National Income and Price

Determination

Macro Unit III

Aggregate DemandMcConnell Brue Chapter 10

Aggregate Demand

• This lesson will help us begin to develop a model of the entire economy (a macroeconomic model) using aggregate measures of demand, supply, output, and price.• Aggregate – “total” or “combined.”

• Aggregate demand – the sum of planned consumption (C), investment (I), government (G), and net export () expenditures on final goods and services.• This was the equation we used to calculate GDP using the

expenditures approach!

Building the Macroeconomic Model

Aggregate Demand • FYI: This is a macroeconomic model and uses aggregate values. AS/AD graphs must be labeled with aggregate values (i.e., AS, AD, the price level, and real GDP) rather than microeconomic labels (e.g., S, D, P, and Q).

Building the Macroeconomic Model

Aggregate Demand • That the AD function is an inverse function between the price level and output:

• An increase in price from PL to results in a decrease in real GDP from Y to .

Aggregate Demand

• As the price level rises, the level of output demanded decreases.

• This is similar to a market demand curve.• Recall that a market demand curve has a

negative slope due to the income effect, the substitution effect, and the law of diminishing marginal returns.

• The reason the AD curve slopes downward is different.

• The negative slope is due to three macroeconomic effects: the interest rate effect, the wealth effect, and the net export effect.

Interest Rate Effect

• The interest rate is the price of borrowing to purchase capital or durable goods (like houses or cars).

• As the price level (including interest rates) increases, businesses buy less capital and consumers buy fewer durable goods.

• As the price level (interest rates) decreases, purchases of capital and durable goods increase—giving the AD curve a negative slope.

Wealth Effect

• Sometimes called the real balance effect

• As the price level increases, it takes more dollars to purchase goods.• In other words, an increase in the price level decreases the purchasing power

of cash balances.

• Faced with a decrease in purchasing power (real wealth), people decrease consumption.

• A decrease in the price level causes an increase in purchasing power so that people increase consumption—giving the AD curve a negative slope.

Net Export Effect

• As the domestic price level increases (relative to a foreign price level), domestic products are more expensive for foreign buyers, and foreign goods are less expensive for domestic consumers to buy.• So an increase in the price level decreases exports and increases imports,

both of which decrease net exports (exports minus imports).

• A decrease in the price level will increase X (as domestic goods become relatively less expensive) and decrease M (as foreign goods become relatively more expensive) so that increases—giving the AD curve a negative slope.

Shifts in Aggregate Demand

• Shifts to the right represent increases (real GDP is higher to the right).

• Shifts to the left represent decreases (real GDP to the left is smaller).

Shifts in Aggregate Demand

• Remember: AD = C + I + G +

• How would each of the following affect the AD curve?• Changes in government spending?

• Changes in income tax

• Changes in consumer expectations of future income

• Changes in foreign income

• Changes in business’ expectations o future sales

Importance of Investment in Determining AD

• To an economist, investment is spending on things that are used to produce other things, for example, plant and equipment, machinery, and buildings that a firm uses to produce output.• Investment is not the purchase of stocks and bonds or any

other financial instrument.

Determinants of Investment

• There are two important determinants of investment: output and interest rate.

• Output• Demand for a business’ products determines investment, and real

GDP is a measure of the level of demand in the economy.

Determinants of Investment

• The benefit of investing depends on the demand for the business’ product.

• The cost of investing depends on the interest rate.

• The interest rate is the cost of the investment because the firm either needs to borrow money to invest (and pay the interest rate on the loan) OR it can invest its own money (in which the interest rate is the opportunity cost of the investment because the business has foregone earning interest by loaning the money).

Investment Demand

• To decide whether to invest, businesses compare the interest rate to the expected profit rate of the investment.

• If the expected profit is greater than the interest rate, firms will invest.

• As the interest rate decreases, there are more investment opportunities for which expected profit is greater than the interest rate and firms will invest more.

Do Activity 3-1

The MultiplierMcConnell Brue Chapter 8

Determining Consumption

• Consumption makes up the largest component of aggregate demand.

