As incomes
rise,
consumption
increase.
Time
1
Chapter 8
Aggregate Demand
3/15/2016
© 2004 Claudia Garcia - Szekely
2
The Components of
Aggregate Demand
1. Consumption
2. Investment
3. Government Spending
4. Net Exports
Expenditures in consumer goods are
70% of GDP
4
GDP=Y
Consumption
Disposable Income
6
As income
increases,
consumption
increases
What determines the level of
All other factors
Consumption?
which affect
Consumption
Disposable Income Yd
Wealth
Prices
Expectations
Add these two components
C=bYd
Induced by
changes in Yd
C=a
Autonomous
from Yd
C=a+
d
bY
Consumption Billions
Consumption has two
d
MPC=DC/DY
components
d d d
C
=
a
+
bY
C = a + (DC/DY )Y
1175
1025
875
Increase in
Consumption
725
DYd
Slope:b
DC
575
Increase in
Disposable
income
425
300
500
700
900
Real Disposable Income
Billions
1100
C=bYd
Induced by
changes in
Disposable
Income
1300
Consumption has two
components
d d
d)Y
C a= +a (DC/DY
+ MPCY
C=
Consumption
1175
1025
875
Slope
725
575
425
a:
Intercept
C = a Autonomous Consumption
300
(Independent from Disposable Income)
responds
to900
changes
in wealth,
500
700
1100
1300
pricesIncome
and expectations
Real Disposable
Billions
Consumption Billions
Calculating the slope
d
C = a + 0.75Y
Choose any two points
d
C = a + bY
1175
1025
875
DC=300 b
MPC
725
MPC=300/400
MPC=DC/DYd
575
425
DYd=400
300
500
700
900
Real Disposable Income
Billions
1100
1300
Consumption Billions
725-525= a
725 = a + 525
725 = a + 0.75(700)
d
C = a + 0.75 Y
1175
1025
875
725
C =725
Choose any point
575
425
a: 200
Intercept
200= a
300
Value of
Y= 700
500
700
900
1100
1300
Real Disposable Income
Consumption
when Disposable Income
Billions
=0
C = a+ MPC*Yd
When
Disposable
Income is zero:
Income not
consumed is
saved
C= a
When
Disposable
Income is zero:
S = Yd – C
S=0-a
S
S=-a
13
MPC for the US is 90%
14
C = a + 0.9Yd
?
DC=0.9*400
MPC=0.9
760+360=1120
DC=0.9*400
400+360=760
MPC=0.9
DC=0.9*400
MPC=0.9
400
DYd=400
300
DYd=400
700
Real Disposable Income
Billions
1100
DYd=400
1500
Dyd=300
Dyd=400
DYd=400
DYd=400
2000
300
700
1100
1500
-90+40=-50
MPS=0.1
-130+40=-90
DS=0.1*400
-170+40=-130
-200+30=-170
-a=-200
MPS=0.1
DS=0.1*400
MPS=0.1
DS=0.1*300
Consumption Billions
4100
3650
320
0
2750
2300
2000
2500
3000
3500
Real Disposable Income
Billions
4000
Same Intercept “a” different
slope “MPC”
2750
C1
Larger
Increase in
consumption
1,350
Larger MPC=0.9
C0
1400
C1
2150
Smaller
Increase in
C0
consumption1100
1,050
aa
Smaller MPC=0.7
1500
Y0
3000
Y1
1,500
18
Different intercept “a” same
slope “MPC”
3300
C1
2250
C0
C1
2150
a*
C0
1100
same Increase
in consumption
1,050
Same MPC
Same Increase
in consumption
1,050
a
Same MPC
1500
Y0
3000
Y1
19
20
d = NIConsumption
Function
YThe
GDP
Taxes
- Taxes
+ Transfers
+ Transfers
C = a + MPC*
d
Y
Consumption
Consumption responds to
responds to changes
changes in wealth,
prices and expectations in after tax income
Changes in income:
Changes in wealth,
Movement Along
prices and expectations:
the C line.
