go UP, consumer wealth increases in value. Consumers feel richer and increase purchases An upward shift in the Consumption Line

35. 34 Factors that shift the consumption function 2.Changes in consumer expectation: Pessimistic expectations about future: employment, incomes, wealth. Consumers slow down purchases A downward shift in the Consumption Line

36. 35 Factors that shift the consumption function 2.Changes in consumer expectation: Optimistic expectations about future: employment, incomes, wealth. Consumers increase purchases An upward shift in the Consumption Line

37. 36 Factors that shift the consumption function 3.Prices When overall prices rise (an increase in the CPI) consumer’s wealth lose buying power. This drop in the purchasing power of saved dollars make consumers feel poorer and they slow down purchases. A downward shift in the Consumption Line

38. Factors that shift the consumption function 3.Prices When overall prices fall (a decrease in the CPI) consumer’s wealth gains buying power. This increase in the purchasing power of saved dollars make consumers feel richer and they increase purchases. An upward shift in the Consumption Line

39. 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. 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 We will assume that changes in interest rates do not shift C

40. 39

41. 40 Investment The acquisition of capital goods

42. 41 Investment Includes…  Residential Construction – consumer purchases of new houses and condominiums.  Non-residential construction – Equipment, software, buildings, tools, etc.  Changes in Inventories: unsold goods are included as investment.

43. 42 Investment Includes…  Residential Construction – consumer purchases of new houses and condominiums. Higher interest rates reduce home purchases.

44. 43 Investment Includes…  Non-residential construction Equipment, software, tools, etc.

45. 44 Determinants of Investment  Interest Rates : – Business borrow to finance investment. As interest rates drop, more investment projects become profitable and investment increases.  Tax Incentives : – If directly tied to capital formation will increase investment.  Technical Change : – New technology creates a boom in investment as firms rush to adopt the new technology (Microchip) – New technologies open new business opportunities: Firms build new factories, stores, offices and equipment to take advantage of these opportunities (Internet Cafes)  Expectations about the strength of demand : – high sustained level of sales and expectations of growing economy boost investment  Political Stability and the rule of law : – Business cannot be conducted without a guarantee that property rights and laws will be respected. (News communist take over will negatively affect investment)

46. 45 Inventories are of two kinds: – Planned (desired) inventories. Firms build up inventories to be able to fulfill future orders. – Unplanned (unwanted) inventories. Firms end up with unsold inventories because sales decreased unexpectedly. Investment Also Includes Inventories

47. 46 Investment  Firms control how much to spend in Investment goods  Firms control how much they want to hold in inventories Firms control Planned Investment

48. 47 Investment does not change with current income Income / GDP Investment Spending Total PLANNED Expenditures on Capital goods and desired inventories Investment

49. 48 Investment  Firms have NO control over how much ends up as inventories. These changes in inventories depend on actual demand: – If demand dropped below what firms expected, inventories rise – If demand was as expected, inventories do not change – If demand increases from expected inventories fall. Firms DO NOT control Actual Investment

50. 49  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. Government expenditures are not a function of current income.

51. Government Spending does not change with current income Income / GDP Government Spending Total PLANNED Expenditures by all levels of government as dictated by the budget G

52. Have two components: 1.Exports: Sales of US goods to other countries.  Incomes abroad: as other countries grow, they increase purchases of U.S. goods.  Relative prices: if prices in U.S. rise faster than prices abroad, U.S. goods become relatively more expensive for foreigners and purchases of U.S. goods drop.  Exchange rates (see discussion next).

53. Have two components: 2.Imports: Purchases of foreign goods by Americans.  Incomes in the US: As the U.S. economy grows Americans purchase more goods from abroad.  Relative prices: as prices in the U.S. fall relative to prices abroad, Americans find foreign goods cheaper and purchase more from abroad.  Exchange rates (See discussion below).

54.  National Incomes: – When US incomes rise, imports increase and vice versa.  GDP of other countries: – When GDP abroad increases, US exports rise as foreigners buy more American goods.  Relative Prices: – When prices in the US rise, American goods become more expensive and exports drop as foreigners buy fewer American goods. – When prices in the US rise, foreign goods become cheaper and imports increase as Americans more foreign goods.  Exchange Rates

55. 54 Net Exports do not change with current income Income / GDP Net exports NX

56. 55 U $1 1DM 0.5 DM U.S. Prices are lower to Germans U.S. Exports increase when the dollar becomes weaker. Weaker dollar One Dollar buys less DM’s

57. 56 1DM 1U$ 2 U$ Foreign Prices are higher to Americans U.S. Imports decrease when the dollar becomes weaker. Weaker dollar One DM buys more Dollars

58. 57 U$1 1DM 2 DM U.S. Prices are higher to Foreigners U.S. Exports decrease when the dollar becomes stronger. Stronger dollar One Dollar buys more DM’s

59. 58 1DM 1U$ 0.5 U$ Foreign Prices are lower to Americans U.S. Imports increase when the dollar becomes stronger. Stronger dollar One DM buys less Dollars

60. 9/19/2015© 2004 Claudia Garcia - Szekely59 The Effect of Changes in Exchange Rates More on Strong Dollar

61. 60 1.Determine the effect on Aggregate Demand. Identify the component of AD which is affected (C, I, G, X or M) and explain how it is affected. a)Prices in the US Increase (decrease) relative to prices abroad. b)The U.S. dollar becomes weaker (stronger) c)Home prices collapse (increase) d)Stock prices collapse (increase) e)Interest rates Increase (decrease) f)A zero-emissions engine is developed. g)Government announces an Increase (decrease) in the number of troops deployed abroad. h)As the economy recovers (enters into a recession) incomes increase (drop). Questions to Prepare for Quiz

62. 2.Use the table in the next slide to answer the following: a)Calculate the MPC and the intercept of the consumption line. b)Write the consumption function: C = intercept (a) + slope (MPC)* Y c)If Income is 5700 what is the value of consumption? How much is saved? d)If autonomous consumption increases by 300 what is the new consumption function? Does this increase represent a shift? Or a Movement along the Consumption line? Does this increase imply an increase or a decrease in saving?

63. OutputConsumptionInvestmentNet Exports 1000800500100 15001200 500100 20001600 500100 25002000 500100 30002400 500100 35002800 500100 40003200 500100

64. 63 C = 100+0.9Y 5,00010,00019,00025,000 4,600 9,100 17,200 22,600

65. 64 I+G+NX 5,00010,00019,00025,000 I =1,000 G = 500 NX = 300 1,800

66. 65 AE = 100 + 0.9Y +1,800 AE = 1,900 + 0.9 Y 5,00010,00019,00025,000 4,600 +1,800= 6,400 9,100 +1,800 = 10,900 17,200 +1,800= 19,000 22,600 +1,800 = 24,400

67. AE = 100 + 0.9Y +1,800 AE = 1,900 + 0.9 Y 5,00010,00019,00025,000 6,400 10,900 19,000 24,400 Sold Produced Produced 5,000 Sold 6,400 Inventories fall Firms increase Production Produced 5,000 Sold 6,400 Inventories fall Firms increase Production Produced 10,000 Sold10,900 Inventories fall Firms increase Production Produced 10,000 Sold10,900 Inventories fall Firms increase Production Produced 19,000 Sold19,000 Inventories do not change Firms do not change Production Produced 19,000 Sold19,000 Inventories do not change Firms do not change Production Produced 25,000 Sold 24,400 Inventories rise Firms decrease Production Produced 25,000 Sold 24,400 Inventories rise Firms decrease Production