• How is a person’s level of consumption determined?• Depends largely (and positively) on income

• More specifically, it depends on disposable income (DI)—the income that consumers have “at their disposal” to spend (e.g., income minus taxes).

• The proportion of their income that a person spends is called the average propensity to consume (APC).

To Spend or to Save…

• Consumers have the option to either spend or save their income, so the APC may be less than one (though it may be equal to one for high school students or teachers who spend all their income!).

• The proportion of income that a consumer saves is called the average propensity to save (APS) and is equal to S/DI.

• Because consumers have only two options, spending and saving, C + S = DI and therefore APC+ APS = 1.• That is, the proportion of income saved plus the proportion of income

spent equals the total income.

VERY IMPORTANT!!!

• In this model consumers do not invest—businesses invest.

• Remember the economic definition of investment: buying equipment and buildings for production.

• When households buy mutual funds or stocks, it is a way of saving (foregoing consumption).

• This is an important distinction because the term investment is used differently in other places.

MPC vs. MPS

• Remember that economics focuses on marginal analysis.• Marginal always means change or additional.

• Here we use the terms marginal propensity to consume (MPC) and marginal propensity to save (MPS).

MPC vs. MPS

• The MPC is the additional spending that results when a consumer receives additional disposable income.• If a consumer receives an additional dollar and they spend half of

it, their MPC is 0.5.

• The MPS is the additional saving that results when a consumer receives additional disposable income.• If a consumer receives an additional dollar of disposable income

and saves half of it, their MPS is 0.5.

MPC vs. MPS

• Because DI = S + C, MPC + MPS = 1, the additional spending from an additional dollar plus the additional saving from an additional dollar must equal the additional dollar.

The Multiplier

• What happens when there is additional spending in the economy?

• Assume the government spends an additional $100 on office supplies (G increases by $100). That spending becomes income for the office supply store owner. What does the store owner do with the additional income?• She consumes part of it and saves part of it!

• How much does she consume?• It depends on the MPC.

• Assume the MPC is 0.8. The store owner spends $80 and saves $20. What happens to the $80 she spends?• It becomes income for someone else.

• Assume she spends it for groceries. The spending becomes income for the grocery store owner. What does he do with it? • He spends some and saves some.

The Multiplier

• How long does this process continue?• Until there is no more income to pass on to the next round…

• One can calculate the final change in spending that results by continuing through all the rounds and adding the spending from each round.

• But there is an easier, more efficient way to calculate the amount spent…

The Multiplier

• What determined the spending passed on in each round of the earlier example?• The MPC.

• What would happen if the MPC were larger?• More is passed on

• Smaller?• Less is passed on.

• Recall the circular flow model, and recall that saving was a leakage from the circular flow.

The Multiplier

• Spending multiplier = 1/(1 – MPC) or 1/MPS.

• Any initial change in spending will be multiplied (C, I, G, ).

• Also note that a change in taxes will affect spending because it affects disposable income.

The Multiplier

• Tax multiplier = –MPC/(1 – MPC) or –MPC/MPS.

• The tax multiplier is slightly different for two reasons.• First, the tax multiplier is negative because an increase in taxes decreases DI and

spending, while a decrease in taxes increases DI and spending.

• Therefore the effect of taxes is inverse so the multiplier has a negative sign.

• Second, a change in taxes must change DI before it changes spending.

• This is different from a change in C, I, G, or Xn that immediately affects spending.

• A $1 change in taxes will only change spending by $1 x MPC.

• For example, if the MPC is 0.8 and consumers get a $1 reduction in taxes, they will only increase spending by $0.80.

• These two differences mean that the tax multiplier is equal to MPC/(1 – MPC).

Tax Multiplier Differences

• or

Do Activity 3-2

Aggregate SupplyMcConnell Brue Chapter 10

Aggregate Supply

• This lesson further develops the macroeconomic model by developing the supply side of the AS/AD model of the economy.

• Aggregate Supply – the total supply of all goods and services in the economy.

