3/6/09

Aggregate Demand and Aggregate Supply

l  Chapter 8

l  (special topics)

l  Chapter 10

l  The Aggregate Demand-Aggregate Supply Model …

l  uses a two-dimensional graph to analyze changes in real GDP and the price level simultaneously.

–       Price level measured as GDP price index or CPI on the Y-axis.

–       Real GDP (Output)  measured as real GDP on the X-axis

l  is used to analyze short-run fluctuations of output and economic growth.

–       How shifts of AD or AS can cause recessions, inflation, and economic growth.

 

l  The Aggregate Demand-Aggregate Supply Model …

l  explains macroeconomic policies to stabilize the economy.

–      How policy makers in order to offset the effects of a recession use tools of monetary and/or fiscal policy (stabilization policies) to influence AD or AS.

 

l  A Framework for Macroeconomic Analysis

l  The AD-AS Model has four components:

*       Aggregate demand

*       Long-run aggregate supply

*       Short-run aggregate supply

*       Macroeconomic equilibrium

 

l  Introduction

l   Aggregate demand …

–          is the total demand for goods and services in an economy.

l   Aggregate supply …

–          is the total supply of goods and services in an economy.

l   Aggregate supply and demand curves are more complex than simple market supply and demand curves.

 

l  Simple Market Model vs. AD-AS Model

l  Comparing the Micro and Macro Model

l  Micro Model

–       The vertical axis measures the price of one specific product

–       The horizontal axis measures the quantity demanded and supplied of the product

–       Equilibrium in any specific market will be reached rapidly

l  Macro Model

–       The vertical axis measures the overall price level

–       The horizontal axis measures the real GDP (income)

–       The speed of adjustment to equilibrium is slower in the macro economy

l  Aggregate Demand

Definition:

    Aggregate demand schedule or curve shows the inverse relationship between the price level and the quantity of real GDP demanded by domestic households, firms, government, and foreigners when all other influences on expenditures plans remain the same.

l  Components of Aggregate Demand

l  Aggregate demand (AD) represents the total spending on domestically produced output at alternative prices.

–      The quantity of real GDP demanded is the sum of

l Household spending – Consumption expenditure (C)

l Firm spending – Investment (I)

l Government purchases (G)

l Foreign spending – Net exports (XN)

 

 

 

l  Why is the Aggregate Demand Downward Sloping?

l  Three effects of a price-level change:

•       Real-Balances Effect

•       Interest-rate Effect

•       Foreign Purchases Effect

l  Real-Balances Effect

l  The relationship between price-Level and consumption.

–      A higher price-level will decrease the purchasing power of people’s assets (savings accounts, bonds).

l People will feel poorer and reduce consumption spending.

l  Interest-Rate Effect

l  The relationship between price-Level and Investment.

–      A higher price-level will decrease the value of money and people will demand more money.

l For a given supply of money, a higher demand for money will increase the interest rate.

–      A higher interest rate, decreases investment and some consumption expenditures.

 

l  Foreign-Purchases Effect

l  The relationship between price-Level and Net Exports.

–      A higher domestic price-level makes U.S. made goods more expensive relative to foreign made goods.

l U.S. exports decrease and U.S. imports increase ΰ net exports declines.

l  Movements along the AD vs. Shifts in the AD

l  Movements along the AD Curve

–       Changes in the price level cause a movement along the Aggregate Demand Curve.

l  Shifts in the AD Curve

–       A change in any factor that influences spending plans, other than the price level, brings a change in aggregate demand.

