Unit 3: Aggregate Supply & Demand
Consumption FunctionDevelopment• John Maynard Keynes originated idea • Measures economic performance of an economy• Focuses on the relationship b/w Consumption &
Savings
Simplifications • Private/closed economy (no int’l influence & gov’t
ignored) • C + Ig
• Assume that all saving is personal • Depreciation & net foreign factor = 0 • Reminder: w/ no gov’t or foreign trade, GDP = NI = PI = DI (all the same!)
Consumption FunctionTools• Theory assumes that the level of output &
employment depend directly on the level of aggregate expenditures • Changes in output reflect changes in agg.
spending • Consumption
• The most important determinant of consumer spending is DI (income)
• 45° angle represents all points where consumer spending equals DI (1:1) • 45° line represents zero savings • If DI increases, both consumption & savings
will increase
Consumption FunctionTools• Consumption Schedule
• Historically, households spend a larger proportion of small income than of a larger income
• Breakeven: C = DI • total income level when H consume all
income • Dissavings occurs at low levels where
consumption exceeds income & households must borrow (credit cards)
Consumption FunctionTools• Non-income Determinants of Consumption &
Saving • Wealth• Expectations• Household Debt• Taxation
• Shifts & Stability • Consumption & saving schedules will shift in
opposite directions • UNLESS caused by a tax change
• Consumption & saving schedules are generally stable unless deliberately shifted by gov’t action
45°
1:1
Dissavings
Savings
Break Even
DI
Consumption
Consumption Function
$500
$500
DissavingsSavings
Break Even DI
Savings
Savings Function
Marginal Propensity to Consume & Save
• MPC: what effect a ∆ Income has on amount C• MPC = change in consumption
change in income• MPS: what effect a ∆ Income has on
amount S• MPS = change in saving
change in income• MPC + MPS = 1
Marginal Propensity to Consume & Save
• Calculate MPC/MPS• If disposable income changes from
$10,000 to $12,000 and consumption changes from $9,000 to $10,000: • What is MPC? • What is MPS?
• Why do MPC & MPS always equal 1?
MPC & MPSLevel of output & income
(NNP=DI)(1)
Consumption(2)
Saving(1)-(2)
(3)
MPCΔ(2)/Δ(1)
(4)
MPSΔ(3)/Δ(1)
(5)
$12,000 $12,100 -100 .90 .1
13,000 13,000 0 9/10 1/10
14,000 13,800 200 .8 .2
15,000 14,500 500 .7 .3
16,000 15,100 900 .6 .4
The Multiplier EffectWhy do cities want the Superbowl in their
stadium? An initial change in spending will set off a spending chain that is magnified in the economy.
Example:• A Seahawks fan spends $120 on dinner at John’s
diner.• John’s income has increased by $120.
• John spends $100 on a new bench from Carol’s furniture shop.
• Carol spends $80 on wood from Dan’s lumber yard. • Dan spends $50 on lunch at Sharon’s restaurant…
The Multiplier Effect shows how spending is magnified in the economy & doesn’t end at the initial purchase/investment.
Multiplier • Multiplier Effect
• Any increase in spending will result in an even larger increase in GDP due to the fact that every $ spent is spent again multiple times.
• Increases in spending can come from either government (G) or businesses (Ig)• Any money spent is someone else’s
income & thus subject to spending. • Contingent on MPC & MPS … WHY? • Limiting factor of multiplier is MPS
• Multiplier = 1/MPS or 1/(1-MPC)• Larger the MPC, larger the
multiplier
Multiplier • What is the multiplier if the MPC is equal to
¾? • 1 / (1 - 0.75) = 4
• What is the multiplier if the MPC is equal to 9/10? • 1 / (1 - 0.9) = 10
• What is the multiplier if the MPS is 1/5? • 1 / 0.2 = 5
Multiplier • Multiplier Effect
• Multiplier is used to calculate how any change in spending will change total spending (AD) or income (GDP)• ∆ Spending x Multiplier = ∆ AD/GDP
George Bush, in an effort to increase GDP during a recession, proposed a stimulus package which provided every American family with $200 more of disposable income. The marginal propensity to consume at that point in time was 0.75. Calculate the multiplier and identify how much more spending this would generate per family. 1/0.25 = 4 4 x 200 = $800
Multiplier • Would the multiplier be larger or smaller if
people saved more of their additional income? (MPS = .25 vs. .3) • Smaller ( 4 vs. 3.33)
• What would happen to the multiplier if people saved all of their income? • It would be 1 & thus spending doesn’t multiply
(Multiplier = 1/1)• What would happen if people spent all of their
income? • It would be infinite & thus spending would be
replicated for every transaction (Multiplier = 1/0)
Multiplier • If the multiplier were 4, how much money
would the gov’t spend to increase aggregate demand by $1 million? • $250,000 ( spending x 4 = 1,000,000 )
• If the gov’t needed to cut AD by $2 million and the multiplier were 4, how much would gov’t spending have to be reduced? • $500,000 ( spending x 4 =
2,000,000 )
Multiplier • How does the multiplier explain why
changes in investment spending cause large fluctuations in GDP? • Because increases in investment cause
endogenous increases in consumption, the ultimate increase in GDP is larger than the initial investment• i.e. minor injections/leakages cause
even greater growth of GDP ($1 M injection can yield growth of $5 M)
• If disposable income changes from $15,000 to $19,000 and saving changes from $10,000 to $11,000:
• MPS: .25
• MPC: .75
• The MULTIPLIER: 4
MPS/MPC & Multiplier
• If disposable income changes from $15,000 to $16,000 and consumption changes from $10,000 to $10,750:
• MPS: .25
• MPC: .75
• The MULTIPLIER: 4
MPS/MPC & Multiplier
Interest Rates & Investment Demand
• What is investment? • Investment decisions made using
cost/benefit analysis. • Benefit = expected rate of return (r)• Cost = interest rates – the “cost” of money
(i)• make sure i is adjusted for inflation
• Rules: • If expected return ≥ real interest –
INVEST • If expected return < real interest – DO
NOT
Interest Rates & Investment Demand
Why is the ID downward sloping?
