Transcript Chapter 13

13.0 Aggregate Demand
13.1.1
One thing that moves AD is a change in
the level of consumption ( C )
What determines C?
C is based upon
perception of long-term financial
prospects
Make a certain amount of income, for a
certain time,
you tend to spend at that level
Bumps along the way, smoothed out on
average
In the aggregate, C is
a function of people’s perception of
permanent income – long-term expected
income status
13.1.2
Amount of current income in economy is
determined by the amount of production
in the economy
Funds paid for production are people’s
income
Current nominal income – price level
times real GDP
P*Y
People spend a portion of their
income for consumption
We will call that fraction b
b is always between zero and one
So, b(PY) is the share of current
aggregate income that is spent on
consumption
For some people,
spending out of current income is the
whole story
For others, spending on consumption
comes from savings
Ex. retirees
Consumption out of accumulated wealth
is called
Autonomous consumption – A
The Consumption Function
C = b (PY) + A
We can now see the source of one of the
forces that moves the macroeconomy
Consumer Confidence
If prospects brighten, perceived
permanent income goes up
Higher consumption results
As C increases, AE increases, and AD
shifts out, increasing real GDP
Since part of C is itself a function of real
GDP, these positive expectations
become somewhat self-fulfilling
13.1.3 Historical Example
Near the end of WWII, people were fearful of
slipping back into the Depression
Where would the demand for products come
from once the war was over?
Much of it came from A
Rationing during the war had made
consumption difficult – sort of a forced
savings
Pent-up demand helped ease transition back to
peace
Consumer confidence and
Autonomous consumption are important
forces that can move the economy, but
they cannot sustain growth by themselves
A major engine for growth is the next
variable, Investment (I)
13.2.1
Level of real investment – in plants,
equipment, etc. is determined in the
long term capital market
This is where people get the money to
make investments
It coordinates the desires of those who
have funds and those who need funds
Financial capital or liquidityfunds that pass through the capital market
Unlike real production capital (machines used to
produce products), financial capital can take
any shape
Funds flow from lenders to borrowers, who
then turn that financial capital into the
investments they imagine
(Blueprints, and backhoes, and buildings…)
Financial intermediaries
like banks or mutual funds act as the gobetween for
savers and borrowers
They help coordinate people’s wishes
Investments like a factory
usually take a significant amount of time
to be paid off
20 or 30 years
This is why we call this a long-term
capital market
r
S
D
Q$
Figure 13.2.1 - Long Term Capital Market
In this graph
Horizontal axis – quantity of financial
capital (Q$)
Vertical axis – nominal interest rate ( r )
Supply and demand lines represent the
attitudes of suppliers and demanders
What determines those attitudes?
13.2.3
r
S
r3
r2
r1
Q1
Q2
Q3
Figure 13.2.2 - Long Term Capital Market Supply Line
Q$
Supply of capital line
The higher the interest rate, the greater
the quantity of capital supplied
Supply comes from accumulated wealth
of savers
13.2.4
Demand line (DI) represents attitudes of those
who wish to borrow funds
to make these real investments
Entrepreneurs have to borrow liquidity now to
make investments that will have a return in
the future
The higher the interest rate, the less attractive
the borrowing
It is an inverse relationship
13.2.5
Combining these two lines,
we reach an equilibrium
This is how I is determined
r
S
r
DI
I
Figure 13.2.3 - Long Term Capital Market Equilibrium
Q$
If attitudes change in
the capital market, then not only do those
lines shift,
but the resulting change in I will move
AD in the big macro picture
Suppose supply of capital
shifts down
Suppliers charge less for their capital
Interest rates fall
Investment (I) increases
AD moves
Right
Graphically,
P
r
S
Shift in AD
Due to
Increase in I
LAS
AS
S'
r
r'
DI
I
I'
AD'
AD
Q$
Y
Y'
YF
Figure 13.2.4 - Capital Market Supply Shift Down, and Macro Consequences, ceteris paribus
Y
Suppose borrowers wanted
to borrow less capital
Demand for capital falls
Interest rates fall
Investment falls
AD moves
Left
Graphically,
P
r
Fall in
Demand
Shift in AD
Due to
Decrease in I
LAS
AS
S
r
r'
DI '
I'
I
AD
DI
AD'
Q
Y'
Y
YF
Figure 13.2.5 - Fall in Capital Market Demand, and Macro Consequences, ceteris paribus
Y
We started with shifts
In capital supply or in
capital demand
Now, we will look at sources of those
shifts
13.2.6 Clarifying shift terms
With supply, most of the time we will use
up and down
Think about whether suppliers will charge
more or less for their capital
r
SUP
Charge Higher
Interest Rate,
A Shift Up
S
SDOWN
Charge Lower
Interest Rate,
A Shift Down
Q$
