Transcript Determining Aggregate Demand (AD)

Determining
Aggregate Demand (AD)
This chapter -- looks at the
components of Aggregate
Expenditure.
Examines the major causes of
Consumption (C), Investment (I),
Government Expenditure Net of
Taxes (G - T), and Net Exports
(X - M).
Causes of Consumption (C)
Aggregate Income (Y),
Y  C
Wealth,
Wealth  C
Consumer Confidence (CC),
CC  C
Applying the Causes to
Aggregate Demand (AD)
Aggregate Income (Y), appears on
the graph, Y  C relationship
affects the shape of the AD curve.
Changes in Wealth or Consumer
Confidence make up autonomous
consumption (consumption due to
causes other than Y) -- shift the AD
curve.
Consumer Confidence
and the Economy
Example -- effect of a decrease in
consumer confidence.
CC  C
Therefore the AD curve shifts
leftward.
In the AD-AS model, this results in
Y*, P*
Causes of Investment (I)
The Capital Market
Investment (I) -- primarily business
purchases of new plant and
equipment along with new
residential housing.
Large expenditures create the
need for long-term borrowing.
Borrowing is done from financial
intermediaries such as banks or by
companies issuing bonds or stock.
Investment and
Capital Market Behavior
Investment results from behavior
in the capital market.
The Capital Market -- the demand
and supply for financial capital
needed to finance purchases of
plant and equipment (I).
The Demand For Financial
Capital (DI) -- Major Causes
Nominal (Long-Term) Interest Rate
(r) – cost of borrowing to finance
investment
r  DI
Expected Inflation Rate (e)
e  DI
Business Confidence (BC)
BC  DI
Formalizing the Demand
for Financial Capital (DI)
Graph DI against one of its causes
-- the nominal interest rate (r).
Inverse relationship implies that
the curve is downward sloping.
Changes in r are described as a
movement along the curve.
Graph is drawn assuming that
other causes are constant (ceteris
paribus).
Shifts in the Demand
for Financial Capital
Changes in causes other than r
are described as shifts of the DI
curve.
Changes that increase the
Demand for Financial Capital shift
the DI curve rightward.
Changes that decrease the
Demand for Financial Capital shift
the DI curve leftward.
The Supply of Financial
Capital (SI) -- Major Causes
Nominal Interest Rate (r)
r  SI
Expected Inflation Rate (e)
e  SI
People’s Willingness to Save (S)
S  SI
Other Causes -Supply of Financial Capital
Monetary Policy -- affects banks
ability to loan (more later).
Foreigners’ willingness to buy US
bonds or stock (Capital Flow).
Next Step -- Formalizing the above
SI relationship
Formalizing the Supply of
Financial Capital (SI)
Graph SI versus one of its causes
-- the nominal interest rate (r).
Positive relationship implies that
the curve is upward sloping.
Changes in r are described as a
movement along the curve.
Graph is drawn assuming that
other causes are constant (ceteris
paribus).
Shifts in the
Supply of Financial Capital
Changes in causes other than r
are described as shifts of the SI
curve.
Changes that increase the Supply
of Financial Capital shift the SI
curve rightward.
Changes that decrease the Supply
of Financial Capital shift the SI
curve leftward.
Equilibrium in the Capital
Market -- Determining I
Investment (I*) occurs where the
Demand for Financial Capital (DI)
equals the Supply of Financial Capital
(SI).
Shifts in the Demand or Supply of
Financial Capital, as a result, change
Investment (I*)
Because they change Investment, they
also change Aggregate Demand, and
Y*, and P* as a result.
Example 1 -- An Increase in
Business Confidence (BC)
BC  DI
DI curve shifts rightward  I
Because investment increases,
the AD curve shifts rightward.
In the AD-AS model, this results in
Y*, P*.
Example 2 -- An Increase in
Foreign Capital Flows to US
Capital Flow  SI
SI curve shifts rightward  I
Because investment increases,
the AD curve shifts rightward.
In the AD-AS model, this results in
Y*, P*.
Causes of (G - T)
Government Purchases of Goods
and Services (G), Net Taxes (T), are
policy variables.
Basically controlled by the
government.
G, T changed for policy purposes
(Fiscal Policy), other reasons as
well.
Example -War and the Economy
War  Need for More Soldiers
and Weapons  G  (G - T)
Because (G - T) increases, the AD
curve shifts rightward.
In the AD-AS model, this results in
Y*, P*.
Causes of Net Exports (NX)
General Principles
-- NX = X - M, must consider
causes of both exports and
imports.
-- Assume for simplicity that the
world consists of 2 countries,
the US and the rest of the world.
Specific Causes of
Net Exports (NX = X - M)
 World Output or Income (YW)
YW  X  NX
US Output or Income (Y)
Y  M  NX
Barriers to Trade (Tariffs, Quotas)
The Exchange Rate (e)
e  NX
A Digression -- Introduction
to Exchange Rates
Exchange Rate (e) -- the amount of
foreign currency needed to be
exchanged for one (US) dollar.
Also known as the “value of the
dollar”.
Conversion Ratio, in units of
(foreign currency)/(US dollar)
Types of Exchange Rates
Bilateral Exchange Rates -exchange rate between the US and
an individual country.
Multilateral (Trade Weighted)
Exchange Rate -- weighted
average of bilateral exchange rates
expressed as an index (macro
measure of exchange rate).
Using Exchange Rates
as a Conversion Ratio
Both Examples: US exchange rate
vs Japanese Yen = 100 (yen/$).
Example 1 -- Suppose that dinner
for two people in the US costs $50.
Find its price in terms of yen.
($50)(100 yen) = 5000 yen
(1 $)
Example 2 -- The Exchange
Rate as a Conversion Ratio
Example 2 -- Suppose that dinner
for two people in Japan costs 6832
yen. Find its price in terms of US
dollars ($).
(6832 yen) (1 $)
= $68.32
(100 yen)
Note: e = 100 (yen/$)
Exchange Rate Changes
e  price of American goods and
services to foreigners
 price of foreign goods and
services to Americans
e  price of American goods and
services to foreigners
 price of foreign goods and
services to Americans
The Exchange Rate
and Net Exports
e (appreciating dollar, stronger
dollar)  X, M  (X - M)
e (depreciating dollar, weaker
dollar)  X, M  (X - M)
Return to Aggregate
Demand -- An Example
Example -- effect of a decrease in
world output or income (YW).
YW  X  (X - M)
Therefore the AD curve shifts
leftward.
In the AD-AS model, this results in
Y*, P*
Aggregate Demand
Changes and the Economy
Lots of factors shift aggregate
demand (AD), affect Y* and P*.
Poses challenges: economy
subject to “buffeting winds,”
blows the economy off course
(either to where Y* < YF or Y* > YF).
Role of Economic Policy -- to
counteract “buffeting winds,” to
take steps to move Y* closer to YF.