–       Two components:

l  Initial change in spending

l  Multiplier effect

l  Shifts in the Aggregate Demand Curve...

l  Basic Macroeconomic Relationships

l  Chapter 8

l  Learning Objectives:

l  The Consumption and Saving Functions

–      Income and consumption (income and saving)

–      Other factors that affect consumption and saving

l  The Investment Demand

–      The real interest rate and investment

–      Other factors that affect investment

l  The Multiplier

–      The relationship between spending and income

l  Introduction

l  Disposable income (YD) - After-tax personal income.

l  It  must be either consumed or saved

l  Introduction

l  Then,

 

 

l  Personal saving is disposable income not consumed

      Consumption and saving are the two sides of the same coin

   They depend on current disposable income

 

 

l  Introduction

l  When we examine:

–      the relationship between income and consumption – Consumption function

–      We also examine the relationship between income and saving – Saving function

l  Income, Consumption, and Saving

l  U.S. Consumption, 1979-2004

l  The Consumption Function

l  The Consumption Function

l  Shows the relationship between disposable income and consumption

l  Mathematically:

 

 

l  The Consumption Function

l  A consumption schedule or a consumption graph shows the alternative amounts households plan to consume at various levels of disposable income when other non-income factors that influence  consumption are fixed

l  Consumption and Saving

l  MPC and MPS

l  The Consumption Function

l  The Marginal Propensity to Consume (MPC)

–       It is the slope of the consumption function

–       It is the fraction of any change in income consumed.

–       It is the ratio of two changes.

 

l  The Consumption Function

l  The Marginal Propensity to Save (MPS)

–       It is the slope of the saving function.

–       It is the fraction of any change in income saved.

 

 

l  Relationship among Income, Consumption, and Saving

l  If                   and                  θ

 

 

l  Then,                                       assuming taxes are constant

 

l  Two Important Results:

 

 

 

 

         

l  Solved Problem: Example of a  Consumption Function

l  Example of a Consumption Function (cont.)

l  At an income of zero, consumption is $100 billion (Co).

l  For every $100 billion increase in income (DY), consumption rises by $75 billion (DC).

–       The MPC = .75

l  Deriving a Saving Function
from a Consumption Function

l  The Consumption Function

l  The Average Propensity to Consume (APC)

–       It is the fraction of total income that is consumed

–       It is the ratio of two levels

 

l  The Consumption Function

l  The Average Propensity to Save (APS)

–       It is the fraction of total income that is saved

–       It is the ratio of two levels

 

l  The Consumption Function

l  Again, since disposable income is either consumed or saved

l  The sum of APC and APS is equal to 1

 

Non-income Determinants of Consumption and Saving

l  Any factor that influences consumption other than income may change consumption levels at each level of current income (real GDP)

–      Both, consumption and saving will shift in opposite directions except for changes in taxes

l  Non-income Determinants of  Consumption and Saving

l  Wealth

l  Expectations

l  Real Interest Rates

l  Household Debt

l  Non-income Determinants of Consumption and Saving

l  Wealth

–       Value of accumulated real and financial assets

–       If, at any current income, wealth increases, consumption schedule shifts upward and saving schedule shifts downward

l  Expectations

–       Expectations about future prices and income will affect current consumption and saving

–       Expectations of a recession will shift consumption downward and saving upward

l  Non-income Determinants of Consumption and Saving

l  Real Interest Rates

–       Real interest income is the cost of borrowing for borrowers and the return on savings for savers

–       If real interest rate rises, then saving increases and consumption decreases at any current income.

l  Household Debt

–       If household debt as a group increases, consumption shifts upward

–       When it gets abnormally high, consumption shifts downward

l  Other Important Considerations

l  Switch to real GDP

    The relationship between consumption and disposable income is the same as the relationship between consumption and real GDP.

l  Shifts vs. Movements along consumption (saving) function

–       A movement along consumption function is solely caused by a change in real GDP.

–       A shift of the consumption function is caused by a change in any of the non-income determinants of consumption.

l  Saving function shifts in the opposite direction.

l  Other Important Considerations

l  Taxation

–      A change in taxes shift both consumption and saving function in the same direction

l An increase in taxation will decrease disposable income at any current income. Both, consumption and saving will decrease (they shift downward)

l  Stability

–      Both consumption and saving function are relatively stable.

l  Solved Problem

l     Explain how each of the following will affect consumption and saving (a movement or a shift). Indicate the direction of the shift:

•                  A large decrease in the value of real state, including private houses.