Shifts in Investment Demand
• Cost of Production• Lower costs shift ID Higher shifts ID
• Business Taxes• Lower business taxes shift ID Higher shifts
ID • Technological Change
• New technology shifts ID • Stock of Capital
• Low on capital shifts ID High shifts ID
• Expectations • Positive expectations shifts ID Negative
shifts ID
Interest Rates & Investment Demand
The real interest rate is 2%. What is investment at that level?
Investment Schedulein
vest
me
nt
GDP = DI
$2 T
If real interest rate was 2%, we would assume that businesses are investing $2T at all levels of output.
The amount invested is very unstable/volatile, however, and investment can & does occur irregularly.
Ig
Ig0$1.8
• Measures Aggregate Demand/Expenditures against real GDP
• POLICY GOAL IS TO MOVE IT UP (increase GDP)
• Leakages (withdrawal of spending from income/expenditure stream)
imports, taxes, savings • Injections (addition of spending to the
income/expenditure stream) spending (G or Ig), investment, net
exports• Must equal each other: S( savings) + M ( imports) + T
( taxes) = I ( investments) + X ( exports) + G( government purchases)
Aggregate Expenditures Model
GDP (NI, NO)
AD/AE
45°
1:1
CC + Ig
Aggregate Expenditures Model
Equilibrium GDP is the intersection of ____ & ____.
International Trade & Equilibrium Output
• Xn & Aggregate Expenditures • Closed economy:
• AE = C + Ig
• Open economy: • AE = C + Ig + Xn
• Measuring AE for domestic goods (X – M)
Government Purchases & Equilibrium GDP
• A mixed economy – adding gov’t spending & taxes.
• Government spending is subject to the multiplier. • Balanced Budget Multiplier: a change in
G is more powerful than a tax change of the same size \• (spend & tax at same amount will yield
growth)• Taxes are leakages
• Lump Sum: tax that provides equal amounts of revenue at each level of GDP• a tax increase shifts AE downward only
by the amount of the tax times the MPC
GDP (NI, NO)
AD/AE
45°
1:1
CC + Ig
C + Ig + GC + Ig + G + (Xn)
C + Ig + G + Xn
U. S.
Aggregate Expenditures Model
Government Purchases & Equilibrium GDP
• Recessionary Gap: • The amount by which AE at full employment
GDP falls short of those required to achieve full employment GDP
• Inflationary Gap• The amount by which an economy’s AE at
full employment exceeds those just necessary to achieve full employment
GDP (NI, NO)
AD/AE
45°
1:1
C
C + Ig
Aggregate Expenditures Model
AE Model AD Curve
GDP
AD
/A
E
45°
1:1
AE1 (at P1)
3500 4000
AE2 (at P2)
GDP
Pric
e Le
vel
0
AD
3500 4000
P1
P2
Thus, GDP is less at P2 (higher price level) than P1
Aggregate Demand• Shows the amounts of real GDP that buyers
desire to purchase at each price level. • If the price level:
• Increases (inflation), then Real GDP demanded ___
• Decreases (deflation), then Real GDP demanded ___Price
Level
Real domestic output (GDPR)
AD = C + I + G + Xn
Aggregate DemandWhy downward slope? • Real-Balances Effect:
• price level reduces purchasing power – GDP • Interest Rate Effect:
• price level leads lenders need to charge higher interest rates – GDP
• Foreign Purchases Effect: • price level reduces foreign D of U.S. goods &
increases U.S. D of foreign goods – GDP (due to –Xn)
Determinants of Aggregate Demand
An increase in spending shifts AD right & decrease in spending shifts AD left.
