Ma ch 09 aggregate expend aggregate demand
- 1. Aggregate Expenditure and Aggregate Demand PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 2. • When driving through a neighborhood new to you, how can you guess the income of the residents? • What’s one of the most predictable and useful relationship in macroeconomics? • Why are consumer confidence and business confidence in the economy so important? • How is spending linked to income? • Why did Americans spend less and save more after the financial crisis of 2008? © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2
- 3. Consumption • Consumption depends on income – Positive and stable relationship between consumption and income – Both for the household and for the economy as a whole • Decisions in the circular-flow model – How much households spent, C – How much they saved, S © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3
- 4. Exhibit 1 U.S. Consumption Depends on Disposable Income Consumption is on the vertical axis and disposable income on the horizontal axis. Notice that each axis measures trillions of 2005 dollars. For example, in 2000, identified by the red point, consumption was $7.6 trillion and disposable income $8.2 trillion. There is a clear and direct relationship over time between disposable income and consumption. As disposable income increases, so does consumption. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 5. The Consumption Function • Consumption, C –Depends on disposable income, DI – Function of income • C – dependent variable • DI – independent variable • Positive slope © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5
- 6. Exhibit 2 The Consumption Function 11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 1011 121314 C Real disposable income (trillions of dollars) Real consumption (trillions of dollars) The consumption function, C, shows the relationship between consumption and disposable income, other things constant. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 7. Marginal Propensities to C and S • Marginal propensity to consume, MPC – Fraction of additional income that is spent • Change in consumption / change in income • Marginal propensity to save, MPS – Fraction of additional income that is saved • Change in saving / change in income • MPC + MPS = 1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7
- 8. MPC Is the Slope of the C Function • Consumption function – Relationship between consumption and income, other things constant • Slope of a straight line – The vertical distance between any two points –Divided by the horizontal distance between those same two points © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8
- 9. MPC Is the Slope of the C Function • ΔC –Change in consumption (vertical distance) • ΔDI –Change in disposable income (horizontal distance) • MPC – The slope of consumption function © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 C MPC DI
- 10. Exhibit 3 The Marginal Propensity to Consume and the Consumption Function Real consumption (trillions of dollars) a b ΔC=0.4 ΔDI=0.5 MPC = ΔC/ΔDI = 0.4/0.5 = 4/5 C Real disposable income (trillions of dollars) 0 The slope of the consumption function equals the marginal propensity to consume. For the straight-line consumption function, the slope is the same at all levels of income and is given by the change in consumption divided by the change in disposable income that causes it. Thus, the marginal propensity to consume equals ΔC/ΔDI, or 0.4/0.5 = 4/5. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 10 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 11. Nonincome Determinants of C • Net wealth – Value of all assets minus liabilities • Decrease in net wealth –Spend less • C decreases • C function shifts down – Save more (increase S) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11
- 12. Exhibit 4 Shifts of the Consumption Function C″ C C′ Real disposable income Real consumption A downward shift of the consumption function, such as from C to C′, can be caused by a decrease in net wealth, an increase in the price level, an unfavorable change in consumer expectations, or an increase in the interest rate. An upward shift, such as from C to C″, can be caused by an increase in net wealth, a decrease in the price level, a favorable change in expectations, or a decrease in the interest rate. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 12 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 13. Nonincome Determinants of C • Changes in price level –Changes in real value of cash and bank accounts – Increase in price level • Decreased purchasing power • Decrease C – Downward shift of C function • Increase S © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13
- 14. Nonincome Determinants of C • Interest rate – Reward for savers – Cost for borrowers – Higher interest rates • Save more • Borrow less • Spend less – Decrease C © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14
- 15. Nonincome Determinants of C • Consumer expectations – Future income increase • Increase C now – Future price level increase • Increase C now – Future interest rate increase • Increase C now © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15
