Transcript Aggregate Demand - Villanova University

Aggregate Demand
Consumption and Saving
Investment
Government Purchases and Net Exports
Demand-Side Equilibrium
A Model of Aggregate Demand
Aggregate Demand (AD) is the economy’s
total demand for goods and services
= total expenditures
= C + I + G + NX
 Question: What determines AD and GDP?
Need to build a model of the U.S. economy.
 Model consists of demand and supply sides.

Consumption




A key determinant of consumption is disposable
income.
There is a positive relationship between C and
DI.
The marginal propensity to consume (MPC) is
the fraction of each additional dollar of income
that is consumed = DC/DDI.
Autonomous consumption is the portion of your
consumption that does not depend on DI.
2: Consumer Spending and
Disposable Income
FIGURE
$8,000
$7,500
$7,000
$6,500
6,000
5,500
Billions of 2000 Dollars
5,000
4,500
4,000
Real disposable income
3,500
3,000
2,500
2,000
1,500
World
War II
Real consumer spending
The Great
Depression
1,000
500
2004
0
1930
1940
1950
1960
1970
1980
1990
2000
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.
3: Consumer Spending and
Disposable Income
FIGURE
2004
2003
2002
2001
2000
1998
1997
$5,619
1995
1994
1992
1990 1991
1989
1988
1987
1986
1999
1996
1985
1984
1979
1980
1978
1976
1974
$3,036
1970
1964
Real Consumer
Spending
1960
1955
1947
1945
1941
1942 1943
1939
1929
0
$3,432
Real Disposable Income
$6,081
Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

We can represent this relationship by a
consumption function that relates C to DI:
C
=
a + b(DI)
or
C
=
a + b(Y – T)
a = autonomous consumption
b = MPC = DC/DDI

The saving function relates saving (S) to
disposable income (DI):
S
=
DI – C
=
DI – [a + b(DI)]
=
-a + (1 – b)(DI)
(1-b) = marginal propensity to save (MPS)
MPC + MPS = b + 1 – b = 1



Example: C = 100 + 0.75(Y-T)
Changes in DI => movement along C-function
Factors which shift C-function:
(1) Consumer Wealth:
Upwards
(2) Price Level:
Downwards
(3) Expected Income:
Upwards
(or consumer confidence)
(4) Real Interest Rate:
Downwards or
Ambiguous!




Factors which shift the consumption function will
change autonomous consumption (a).
Effects of Taxes on Consumption
Consumption versus Disposable Income.
MPC is likely low for temporary DDI
MPC is likely high for permanent DDI
Example: Tax Rebate Policy of 2001.
Investment Demand



Investment is spending by businesses on new
productive (physical) capital goods.
Three categories of investment:
(i) Business spending on new plant/equipment.
(ii) Change in business inventories.
(iii) Residential construction (new homes).
Remember investment is the change in the
nation’s capital stock.

Investment can be divided into two parts:
(1) Planned Investment or Investment Demand:
ID = investment in plant and equipment +
residential construction + planned
inventory investment
(2) Unplanned Inventory Investment (IU) = the
unexpected build up or run down of business
inventories.
I = ID + IU


A key determinant of ID is the real interest rate
(r) – must compare interest rate to return on
investment projects.
Factors which determine ID. An Increase In:
(1) Real Interest Rate (r):
Decreases ID
(2) Business Confidence/Expectations:
Increases ID
(3) Corporate Taxes:
Decreases ID
(4) Tech Innovations (long-run)
Increases ID
Government Purchases




Government Purchases (G) is determined by
(i) Executive Branch (President)
(ii) Legislative Branch (Congress)
Government Spending = G + Transfer Payments
Net Taxes = T – Transfers.
Fiscal policy deals with the government
adjustment of government purchases (G) and
net taxes (T).
Net Exports


NX = Exports (X) – Imports (IM)
Many domestic and foreign economic factors
determines NX (domestic and foreign GDP,
exchange rates). For now assume NX given.
Aggregate Demand-Side Equilibrium