Price Level
Real domestic output (GDP)
AD = C + I + G + Xn
AD1
AD2
1.Change in Consumer Spending Consumer Wealth (Boom in the stock
market…)Consumer Expectations (People fear a
recession…)Household Indebtedness (More consumer
debt…)Taxes (Decrease in income taxes…)
2. Change in Investment SpendingReal Interest Rates (Price of borrowing $...)Rate of Return: Future Business Expectations (High
expectations…) Productivity and Technology (New robots…) Business Taxes (Higher corporate taxes…)
Determinants of Aggregate Demand
3.Change in Government Spending (War…)(Decrease in defense spending…)
4.Change in Net Exports (X-M) Exchange Rates(If the us dollar depreciates relative to the
euro…) National Income Abroad
AD = GDP = C + I + G + Xn
Determinants of Aggregate Demand
Aggregate Supply• Shows the level of real GDP that firms will
produce at each price level. • Three ranges:
Price Level
GDPR
A B
C
D
Q1 Q2 Q3
Keynesian
Classical
Cost-Push Inflation vs. Demand Pull Inflation
• Outcome on price level is the same, but GDP differs.
Price Level
GDPR
A B
C
D
Q1 Q2 Q3
Keynesian
ClassicalADAS
SRAS & LRAS• AS differentiates b/w short-run & long-run
• SRAS: immediately after change in PL (input costs haven’t yet adjusted to change in PL)
• LRAS: measures potential output / NRU; point at which input prices have adjusted to change in PL
Actual GDP = SRASPotential GDP = LRAS
SRAS & LRAS• The LRAS & SRAS curves also indicate our PPF &
can be used to identify GDP gaps.
Price Level
GDPR
A
B
C
LRAS SRAS
500 550 600
P1
Capital Goods
Con
sum
er G
oods
Determinants of Aggregate Supply
• Firms are able to produce more or less at every price level.• per-unit production costs change for reasons
outside changes in real GDP • SRAS shifters mostly
Price Level
GDPRQ1 Q2 Q3
AS1 AS2AS3
1.Inputs• Costs of Domestic Resources
Factors of Production• Cost of Imported Resources
Exchange rate value• Market Power
Competition
Determinants of Aggregate Supply
2. Legal-Institutional Environment• Business taxes & subsidies • Gov’t regulation:
Anti-trust laws Labor laws Environmental laws
3. Productivity worker education management skilltechnology
Determinants of Aggregate Supply
Equilibrium Price Level & Real Output
• Shifts in SRAS/AD will reveal inflationary/recessionary gaps.
Price Level
GDPR
Inflationary Gap
Recessionary Gap LRAS
• The use of government spending (the BUDGET) & revenue collection (TAXES) to influence the economy
• Fiscal yearoOctober 1- September 30
• Federal Budget: o Revenues = Spending… Balanced Budget o Revenues > Spending… Budget Surplus o Revenues < Spending… Budget Deficit
Fiscal Policy
National DebtFederal Debt = accumulated deficits - accumulated surpluses $17.3 T
TOOLS
Types of Fiscal Policy
Contractionary: works to fight inflation but can lead to a fall in GDP. 1. Raise taxes: take money out of
circulation2. Reduce gov’t spending: cuts back on
funding social programs & business contracts
Results in…• Budget surplusResolves inflationary / recessionary gap.Republicans would prefer which option?
TOOLS
Types of Fiscal Policy
Expansionary: works to fight deflation, unemployment, & recessions. Used to raise the level of output in the economy. 1. Reduce taxes: gives consumers more to
spend & less to pay the gov’t2. Increase gov’t spending: gov’t spends
money on social programs & business contracts
Results in…• Budget deficitResolves inflationary / recessionary gap
Republicans would prefer which option?
• Focuses on changing AD• Gov’t or consumer spending to help the
economy. • Policy used traditionally by Democrats• John Maynard Keynes (1883-1946)o Gov’t should depend more on public works to
fix unemployment.o Gov’t should decrease spending to fix inflation.
Demand Side Economics
• Focuses on changing AS• Stresses influence of taxation on the
economy, especially businesses • Gov’t should cut taxes on personal &
corporate income• Gov’t should reduce regulations to decrease
the costs of production• John Baptiste Sayo Says Law: supply creates it’s own demand?o If you make a product, people will get paid and
have money to spend and therefore purchase more goods
• Reaganomics
Supply Side Economics:
Nondiscretionary/Automatic Fiscal Policy
• Built-in Stabilizers: automatic changes in G & T as the economy changes• Don’t require new legislation – already
embodied in law• e.g. unemployment compensation,
food stamps, SS, Medicare • Progressive Tax System
• Recession: as incomes drop, ppl pay less of their income in taxes – more to spend
• Inflation: as incomes rise, ppl pay more of their income in taxes – less to spend