•                  A sudden increase in the stock prices.

•                  An increase in the Federal personal income tax

l  Investment Spending

l  Investment consists of expenditures on new plants, equipment, structures (physical capital) and changes in business inventories in a given time period,.

l  U.S. Real Investment, 1979 - 2004

l  Fluctuations in Investment
Spending and Consumer Spending

l  Investment Decision

l  The investment decision is a marginal decision.

–      Firms compare the marginal benefit to the marginal cost of the investment.

 

 

l   Expected Rate of Return

l  It is the expected profit rate from one additional unit of capital.

 

 

 

l  Terminology:

–       Net Revenue – is the revenue from one additional unit of capital minus operating costs (maintenance, energy, labor costs and taxes are paid).

–       Price of capital – is the cost of that unit of capital

l  Numerical Example

l  Ford is considering whether to build a new $100 million automobile assembly line that has a useful life of only one year.

–      Ford expects a net revenue of $120 million from operating the plant.

Calculate:

–      The expected profit of this assembly line

–      The expected rate of return of this assembly line

l  Numerical Example

l  The expected profit is:

= 120 million – 100 million = 20 million

l  The expected rate of return of this assembly line is:

=  (20 million / 100 million) x 100 = 20%

 

l   Interest Rate

l  The Real Interest Rate

–      It is the cost of borrowing funds to finance buying a new capital good

–      It is the opportunity cost of using one’s own funds

 

l  Investment Decision

l  The firm will invest, only if the investment is profitable:

l Its expected rate of return must exceed the real interest rate.

l  The firm maximizes profits when it invests up to the point where: 

–       Expected rate of return is equal to the real interest rate

 

l  Numerical Example

l  Example (cont.):

–      If the real interest of borrowing funds to build the assembly line is 10%, will Ford undertake the investment project?

l Yes, (20% > 10%); then, investment is undertaken

–      If the real interest is 25%?

l No,  (20%< 25%); then, investment is not profitable, not undertaken

 

l  The Investment Demand

l  There is an inverse relationship between the real interest rate and investment

–      As the real interest rate rises, fewer investment projects are profitable and, therefore, the number of investment projects undertaken decreases (investment decreases)

l  Investment demand is downward sloping

l  Investment Demand Curve

l  Shifts of the Investment Demand Curve

l  Determinants of Investment

l A change of any of these determinants will shift the investment demand curve

–      Acquisition, Maintenance, and Operating Costs

–      Business Taxes

–      Technological Change

–      Stock of Capital Goods on Hand

–      Expectations

l  Determinants of Investment

l   Acquisition, Maintenance, and Operating Costs

–       They refer to the initial cost of capital, cost of maintaining and operating the capital (fuel, electricity, labor)

–       If these costs rise, net expected revenues fall, and consequently expected profits and the expected rate of return.

l  Investment demand decreases; it shifts to the left

l  Determinants of Investment

l  Business Taxes

–      To determine the optimal level of investment, firms consider the after-tax expected rate of return

–      The higher the tax rate; the lower the real return to capital after taxes

l An increase in business taxes, decreases investment demand, it shifts to the left

l  Determinants of Investment

l  Technological Change

–      Increases the productivity of capital, net expected revenue increases

–      Drives new investment (computer industry)

l  Stock of Capital Goods at Hand

–      It refers to the production capacity of the firms

–      Firms with excess production capacity have little incentive to invest in new capital

l Investment demand shifts to the left

 

l  Determinants of Investment

l  Expectations

–      Expectations play a critical role in investment decisions.