- 16. Other Spending Components • Consumption, C – The most important spending component • Investment, I • Government purchases, G • Net exports, NX © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16
- 17. Investment • Gross private domestic investment, I –Spending on new physical capital –Spending on new housing – Net increases to inventories • Firms buy new capital goods – Only if they expect this investment to yield a higher return • Than other possible uses of their funds © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17
- 18. Investment • Investment demand curve – Inverse relationship • Quantity of investment demanded • Market interest rate – Other things constant • Business expectations • Optimistic expectations – Investment demand increases © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18
- 19. Exhibit 5 Investment Demand Curve for the Economy 10 8 6 0 0.9 1.0 1.1 DI Investment (trillions of dollars) Nominal interest rate (percent) The investment demand curve for the economy sums the investment demanded by each firm at each interest rate. At lower interest rates, other things constant, more investment projects become profitable for individual firms, so total investment in the economy increases. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 19 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 20. Investment and Income • Investment –Depends more on interest rates and on business expectations • Than on the prevailing income level • The investment decision – Is forward looking • Based more on expected profit than on current income in the economy • Assumption • Investment is unrelated to income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20
- 21. Investment Varies More than Consumption • Consumption – 70% of GDP, largest spending component • Investment – 15% of GDP – Fluctuates more than consumption and GDP – Accounts for almost all year-to-year GDP fluctuations © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 21 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 22. Exhibit 6 Annual Percentage Change in U.S. Real GDP, Consumption, and Investment Investment varies much more year-to-year than consumption does and accounts for nearly all the variability in real GDP. This is why economic forecasters pay special attention to the business outlook and investment plans. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 22 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 23. Government Purchases • Government purchases, G – Government purchases of goods and services – 19% of GDP • Most by state and local governments –Spending decisions do not depend directly on income in the economy • Assume • Government purchases are independent of income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23
- 24. Government Purchases • Government outlays – Government purchases – Transfer payments • Transfer payments, TP – Outright grants from government to households – Vary inversely with income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24
- 25. Government Purchases • Government outlays – Funded with taxes • Taxes, T – Vary directly with income • Net taxes = T-TP – Independent of income – Affect aggregate spending indirectly • By changing disposable income • Which in turn changes consumption © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25
- 26. Net Exports • The U.S. –One-twentieth of the world’s population –About one-eighth of the world’s imports –And one-ninth of the world’s exports • Imports – Affected by income –When incomes rise Americans spend more on all normal goods, including imports © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26
- 27. Net Exports • Exports –Depend on the income of foreigners, not on U.S. income • Net exports = Exports – Imports = X – M – Tend to decline as U.S. incomes increase – Assumption: independent of income – If M > X: Net exports < 0 – If X > M: Net exports > 0 – If X = M: Net exports = 0 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27
- 28. Aggregate Expenditure and Income • A dollar spent (expenditure) – Translates directly into a dollar earned (income) • Aggregate expenditure components, AE = C + I + G + (X – M) – Varies with income: C – Independent of income: I, G, (X – M) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28
- 29. Aggregate Expenditure and Income • Aggregate expenditure line – A relationship tracing, for a given price level, spending at each level of income, or real GDP • Slope of AE line = MPC – Because only C varies with income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29
- 30. Aggregate Expenditure and Income • Income – Expenditure model – AE line, given price level – 45-degree line • Spending = real GDP –Aggregate output demanded (real GDP) • AE = real GDP © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30
- 31. Aggregate Expenditure and Income • If spending > real GDP – Decrease inventories – Increase • Production, employment, income, spending • If real GDP > spending – Unsold goods: increase inventories – Decrease • Production, employment, income, spending © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31
