Download Unit 3 Notes - Phoenix Union High School District

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