Download Sec 4, Mod 16, 17 Aggregate Demand

ECONOMICS
What does it mean to me?
Unit III:
•Aggregate Demand
•The Consumer Confidence Index
•Multiplier
•Crowding Out Effect
READ Krugman Sec 4, Mod 16
Mankiw Ch 33
DO Morton Unit 3
READ
Mankiw, Chapter 33, 34
Krugman Sec 4, Mod 16
Morton Unit 3
Module 16
Income and
Expenditure
•KRUGMAN'S
•MACROECONOMICS for AP*
Margaret Ray and David Anderson
Use a
Picture of
a retiree
here
What you will learn
in this Module:
•
The nature of the multiplier, which shows how
initial changes in spending lead to further
changes
•
The meaning of the aggregate consumption
function, which shows how current disposable
income affects consumer spending
•
How expected future income and aggregate
wealth affect consumer spending
•
The determinants of investment spending
•
Why investment spending is considered a leading
indicator of the future state of the economy
Krugman, Sec 4 Mod 16
GROSS DOMESTIC PRODUCT---GDP
The value of the TOTAL of
final goods and services
produced within the
boundaries of the US whether
by Americans or foreigners.
Module 17
Aggregate Demand:
Introduction and
Determinants
•KRUGMAN'S
•MACROECONOMICS for AP*
Margaret Ray and David Anderson
What is AGGREGATE DEMAND?
…a schedule or curve showing the sum of the demand
for all goods and services in the economy……
It can also be seen as the quantity of real
GDP demanded at different price levels.
It reflects the summation of
desired expenditures by domestic
consumers, businesses,
government, and foreign buyers
on newly produced goods and
services.
The Aggregate
Demand Curve is
downsloping, which
indicates an inverse
relationship
between the price
level and the
amount of real
domestic output
purchased.
P
R
I
C
E
L
E
V
E
L
AD0
Real Gross Domestic Product
The Aggregate Demand Curve
*Krugman
Aggregate Demand
•
•
•
•
Aggregate Demand Curve
Horizontal axis
Vertical axis
Relationship between price
level and real GDP
demanded
Krugman, Sec 4, Mod 17
What you will learn
in this Module:
• How the aggregate demand curve
illustrates the relationship between the
aggregate price level and the quantity of
aggregate output demanded in the
economy
• How the wealth effect and interest rate
effect explain the aggregate demand
curve’s downward slope
• What factors can shift the aggregate
demand curve
Krugman, Sec 4, Mod 17
Why is the Aggregate Demand
Curve Downward Sloping?
• The effect of price level
on C, I, and
X-M
p
’
• Not the Law of Demand
• Wealth Effect
p
• Interest Rate Effect
Y’
Krugman, Sec 4, Mod 17
Y
Aggregate Demand
p’
p
p
Y’
Y
Y
Shifts of the Aggregate
Demand Curve
Changes in
Expectations
Any part of the GDP equation
Wealth
Stock of physical capital
*Krugman
Shifts of the Aggregate Demand Curve
• ∆C, ∆I, ∆G, ∆X - ∆M
•∆Expectations
•∆Wealth
•∆Existing Stock of Capital
•∆Fiscal Policy
•∆Monetary Policy
Shifts of the Aggregate Demand Curve
*Krugman
There are 3 reasons why the aggregate
demand curve is negatively sloped:
1) Pigou’s REAL WEALTH EFFECT.
2) Keynes’s INTEREST RATE EFFECT.
3) Mundell-Fleming’s EXCHANGE-RATE
EFFECT (also called the OPEN ECONOMY
EFFECT or the FOREIGN PURCHASES
EFFECT)
A higher price level reduces the real value or purchasing power of the total
financial assets of the public.
When the purchasing power of your money is reduced, it is called the REAL
WEALTH EFFECT. It holds true for any asset of fixed dollar amount.
The wealth effect was
emphasized by Arthur
Pigou (1877-1959) and
is sometimes called the
Pigou Effect.
Suppose that you were a
retired person living on a
pension (fixed-income)
during a period of high
inflation. The costs you
incur continue to rise in
price but your income
remains the same.