• The AS curve shows the relationship between total quantity of output supplied by all firms and the overall price level.

• REMEMBER: This is a macroeconomic model and uses aggregate values. AS/AD graphs must be labeled with aggregate values (i.e., AS, AD, the price level, and real GDP) rather than microeconomic labels (e.g., S, D, P, and Q).

Aggregate Supply

• AS, or real GDP, depends on the quantity of labor, the quantity of capital, and the level of technology.

• In the short run, the capital and level of technology are fixed, and only the quantity of labor changes.

• An SRAS curve assumes the nominal wage, and other resource prices are constant.

• As the price level rises, firms will produce more output because their profit per unit will increase because their input costs remain the same while they sell their product for a higher price.

Shifts in Aggregate Supply

• The SRAS will shift if nominal wages or other resource prices change or if there is a change in productivity.

• Shifts to the right represent increases in SRAS because real GDP is higher to the right.

• Shifts to the left represent decreases because real GDP to the left is smaller.

Do Activities 3-3 and 3-4

Short-Run Equilibrium and Changes in AS/AD

McConnell Brue Chapter 10

Short-Run Macroeconomic Equilibrium

• Short-run macroeconomic equilibrium occurs when real GDP demanded equals real GDP supplied.• This is Point A in the graph, or the level of

output Y.

• If the price level is above the equilibrium, then AS is greater than AD and firms experience an accumulation of inventory.• So, they cut production and real GDP

decreases toward the equilibrium level.

• What would a comparable story be if the price level is below equilibrium?

Change in AD

• Let’s say there is an increase in AD.

• The new equilibrium is at a higher price level and a higher level of output.

• In response to the increase in demand, firms increase production and price.

Other Changes to Macroeconomic Equilibrium

• Use your whiteboard to illustrate what would happen in the following scenarios:• A decrease in AD

• A decrease in SRAS

• An increase in SRAS

Changes to Macroeconomic Equilibrium and Inflation

• Changes in AD and AS lead to changes in the price level (inflation and deflation).

• Whether changes in the price level are due to changes in AD or AS determines the type of inflation the economy experiences.

Demand-Pull Inflation

• Demand-pull inflation is caused by a shift in the AD curve.

• Demand-pull inflation occurs when the demand for goods and services increases at a time when the production of G/S is already high.

• The increase in AD causes real GDP to expand and price level to increase

• “Too much money chasing too few goods”

Cost-Push Inflation

• Cost-push inflation is caused by a shift in the AS curve.

• It’s caused by an increase in the cost of an input with economy-wide importance.

• For example, an increase in wages will cause an economy-wide increase in input costs.

Complete Activities 3-5, 3-6, and 3-7

Aggregate Supply in the Long Run

McConnell Brue Chapter 15

In the long run…

• Today, we’ll focus on the long run.• Specifically, an introduction to long-run aggregate supply.

• Recall that the definition of the long run is a period of time long enough for firms to change any of their inputs.• That is, all costs are variable, and there are no fixed costs.

Long-Run Aggregate Supply (LRAS)

• The LRAS is vertical at the full employment, or potential level of real GDP.

• Full employment output is the level of real GDP that exists when the economy’s unemployment rate is at its natural rate.

• This natural rate of unemployment doesn’t correspond to an unemployment rate of zero.• Rather, it is the unemployment rate that

exists when there is no cyclical unemployment.

Long-Run Equilibrium

• The level of real GDP is directly related to the level of employment because more production requires more employment.

• This means that real GDP is inversely related to the level of unemployment— as real GDP and employment increase, unemployment decreases and vice versa.

• As real GDP increases (equilibrium moves to the right along the horizontal axis), unemployment decreases and vice versa.

Recession

• When the economy is in a recession, equilibrium real GDP will be less than the potential level and the unemployment rate will exceed the full employment or natural rate.

Inflationary Gap

• When the economy is experiencing an inflationary gap, the equilibrium real GDP will exceed the potential level and the unemployment rate will fall below the full employment or natural rate.

Complete Activities 3-8 and 3-9