Download Chapter 13 -- Determining Aggregate Demand (AD)

Chapter 13 -- Determining
Aggregate Demand (AD)
This chapter -- looks at the
components of Aggregate
Expenditure.
Examines the major causes of
Consumption (C), Investment (I),
Government Expenditure Net of
Taxes (G - T), and Net Exports
(X - M).
“Unzipping”
Aggregate Expenditure (AE)
Causes of AD
I. Price Level (P)
II. AE = C + I + (G – T) + (X – M)
(a) C
(i) ----------------(ii) ---------------(b) I
(i) ----------------(ii) ---------------(c) (G – T)
…
Causes of Consumption (C)
Aggregate Income (Y),
Y  C
Wealth,
Wealth  C
Consumer Confidence (CC),
CC  C
Applying the Causes to
Aggregate Demand (AD)
Aggregate Income (Y), appears on
the graph, Y  C relationship
affects the shape of the AD curve.
Changes in Wealth or Consumer
Confidence make up autonomous
consumption (consumption due to
causes other than Y) -- shift the AD
curve.
Consumer Confidence
and the Economy
Example -- effect of a decrease in
consumer confidence.
CC  C
Therefore the AD curve shifts
leftward.
In the AD-AS model, this results in
Y*, P*
Causes of Investment (I):
The Capital Market
Investment (I) – primarily business
purchases of new plant and equipment.
Also includes new residential housing
and changes in inventories (small).
Large expenditures create the need for
long-term borrowing. Borrowing is
done from banks (or similar loaning
institutions), or by companies issuing
bonds or stock.
Investment and
Capital Market Behavior
Investment results from behavior
in the (financial) capital market.
The Capital Market -- The Demand
and Supply for financial capital
needed to finance purchases of
plant and equipment and new
residential housing (I).
The Demand For Financial
Capital (DI) -- Major Causes
Nominal (Long-Term) Interest Rate
(r) – cost of borrowing to finance
investment.
r  DI
Expected Inflation Rate (e)
e  DI
Business Confidence (BC)
BC  DI
Formalizing the Demand
for Financial Capital (DI)
Graph DI against one of its causes
-- the nominal interest rate (r).
Inverse relationship implies that
the curve is downward sloping.
Changes in r are described as a
movement along the curve.
Graph is drawn assuming that
other causes are constant (ceteris
paribus).
Shifts in the Demand
for Financial Capital
Changes in causes other than r
are described as shifts of the DI
curve.
Changes that increase the
Demand for Financial Capital shift
the DI curve rightward.
Changes that decrease the
Demand for Financial Capital shift
the DI curve leftward.
The Supply of Financial
Capital (SI) -- Major Causes
Nominal Interest Rate (r)
r  SI
Expected Inflation Rate (e)
e  SI
Tastes/Preferences Toward Saving
(SAVE)
SAVE  SI
Other Causes -Supply of Financial Capital
Monetary Policy -- affects banks
ability to loan (more later).
Foreigners’ willingness to buy US
bonds or stock (Capital Flow).
Next Step -- Formalizing the above
SI relationship
Formalizing the Supply of
Financial Capital (SI)
Graph SI versus one of its causes
-- the nominal interest rate (r).
Positive relationship implies that
the curve is upward sloping.
Changes in r are described as a
movement along the curve.
Graph is drawn assuming that
other causes are constant (ceteris
paribus).
Shifts in the
Supply of Financial Capital
Changes in causes other than r
are described as shifts of the SI
curve.
Changes that increase the Supply
of Financial Capital shift the SI
curve rightward.
Changes that decrease the Supply
of Financial Capital shift the SI
curve leftward.
Equilibrium in the Capital
Market -- Determining I
Investment (I*) occurs where the
Demand for Financial Capital (DI)
equals the Supply of Financial Capital
(SI).
Shifts in the Demand or Supply of
Financial Capital, as a result, change
Investment (I*)
Because they change Investment, they
also change Aggregate Demand (AD),
and Y* and P* as a result.
Example 1 -- An Increase in
Business Confidence (BC)
BC  DI
DI curve shifts rightward  I*
Because investment increases,
the AD curve shifts rightward.
In the AD-AS model, this results in
Y*, P*.
Example 2 -- An Increase in
Foreign Capital Flows to US
Capital Flow  SI
SI curve shifts rightward  I*
Because investment increases,
the AD curve shifts rightward.
In the AD-AS model, this results in
Y*, P*.
Causes of (G - T)
Government Purchases of Goods
and Services (G), Net Taxes (T), are
policy variables.
Basically controlled by the
government.
G, T changed for policy purposes
(Fiscal Policy), other reasons as
well (as in war example).
Causes of
US Net Exports (NX)
General Concepts
-- NX = (X – M), must consider
causes of both exports and
imports.
-- Assume for simplicity that the
world consists of 2 countries,
the US and the rest of the world.
Specific Causes of
US Net Exports (NX = X - M)
 World Output or Income (YW)
YW  X  NX
US Output or Income (Y)
Y  M  NX
Barriers to Trade (Tariffs, Quotas)
The Exchange Rate (e)
e  NX
Introduction to
Exchange Rates
Exchange Rate (e) -- the amount of
foreign currency needed to be
exchanged for one (US) dollar.
Also known as the “value of the
dollar”.
Conversion Ratio, in units of
(foreign currency)/(US dollar).
Types of Exchange Rates
Bilateral Exchange Rate -exchange rate between the US and
an individual country.
Multilateral (Trade Weighted)
Exchange Rate -- weighted
average of bilateral exchange rates
expressed as an index (macro
measure of exchange rate).
Using Exchange Rates
as a Conversion Ratio
In Both Examples: US exchange rate vs
Japanese Yen = 100 (yen/$).
Example 1 -- Suppose that dinner for
two people in the US costs $50. Find
its price in terms of yen.
($50)(100 yen) = 5000 yen
(1 $)
Example 2 -- The Exchange
Rate as a Conversion Ratio
Example 2 -- Suppose that dinner
for two people in Japan costs 6832
yen. Find its price in terms of US
dollars ($).
(6832 yen) (1 $)
= $68.32
(100 yen)
Note: e = 100 (yen/$)
Exchange Rate Changes
e  price of American goods and
services to foreigners
 price of foreign goods and
services to Americans
e  price of American goods and
services to foreigners
 price of foreign goods and
services to Americans
The Exchange Rate
and Net Exports
e (appreciating dollar, stronger
dollar)  X, M  (X - M)
e (depreciating dollar, weaker
dollar)  X, M  (X - M)
Exchange Rate Regimes
Fixed (Pegged) Exchange Rates -exchange rates are fixed by the
government, unless changed by
economic policy (e.g. US and China).
Floating Exchange Rates -- exchange
rates are determined by natural forces
in the foreign exchange market (e.g. US
and Japan, US and European Union).
Return to Aggregate
Demand -- An Example
Example -- effect of a decrease in
world output or income (YW).
YW  X  (X - M)
Therefore the AD curve shifts
leftward.
In the AD-AS model, this results in
Y*, P*
Aggregate Demand
Changes and the Economy
Lots of factors shift aggregate
demand (AD), affect Y* and P*.
Poses challenges: economy
subject to “buffeting winds,”
blows the economy off course
(either to where Y* < YF or Y* > YF).
Role of Economic Policy –
“medicine” designed to move
Y* closer to YF.