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Transcript
Unit 3 Aggregate Demand & Supply CONSUMPTION & SAVINGS • Having described GDP it is important to understand the reasons that GDP fluctuates. • As the largest component of GDP, consumption is the most important factor Consumption and Saving Functions The most important element affecting consumption ( and saving) is disposable income. DY is what consumers have left over to spend or save after taxes. DY = Gross Income – Net Taxes where net taxes = (taxes paid – transfers received) Typical consumers spend the majority of their DY and S what is left over. Consumption function - The relationship between DY and C The C and S schedules are the direct relationship between DY and C and S. Even with $0 DY we still consume as we sell assets, spend savings, or borrow (dissavings) Every extra $100 of DY, we consume an extra $80 and save and extra $20 Linear equation of table Consumption function : C = 40 + .80(DY) DY C S 0 40 -40 100 120 -20 200 200 0 300 280 20 400 360 40 500 440 60 Plotted consumption function The constant $40 is referred to as autonomous consumption because it does not Δ with DY Consumption Function Consumption 280 200 S = $20 40 200 300 DY Saving The previous table can also be converted into a saving function: S = - 40 + .20(DY) Saving Dissaving, S <0 Saving, S>0 Saving function 0 -40 DY DY =200 Homework: Consumption and Saving Read pages 147 – 152; answer questions 1-3 on page 163. Where does it go? In your notes. Changes to Consumption and Saving Marginal Propensity to Consume • MPC is the Δ in C caused by a Δ in DY. It is the slope of the consumption function • MPC = ΔC/ΔDY = slope of consumption function • Marginal propensity to save (MPS) is the Δ in S caused by the Δ in DY. • MPS = ΔS/ ΔDY = slope of the saving function • MPC + MPS = 1, always Δ in Consumption and Saving • Determinants of C and S • Wealth – value of accumulated wealth h, consumption function h, and saving function i, because households sell assets to consume more at present level of DY. • Expectations – A low expectation about future Y prompts households to i C and h S. • Household debt – Households can increase C with borrowing, or debt, but as they accumulate more debt they must use more DY to pay off their debt and C decreases. • Taxes and transfers – Increase in taxes decreases both C and S. Increase in transfer payments increases both C and S. Change in Consumption Consumption Change in Saving Saving CHigh SHigh C0 S0 SLow CLow 0 DY DY Investment Decision to Invest • Firms will spend money on new machinery or construction based upon MB and MC. • The MB of an investment is the expected real rate of return (r) the firm anticipates from the expenditure. • The MC of the investment is the real rate of interest (i), or the cost of borrowing. Expected Real Rate of Return • A pizza restaurant invests $10,000 in a new delivery car. The car will last 1 year and increased real profits should be $2,000. • The expected real rate of return is $2,000/$10,000 = .20 or 20%. • The bank offers the pizza shop owner a $10,000 loan at 15%, 5% for anticipated inflation and 10% as the real rate of borrowing. • The real interest is $1,000 on the loan. The Decision • Since the new car provides $2,000 in additional real profits (r = 20%), and the loan costs $1,000 in real interest (i = 10%), this investment should be made. • If r % ≥ i %, make the investment. • If r % < i %, do not make investment The Economist’s Creed • This is my graph. There are many like it, but this one is mine. My graph is my best friend. It is my life. I must master it as I must master my life. My graph, without me, is useless. Without my graph, I am useless. I must draw my graph true. I must avoid inefficiency who is trying to destroy me. I must find equilibrium before time runs out. I will... • My graph is human, even as I, because it is my life. Thus, I will learn it as a brother. I will learn its weaknesses, its strength, its parts, its determinants, its X and Y axes. I will keep my graph clean and ready, even as I am clean and ready. We will become part of each other. We will... • Before Danskin, I swear this creed. My graph and myself are the defenders of macroeconomics. We are the masters of our enemy. We are the saviors of my life. So be it, until victory is ours and there is no inflation or recession, but full-employment. Investment Demand i% • The demand for Investment increases as i % falls. • With Investment, price is directly related to the real interest rate. 5 • As the real interest rate