Download The Aggregate Economy

The Aggregate Economy
Price Level
LRAS
AS
PL1
Q1
FE
RGDP
The Aggregate Economy
• Economic well being is determined by the
level of Real GDP
• The level of RGDP is determined by
current levels of aggregate demand (AD)
and aggregate supply (AS).
• Since spending levels are more easily
changed than production levels most
macroeconomic policy focuses on
aggregate demand.
The Aggregate Demand
• The level of total spending in an economy
is the most important determinant of GDP.
– Aggregate demand is the total spending by
all four sectors of our economy.
AD = Consumption + Investment + Government +
Net Exports = GDP
– Aggregate demand is determined by current
price level and the determinants of
Consumption, Investment, Government , Net
Exports
Aggregate Demand (AD)
AD
A change in Price Level
moves the economy along
the AD curve.
Price Level
A change in C , I , G or NX
moves the location of the
curve.
AD2
AD
Real GDP
Aggregate Demand
• Aggregate Demand slopes downward for three
reasons:
• The Wealth Effect
• The Interest-rate Effect
• The Exchange-rate Effect
• This differs from the demand curve for an
individual item in that an increase in price level
overall does NOT diminish my purchasing power
in that overall income is tied to overall price
levels in the macroeconomy.
Consumption
• Consumption (C)
–spending by households on
goods and services
Determinants of
Consumption
1. Disposable income
2. Taxes
3. Wealth (Real Asset Effect or Wealth Effect)
4. Expectations of prices or income
5. Debt
Disposable Income (DI) =Yd
• Disposable income is the income available after taxes.
• All income can either be spent or saved.
• The higher your income the more you spend and save
and vice versa.
• Taxes come out of personal income (personal income –
taxes = disposable income = spending + saving)
• An increase in taxes reduces both spending and saving
and vice versa.
Autonomous Consumption
• There is a constant level of Consumption
across all levels of disposable income.
• If income falls to zero Consumption does
not become zero.
• Savings become negative because
households either use past savings or
borrow.
Wealth
• Wealth is the accumulation of savings.
• It can take the form of financial assets or
real assets. (Changes in stock or real estate prices
will affect your wealth & your spending habits).
• The greater your present wealth the less
need you have to save and the more you
will spend which increases consumption.
• An increase in savings decreases
consumption.
Expectations of Future Income or
Prices
• If you expect a raise in the near future you
will spend more now and vice versa.
• If you think prices will rise in the near
future you will spend more now and vice
versa.
Debt
• Debt is what is owe on previous spending.
• The more I owe the less I can spend now.
• Debt accumulation is seen as an increase
in consumption and a decrease in savings.
• Debt reduction is seen as a decrease in
consumption and an increase in savings.
Aggregate Demand (AD)
These determinants of Consumption cause the
aggregate demand curve to shift because
Consumption is a direct component of AD.
PL
AD3
AD2
AD1
RGDP
GLOBAL PERSPECTIVE
Average Propensities to Consume,
Selected Nations, 1999
.80
.85
.90
.95
1.0
Canada
.986
United States
.976
Netherlands
.972
United Kingdom
.940
Germany
.907
Italy
.873
Japan
.869
France
.842
Statistical Abstract of the United States, 2000
Investment
• Investment (I)
– Spending by businesses on capital
• Machinery, factories, technology, inventories
– Investment Demand (Id) is the quantity
businesses want to spend within a given time
period.
• It is based on a business’s expected rate of net
profit.
• Net profit is determined by subtracting the
expected cost (interest rate) from the expected
profit.
Real Interest Rate
Investment Demand
Id
Quantity of
Investment
Determinants of Investment
Demand
1. Interest rates – this is the cost of
borrowing or forgoing savings
– If interest rates are high it would be more
profitable to save and less profitable to
borrow to spend (point A)
– If interest rates are low it would be more
profitable to borrow to spend and less
profitable to save (point B)
– A change in interest causes movement
along the investment demand curve
Real Interest Rate
Affect of Interest Rates on
Investment Demand
i1
A
B
i2
Id
Q1
Q2
Quantity of Investment
Determinants of Investment
Demand
Profit expectations – the following
effect business profit expectations
a.
