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

04/21/23 © 2004 Claudia Garcia - Szekely

1

Chapter 8

Aggregate Demand

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“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

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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 KrugmanNew York Times

The Keynesian Model

Developed within of the urgency to get the economy out of the Great Depression

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• Concern is finding a short term solution to unemployment • Concern is NOT inflation

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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

Rest of World

InterestRent

ProfitsWages

Goods and Services

HouseholdsFirms

S

=300

C

I

T

G

G

Circular Flow Diagram

pay

to

NX

The Components of Aggregate Demand

8

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

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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

11Time

12Disposable Income

Con

sum

pti

on

Consumer Spending and Disposable Income

What determines the level of Consumption?

Income Wealth Prices Expectations Real Interest

Rate

AutonomousComponent 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

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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

1900 1700 1500 1300 1100 900

1947

Real Disposable Income

Real

Con

sum

er

Sp

en

din

g

1963

0

MPC = DC/DYMPC = 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

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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)

The Consumption Function

Induced Consumption:As income increase

consumption increases.

Income Consumption0 ?

100 190150 235200 280250 325300 370350 415400 460450 505

Autonomous Consumption:

Value of Consumption when income is zero.

Determines the height of the Consumption Function

Disposable income Consumption Saving

0

1000 1,400

2000 2,200

3000

4000 3,800

5000 4,600

6000 5,400

1. Calculate the MPC2. Calculate the Intercept3. Write down the formula for the Consumption function4. What is the value of Consumption when Income is 10,0005. Calculate Savings6. At what value of Y is Consumption equal to Income? 7. Write down the formula for the Savings function

The Consumption Function

C = a + b YValue of C when Y is 0 MPC

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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.

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Saving (S)

We will assume that income not

consumed is saved

Y - C = S

Consumption (C) Mirror Saving (S)

S = Y – CS = 0 - a

Intercept of Saving Function is – a

Value of C when Y = 0

When income is zero, saving = - a

Recall:Y - C = S

When Y = 0

C = a + (b x 0)C = a

C = a + b Y

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The Saving Function

- a Intercept of Saving Function is – a

S = -a + ?S

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A $200 increase in

income

Causes a $180Increase in C

3420

3240

MPC = C/Y

MPC = 180/200=0.9

3600 3800

C

S = Y – C

20 = 200 - 180

Recall:S = Y - C

The MPS= S/Y = 20/200 = 0.1 or 10%

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 $20Increase in S

3600 3800

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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.

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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 = 0.1MPC + MPS = 1

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The Saving Function

S = -a + (1- b) Y

Value of Saving when Y(Income) is

0

1 – MPC


0

1000 1,400

2000 2,200

3000

4000 3,800

5000 4,600

6000 5,400

1. Calculate the MPC2. Calculate the Intercept3. Write down the formula for the Consumption function4. What is the value of Consumption when Income is 10,0005. Calculate Savings: S = Y - C6. Write down the formula for the Savings function7. At what value of Y is Consumption equal to Income?


0 600 -600

1000 1,400 -400

2000 2,200 -200

3000 0

4000 3,800 200

5000 4,600 400

6000 5,400 600

1. Calculate the MPC =800 /1002. Calculate the Intercept = 6003. Write down the formula for the Consumption function = 600 +0.8 Y4. What is the value of Consumption when Income is 10,000 = 600 + 0.8*10,0005. Calculate Savings6. At what value of Y is Consumption equal to Income? At 3,0007. Write down the formula for the Savings function = -600 + 0.2Y

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31

Events that cause a movement along the Consumption

Function

Changes in incomes ONLY!

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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


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

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2. Changes in consumer expectation:

Pessimistic expectations about future: employment, incomes, wealth.

Consumers slow down purchasesA downward shift in the Consumption Line

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2. Changes in consumer expectation:

Optimistic expectations about future: employment, incomes, wealth.

Consumers increase purchasesAn upward shift in the Consumption Line

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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


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


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

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40

Investment

The acquisition of capital goods

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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.

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Investment Includes…

Residential Construction– consumer purchases of new houses

and condominiums. Higher interest rates reduce home purchases.

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Investment Includes…

Non-residential construction Equipment, software, tools, etc.

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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)

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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

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InvestmentFirms control how much to

spend in Investment goodsFirms control how much they

want to hold in inventories

Firms control Planned Investment

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Investment does not change with current income

Income / GDP

Inve

stm

en

t S

pen

din

g Total PLANNED Expenditures on Capital goods and desired inventories

Investment

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

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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.

Government Spending does not change with current income

Income / GDP

Gove

rnm

en

t S

pen

din

gTotal PLANNED Expenditures by all levels of government as dictated by the budget

G

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).

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).

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

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Net Exports do not change with current income

Income / GDP

Net

exp

ort

s

NX

55

U$1

1DM 0.5 DMU.S. Prices are

lower to GermansU.S. Exports increase

when the dollar becomes weaker.

Weaker dollar

One Dollar buys less DM’s

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1DM

1U$ 2 U$

Foreign Prices are higher to

AmericansU.S. Imports decrease when the dollar becomes weaker.

Weaker dollar

One DM buys more Dollars

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U$1

1DM 2 DMU.S. Prices are

higher to ForeignersU.S. Exports decrease when

the dollar becomes stronger.

Stronger dollar

One Dollar buys more

DM’s

58

1DM

1U$ 0.5 U$Foreign Prices are

lower to AmericansU.S. Imports increase when

the dollar becomes stronger.

Stronger dollar

One DM buys less Dollars


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The Effect of Changes in Exchange Rates

More on Strong Dollar

http://money.cnn.com/2003/05/21/pf/investing/dollar_splash/index.htm

http://money.cnn.com/2003/05/21/pf/investing/dollar_splash/index.htm

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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

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?

Output Consumption Investment Net Exports

1000 800 500 100

1500 1200 500 100

2000 1600 500 100

2500 2000 500 100

3000 2400 500 100

3500 2800 500 100

4000 3200 500 100

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C = 100+0.9Y

5,000 10,000 19,000 25,000

4,600

9,100

17,200

22,600

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I+G+NX

5,000 10,000 19,000 25,000

I =1,000G = 500NX = 300

1,800

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AE = 100 + 0.9Y +1,800AE = 1,900 + 0.9 Y

5,000 10,000 19,000 25,000

4,600 +1,800= 6,400

9,100 +1,800 = 10,900

17,200 +1,800= 19,000

22,600 +1,800 = 24,400

AE = 100 + 0.9Y +1,800AE = 1,900 + 0.9 Y

5,000 10,000 19,000 25,000

6,400

10,900

19,000

24,400

Sold

Produced

Produced 5,000Sold 6,400

Inventories fallFirms increase Production

Produced 10,000Sold10,900

Inventories fallFirms increase Production

Produced 19,000Sold19,000

Inventories do not changeFirms do not change Production

Produced 25,000Sold 24,400

Inventories riseFirms decrease Production

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

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