falls, the total amount of Investment rises because firms receive loans cheaper Investment Demand 20 $ Investment (I) Market for Loanable Funds • Market for Loanable Funds – Relationship between saving and investment. • When savers place their money in banks or buy bonds, those funds are available to be borrowed by firms for private investment. Demand for loanable funds • As the i % falls, borrowing becomes less costly, and large investment projects become more attractive to firms. • This investment demand curve can also be thought of as a demand for loanable funds. Supply of Loanable Funds • The supply of loanable funds comes from saving on the part of households and government. If DY is greater than C, private savings exists, and is positively related to the i %. • Public savings is the difference between tax revenue and dollars spent by government. If taxes are greater than G, public savings exists, and is positively related to the i %. • The supply of loanable funds comes from saving. • The demand for loanable funds comes from investment • Equilibrium is at the real interest rate where dollars saved equals dollars invested. Market for Loanable Funds Interest Rate S i% D $F Loanable Funds ($) Homework: • Read pages 153 – 155 and answer question 7 and 8 on page 163 Interest • Read pages 529-534 • Answer questions 6-8 on page 539 Notebook Check 1. 2. 3. 4. 5. 6. 7. 8. 9. The Market System – pgs 29-38; #1-4, 11-13 Demand – pgs 45-50; # 1-2 Equilibrium – pgs 53-61; #9 Circular Flow diagram GDP pgs 116-118; #11-12 Inflation - pgs 134-137; # 10-11 Unemployment – 129-133; #5-7 Consumption & Saving – pgs147-152; #1-3 Investment – pgs 153-155; #7-8 The Multiplier Effect • Every dollar spent serves as a dollar of Y for some other person. • When you go and buy a pizza, the store owner keeps some and pays his employees’ wages. • Store employees use those wages to buy other goods and services. • The circular flow explains how the injection of a few dollars creates many more dollars. If the MPC = 0.80… • Round 1: You spend $10 on a pizza which acts as an injection of new money into the economy. • Round 2: The $10 is income for resource suppliers and with an MPC = 0.80, households spend $8 and save $2. • Round 3: The $8 of new spending is income for other households and they spend 80 percent, or $6.40 and save $1.60. • Round 4: The new $6.40 is income for other households who spend $5.12 and save $1.28 • The process repeats, and after only 4 rounds we have $29.52 of new GDP. • This is the spending multiplier effect • Multiplier = 1/(1 – MPC) • Multiplier = 1/MPS • Multiplier = (ΔGDP)/(ΔSpending) • The multiplier effect is true for C, I, G, and (X – M). • When M > X the multiplier decreases. Tax multiplier • A i in taxes will also multiply GDP, but the Δ will be smaller because it first must go through a consumers consumption function as DY. • Tm = (ΔGDP)/(Δtaxes) • Tm = MPC × M = MPC/MPS Homework • Read pages 158-162; Answer questions Aggregate Demand • Aggregate Demand – the relationship between all spending on domestic output (real GDP) and the average Price Level • AD measures the sum of C + I + G + (X – M) • AD IS SPENDING The Shape of AD • The AD curve is down-sloping for different reasons than a D curve for one product. • 3 general groups of substitutes for national output: – Goods produced in other nations (foreign purchases effect) – Goods in the future (interest rate effect) – Money and financial assets (wealth effect) • Foreign Purchases effect – When the average price of US goods and services increases, consumers will look for lower priced goods produced elsewhere. • Interest rate effect – If price levels rise consumers may need to borrow more for bigticket items. As the D for money increases, so does the price for its use (i %). Higher i % cause a decrease in I and some C (like cars). • Wealth effect – Wealth is the value of assets like stocks, bonds, savings, and cash on hand. Purchasing power of wealth decreases so the public becomes poorer in real terms and C decreases. Price Level b a AD • Because foreign goods seem less expensive, I becomes more costly, and people become less wealthy, real GDP decreases as Price Level increases. Real GDP Classwork/Homework: • Read Pages 188-191 • Answer questions 1 and 2 on page 203 Determinants of AD • Change in Consumer Spending – Consumer Wealth – Expectations – Taxes • Changes in Investment Spending – Interest Rates – Expected Returns • Changes in Government Spending • Changes in Net Export Spending – Foreign Income – Exchange Rates Aggregate Supply • Aggregate