Shift C line
Given the Consumption function, C = 200+0.75Y
Find the value of consumption for each of
these values of Y:
C=18,950
C=14,450
C = 200+0.75*25,000
C = 200+0.75*19,000
C=7,700
C = 200+0.75*10,000
C=3,950
C = 200+0.75*5,000
5,000
10,000
19,000
25,000
Y
22
Movement along the Consumption
Function
C
Changes in
Disposable Income
ONLY!
18,950
14,450
7,700
3,950
5,000
10,000
19,000
25,000
Yd
Movement along
C0
2170
DC=MPC*DYd
Income Increase:
Wages Increase
Profits Increase
Interest Increase
Rents Increase
2080
1200
1300
S0
-870
-880
1200
1300
DS=MPS*DYd
24
Shifts in Consumption
C0
C1
a = 300
Smaller
intercept
a = 200
S1
S0
-a = -200
Higher
intercept
-a = -300
25
Shifts in the consumption
function
1.
Changes in wealth: stocks, bonds, consumer
durables, homes.
When stock prices go down, consumer wealth drops.
Consumers feel poorer (even though incomes may be
the same!) decrease purchases.
A downward shift in the
Consumption Line: a
smaller intercept.
An upward shift in the
Savings Line: a larger
intercept.
Shifts in the consumption
function
2. Changes in consumer expectations:
Pessimistic expectations about future:
employment, incomes, wealth.
Consumers slow down purchases (even though
incomes are the same!)
A downward shift in the
Consumption Line: a
smaller intercept.
An upward shift in the
Savings Line: a larger
intercept.
Shifts in Consumption
3.
Overall Prices of goods and services
When prices rise (an increase in the CPI) consumers lose
buying power.
Real Wealth Decrease
This drop in the purchasing power of saved dollars make
consumers feel poorer: slow down purchases.
A downward shift in the
Consumption Line: a
smaller intercept.
An upward shift in the
Savings Line: a larger
intercept.
Factors that shift the
consumption function Interest Rates
are NOT in the
list!
Changes in wealth
value of stocks, bonds, consumer durables,
homes.
Changes in consumer expectations
Pessimistic expectations decrease
autonomous consumption.
Changes in Prices
Shift Consumption
line
Affect the purchasing power of assets.
Statistical studies: interest rates have no effect on Consumption
Interest rates
do not shift C
Interest rates affect
INVESTMENT: New home
purchases
Wealth
Expectations
Prices
C0
C1
a = 300
Smaller
intercept
a = 200
S1
S0
-a = -200
Higher
intercept
-a = -300
30
Wealth
Expectations
Prices
C1
C0
Larger
intercept
S0
S1
Lower
intercept
31
We
that C
= 700 when for
Ywe
=1,000.
Write
equation
this
To know
getthe
the
equation,
choose any
700 = a + 2/3 (1,000) solve for a = 700 – 2,000/3 = 700
consumption
function
two
points:
– 666.67
1200 = 33.33
C = 33.33 + 2/3 Y
1100
1000
900
900
200
800
700
700
MPC
=200/300
= 2/3
300
600
1000
1300 1400
1000
1200
1600
To calculate the intercept (a), use the MPC and the consumption
function: C = a + 2/3 Yd
600
800
32
C = 33.34 + 2/3 * Y
Set C =Y:
33.34 + 2/3*Y = Y
Solve for Y = 100
C
C= Y
What
is is
the
value
of of
YY
What
the
value
such
that
C=Y?
such
that
Saving = 0?
33.34
S
Y= 100
Y
S = -33.34 + 1/3*Y
S= 0
Y
Y=
Y=100
-33.34
Set S =0:
-33.34 + 1/3*Y = 033
Solve for Y = 100
1.
2.
3.
4.
5.
6.
7.
8.
Calculate the MPC
Calculate the Intercept
Write down the formula for the Consumption function.
Fill in the missing Consumption Values
What is the value of Consumption when Income is 10,000
Fill in the value of Savings in the table
At what value of Y is Consumption equal to Income?