In an economic model:
exogenous variable =>
variables that have
assigned values
endogenous variable => variables that are
unknown and
determined by model
Question: How much GDP is the entire
economy willing to demand? This will give us
“demand-side” GDP: AD = C + I + G + NX



The Simple Demand-Side Equilibrium Model:
Exogenous (given): ID, G, NX, T and a.
Endogenous:
Y (GDP demanded)
Always True:
Y = C + I + G + NX
I = ID + IU
Equilibrium is a situation of no change; there is
no incentive for firms to increase or decrease
production.
 A demand-side equilibrium occurs when
(i) IU = 0
(ii) I = ID
(iii)Y = C + ID + G + NX

Graphical Interpretation: The 450 Diagram
(i) Slope of Expenditures Line (C+ID+G+NX) is
MPC.
(ii) Intercept of Expenditures Line is
Autonomous Spending (ATS) – the level of
overall spending that does not depend on
income:
ATS = a – bT + ID + G + NX
(iii)
450 Line Represents Income or GDP
(Y=Y).


Case I: YH > Y*
YH = C + I + G + NX > C + ID + G + NX
I > ID and IU > 0
Decrease Y.
Case II: YL < Y*
YL = C + I + G + NX < C + ID + G + NX
I < ID and IU < 0
Increase Y.
 Case III: Y = Y*
IU = 0
I = ID
Y = C + ID + G + NX
EQUILIBRIUM

Formula for Simple Equilibrium Model:
(i) C = a + b(Y-T)
(ii) Given T Given (“lump-sum”)
(iii) Given ID,G,NX
Equilibrium GDP is given by
1
)( ATS )
Y* = (
1 b
1
)[ a  bT  ID  G  NX ]
= (
1 b
What Causes Changes in GDP?


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Question: What factors can cause a change in
(demand-side) equilibrium GDP?
Answer: Changes in autonomous spending
(ATS).
Factors which shift expenditures line and change Y*:
(i) autonomous consumption (a)
(ii) Investment Demand (ID)
(iii) Government Purchases (G)
(iv) Net Exports (NX)
(v) Net Taxes (T)



Question: How much does equilibrium GDP
change for every dollar of additional ATS.
Example: Kaitlyn Buys a DVD player for $100
from Bob’s Electronics.
The spending multiplier indicates the change in
equilibrium GDP for each additional dollar of
ATS.
Spending Multiplier = DY*/DATS

The Simple Spending Multiplier:
DY
DY
DY
DY
DY
1





1
Da DID DG DNX DATS 1  b

The Simple Tax Multiplier shows the change in
equilibrium GDP for each additional dollar of
taxes:
DY
b

0
DT 1  b

Application – Business Cycles
*
Great Depression
*
Self-Fulfilling Expectations

Application – Fiscal Policy
*
Expansionary Fiscal Policy
*
Government Spending versus Taxes
The Growth Rate of U.S. Real Gross
Domestic Product since 1870

Shortcomings of the simple spending and tax
multipliers:
(i) Ignores variable (marginal) income taxes.
(ii) Ignores the effect of interest rates and
prices.
(iii) Ignores variable imports.
Variable Taxes and the Multiplier

The Federal government collects two types of
taxes:
(1) Fixed Taxes – do not depend on income
(T0).
(2) Variable Taxes – Income taxes.
T
=
T0
+
tY
(Total Taxes)
(Fixed)
where t = income tax rate.
(Variable)
Formulas w/ Variable Taxes:
(1) Equilibrium GDP:
1
Y*  (
)( ATS)
1  b(1  t )
(2) Spending Multipliers:
DY
1

DATS 1  b(1  t )
(3) Tax Multiplier:
DY
b

DT 1  b(1  t )
Aggregate Demand Curve



Question: What’s the relationship between
(demand-side) equilibrium GDP (YD) and
Prices?

=>
 P
 real vale of money-fixed assets
=>
autonomous consumption

=>
Y*
The aggregate demand (AD) curve shows the
negative relationship between demand-side Y
and prices.


Any factor other than P which changes YD =>
shifts AD curve:
An increase in
(1) consumer wealth or confidence => right
(2) ID =>
right
(3) G =>
right
(4) NX =>
right
(5) T =>
left