Chapter 9, 10, 11, 17Aggregate Demand and

Aggregate Supply

Chap 9,10,11 Vocabulary

Investment demand curve MPC MPS Multiplier Recessionary gap Inflationary gap Aggregate demand Aggregate supply

Determinants of AD Determinants of AS Productivity Equilibrium price level Real-balances effect Interest rate effect Foreign purchases effect

Aggregate Expenditures (or Aggregate Demand) Ch 9 Pg 160-165)

The Aggregate Expenditures (AE) approach was developed by John Maynard Keynes. Aggregate demand is directly related to AE.

The AE approach looks at total spending in the economy:

C= Personal consumption (70%) I = Investment Spending (15%) G = Government Spending (15%) Xn = Exports less Imports (?)

Keynes and the Long Run The British economist Sir John Maynard Keynes (1883–

1946), probably more than any other single economist, created the modern field of macroeconomics.

Published: The General Theory of Employment, Interest and Money

In it he decried the tendency of many of his colleagues to focus on how things work out in the long run:

“This long run (a Classical Economic concept) is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the sea is flat again.”

Personal Consumption

Personal Consumption is the largest component of the AE (or AD) approach

Consumption is most dependent upon the level of Disposable (spendable) Income (DI)

According to Keynes, we either spend or consume our incomes.

Autonomous Spending

Average Propensity to Consume (APC)• Spending that occurs at a specific level of

income (and in a specific country). Based upon historical patterns, the APC can be anticipated for income levels.

• In determining the APC/APC, economists assume that we either Spend or Save our incomes, what is not spent is saved.

• And a very important concept is that “consumption is dependant upon disposable income”!!!!

$50,000 $100,000 $150,000

Current disposable income

$100,000

80,000

60,000

40,000

20,000

0

Consumer spending

2006 Disposable Income and Consumer Spending

Disposable income was $43,799 andSpending (APC) was $43,131.

APC/APS Continued

The formula for the APC is:• APC = consumption/income

The formula for the APS is:• APS = savings/income

Since we either save or spend our income, the APC + the APS = 1

A very important concept is that savings is related to investment spending. Remember in the circular flow model, savings is a leakage, and investment is an injection. Savings creates investment spending.

We will not need to know these formulas, but we do need to understand the concept of “autonomous” spending.

Marginal Propensity to Consume/Save (MPC and MPS)

The Marginal Propensity to Consume is the fraction of any change in disposable income that is consumed.

MPC= Change in Consumption Change in Disposable Income

The Marginal Propensity to Save is the fraction of any change in disposable income that is saved.

MPS= Change in Savings Change in Disposable Income

Marginal Propensities MPC + MPS = 1

• MPC = 1 – MPS• MPS = 1 – MPC

Remember, people do two things with their disposable income (or a change to that income), consume it or save it! So MPC + MPS must equal 1.

“Autonomous spending” is that spending that occurs independent of the change in income. The MPC and MPS only examines how the “change” in income is consumed or saved.

The Multiplier (pg 182-186)MPC/MPS (pg 163-164)

The Multiplier assumes that an initial change in spending causes a larger change in the GDP as the initial spending creates a chain of spending as it works through the economy.

The Multiplier is based upon the Marginal Propensity to Consume (MPC). The MPC assumes that if a change in income occurs, we will consume (MPC) a portion of the change, and we will save (MPS) part of the change. MPC and MPS are inversely related.

The MultiplierRound 1A change in income of $1,000 creates ……….

Income +

$1,000

Consumption

$500

Savings

$500

Round 2 $500 $250 $250

Round 3 $250 $125 $125

Changein GDP =Multiplier x initial change

in spending

THE MULTIPLIER EFFECT

For example, the tax rebate of 2008 totaled $80 billion and the MPC was .2 (Multiplier = 1/1-.2 or 1.25), multiplier was 1.25. So we consumed $16 billion (20%). $16 billion X 1.25 equals a

$20 billion increase in the GDP. Originally, the government projected an MPC of .5 which would have resulted in $80

Billion increase in the GDP

Multiplier = 1/MPS (or 1/ 1-MPC)

We use the following formula to find the multiplier

The Current Economy

The Marginal Propensities help explain the political argument over tax cuts versus increased government spending. During a recession (when tax cuts seem like a good idea) people tend to spend less and save more. Consequently tax cuts may have less effect on the GDP. We will continue looking at this topic in chapter 12.