Supply – the relationship between domestic output produced (real GDP) and the average Price Level • Short-Run vs. Long-Run – The model of AS and the shape of the AS curve depends upon whether the economy has fully adjusted to market forces and price changes. Macro Short Run • In the macro short run, P of goods and services are changing, but input prices (land, labor, and capital) have not yet adjusted to product market prices. • This lag gives us a shape of the AS curve that is described in 3 stages. • Stage 1 – The economy is in recession with low production, many unemployed resources. Increasing output puts little pressure on input costs or overall PL • Stage 2 – As real GDP increases, and approaches full employment, resources become harder to find and input costs begin to rise. If PL for output P rises faster than input, producers have incentive to increase production. • Stage 3 – Approaching nation’s productive capacity, firms cannot find unemployed units. Input costs and PL rise quickly and this stage is almost vertical. Price Level AS Stage 1 Real GDP Macro Long Run • This period is long enough for input prices to have adjusted to market forces. Price Level Markets are in equilibrium and economy is at full employment. The LRAS curve is a vertical line. • The “Classical School “ of econ says the economy will naturally enter this phase. LRAS Real GDP Changes to AD and AS • Create a 1-2 sentence summary for each: • Determinants of Aggregate Demand (pg. 190) • Determinants of Aggregate Supply (pg.194) Aggregate Supply • Read pages 192-195; answer question 3-8 on page 203 1. The graph shows the loanable funds market for a country. a. Assume that the country’s government increases deficit spending, and therefore decreases its savings. Explain how the increase in deficit spending will affect the real interest rate. b. Indicate how the real interest rate change identified in part (a) will affect the investment in plant and equipment. c. Explain how the real interest rate change identified in part (a) will affect long-term economic growth. Writing Assignment #2 Market for Loanable Funds Interest Rate S i% D $F Loanable Funds ($) Determinants of AS How will each of the following cause AS to increase? Short-Run Shifts: • Change in Input Prices – Domestic Resource Prices – Prices of Imported Resources • Business Taxes and Subsidies • Government Regulation Long-Run Shifts • Productivity and Technology • Availability of Resources The Economist’s Creed • This is my graph. There are many like it, but this one is mine. My graph is my best friend. It is my life. I must master it as I must master my life. My graph, without me, is useless. Without my graph, I am useless. I must draw my graph true. I must avoid inefficiency who is trying to destroy me. I must find equilibrium before time runs out. I will... • My graph is human, even as I, because it is my life. Thus, I will learn it as a brother. I will learn its weaknesses, its strength, its parts, its determinants, its X and Y axes. I will keep my graph clean and ready, even as I am clean and ready. We will become part of each other. We will... • Before Danskin, I swear this creed. My graph and myself are the defenders of macroeconomics. We are the masters of our enemy. We are the saviors of my life. So be it, until victory is ours and there is no inflation or recession, but full-employment. Macroeconomic Equilibrium • When the Q of real output demanded is equal to the Q of real output supplied, the macroeconomy is in equilibrium. • This figure shows the economy at full employment. Price Level LRAS SRAS PL AD Q Real GDP • Recessionary gaps Price Level exist when the economy is operating below full employment (LRAS) PL and is likely experiencing high unemployment. LRAS SRAS AD Q Recessionary Gap Real GDP • Inflationary gap exists when the economy is operating above GDP. Rising prices are likely. Price Level LRAS SRAS PL AD Q Inflationary Gap Real GDP Class work or Homework: • Macroeconomic Equilibrium • Read pages 196-202 in your book, and answer questions 4, 6, 7, and 10 on page 203 in your notes section. Notebook Check 1. 2. 3. 4. 5. 