The reverse would be true if the price level were
to fall. A decline in the price level will increase
the real value or purchasing power of a
household’s wealth and increase consumption
spending.
In summary:
Price Level => Real Wealth => Purchasing
Power => RGDP demanded
Price Level => Real Wealth => Purchasing
Power => RGDP demanded
The INTEREST RATE EFFECT also causes
aggregate demand to have a negative slope.
As price level increases, so do interest rates.
When interest rates increase, most goods and
services will have a higher price tag.
Consumers will wish to hold more dollars in
order to purchase those items they want to buy.
This will increase demand for money.
To put it another way, the aggregate demand curve
assumes the money supply is fixed.
When the price level increases, people need more
money for their purchases.
A higher price level increases the demand for money.
The increase in demand drives up the price paid to use
money (interest rate).
A higher interest rate will cause……..
Other repercussions such as:
Delayed expansion by businesses.
Delayed replacement of worn parts in
businesses.
Delayed purchases of
boats, cars, or homes by
consumers.
The Interest Rate
Effect was
emphasized by the
only economist to
have a branch of
economics named
after him: John
Maynard Keynes
(1883-1946). It is
sometimes called the
Keynes Effect.
If the demand for money
increases and the
FEDERAL RESERVE
SYSTEM does not alter the
money supply, then
interest rates will rise.
At higher interest rates, the
opportunity cost of borrowing
rises, and fewer interestsensitive investments will be
profitable, reducing the
quantity of investment goods
demanded.
The net effect of the higher interest rate is fewer
investment goods demanded and, as a result, a
lower RGDP demanded.
In summary:
Price level
Interest rate
Money demanded (money supply unchanged)
Investments
RGDP demanded
and
Price level
Interest rate
Money demanded (money supply unchanged)
Investments
RGDP demanded
The third reason for a negatively sloped aggregate
demand curve is the OPEN ECONOMY EFFECT,
also called the FOREIGN PURCHASES EFFECT
of changes in the price level.
A higher domestic price level causes the price of goods
and services to rise relative to the Global markets.
Consumers tend to buy fewer domestic goods and more
foreign goods.
This lowers the real GDP demanded at the higher price
level.
In summary:
Price level
Demand for domestic goods
RGDP demanded
and
Price level
Demand for domestic goods
RGDP demanded
Price level changes affects the level
of aggregate spending, which, in
turn, affects the amount of real GDP
demanded in the economy.
Change in the quantity of real
output demanded, caused by
changes in the price level (real
wealth effect, interest rate effect,
foreign market effect).
P
R
I
C
E
Change in aggregate demand, which
is caused by changes in one or more
of the determinants of aggregate
demand (consumer spending,
investment spending, government
spending, net export spending).
P
r
i
c
e
L
E
V
E
L
AD0
Real Gross Domestic Product
L
e
v
e
l
AD2
AD1
AD3
Real Domestic Output, GDP
To be more specific, an
increase in the price
level, other things equal,
will decrease the
quantity of real GDP
demanded.
P
r
i P2
c
e
2
1
By the same token, a
decrease in the price level,
other things equal, will
increase the quantity of real
GDP demanded.
P
L 1
e
v
P
e 3
l
3
AD
GDP2 GDP1
GDP3
Real Domestic Output, GDP
Additionally, aggregate expenditures schedule will
rise (to P3) when the price level declines and fall (to
P2) when the price level increases.
A
g
g
r
e
g
a
t
e
E
x
p
e
n
d
i
t
u
r
e
s
3
(Ca + Ig + Xn + G)3 at P3
(Ca + Ig + Xn + G)1 at P1
(Ca + Ig + Xn + G)2 at P2
1
2
We will discuss this in
greater detail when we
get to Aggregate Supply.
450
GDP2 GDP1
GDP3
Real Domestic Output, GDP
Compare the GDP at each level.
