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Chapter 8
Aggregate Demand
5/23/2017
© 2004 Claudia Garcia - Szekely
1
“Only suppliers can supply us
with goods and services; the
demand side can’t will a product
or service into existence, no
matter how hard it tries. Society
therefore advances economically
when it reduces tax and
regulatory barriers to the creation
of goods and services”
Supply Side View
2
Old fashioned voodoo
economics- the belief in tax cut
magic- has been vanished from
civilized discourse. The supplyside cult has shrunk to the point
that it contains only cranks,
charlatans and Republicans
Paul Krugman
New York Times
3
The Keynesian Model
Developed within of the urgency to get
the economy out of the Great
Depression
• Concern is finding a
short term solution to
unemployment
• Concern is NOT inflation
4
The Keynesian Model
 Is a Short Run (Unemployment) model.
 Assumes that Aggregate Demand
determines the level of production.
 Focuses on how variables that affect
Aggregate Demand are interrelated.
 Develops tools for the government to
manage the amount of spending in the
economy
5
G
Circular Flow Diagram
to
Interest
Rent
Profits
Wages
T
S
Rest of
World
G
Households
NX
Firms
C
Goods and
Services
I=300
pay
The Components of
Aggregate Demand
8
National Income
The sum of the incomes that all individuals
in the economy earned in the forms of
wages, interest, rents, and profits.
– Excludes government transfer payments
– Income before paying taxes
9
Disposable Income
The sum of the incomes of all the individuals
in the economy after all taxes have been
deducted and all transfer payments have
been added
DI = GDP - Taxes + Transfers = Y - T
10
Time
11
Consumption
Consumer Spending and
Disposable Income
Disposable Income
12
What determines the level of
The effect of these
As income
components is
Consumption?
increases,
Induced
“bunched”
together
consumption
increases
 Income
 Wealth
 Prices
 Expectations
 Real Interest Rate
Add these two components
component of
C=bY
consumption
Autonomous
Component
C=a
of
consumption
C = a + bY
The Reaction of Consumption
Spending to a Change in Income
Real Consumer Spending
1900
1700
1500
1360
1300
MPC = 180/200=0.9
MPC = DC/DY
This reaction is
1963
measured by the
slope of the C
function.
B
$180 billion
1180
A
1100
$200
900
0
1947
900
1100
billion
1300
1500
The slope is the
Marginal Propensity to
Consume
MPC = DC/DY
1700
1900
Real Disposable Income
14
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
When income
drops, people use
savings (their
in income,
own or
borrowed)
by 90
cents…
MPC = 0.9 or 90%
For each $1 increase
consumption increases
90% of the increase in income will be
consumed.
For each $1 decrease in income,
consumption decreases only by 90 cents…
Only 90% of the decrease in income
translates into a reduction in consumption.
15
The Consumption Function
Autonomous Consumption:
Value of Consumption when
income is zero.
Determines the height of the
Consumption Function
Induced Consumption:
As income increase
consumption increases.
Income
0
100
150
200
250
300
350
400
450
Consumption
?
190
235
280
325
370
415
460
505
1.
2.
3.
4.
5.
6.
7.
Calculate the MPC
Calculate the Intercept
Write down the formula for the Consumption function
What is the value of Consumption when Income is 10,000
Calculate Savings
At what value of Y is Consumption equal to Income?
Write down the formula for the Savings function
Disposable
income
Consumption
0
1000
2000
3000
1,400
2,200
4000
5000
6000
3,800
4,600
5,400
Saving
The Consumption Function
C=a+bY
Value of C when Y is 0
MPC
How Important is
Consumption?
 Consumption is by far the largest
component of aggregate demand.
 Expenditures in consumer goods are
70% of GDP.
 Understanding the determinants of
consumption then, is critical.
19
Saving (S)
We will assume
that income not
consumed is
saved
Y-C=S
20
Consumption (C) Mirror Saving
(S)
Recall:
Y-C=S
C=a+bY
Value of C when Y = 0
C = a + (b x 0)
C=a
When Y = 0
S=Y–C
S=0-a
When income is zero, saving = - a
Intercept of Saving Function is – a
The Saving Function
S
S = -a + ?
-a
Intercept of Saving Function is – a
22
DS = DY – DC
20 = 200 - 180
Recall:
S=Y-C
C
3420
Causes a $180
Increase in C
3240
A $200 increase
in income
3600
3800
The MPS= DS/DY = 20/200 = 0.1 or 10%
23
The Slope of the Savings
Function: MPS
Saving
380
360
Causes a $20
Increase in S
A $200
increase in
3600 income 3800
The Marginal Propensity to
Save
 Is the proportion of an increase in
income that is used to increase saving..
 Is the proportion of an decrease in
income by which saving decrease
 Is a percentage or a number between o
and 1.
25
MPS = 1 - MPC
 If the MPC = 90%, you will consume 90% of
any increase in income…
 If you consume 90% of any increase in
income, you save the rest: 10%
MPC + MPS = 100%
MPC = 0.9 then MPS = 0.1
MPC + MPS = 1
26
The Saving Function
S = -a + (1- b) Y
1 – MPC
Value of Saving when
Y(Income) is 0
27
1.