THE MULTIPLIER EFFECT

.9

.8

.75

.67

.5

10

5

4

3

2

MPC Multiplier

MPC and the Multiplier

Chapter 11Understanding Aggregate Demand

Aggregate demand is the total demand for goods and services in an entire economy.

The aggregate demand curve plots the total demand for GDP as a function of the price level.

The aggregate demand curve slopes downward.

Why the Aggregate Demand Curve Slopes Downward

The increase in spending that occurs because the real value of money increases when the price level falls is called the Real Balances.

The interest rate effect: With a given money supply in the economy, a lower price level will lead to lower interest rates and higher consumption and investment spending.

The impact of foreign trade: A lower price level makes domestic goods cheaper relative to foreign goods.

Why the Aggregate Demand Curve is Downward-Sloping?

Why the Aggregate Demand Curve is Downward-Sloping?

Why the Aggregate Demand Curve is Downward-Sloping?

Factors That Change Aggregate Demand

Factors That Change Aggregate Demand (Continued)

and indebtedness

4. Degree of excess capacity5. Technology

The Components of Aggregate Demand

Aggregate Demand (also referred to as “Mainstream Economics”) is Keynesian Economic Theory.

In our study of GDP accounting, we divided GDP into four components:• Consumption spending (C), investment spending (Ig), government purchases (G), and

net exports (Xn).

These four components (using In, net

investment) instead of Ig because Gross

Investment includes depreciation and inventory ) are also four parts of aggregate demand because the aggregate demand curve really just represents

total spending.

What is Investment Spending ?

Money spent or expenditures on:• New plants (factories)• Capital equipment (machinery)• Technology (hardware & software)• New Homes (40+% of the total

investment spending) (an explanation of why the current financial crisis is being compounded by Housing)

Expected Rates of Return How does business make investment

decisions?• Cost / Benefit Analysis

How does business determine the benefits?• Expected rate of return (Marginal Benefit > Marginal

Cost) How does business count the cost?

• Interest costs How does business determine the amount of

investment they undertake?• Compare expected rate of return to interest cost

If expected return > interest cost, then invest If expected return < interest cost, then do not invest

Real v. Nominal Interest Rate What’s the difference?

• Nominal is the observable rate of interest. Real subtracts out the rate of inflation and is only known after the fact.

Businesses and banks attempt to anticipate upcoming inflation rates. Remember if inflation is 5% per year and the bank makes no allowance for the 5%, they are being paid back with dollars that are worth 5% less.

• How do you compute the real interest rate? Nominal Interest Rate minus Rate of Inflation

= Real Interest Rate• What then, determines the cost of an investment

decision? The Real Interest Rate

The Investment Demand Curve

I

N

T

E

R

E

S

T

R

A

T

E IG

ID

Changes in rate cause changes in In. Factors other than interest rates may shift the entire ID curve

5%

3%

$2 trillio

n

$3 trillio

n

Shifts in Investment Demand

r%

IG

ID

4%

$2.5 trillio

n

$3.25 trillio

n

ID1

When investment demand shifts, different levels of gross private investment occur even while interest rate remains constant

INTEREST

RATE

QUANTITY OF $ INVESTED

What Causes Shifts in Investment Demand

• Interest Rates• Expected Rate of Return

Cost of Production Business Taxes Technological Change Stock of Capital Expectations Degree of Excess Capacity.

Understanding Aggregate Supply

The aggregate supply curve depicts the relationship between the level of prices and the total quantity of final goods and services that firms are willing and able to supply.

• To determine both the price level and real GDP, we need to combine both aggregate

demand and aggregate supply.