Figure 13.2.6 - A Shift in Long Term Capital Market Supply
With the demand side,
we will use left and right
Think about is there is more or less
capital demanded at that given interest
rate
r
Want More
Capital At Given
Interest Rate,
Shift Right
Want Less
Capital At Given
Interest Rate,
Shift Left
DILEFT
DI
DIRIGHT
Q$
Figure 13.2.7 - Shifts in Long Term Capital Market Demand
13.2.7
One of the main determinants of the level
of interest people charge for their
capital is
their perception of the risk of not being
paid back
Individual like me or you –most risky
General Motors – less risky
U.S. government - least risky of all
SYOU AND
r
ME
SGM
SU.S. GOVERNMENT
Q$
Figure 13.2.8 - Array of Long Term Capital Lines
More risk means you pay a
higher rate
U.S. Gov’t pays the U.S. Treasury bond rate
A firm like GM pays the prime rate
Individuals usually pay higher rates, depending
on past actions
Depending on risk, even different governments
might pay more for the same loan
13.2.8-13.2.9
One thing that determines the level of long
term capital supply is
Short term level of supply
People are more comfortable making short term
loans than longer ones
They want control back sooner
Short term loans (less than a year) get supplied
at lower interest rates than long ones
Several “premiums”, or added
costs,
Are part of the long term line
They are above and beyond the short term line
Waiting premium – extra cost for having to wait
to get the money back
Inflationary expectation premium – the longer
the loan, the more likely the real return will
be eaten up by inflation
Ex. 5% return on loan, but inflation is 5%, you
made 0% real return
Longer loans are more susceptible to this
NOTE:
r
Sizes of Premiums Vary
Independently Of One Another
Long Rates
Inflationary
Expectation Premium
Waiting Premium
Short Rates
Q$
Figure 13.2.9 - Short Rate Floor And Premiums That Make Long Rates
13.2.10
3 factors
Determine long term capital supply line
Short term supply line
Inflationary expectations
Waiting premium
These become the shift variables for S
13.2.11
One more shift variableEntry into or exit out of
a country’s capital market
More funds in- increases quantity supplied
– S shifts right
More funds out – decreases quantity
supplied – S shifts left
r
Exit Results In Less
Capital Available at a
Given Interest Rate
SEXIT
S
SENTRY
Entry Results In More
Capital Available at a
Given Interest Rate
Q$
Figure 13.2.10 - Capital Market Entry or Exit
Sources of entry
Accumulated wealth within country –
more wealth, more potential funds for
the capital market
 International capital flows – flows into a
country occur when conditions are
improving
(more political stability, more opportunity)

An example
Capital flow into the country
Shifts S right
Lower interest rates
More I
If the holders of the international capital
make the actual investment themselves,
It is called foreign direct investment
Graphically,
Event Begins with
Shift Due to Capital Flow In
LAS
P
r
Shifting AD Out
AS
S
S'
r
r'
AD'
DI
I
I'
AD
Q
Ceteris Paribus, I Increases
Y
Y'
YF
Increasing Real GDP
Figure 13.2.11 - International Capital Flow In, and Macro Consequences, ceteris paribus
Y
If funds flow into one country,
They must be flowing out of another
Flows out occur because of
Political instability, or more attractive
opportunities elsewhere
Contraction of S means
Higher interest rates
Less I
AD left
More unemployment
Less real GDP
Just the opposite of previous graph
13.2.12
Demand for long term capital is greatly
influenced by
Expectations
More positive expectations shift the
demand for capital (DI)
Right
A rightward shift in DI
means
Higher interest rates
More I
AD right
More real GDP
Less unemployment
Graphically,
LAS
P
Shift In AD
Due to
Increase in I
r
S
AS
Shift Due to
Increasingly
Positive
Expectations
r'
r
DI '
DI
I
I'
AD'
AD
Q$
Ceteris Paribus, I Increases
Y
Y'
YF
Increasing Real GDP
Figure 13.2.12 - Shift In Capital Market Demand to the Right Given Increasingly Positive
Expectations and, ceteris paribus, the Effect of this on the Macroeconomy
Y
Conversely,
More negative expectations do just the
opposite
Lower interest rates
Less I
AD left
Less real GDP
More unemployment
In the real world,
Many war-torn countries find themselves in
similar situations
Others do not want to invest in their country
because of the risk that investment might be
destroyed
Peace can bring both stability and more positive
expectations
Capital supply and demand both would shift
right
More I, more real GDP, less unemployment
Another example
Great Depression
Deeply depressed expectations of future
DI shifted way left
I fell
AD went way left
Less real GDP
More unemployment
Deflation
13.3 The Trade Balance
13.3.1
We’ve seen how changes in I can move AD
Now, we’ll see how the trade balance (X-M) can
also have an effect on the
overall macro economy
International trade exists because
specialization can lead to surpluses
and gains from trade can be realized
(Remember Wayne and Garth?)
