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Aggregate Demand Consumption and Saving Investment Government Purchases and Net Exports Demand-Side Equilibrium A Model of Aggregate Demand Aggregate Demand (AD) is the economy’s total demand for goods and services = total expenditures = C + I + G + NX Question: What determines AD and GDP? Need to build a model of the U.S. economy. Model consists of demand and supply sides. Consumption A key determinant of consumption is disposable income. There is a positive relationship between C and DI. The marginal propensity to consume (MPC) is the fraction of each additional dollar of income that is consumed = DC/DDI. Autonomous consumption is the portion of your consumption that does not depend on DI. 2: Consumer Spending and Disposable Income FIGURE $8,000 $7,500 $7,000 $6,500 6,000 5,500 Billions of 2000 Dollars 5,000 4,500 4,000 Real disposable income 3,500 3,000 2,500 2,000 1,500 World War II Real consumer spending The Great Depression 1,000 500 2004 0 1930 1940 1950 1960 1970 1980 1990 2000 Copyright © 2006 South-Western/Thomson Learning. All rights reserved. 3: Consumer Spending and Disposable Income FIGURE 2004 2003 2002 2001 2000 1998 1997 $5,619 1995 1994 1992 1990 1991 1989 1988 1987 1986 1999 1996 1985 1984 1979 1980 1978 1976 1974 $3,036 1970 1964 Real Consumer Spending 1960 1955 1947 1945 1941 1942 1943 1939 1929 0 $3,432 Real Disposable Income $6,081 Copyright © 2006 South-Western/Thomson Learning. All rights reserved. We can represent this relationship by a consumption function that relates C to DI: C = a + b(DI) or C = a + b(Y – T) a = autonomous consumption b = MPC = DC/DDI The saving function relates saving (S) to disposable income (DI): S = DI – C = DI – [a + b(DI)] = -a + (1 – b)(DI) (1-b) = marginal propensity to save (MPS) MPC + MPS = b + 1 – b = 1 Example: C = 100 + 0.75(Y-T) Changes in DI => movement along C-function Factors which shift C-function: (1) Consumer Wealth: Upwards (2) Price Level: Downwards (3) Expected Income: Upwards (or consumer confidence) (4) Real Interest Rate: Downwards or Ambiguous! Factors which shift the consumption function will change autonomous consumption (a). Effects of Taxes on Consumption Consumption versus Disposable Income. MPC is likely low for temporary DDI MPC is likely high for permanent DDI Example: Tax Rebate Policy of 2001. Investment Demand Investment is spending by businesses on new productive (physical) capital goods. Three categories of investment: (i) Business spending on new plant/equipment. (ii) Change in business inventories. (iii) Residential construction (new homes). Remember investment is the change in the nation’s capital stock. Investment can be divided into two parts: (1) Planned Investment or Investment Demand: ID = investment in plant and equipment + residential construction + planned inventory investment (2) Unplanned Inventory Investment (IU) = the unexpected build up or run down of business inventories. I = ID + IU A key determinant of ID is the real interest rate (r) – must compare interest rate to return on investment projects. Factors which determine ID. An Increase In: (1) Real Interest Rate (r): Decreases ID (2) Business Confidence/Expectations: Increases ID (3) Corporate Taxes: Decreases ID (4) Tech Innovations (long-run) Increases ID Government Purchases Government Purchases (G) is determined by (i) Executive Branch (President) (ii) Legislative Branch (Congress) Government Spending = G + Transfer Payments Net Taxes = T – Transfers. Fiscal policy deals with the government adjustment of government purchases (G) and net taxes (T). Net Exports NX = Exports (X) – Imports (IM) Many domestic and foreign economic factors determines NX (domestic and foreign GDP, exchange rates). For now assume NX given. Aggregate Demand-Side Equilibrium In an economic model: exogenous variable => variables that have assigned values endogenous variable => variables that are unknown and determined by model Question: How much GDP is the entire economy willing to demand? This will give us “demand-side” GDP: AD = C + I + G + NX The Simple Demand-Side Equilibrium Model: Exogenous (given): ID, G, NX, T and a. Endogenous: Y (GDP demanded) Always True: Y = C + I + G + NX I = ID + IU Equilibrium is a situation of no change; there is no incentive for firms to increase or decrease production. A demand-side equilibrium occurs when (i) IU = 0 (ii) I = ID (iii)Y = C + ID + G + NX Graphical Interpretation: The 450 Diagram (i) Slope of Expenditures Line (C+ID+G+NX) is MPC. (ii) Intercept of Expenditures Line is Autonomous Spending (ATS) – the level of overall spending that does not depend on income: ATS = a – bT + ID + G + NX (iii) 450 Line Represents Income or GDP (Y=Y). Case I: YH > Y* YH = C + I + G + NX > C + ID + G + NX I > ID and IU > 0 Decrease Y. Case II: YL < Y* YL = C + I + G + NX < C + ID + G + NX I < ID and IU < 0 Increase Y. Case III: Y = Y* IU = 0 I = ID Y = C + ID + G + NX EQUILIBRIUM Formula for Simple Equilibrium Model: (i) C = a + b(Y-T) (ii) Given T Given (“lump-sum”) (iii) Given ID,G,NX Equilibrium GDP is given by 1 )( ATS ) Y* = ( 1 b 1 )[ a bT ID G NX ] = ( 1 b What Causes Changes in GDP? Question: What factors can cause a change in (demand-side) equilibrium GDP? Answer: Changes in autonomous spending (ATS). Factors which shift expenditures line and change Y*: (i) autonomous consumption (a) (ii) Investment Demand (ID) (iii) Government Purchases (G) (iv) Net Exports (NX) (v) Net Taxes (T) Question: How much does equilibrium GDP change for every dollar of additional ATS. Example: Kaitlyn Buys a DVD player for $100 from Bob’s Electronics. The spending multiplier indicates the change in equilibrium GDP for each additional dollar of ATS. Spending Multiplier = DY*/DATS The Simple Spending Multiplier: DY DY DY DY DY 1 1 Da DID DG DNX DATS 1 b The Simple Tax Multiplier shows the change in equilibrium GDP for each additional dollar of taxes: DY b 0 DT 1 b Application – Business Cycles * Great Depression * Self-Fulfilling Expectations Application – Fiscal Policy * Expansionary Fiscal Policy * Government Spending versus Taxes The Growth Rate of U.S. Real Gross Domestic Product since 1870 Shortcomings of the simple spending and tax multipliers: (i) Ignores variable (marginal) income taxes. (ii) Ignores the effect of interest rates and prices. (iii) Ignores variable imports. Variable Taxes and the Multiplier The Federal government collects two types of taxes: (1) Fixed Taxes – do not depend on income (T0). (2) Variable Taxes – Income taxes. T = T0 + tY (Total Taxes) (Fixed) where t = income tax rate. (Variable) Formulas w/ Variable Taxes: (1) Equilibrium GDP: 1 Y* ( )( ATS ) 1 b(1 t ) (2) Spending Multipliers: DY 1 DATS 1 b(1 t ) (3) Tax Multiplier: DY b DT 1 b(1 t ) Aggregate Demand Curve Question: What’s the relationship between (demand-side) equilibrium GDP (YD) and Prices? => P real vale of money-fixed assets => autonomous consumption => Y* The aggregate demand (AD) curve shows the negative relationship between demand-side Y and prices. Any factor other than P which changes YD => shifts AD curve: An increase in (1) consumer wealth or confidence => right (2) ID => right (3) G => right (4) NX => right (5) T => left