- 32. Exhibit 7 Deriving the Real GDP Demanded for a Given Price Level C+I+G+(X-M) e a d 15.0 14.8 14.0 13.2 13.0 b 45° c 0 13.0 14.0 15.0 Real GDP (trillions of dollars) Aggregate expenditure (trillions of dollars) Real GDP demanded for a given price level is found where aggregate expenditure equals aggregate output—that is, where spending equals the amount produced, or real GDP. This occurs at point e, where the aggregate expenditure line intersects the 45- degree line. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 32 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 33. The Simple Spending Multiplier • Increased spending: AE line shifts upward –Round one, Spending > Output • Unplanned reduction in inventories • Expand production • Increased income –Round two • Increased spending and saving • Increased output, • Increased income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 33
- 34. The Simple Spending Multiplier • Increased spending: AE line shifts upward –Round three and beyond • Increased spending and saving • Increased output • Increased income • … as long as spending exceeds output © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 34
- 35. Exhibit 8 Tracking the Rounds of Spending Following a $100 Billion Increase in Investment (billions of dollars) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 35 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 36. The Simple Spending Multiplier • The larger the MPC – The larger the simple spending multiplier • Simple spending multiplier – Ratio of a change in real GDP demanded • To the initial change in spending that brought it about • Only consumption varies with income © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 36 1 1 1 MPC MPS
- 37. The Aggregate Demand Curve • For each price level – Unique AE line • Yields a unique real GDP demanded • Changing the price level – Different real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 37
- 38. The Aggregate Demand Curve • Higher price level – Decreased C – Higher interest rate – Decreased I – Decreased (X-M) –Reduced aggregate spending • AE shifts down – Decrease real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 38
- 39. The Aggregate Demand Curve • Lower price level – Increase: C, I, (X-M) – Increased aggregate spending – AE line shifts up – Increase real GDP demanded • Aggregate demand curve – Various price levels –Quantities of real GDP demanded © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 39
- 40. Exhibit 9 Changing the Price Level to Find the Aggregate Demand Curve AE″(P=100) AE (P=110) AE′ (P=120) (trillions of dollars) AD Aggregate expenditure (trillions of dollars) e′ 45° e e″ 0 13.5 14.0 14.5 Real GDP 120 110 100 At the initial price level of 110, the aggregate expenditure line is AE, which identifies real GDP demanded of $14.0 trillion. This combination of a price level of 110 and a real GDP demanded of $14.0 trillion determines one combination (point e) on the aggregate demand curve in panel (b). At the higher price level of 120, the aggregate expenditure line shifts down to AE′, and real GDP demanded falls to $13.5 trillion. This price-quantity combination is identified as point e’ in panel (b). At the lower price level of 100, the aggregate expenditure line shifts up to AE″ which increases real GDP demanded. This combination is plotted as point e″ in panel (b). Connecting points e, e′, and e″ in panel (b) yields the downward-sloping aggregate demand curve AD, which shows the inverse relation between the price level and real GDP demanded. e″ e e′ 0 13.5 14.0 14.5 Real GDP (trillions of dollars) Price level © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 40 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
- 41. The Aggregate Demand Curve • A given price level – AE line – relationship between • Spending plans and income (real GDP) • Change in price level – Shifts AE line –Changes real GDP demanded –Movement along AD curve • A given price level – For changes in spending: shift AD curve © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 41
- 42. Exhibit 10 A Shift of the AE Line That Shifts the AD Curve C+I′+G+(X-M) (trillions of dollars) AD C+I+G+(X-M) Aggregate expenditure (trillions of dollars) 0.1 45° e e′ 0 14.0 14.5 Real GDP 110 (a) Investment increase shifts up the aggregate expenditure line A shift of the aggregate expenditure line at a given price level shifts the aggregate demand curve. In panel (a), an increase in investment of $0.1 trillion, with the price level constant at 110, causes the aggregate expenditure line to increase from C+I+G+(X-M) to C+I′+G+(X-M). As a result, real GDP demanded increases from $14.0 trillion to $14.5 trillion. (b) Investment increase shifts aggregate demand rightward AD′ e′ e In panel (b), the aggregate demand curve has shifted from AD out to AD′. At the prevailing price level of 110, real GDP demanded has increased by $0.5 trillion. 0 14.0 14.5 Real GDP (trillions of dollars) Price level © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 42 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.