–      Most capital goods are long-lived, the expected rate of return depends on firm’s expectations about the future.

l Keynes called them “animal spirits”

–      If firms are optimistic about the future, the investment demand will shift to the right

l  Investment and The Stock Market

l  The stock market influences investment decisions because

–      A rise in the price of stocks means that financial investors are confident about the future and expect higher future profits

–      A bull market will induce more investment in the economy

l  Shifts of Investment Demand Curve

 

l  The Multiplier Effect

l  Changes in spending generate even larger changes in real GDP

–      The multiplier is the multiple by which equilibrium real GDP changes as a result of a change in autonomous expenditure.

l  The Multiplier Effect

l  The size of the multiplier is:

 

 

 

l  The multiplier works in both directions

–       A decrease in spending may result in a larger decrease in GDP

–       An increase in spending may result in a larger increase in GDP

l  The Multiplier Effect

l  The multiplier is greater than 1 because the initial change in spending induces further increases in expenditure dependent on income; such as consumption.

l  The Multiplier in Reverse:  The Great Depression of the 1930s

–        The multiplier effect contributed to the very high levels of unemployment during the Great Depression.

l  The Multiplier and the Paradox of Thrift

l  Changes in Aggregate Demand

l   Components of AD are:

 

 

 

     Other factors that influence

l   Consumption

–       Wealth

–       Expectations

–       Household’s debt

–       Personal Taxes

 

l  Changes in Aggregate Demand

l  Investment Spending

–       Real Interest Rates

–       Expected Returns

l  Expectations about future conditions

l  Technology

l  Degree of excess capacity

l  Business taxes

l  Net Export Spending

–       National Income Abroad

–       Exchange Rates

 

l  Government Spending

–       G depends on the decisions of policy makers

l  It is an instrument of fiscal policy

l   

Solved Problem: Movements along the Aggregate Demand Curve versus Shifts of the Aggregate Demand Curve

l  The Multiplier Effect  and Shifts of Aggregate Demand

l  The multiplier effect magnifies changes in expenditures and brings potentially larger fluctuations in real GDP.

l  The total change in AD is the initial change in expenditure plus the induced increase in consumption expenditure.

l  Aggregate Demand

l  Aggregate Demand

l  Solved Problem:

l      Using the following list of events, determine whether the event will change the location of aggregate demand. In the case, the event shifts aggregate demand determine the direction of the shift.

The U.S. government increases personal income taxes.

The U.S. price level rises.

The Federal Reserve raises the interest rate.

The foreign exchange rate between the U.S. and E.U. goes from $1 for 0.64 Euros to $1 for 0.79 Euros.

 

l  Aggregate Supply

Definition:

    Aggregate supply schedule or curve shows the relationship between the price level and the quantity supplied of domestic output when all other influences on production plans remain the same.

 

l  Long-Run Aggregate Supply

l  In the long run, the aggregate supply curve is vertical at the economy’s full-employment output.

–      Changes in nominal wages adjust completely to changes in prices. Real variables are unchanged.

–      Real GDP does not respond to changes in nominal prices

l  Determinants of long-run AS curve

l  In the long-run, the aggregate supply depends on

–      The supplies of resources

l Land

l Labor

l Capital

l Entrepreneurship

–      The state of technology

l  Shifts in Potential GDP - Long-run Aggregate Supply…

l  Aggregate Supply

l  Short-Run Aggregate Supply

l  In the short-run, the aggregate supply curve is upward sloping.

–      There is a direct relationship between the price level and real output.

–      Nominal wages do not match changes in the price level and firms find profitable to increase output when the price level rises.

 

 

l  Real GDP and
the Price Level in the United States,
1970 to the Present

l  Why is the Short-Run Aggregate Supply Upward Sloping?

l  When the price level rises and the money wage rate is constant, the real wage rate falls and employment increases. The quantity of real GDP supplied increases.

l  Vice versa for a fall of the price level.

l  Shape of the S-R Aggregate Supply

l  Short-run AS has two segments:

–      A relatively flat segment at output levels below the full-employment output.

l Idle resources and excess capacity allow firms to increase output without substantial increases in per-unit production costs.

 

l  Aggregate Supply

–      A relatively steep segment at output levels beyond the full-employment output.

 

l The closer the output is to the full-employment level the steeper the AS curve becomes.

l When firms are working at capacity, additional labor reduces efficiency and creates bottlenecks in production increasing per-unit production costs.

l  Changes in S-R Aggregate Supply

l  Aggregate supply changes when any influence on production plans other than the price level changes.

l An increase in AS shifts the curve to the right.

l A decrease in AS shifts the curve to the left.