2.
3.
4.
5.
6.
7.
Calculate the MPC
Calculate the Intercept
Write down the formula for the Consumption function
What is the value of Consumption when Income is 10,000
Calculate Savings: S = Y - C
Write down the formula for the Savings function
At what value of Y is Consumption equal to Income?
Disposable
income
Consumption
0
1000
2000
3000
1,400
2,200
4000
5000
6000
3,800
4,600
5,400
Saving
1.
2.
3.
4.
5.
6.
7.
Calculate the MPC =800 /100
Calculate the Intercept = 600
Write down the formula for the Consumption function = 600 +0.8 Y
What is the value of Consumption when Income is 10,000 = 600 + 0.8*10,000
Calculate Savings
At what value of Y is Consumption equal to Income? At 3,000
Write down the formula for the Savings function = -600 + 0.2Y
Disposable
income
Consumption
Saving
0
1000
2000
3000
600
1,400
2,200
-600
-400
-200
0
4000
5000
6000
3,800
4,600
5,400
200
400
600
30
Events that cause a
movement along the
Consumption Function
Changes in
incomes ONLY!
5/23/2017
© 2004 Claudia Garcia - Szekely
31
Factors that shift the
consumption function
1.
Changes in wealth
Example: value of stocks, bonds, consumer durables,
homes.
When stock prices go down, consumer wealth
decreases in value.
Consumers feel poorer and slow down purchases
A downward shift in the
Consumption Line
32
Factors that shift the
consumption function
1. Changes in wealth
When stock prices go UP, consumer wealth
increases in value.
Consumers feel richer and increase
purchases
An upward shift in the
Consumption Line
Factors that shift the
consumption function
2. Changes in consumer expectation:
Pessimistic expectations about future:
employment, incomes, wealth.
Consumers slow down purchases
A downward shift in the
Consumption Line
34
Factors that shift the
consumption function
2. Changes in consumer expectation:
Optimistic expectations about future:
employment, incomes, wealth.
Consumers increase purchases
An upward shift in the
Consumption Line
35
Factors that shift the
consumption function
3. Prices
When overall prices rise (an increase in the CPI)
consumer’s wealth lose buying power.
This drop in the purchasing power of saved
dollars make consumers feel poorer and they
slow down purchases.
A downward shift in the
Consumption Line
36
Factors that shift the
consumption function
3. Prices
When overall prices fall (a decrease in the CPI)
consumer’s wealth gains buying power.
This increase in the purchasing power of saved
dollars make consumers feel richer and they
increase purchases.
An upward shift in the
Consumption Line
Factors that shift the
consumption function Interest Rates
Changes in wealth
are NOT in the
list!
value of stocks, bonds, consumer durables,
homes.
Changes in consumer expectations
Pessimistic expectations decrease
autonomous consumption.
Prices
Shift Consumption
line
Affect the purchasing power of assets.
Statistical studies: interest rates have no effect on Consumption
We will assume that changes in interest rates do not
shift C
39
Investment
The acquisition of
capital goods
40
Investment Includes…
 Residential Construction
– consumer purchases of new houses and
condominiums.
 Non-residential construction
– Equipment, software, buildings, tools, etc.
 Changes in Inventories: unsold goods
are included as investment.
41
Investment Includes…
 Residential Construction
– consumer purchases of new houses and
condominiums. Higher interest rates
reduce home purchases.
42
Investment Includes…
 Non-residential construction
Equipment, software, tools, etc.
43
Determinants of Investment
 Interest Rates:
– Business borrow to finance investment. As interest rates
drop, more investment projects become profitable and
investment increases.
 Tax Incentives:
– If directly tied to capital formation will increase investment.
 Technical Change:
– New technology creates a boom in investment as firms rush
to adopt the new technology (Microchip)
– New technologies open new business opportunities: Firms
build new factories, stores, offices and equipment to take
advantage of these opportunities (Internet Cafes)
 Expectations about the strength of demand:
– high sustained level of sales and expectations of growing
economy boost investment
 Political Stability and the rule of law:
– Business cannot be conducted without a guarantee that
property rights and laws will be respected. (News
communist take over will negatively affect investment)
44
Investment Also Includes
Inventories
Inventories are of two kinds:
– Planned (desired) inventories.
• Firms build up inventories to be able to fulfill
future orders.
– Unplanned (unwanted) inventories.
• Firms end up with unsold inventories because
sales decreased unexpectedly.
45
Investment
Firms control how much to
spend in Investment goods
Firms control how much they
want to hold in inventories
Firms control Planned
Investment
46
Investment Spending
Investment does not change with current
income
Total PLANNED Expenditures on
Capital goods and desired inventories
Investment
Income / GDP
47
Investment
 Firms have NO control over how much
ends up as inventories. These changes
in inventories depend on actual
demand:
– If demand dropped below what firms
expected, inventories rise
– If demand was as expected, inventories do
not change
– If demand increases from expected
inventories fall.