Write down the formula for the Savings function
Disposable
income
Consumption
0
1000
2000
1,400
2,200
3000
4000
5000
3,800
4,600
6000
5,400
Saving
1.
2.
3.
5.
7.
8.
Calculate the MPC =800 /1000
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
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
3,000
-600
-400
-200
0
4000
5000
6000
3,800
4,600
5,400
200
400
600
Using C function
from previous slide,
fill in the missing
values/labels
C= Y
What is the value of Y
such that Saving
C=Y? = 0?
S= 0
Y=
36
Event
Movement
Movement
Consumption
Along the
Savings line
Along the
Consumption
line shifts
Consumption Saving
shifts
Savings Line
Purchases
Line
Increase?
Increase?
Decrease?
Decrease?
Up? Down?
Up? Down? Remain the
Remain the Up? Down? No
Up? Down?
No
No movement Same?
Same?
shift?
No shift?
movement
along?
along?
1
A cut in taxes which increases
Disposable Income.
2
Stock prices collapse
Shift down
Shift up
3
The CPI (overall prices) increase
Shift down
Shift up
4
A decrease in transfer payments
from the government to consumers
which decreases Disposable Income
5
Home prices increase
6
Profits increase
7
Consumers decide to save more
8
Consumers become pessimistic
9
Decrease in interest rates
10
Employer announces major layoffs
of employees
11 Massive
layoffs of employees.
Up along
Down Along
Shift up
Up along
Shift down
Shift down
No Change
Shift down
Down Along
Up along
Down Along
Shift down
Up along
Shift up
Shift up
No Change
Shift up
Down Along 37
Investment Includes…
 Residential Construction
– Consumer purchases of new houses and
condominiums.
 Non-residential Construction
– Factories, Office buildings.
 Firms’ purchases of equipment
– software, tools, etc.
 Changes in Inventories: unsold goods
are included as investment.
38
Chapter 7
Investment
“Growth Policy:
Encouraging Capital
Formation”
3/15/2016
© 2004 Claudia Garcia - Szekely
39
Aggregate Demand
Price Level
Po
P1
AD = C + I + G + NX
Goods and Services Purchased
GDPo
GDP1
Real GDP
40
Aggregate Demand
Aggregate Expenditures
AD = C + I + G + NX
AE = C + I + G + NX
Price Level
Goods and Services
Purchased at
different Price Levels
C + I + G + NX
C + I + G + NX
Po
Goods and Services
Purchased at
different Income
Levels
AD=C +
AD=C
+ II++GG++NX
NX
Income Y0
Consumption
2170
2080
Disposable
Income
Increase:
Savings
1200
1300
S0
1200
-870
-880
1300
Downward shift in Consumption
Upward shift in Savings
1.
Interest Rates:
– Business borrow to
finance investment.
– Consumers borrow to
purchase new homes.
As interest rates drop,
more investment
projects become
profitable and
investment increases.
44
2. Tax Incentives
3.
Technical Change
– Create incentive to invest as firms rush to adopt
new technologies (Microchip, Internet, Faster
Computers, bio - fuels)
– Open business opportunities to take advantage of
these new technologies (Internet Cafes)
4. Expectations
– High sustained level of sales and expectations of
growing economy boost investment
45
5. Political Stability and the rule of law
– Business cannot be conducted without a guarantee
that property rights and contracts will be
respected. (Danger of communist take over, public
unrest, will negatively affect investment)
Political Stability can
be achieved with
many types of
Government
Dictatorship
Democracy
Monarchy
Theocracy
Kleptocracy
46
3. Government Spending
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.
47
1. U.S. GDP/National Income
2. GDP/Income in other countries
1.
U.S Prices rise relative to prices abroad
Weaker dollar
One Dollar
buys fewer
Euros
U$1
1Euro
Germans now pay
0.5 Euro
U.S. Goods are
cheaper to Germans
U.S. Exports increase when the
49
dollar becomes weaker.