A
g
g
r
e
g
a
t
e
E
x
p
e
n
d
i
t
u
r
e
s
P3
3
P1
P2
1
P
r
i P2
c
e
2
1
P
L 1
e
v
P
e 3
l
2
3
AD
450
GDP2
GDP1
GDP3
Real Domestic Output, GDP
GDP2 GDP1
GDP3
Real Domestic Output, GDP
With respect the U.S. exports, a $30
pair of U.S.-made blue jeans now
might be brought for 2880 yen
compared to 3600 yen. In terms of
U.S. imports, a Japanese watch might
now cost $225 rather than $180.
Under these circumstances, U.S. exports will
rise and imports will fall. This increase in NET
EXPORTS translates into a rightward shift in
U.S. aggregate demand.
The aggregate
demand curve
reflects the total
amounts of
goods and
services that all
groups together
want to purchase
in a given time
period.
P
R
I
C
PL1
E
L
PL0
E
V
E
L
B
A
AD
RGDP1
RGDP0
Real Gross Domestic Product
In other words, it indicates the quantities
of real gross domestic product
demanded at different price levels.
The aggregate
demand curve slopes
downward to reflect an
inverse relationship
between overall
PRICE LEVEL and
the quantity of REAL
GROSS
DOMESTIC
PRODUCT.
P
R
I
C
PL1
E
L
PL0
E
V
E
L
B
Notice that as we
move from point A
to point B, price
level increases as
RGDP decreases
A
AD
RGDP1
RGDP0
Real Gross Domestic Product
In other words, when price level decreases ( ), the
quantity of RGDP increases ( ); when price level
increases ( ), the quantity of RGDP decreases ( ).
P
R
I
C
E
L
E
V
E
L
AD1
AD2
AD0
Real Gross Domestic Product
But what are some of the factors
that cause the curve to shift to the
right or left??
Shifts of Aggregate Demand: Short-Run
Effects
*Krugman
An increase in any
component of
GDP (C, I, G, X M) can cause the
aggregate demand
curve to shift to
the right.
P
R
I
C
E
L
E
V
E
L
AD1
AD0
Real Gross Domestic Product
Conversely,
decreases in C, I,
G, or (X - M) will
shift the aggregate
demand curve to
the left.
P
R
I
C
E
L
E
V
E
L
AD2
AD0
Real Gross Domestic Product
Long-Run Macroeconomic Equilibrium
*Krugman
THE
MULTIPLIER
EFFECT
The Multiplier: An Informal
Introduction
• Marginal Propensity to
Consume (MPC)
• Marginal Propensity to
Save (MPS)
MPC = ∆ Consumer Spending
∆ Disposable Income
MPS =
∆ Saving
∆ Disposable Income
MPC + MPS = 1
MPC = 1 - MPS
MPS = 1 - MPC
Krugman Sec 4, Mod 16
The Multiplier Effect
• Government purchases are said to have
a multiplier effect on aggregate
demand.
– Each dollar spent by the government can
raise the aggregate demand for goods and
services by more than a dollar.
The Multiplier Effect
• The multiplier effect refers to the
additional shifts in aggregate demand
that result when expansionary fiscal
policy increases income and thereby
increases consumer spending.
The Multiplier: An Informal
Introduction
• Autonomous Change in
Aggregate Spending (AAS)
• Multiplier
1
∆Y = _________
X ∆AAS
(1 - MPC)
Multiplier =
_____
∆Y = _________
1
∆AAS (1 - MPC)
Figure 4 The Multiplier Effect
Price
Level
2. . . . but the multiplier
effect can amplify the
shift in aggregate
demand.
$20 billion
AD3
AD2
Aggregate demand, AD1
0
1. An increase in government purchases
of $20 billion initially increases aggregate
demand by $20 billion . . .
Quantity of
Output
*Mankiw
Copyright © 2004 South-Western
A Formula for the Spending
Multiplier
• The formula for the multiplier is:
Multiplier = 1/(1 - MPC)
• An important number in this formula is
the marginal propensity to consume
(MPC).
– It is the fraction of extra income that a
household consumes rather than saves.
A Formula for the Spending
Multiplier
• If the MPC is 3/4, then the multiplier will
be:
Multiplier = 1/(1 - 3/4) = 4
• In this case, a $20 billion increase in
government spending generates $80
billion of increased demand for goods
and services.