Firms DO NOT control
Actual Investment
48
 Expenditures by federal, state and local
governments.
– Include final, intermediate and capital goods
purchased by the government.
– Exclude transfer payments (social security,
unemployment benefits, etc)
Government expenditures are
determined by the budget process: The
president, Congress and the Senate.
Government expenditures are not a
function of current income.
49
Government Spending
Government Spending does not change
with current income
Total PLANNED Expenditures by all
levels of government as dictated by the
budget
G
Income / GDP
Have two components:
1. Exports: Sales of US goods to other
countries.
 Incomes abroad: as other countries grow,
they increase purchases of U.S. goods.
 Relative prices: if prices in U.S. rise faster
than prices abroad, U.S. goods become
relatively more expensive for foreigners
and purchases of U.S. goods drop.
 Exchange rates (see discussion next).
Have two components:
2. Imports: Purchases of foreign
goods by Americans.
 Incomes in the US: As the U.S.
economy grows Americans purchase
more goods from abroad.
 Relative prices: as prices in the U.S.
fall relative to prices abroad,
Americans find foreign goods
cheaper and purchase more from
abroad.
 Exchange rates (See discussion
below).
 National Incomes:
– When US incomes rise, imports increase and vice versa.
 GDP of other countries:
– When GDP abroad increases, US exports rise as foreigners
buy more American goods.
 Relative Prices:
– When prices in the US rise, American goods become more
expensive and exports drop as foreigners buy fewer
American goods.
– When prices in the US rise, foreign goods become cheaper
and imports increase as Americans more foreign goods.
 Exchange Rates
Net exports
Net Exports do not change with
current income
NX
Income / GDP
54
Weaker dollar
One Dollar
buys less DM’s
1DM
U$1
0.5 DM
U.S. Prices are
lower to Germans
U.S. Exports increase when the
55
dollar becomes weaker.
Weaker dollar
One DM buys
more Dollars
1U$
1DM
2 U$
Foreign Prices are
higher to Americans
U.S. Imports decrease when
the dollar becomes weaker.
56
Stronger dollar
One Dollar
buys more
DM’s
1DM
U$1
2 DM
U.S. Prices are higher to
Foreigners
U.S. Exports decrease when the
dollar becomes stronger.
57
Stronger dollar
One DM buys
less Dollars
1U$
1DM
0.5 U$
Foreign Prices are
lower to Americans
U.S. Imports increase when the
dollar becomes stronger.
58
The Effect of Changes
in Exchange Rates
More on Strong
Dollar
5/23/2017
© 2004 Claudia Garcia - Szekely
59
Questions to Prepare for Quiz
1. Determine the effect on Aggregate Demand. Identify the
component of AD which is affected (C, I, G, X or M) and
explain how it is affected.
a) Prices in the US Increase (decrease) relative to prices
abroad.
b) The U.S. dollar becomes weaker (stronger)
c) Home prices collapse (increase)
d) Stock prices collapse (increase)
e) Interest rates Increase (decrease)
f) A zero-emissions engine is developed.
g) Government announces an Increase (decrease) in the
number of troops deployed abroad.
h) As the economy recovers (enters into a recession)
incomes increase (drop).
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2. Use the table in the next slide to answer the following:
a) Calculate the MPC and the intercept of the consumption
line.
b) Write the consumption function: C = intercept (a) +
slope (MPC)* Y
c) If Income is 5700 what is the value of consumption? How
much is saved?
d) If autonomous consumption increases by 300 what is the
new consumption function? Does this increase represent
a shift? Or a Movement along the Consumption line?
Does this increase imply an increase or a decrease in
saving?
Output
Consumption
Investment
Net Exports
1000
800
500
100
1500
1200
500
100
2000
1600
500
100
2500
2000
500
100
3000
2400
500
100
3500
2800
500
100
4000
3200
500
100
C = 100+0.9Y
22,600
17,200
9,100
4,600
5,000
10,000
19,000
25,000
63
I =1,000
G = 500
NX = 300
I+G+NX
1,800
5,000
10,000
19,000
25,000
64
AE = 100 + 0.9Y +1,800
AE = 1,900 + 0.9 Y
22,600 +1,800 = 24,400
17,200 +1,800= 19,000
9,100 +1,800 = 10,900
4,600 +1,800= 6,400
5,000
10,000
19,000
25,000
65
Sold
AE = 100 + 0.9Y +1,800
AE = 1,900 + 0.9 Y
Produced
5,000
Produced
10,000
Produced
Produced
25,000
19,000
Sold
6,400
Sold10,900
Sold
Sold19,000
24,400
Inventories
fall
Inventories
fall
Inventories
Inventories
do
rise
not change
Firms
increase
Production
Firms
Production
Firmsincrease
decrease
do not change
Production
Production
24,400
19,000
10,900
6,400
Produced
5,000
10,000
19,000
25,000