Weaker dollar
One Euro buys
more Dollars
1Euro
1U$ Americans now pay 2 U$
Foreign goods are more
expensive to Americans
U.S. Imports decrease when
the dollar becomes weaker.
50
WEAKER DOLLAR INCREASE
EXPORTS AND DECREASE
IMPORTS
51
Y = 5,000
Income (Y)
Y = 10,000
Y = 19,000
C = 22,600
C = 17,200
C = 9,100
C = 4600
AE = 24,400
G=
500
G=
500
I = 1000
AE = 19,000I = 1000
I = 1000
AE = 10,900
= 1000
AE =I 6,400
G=
500
NX=
300
NX=
300
G=
500
NX=
300
NX=
300
AE = C + I + G + NX
AE
Y = 25,000
Class Work
Identify the component of AE which is affected (C, I, G, X or
M) explain how it is affected (increase, decrease).
Determine the effect on Aggregate Expenditures (AE
increase, decrease).
a) Prices in the US decrease relative to prices abroad.
b) The U.S. dollar becomes stronger
c) Home prices increase
d) Stock prices decrease
e) Interest rates decrease
f) A zero-emissions engine is developed.
g) Government announces a decrease in the number of
troops deployed abroad.
h) U.S GDP increase
53
The Effect of Changes
in Exchange Rates
More on Strong
Dollar
3/15/2016
© 2004 Claudia Garcia - Szekely
54
Review
Which component of AE is affected?
a) Prices Increase
b) Wealth Increase
c) Interest rates Increase
d) Technological Improvement
e) Government spending Increase
f) Taxes Increase
g) Transfers Increase
AE component affected
Prices Increase
Prices Decrease
NX Increase
NX Decrease
Exports Increase
Exports Decrease
Imports increase
Imports
Decrease
Wealth Increase
Wealth Decrease
Shift?
Movement
Along?
AE
Shifts Equilibrium Y
AD
AE component affected
Shift?
Movement
Along?
C drops due to wealth
effect: consumers feel
Prices Increase poor
C shifts down
C increases due to
wealth effect: consumers
Prices Decrease feel rich
C shifts up
AE
Shifts Equilibrium Y
AD
down decreases
Movement
up along
up
increases
Movement
down along
up
increases
shifts right
NX Increase
NX increase
NX shifts up
NX Decrease
NX decrease
NX shifts down down decreases
shifts left
Exports Increase NX increase
NX shifts up
shifts right
Exports Decrease NX decrease
NX shifts down down decreases
shifts left
Imports increase NX decrease
Imports
Decrease
NX increase
C increases due to
Wealth Increase wealth effect
C drops due to wealth
Wealth Decrease effect
NX shifts down down decreases
shifts left
NX shifts up
up
increases
shifts right
C shifts up
up
increases
shifts right
C shifts down
down decreases
up
increases
shifts left
Shift? Movement AE Equilibrium
AE component affected
Along?
Shifts
Y
Interest rates
increase
Interest rates
Decrease
Technological
Improvement
Government
Spending
Increase
Government
Spending
Decrease
Taxes Increase
Taxes Decrease
Transfers
Increase
Transfers
Decrease
AD
Shift? Movement AE Equilibrium
AE component affected
Along?
Shifts
Y
Interest rates
increase
Interest rates
Decrease
Technological
Improvement
Government
Spending
Increase
Government
Spending
Decrease
Taxes Increase
Investment drops
I shifts down
Investment Increases I shifts up
Investment increases I shifts up
down decrease
up
up
increase
shifts left
shifts
right
increase
shifts
right
increase
shifts
right
G increases
G shifts up
G drops
C drops
G shifts down down decrease
C shifts down down decrease
Taxes Decrease C increases
Transfers
Increase
C increases
Transfers
Decrease
C drops
up
AD
C shifts up
up
increase
C shifts up
up
increase
shifts left
shifts left
shifts
right
shifts
right
C shifts down down decrease
shifts left
AE component affected
Shift? Movement AE
Along?
Shifts
Relative US
Prices Increase
Relative US
Prices Decrease
Dollar weaker
Dollar Stronger
60