 

 

l  Determinants of Aggregate Supply

–      Input prices

l Domestic resource prices

l Foreign resource prices

l Market power

–      Productivity and Availability of resources

–      Legal-Institutional Environment

l Changes in taxes and subsidies

l Changes in the extent of government regulation

 

l  Shifts of the Short-Run
Aggregate Supply Curve

l  Short-Run Aggregate Supply

l  Short-Run Aggregate Supply

l  Solved Problem:

l      Determine whether the following events affect short-run aggregate supply or/and long-run aggregate supply, indicate the direction of the shift.

A rise in the world oil price that reduces the productivity of capital and labor.

The U.S. price level falls.

The wage rate in the U.S. increases.

A huge scientific breakthrough doubles U.S. labor productivity.

l  The  Aggregate Demand and Aggregate Supply Model

l  Remember, the AD-AS model has three components, all plotted in (P,Y) space:

–       Aggregate Demand (AD)

l  AD slopes downward because a rise in the P decreases investment, consumption and net exports.

–       Short-run Aggregate Supply (SRAS)

l  SRAS is an upward sloping line because a rise in the P increases output supplied. Firms respond to changes in demand because prices or wages are sticky.

–       Long-run Aggregate Supply (LRAS)

l  LRAS is a vertical line at the potential output because output does not respond to changes in prices and depends on real factors (productivity and factor supplies)

l  Equilibrium in the AD – AS Model

l  Aggregate demand and aggregate supply determine the price level and real GDP in equilibrium.

l  Graphically:

    The economy is at equilibrium when the AD curve intersects the AS curve

l Equilibrium price level is the only price at which output demanded is equal to output supplied

l Equilibrium and Changes in Equilibrium

l Equilibrium and Changes in Equilibrium

l  Equilibrium in the AD – AS Model

l  Three Types of Macroeconomic Equilibrium

l  Equilibrium in the AD-AS Model

l  Long-run macroeconomic equilibrium

–       the aggregate demand curve intersects the short-run aggregate supply at a point on the long-run aggregate supply curve.

l The output produced is the full-employment output.

l Firms will be operating at their normal level of capacity.

l Only structural and frictional unemployment exist

–     The unemployment rate is the natural rate of unemployment.

l  Long-Run Equilibrium and Short-Run Equilibrium

l  Explaining Short Run Fluctuations Using the AD – AS Model

l  Changes in short-run aggregate supply and aggregate demand bring changes in real GDP and the price level.

–      These changes generate the business cycle.

 

l  Increase in AD: Demand – Pull Inflation

l  When the economy operates at or above its full employment level of output, an increase in AD causes demand-pull inflation.

–      Output does not increase by the full extent of the multiplier effect because part of the increase in AD is absorbed as inflation.

–      Actual GDP exceeds full-employment output (positive GDP gap)

l  Decreases in A D: Recession and Cyclical Unemployment

l  The economy is initially at full-employment equilibrium.

l  Effects of a decrease in AD:

–         The AD curve decreases; it shifts to the left.

–         Short-run equilibrium is to the left of the full-employment output ΰ it causes a recession.

–         Actual Y is less than full-employment output (negative GDP gap)

–         P will remain the same (deflation is a rarity in the U.S.)

l Equilibrium and Changes in Equilibrium

l  A Decrease in AS: Cost – Push Inflation

l  Decreases in AS cause cost-push inflation.

l Output falls below the full employment level of output (negative GDP gap).

l Unemployment rises

l The price level rises

l Stagflation results!

l  Increases in AS: Full Employment with Price-Level Stability

l  The Economy is initially at full employment.

l  An increase in AD along with an increase in AS due to an advance in technology will result in:

–      A larger full-employment output

–      A mild inflation rate

–      A lower natural rate of unemployment

l Equilibrium and Changes in Equilibrium

l  The End

l  Practice with Key questions: 4, 6, and 7.