CHANGES IN SHORT RUN AGGREGATE SUPPLY (SRAS)

Pric

e le

vel

Real domestic output, GDPQ

P SRAS3

SRAS1

SRAS2

Increase InAggregate

Supply

Decrease InAggregate

Supply

DETERMINANTS OF AGGREGATE SUPPLY (What shifts AS)

1. Change in Input Prices

Domestic Resource Availability• Land• Labor• Capital• Entrepreneurial Ability

• Per unit production costs increase• Per unit cost = total input cost

total outputPrices of Imported Goods, for example Negative supply shocks (like oil price

increases in the 70s)

DETERMINANTS OF AGGREGATE SUPPLY (contd)

2. Change in Productivity

Productivity =Real Output

Input

3. Change in Legal-Institutional Environment• Business Taxes and Subsidies• Government Regulation

Negative Supply Shocks (decreases AS)

Original Keynesian AD/AS Model

P1

Q1

Pri

ce L

evel

Real Domestic Output/GDP

AS

AD1

AD2

Q2

(New)Keynesian (AS/AD)

P1

Q

Pri

ce L

evel

Real Domestic Output/GDP

AS

AD

LRAS/FullEmployment

The new Keynesian graph reflects an “intermediate” range to reflect increasing price levels while GDP increases.

Pric

e Le

vel

Real Domestic Output, GDP

Q

P SRAS

AD1

Equilibrium in theIntermediate Range

QeQ1

EQUILIBRIUM: REAL OUTPUTAND THE PRICE LEVEL

P1

Pe

Economy tends to returnto equilibrium (or Full

Employment) as AD increases

LRAS

AD

How to Increase AD!

Pric

e Le

vel

Real Domestic Output, GDP

Q

P SRAS

AD

Point Pe, Qe, represents a fullyemployed economy; i.e. about a 5% rate ofUnemployment; 3.5% Real GDP growth; and an Inflation rate of 2-3%.

Qe

Where is the best place forthe U.S. economy

Pe

LRAS

Growth Illustrated on PPCAlso Increased LRAS on AD/AS

Graph

PPC

Cap

ital G

ood

s

Consumer Goods

..

PPC1

Growth Illustrated on PPCAlso Increased LRAS on AD/AS

Graph

PPC

Cap

ital G

ood

s

Consumer Goods

..

PPC1

Classical Economic Theory

We will review several economic theories in detail in Chapter 16.

The next few slides introduce the Classical approach to economics and the graphs that explain this theory.

One of the major tenets of this approach is that the government should NOT intervene in the economy. The economy is self regulating and will correct itself.

Full Employment

THE LONG RUN AGGREGATE SUPPLY (LRAS) REPRESENTS FULL EMPLOYMENT.

GDPR

PL

AD

SRASLRAS

YF

P

THE MOST IMPORTANTGRAPH INMACROECONOMICS (at least for the AP test.)

YF refers to Full Employment

Recessionary Gap A recessionary gap exists when

equilibrium occurs below full employment output.

GDPR

PL

AD

SRASLRAS

YF

P

Y

Inflationary Gap An inflationary gap exists when equilibrium

occurs at a point above full employment.

GDPR

PL

AD

SRASLRAS

YF

P

Y

Increase in AD

Price level increases, GDP increases and unemployment decreases

GDPR

PL

AD

SRASLRAS

YF

P

Y

AD1

P1

Decrease in AD

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

AD1

P1

The decrease in AD causes the price level to decrease,The GDP to decrease and unemployment to increase.

Increase in SRAS

Price level decreases, GDP increases and unemployment decreases

GDPR

PL

AD

SRASLRAS

YF

P

Y

SRAS1

P1

Decrease in SRAS

Increase in input costs causes SRAS to decrease. GDP decreases, unemployment increases and Price

increases

GDPR

PL

AD

SRAS

LRAS

YF

P

Y1

SRAS1

P1

ECONOMIC GROWTH

GDPR

PL

AD

SRASLRAS

YF

P

Y

SRAS1

AD1

LRAS1

Economic growth occurs as an economy is able to produce more goods and increase the Real GDP. In the graph above,growth occurs as both AD and SRAS increase simultaneouslyand this enables price level to remain stable.

Growth Illustrated on PPCAlso Increased LRAS on AD/AS

Graph

PPC

Cap

ital G

ood

s

Consumer Goods

..

PPC1