As long as channels of exchange are open,
markets will form
to coordinate the exchange of these surpluses
How much trade?
It depends upon the underlying conditions in
the markets
for those items being traded
Assume two countries
France and Germany
Determinants of trade in French wine:
 Attitude of French wine producers, as
represented by the French wine supply line
 Attitude of French demanders of French wine,
as represented by the domestic demand line
 Attitude of the German demanders of French
wine
Price In
Euros
C
Price In
Euros
C
French Domestic
Wine Market
German Demand
for French Wine
S
D
D
Q
Figure 13.3.1 - French Wine Market - In France and In Germany
Q
Adding German demand to the
French demand
yields the full demand conditions
At this full equilibrium price,
follow over to the German demand line to
identify the size of the
French export / German import
FRENCH WINE THE FULL MARKET
C
S
C
Size of
Export
DG
DF
Underlying
Underlying
German Demand French Demand
D
Total Demand Adding
German to French Demand
Q
Figure 13.3.2 - Adding German Demand to French Demand to Represent Full Market
Conditions, and Identifying the Amount That Goes from France to Germany
13.3.2
International trade is often complicated by the
fact that
different countries use different currencies
Each nation uses a different
kind of fiat money
In order to buy European goods, we must
first buy euros (€)
In order for European people to buy
American goods, they must first buy
dollars ($)
What this means is that
somewhere along the line, dollars have
been exchanged for euros
While you personally may not have done
it, the guys who made the good in
Europe got paid in their own currency.
We say that these exchanges of
currencies occur in a foreign exchange
market.
You may have experienced
part of a foreign exchange market
if you have traveled to another country
and had to exchange currencies
There is a foreign exchange
market for any two currencies
For now, we will assume a two-currency world
with only dollars and euros being exchanged
13.3.3
2 perspectives on the foreign exchange market
The first has euros as the commodity being
purchased
The price of the euros is measured in dollars
There is an exchange rate for euros that is
measured in dollars
Ex. $1.20 = 1 euro
$
SC
$
DC
C
Figure 13.3.3 - Foreign Exchange Market: the Euro-Dollar Market with Euro as
the Commodity Priced in Dollars
13.3.4
Another perspective on the foreign exchange
market has
The dollar as the commodity
The price of a dollar is measured in euros
Ex. .833 € = 1 dollar
Graphically, both perspectives
$
EURO AS
COMMODITY
C
DOLLAR AS
COMMODITY
SC
S$
C
$
DC
D$
C
Figure 13.3.4 - Two Perspectives on the Euro-Dollar Exchange Market
$
13.3.5
Here’s the keyThe demand for euros is the source of the
supply of dollars
Every dollar we wish to exchange for a
euro is a dollar we are willing to supply
to the Europeans
There are only two goods exchanged, so
if D€ increases, the S$ increases
Connecting Perspectives on
the Foreign Exchange Market
C
$
S$
SC
S$'
D C'
DC
D$
C
Figure 13.3.5 - Expanding The Supply of Dollars and the Demand for Euros
$
Or, in reverse,
if S€ increases, the D$ increases
C
$
SC
S$
S C'
D$'
D$
DC
C
Figure 13.3.6 - Expanding The Demand for Dollars and the Supply of Euros
$
These are just two
perspectives
on the same market
The exchange rates show the exact same
information
If it takes X dollars to buy 1 euro
Then it takes 1/x euros to buy 1 dollar
http://finance.yahoo.com/m3?u
C
$
SC
S$
1/2 C
$2
DC
D$
C
Figure 13.3.7 - Exchange Rates from Different Perspectives
$
13.3.6
Exchange rates are just the prices in the
foreign exchange markets
Changes in the supply and demand for
the currencies will change the exchange
rates
Suppose the demand for euros
increases
The dollar price of a euro goes up
If demand for euros is increasing, it
means that the supply of dollars is also
increasing
The euro price of a dollar goes down
$
SC
$4
Expanding Demand
For Euro
$
2
D C'
DC
QC
Figure 13.3.8 - Exchange Market Shifts and New Exchange Rates
When one currency can buy
more of another,
economists say that currency is getting
stronger
Before, 1 euro = 2 dollars
Now, 1 euro = 4 dollars
The euro is stronger and the dollar is
weaker
13.3.7
These changes in exchange rates will
affect many people’s decisions
Before, when a European tourist in NY
wants to buy something that costs
$400,
It cost 200euro
Now, with the stronger euro, it only costs
100euro
However, if you are in Europe,
An apartment that was 400euro a month
Used to cost you $800, but with the
weaker dollar now costs
$1,600
Stronger or weaker currencies aren’t
necessarily bad or good, but they will
affect who buys what
13.3.8
If the only reason people ever bought
currencies was for exports and imports,
and exchange rates were allowed to float,
the trade balance would be in balance
X=M, or X-M=0
Many times, the trade balance is not in
balance
How can that happen?