Cost of production
b.
Business taxes
c.
Technological change
d.
Expectations of future profit
e.
Stock of capital on hand
Changes in profit expectations lead to a change
in Investment demand – the curve shifts right
or left (Id1 to Id2)
2.
Real Interest Rate
Affect of Change in Profit
Expectations
i1
I d2
Q2
I d1
Q1
Quantity of Investment
Cost of Production
• Any change in the cost of inputs will
change businesses’ profit expectations
and their investment demand.
• Cost of inputs increases therefore
investment demand decreases (shifts left).
• Cost of inputs decreases therefore
investment demand increases (shifts
right).
• The major costs of inputs are wages and
oil.
Business Taxes
• Increases in businesses taxes reduces
businesses’ profits and therefore their
investment demand.
• Business taxes include corporate income
tax, capital gains tax, excise tax.
• Increases in taxes shift the investment
demand curve left; decreases shift the
curve right.
Technological Change
• An increase in technology allows
businesses to produce at a lower cost and
therefore increases their profits and their
investment demand.
• An increase in technology shifts the
investment demand right; a decrease
shifts the curve left.
Expectations of Future Profit
• An expected future increase in demand for
their product will lead to larger profits and
therefore leads to an immediate increase
in investment demand.
• An increase in expected future profit shifts
the investment curve to the right; a
decrease shifts the curve to the left.
Stock of Capital on Hand
• If companies have capital equipment
(factories, tools, etc.) on hand that are not
being utilized there is no reason to
purchase more (investment demand
decreases).
• If companies are maximizing their use of
capital equipment then they will purchase
more (investment demand shifts right).
Aggregate Demand (AD)
Price Level
AD
An increase in Investment of
causes an increase in AD. A
decrease in I causes a
decrease in AD.
AD2
AD3 AD1
Real GDP
Volatility of Investment
• Investment demand is much more
unstable than Consumption. It changes
often and to a large degree, due to the
following:
– The durability of capital goods.
– Innovation occurs irregularly.
– Profits vary considerably.
– Business expectations are easily changed.
Adding Government and Taxes
• Government spending creates an injection of funds in
the economy.
• Government spending increases automatically in a
recession.
• An increase G increases AD
An increase in
Government spending
increases AD
PL
AD1
AD2
RGDP
Taxes
• Taxes are leakages
• They reduce AD, but any change in taxes results in a
change in savings and spending
• Taxes reduce Consumption spending by change in taxes
x households marginal propensity to consume
• AD decreases by less than the change in taxes
A reduction in taxes of
$600 reduces
Consumption and AD by
$450.
PL
$450b
AD2
RGDP
AD1
Net Exports
Net Exports (exports – imports)
Determinants of Net Exports:
• Income abroad (if foreign income is up our exports go
up)
• Exchange rates (if the dollar appreciates our exports go
down)
• Tariffs (if we place a tariff on imports our imports go
down)
An increase in NX leads to an increase in AD
A decrease in NX leads to a decrease in AD
Problems of a National Debt
Crowding-out effect
When government borrows it competes
with businesses for savers dollars, raising
the interest rate and making it harder for
private businesses to borrow. This
decrease in business spending can reduce
overall GDP.
The Crowding Out Effect
AD/AS
Price
Level
AS
Real
Interest
PL2
PL3
Loanable
Funds Mkt
Real
Interest
s
i2
i2
i1
i1
PL1
Investment
Demand
D2
AD1 AD3
AD2
Q1 Q3 Q2
RGDP
Id
D1
Q1 Q2
Q of Loans
Q2
Q1
Q of Investment
Graph 1: At AD1 we are in a recession. Government cuts Taxes and increases Spending to move the economy to AD2.
Graph 2: Because the government is now deficit spending the demand for loanable funds increases causing interest rates to
rise.
Graph 3: This increase in interest rates decreases Investment spending which causes AD to fall back to AD3 (Graph1 again).
The Aggregate Economy
• Aggregate supply measures total
production within our economy
– It is determined by current price levels and
three factors of production
• Input prices, productivity levels and legalinstitutional factors