6. Market for Loanable Funds – Page 163 # 7, 8 Aggregate Demand – Page 203 # 1, 2 Determinants of AD Aggregate Supply – Page 203 # 3 Determinants of AS Macro Equilibrium – Page 203 # 4, 6, 7, 10 Shifts of AD on Macroequilibrium Increases in AD • The economy is currently at equilibrium, but at a recessionary level of GDP. If AD increases from AD0 to AD1, PL slightly increases while real GDP increases rapidly and unemployment falls. Price Level LRAS SRAS AD0 AD1 Real GDP Move to Full-Employment Price Level • If AD continues to increase to AD2 in the up-sloping range of SRAS, PL rises and inflation is felt. • Demand-pull inflation is the result of rising spending from all sectors of AD LRAS SRAS AD1 AD2 Real GDP Beyond Full-Employment Price Level • If AD increases much beyond full employment to AD3, inflation is significant while RGDP sees minimal increases. LRAS SRAS AD2 AD3 Real GDP The Multiplier Again • The multiplier effect of an increase in AD is greater if there is no increase in PL • The effect is smaller with a large increase in PL Classwork/Homework • Changes to AS on Macro Equilibrium • Read pages 286-290; answer question 2 – 5 on page 300. Ticket Out the Door • Objective Question: • What are the effects of changes in AD on levels of RGDP and PL? How do these change based on the stage of AS equilibrium occurs? Shifts of AS on Macroequilibrium Supply-Side Boom • If the economy is at full employment and input prices fall, the Price SRAS curve shifts Level outward to SRAS1. This is known as a supply-side boom. • If a more permanent factor (technology or productivity) increases, LRAS would move out to LRAS1. LRAS SRAS LRAS1 SRAS1 AD Real GDP Cost-push Inflation • A leftward shift in AS creates a decrease in RGDP Price Level and cost-push inflation also known as stagflation. • Permanent decreases in LRAS are rare and can be devastating to an economy. SRAS1 LRAS SRAS LRAS1 AD Real GDP Supply Shocks • Changes in AS are the result of positive or negative supply shocks, which affect costs to firms. • Positive supply shocks may be the result of higher productivity or lower energy prices. • Negative supply shocks occur when economywide input prices suddenly increase. The Phillips Curve Short Run Phillips Curve Inflation Rate • There is an inverse relationship between inflation and the unemployment rate which has come to be known as the Phillips PC curve which is down Unemployment sloping in the short Rate run. Shifts to SRPC Inflation Rate • When SRAS shifts left, we get stagflation, where unemployment and inflation both increase. This causes a rightward PC2 shift of the SRPC. (PC2) PC1 • When SRAS shifts right, PC3 we get a leftward shift of Unemployment SRPC as unemployment Rate and inflation both decrease. (PC3) Long-Run Phillips Curve Inflation Rate LRPC SRPC 4% Unemployment Rate • The long-run Phillips curve is vertical at the natural rate of unemployment, where cyclical unemployment is equal to zero. Expectations • The differences between SRPC and LRPC when there is a gap, is the actual rate of inflation and the expected rate of inflation. • Inflationary expectations play a role in the derivation of the LRPC Inflation Rate LRPC 5% c b PC2 a 2% PC1 2% 4% Unemployment Rate 1. Expected inflation is 2% at the natural unemployment rate (4%) (point a). 2. If AD unexpectedly rises, this drives up the rate of inflation to 5% and as a result firms earn higher profits. Inflation Rate LRPC 5% c b PC2 a 2% PC1 2% 4% Unemployment Rate 3. Firms respond by hiring more people and the unemployment rate drops to 2% (point b). This is a movement along the SRPC. 4. Workers will realize their real wages are falling and demand a raise, causing inputs to become more expensive and SRAS will decrease, bringing the SRPC back to LRPC. Homework: • The Phillips Curve • Read pages 291-295; answer question 6 and 7 on page 300. Notebook Check #1 1. 2. 3. 4. 5. 6. 7. 8. 9. The Market System – pgs 29-38; #1-4, 11-13 Demand – pgs 45-50; # 1-2 Equilibrium – pgs 53-61; #9 Circular Flow Diagram GDP pgs 116-118; #11-12 Inflation - pgs 134-137; # 10-11 Unemployment – 129-133; #5-8 Consumption & Saving – pgs147-152; #1-3 Investment – pgs 153-155; #7-8 Notebook Check #2 1. 2. 3. 4. 5. 6. Consumption & Saving – pgs147-152; #1-3 Interest – pg. 529; #6-8 Aggregate Demand - pgs. 188-191 #1, 2 Aggregate Supply - pgs. 192-195; # 3-8 Changes to AS – pgs. 286-290; 2-5 Phillips Curve – pgs. 291-295; #6, 7 Notebook Check #1 1. The Market System – pgs 2938; #1-4, 11-13 2. Demand – pgs 45-50; # 1-2 3. Equilibrium – pgs 53-61; #9 4. Circular Flow Diagram 5. GDP pgs 116-118; #11-12 6. Inflation - pgs 134-137; # 1011 7. Unemployment – 129-133; #5-8 8. Consumption & Saving – pgs147-152; #1-3 9. Investment – pgs 153-155; #7-8 Notebook Check #2 1. Aggregate Demand pgs. 188-191 #1, 2 2. Determinants of AD - 8 3. Aggregate Supply - pgs. 192-195; # 3 4. Determinants of AS – 6 5. Macro Equilibrium – pgs. 196-202; # 4, 6, 7, 10 6. Phillips Curve – pgs. 291-295; #6, 7 PL AS AD RGDP