13.3.9
There are other reasons currencies get
exchanged besides exports and imports
International capital flows also mean
currency gets exchanged
For example,
Suppose demand for financial capital
increases in the U.S.
Interest rates rise, ceteris paribus
Rising interest rates attract a greater
quantity supplied
Suppose some of the new quantity
supplied comes from Europe
When European capital comes
into the U.S.,
Euros will be exchanged for dollars
Increased demand for dollars
Increased supply of euros
These foreign exchange market shifts
make the dollar stronger
r
S
Quantity
Supply
Increases
In Response
to Demand
Shift
DI' Demand For
Financial
Capital
Increases
DI
Some of This
New Qty.
Supply
Comes In The
Form Of
International
Capital Flow
Into the U.S.;
Effect of Flow
From Europe
on Foreign
Exchange
Market
C
S$
D$'
D$
$
$
SC
S C'
DC
Q$
Figure 13.3.9 - Expanding Demand in the Capital Market,
Capital Flow In to Meet that Demand, Effect of that Capital Flow on the Exchange Rate
C
A stronger dollar means
More U.S. imports
Less U.S. exports
Trade balance becomes more negative
AD moves left
13.3.10
Suppose confidence in the U.S. economy
declines sharply
Less demand for financial capital means
lower interest rates
Capital flows out
If it flows to Europe, then increased demand for
euros means a
weaker U.S. dollar
More U.S. exports, less U.S. imports
13.3.11 Countervailing forces
When would a capital flow stop?
Capital flows out make the euro more
expensive, and
the supply of capital in Europe expands, which
lowers the European interest rate
As the capital flow continues, the cost of going
(exchange rate) keeps increasing, and
the advantage of going (the higher interest
rate) keeps falling
Eventually, you reach a new equilibrium
13.3.12
The model assumes there is time for
information to flow and be thoughtfully
processed
People can now move international capital in
seconds
Bad news can cause a wave of independent
actions,
but collectively they can cause a global
financial panic
For example,
1997-financial instability in Thailand
Concern about stability in other countries
“Asian contagion”
Fear becomes self-fulfilling
Capital flees to safe havens like the U.S. or
Europe
Capital flows out mean a big fall in the value of
their currencies
Plus, investment nearly vanished as confidence
also disappered
Asian economies go into deep
recessions
Weak currencies mean not being able to buy
U.S. exports
U.S. bought lots of foreign imports with our
stronger dollar
Highest trade deficit in U.S. history by 1998
Even though these countries were exporting
huge amounts, and
exports can help an economy, they are not a
sufficient foundation for a healthy economy
13.3.13 Summary of the Trade
balance (X-M)
Trade in an item depends upon:
Underlying market conditions in the producing
country
Exchange rate
Demand conditions in the other country
Plus,
International capital flows that can change
exchange rates by making the dollar stronger
or weaker
13.4.1
The last two variables that move AD are the
ones
that make up the government budget position
(G-T)
(Government spending – Taxes)
Determined by the President and Congress –
536 people in all
13.4.2
In reality, the budget position is
complicated by many special interest
groups
who lobby for certain causes
This affects G and T
Occasionally,
International events can dramatically
change the budget position
Ex. Pearl Harbor
P
LAS
AS
AD Increase Due
To Gearing Up for
War
AD'
AD
Y
YF Y'
Figure 13.4.1 - Gearing Up for World War II
Y