The Multiplier
*Krugman
Current Disposable Income and
Consumer Spending
•Relationship between Disposable Income and
Consumer Spending
•Consumption Function (equation showing how an
individual household’s consumer spending varies with the
household’s current disposable income) (c = a + MPC x yd)
•Autonomous Consumer Spending (A) (the
amount of spending a household would spend if it had no
disposable income
Krugman,
Sec 4, Mod
16
•Aggregate Consumption Function
• C = A + MPC X DI
Shifts of the Aggregate
Consumption Function
•Changes in Expected Future Disposable
Income (consumer expectations)
• Permanent Income Hypothesis
(Milton
Friedman argued that consumer spending depends
mainly on the income people expect to have over the
long-term, not just their current income)
•Changes in Aggregate Wealth (wealth has an
Krugman,
Sec 4, Mod
16
effect on consumer spending)
• Life-cycle Hypothesis
(consumers plan their
spending over their lifetime, not just the current DI)
Investment Spending
• Planned Investment
Krugman,
Sec 4, Mod
16
The Interest Rate and Investment
Spending
Krugman,
Sec 4, Mod
16
r
r’
I
A decrease in
the real
interest rate
will result in
more gross
private
investment
I’
eve
Expected Future Real GDP, Production
Capacity, and Investment Spending
r
Krugman, Sec 4, Mod 16
I
An increase
in either
expected
future real
GDP or
production
capacity will
result in more
investment at
the same
interest rate
I’
THE CROWDING
OUT EFFECT
The Crowding-Out Effect
• Fiscal policy may not affect the
economy as strongly as predicted by
the multiplier.
• An increase in government purchases
causes the interest rate to rise.
• A higher interest rate reduces
investment spending.
The Crowding-Out Effect
• This reduction in demand that results
when a fiscal expansion raises the
interest rate is called the crowding-out
effect.
• The crowding-out effect tends to
dampen the effects of fiscal policy on
aggregate demand.
Figure 5 The Crowding-Out Effect
(a) The Money Market
Interest
Rate
(b) The Shift in Aggregate Demand
Price
Level
Money
supply
2. . . . the increase in
spending increases
money demand . . .
$20 billion
4. . . . which in turn
partly offsets the
initial increase in
aggregate demand.
r2
3. . . . which
increases
the
equilibrium
interest
rate . . .
AD2
r
AD3
M D2
Aggregate demand, AD1
Money demand, MD
0
Quantity fixed
by the Fed
Quantity
of Money
0
1. When an increase in government
purchases increases aggregate
demand . . .
Quantity
of Output
*Mankiw
Copyright © 2004 South-Western
The Crowding-Out Effect
• When the government increases its
purchases by $20 billion, the aggregate
demand for goods and services could
rise by more or less than $20 billion,
depending on whether the multiplier
effect or the crowding-out effect is
larger.
2….the increase in spending
increases money demand….
3…which increases the
equilibrium interest rate….
Interest
Rate
1…When an increase in
government purchases
increases aggregate demand…
4…which in turn partly offsets
the initial increase in demand.
Sm
r2
AD2
r1
MD2
AD3
MD1
Quantity of
money fixed by
AD1
0
4
7
Quantity of Output
The increase in the interest rate
tends to reduce the quantity of
goods and services demanded,
especially in the investment sector.
This CROWDING OUT of
investment will offset the expansion
of Aggregate Demand and the AD
curve will shift only to AD3.
Macroeconomic Policy
Fiscal policy affects aggregate demand
directly through government purchases and
indirectly through changes in taxes or
government transfers that affect consumer
spending.
Monetary policy affects aggregate demand
indirectly through changes in the interest rate
that affect consumer and investment
spending.
*Krugman
Compiled by:
Virginia H. Meachum, Economics Teacher
Coral Springs High School
Sources:
Principles, Problems, and Policies, by Campbell McConnell
& Stanley Brue
Economics, by Krugman, Wells
Principles of Economics, by N. Gregory Mankiw
Notes by Florida Council on Economic Education and FAU
Center for Economic Education
Notes by Foundation for Teaching Economics