Transcript Chapter 13

Aggregate Demand
Chapter 13
Consumption
“C”
Consumption
• The aggregate nominal amount of spending
we do as consumers … at the grocery or the
mall and so on.
– Makes up 65-70% of AD.
• Doesn’t usually change dramatically, quickly.
– People tend to maintain their standard of living.
Consumption
• At any point in life we each have a perception
of our “permanent income”…
– The amount we need and have been able to count
on to maintain our current lifestyle
– If we enjoy a temporary “windfall”, we don’t
change our lifestyle …we spend some and save
some if we see our prospects improving
permanently, we begin to “spend up” to our new
standard of living
Consumption
• Hit by a temporary hard time, we use some of
our accumulated wealth (our savings) to
bridge that time and maintain lifestyle
• If harder times seem to be the new reality, we
adjust our perception of our permanent
income
– Decrease it
Consumption
• We can model this consumption behavior in
the aggregate, summing up the behavior of all
consumers, with the
• Consumption Function:
– C = A + b (PY)
• C is aggregate nominal consumption
• B is propensity to consume (amount of income used for
consumption)
• PY is nominal aggregate income
• A is autonomous consumption
Consumption (C = A + b (PY))
• …So if PY = $100 billion and b = 0.8 for the
nation
– as a nation we’d spend $80 billion of our income
on consumption…
– and save $20 billion of our income
“b”
• “b” is a big deal … and it’s not a constant
– It varies across nations and within a nation
– It varies across circumstances …
– It changes with expectations about the future
– It is significantly influenced by expectations about
the future … which is why one of the economic
indicators macro economists watch closely is the…
• Consumer Confidence Index
Consumer Confidence
• Ceteris Paribus, increasing consumer
confidence helps the economy because when
people are confident about the future they
feel more free to spend on consumption
If C
then AD
and this drives Y
pushing UMP
“b”
• “b” also changes with perceptions of wealth
– If you lose your job, your savings, and your house,
then clearly you are poorer and you’ll reduce your
consumption ...
– If you still have your job and your stocks and your
house, but the value of your stock portfolio
and/or your house goes down significantly, then …
you feel poorer and “b” goes down as you cut
back on consumption to rebuild your perceived
wealth
“b”
• During the Great Recession many people lost
their homes and savings, but for many more
the loss was a significant fall in the value of
their stock portfolio and their home
– This negative “wealth effect” led people to hold
back on consumption …
– “b” went down and that fed into the downward
spiral of the economy
b
C
AD
Y
UMP
b
A
• “A” is the Autonomous Consumption
– It is “autonomous” in the sense that it is
independent of (PY)
– It is spending out of wealth … often to bridge
difficult times
Investment
“I”
Investment (I)
• The aggregate nominal amount of spending
we do as individuals or firms to increase our
production capital and/or inventories
• People generally need to borrow to make a
significant investment
– It takes time for the investment to pay off so they
borrow for long terms … 10, 20, 30 years
• Long Term Capital Market
Investment (I)
• The funds borrowed in the Long Term Capital
Market are financial capital or “liquidity”
– As in liquid value … value that can take any shape
it’s poured into…
• a new business, an expanded factory, an education
Investment (I)
• In order to understand the sources of the
forces that determine I, we need to
understand the Long Term Capital Market
On the
vertical
axis is the
nominal
interest
rate –
the price
of borrowing
r
On the horizontal
axis is the quantity
of financial capital
Q$
Investment (I)
• In the Long Term Capital Market “r” must
compensate the lender for the discount rate
(waiting) and for any risks involved in the loan
• Q$ - is the quantity of the financial capital, the
liquidity
Investment (I)
The Long Term Capital Market graph looks like:
r
For now we are
assuming that the only
demand is for the purposes
of Investment, ergo the
subscript
S
r0
DI
I0
Q$
Given our assumption … the total
quantity of financial capital exchanged
all goes to investment, I
Investment (I)
• There are two players in the Long Term Capital
Market (LTCM)
– Suppliers – have financial capital, Q$ , they are
willing to lend but must be sufficiently
compensated for waiting on their return and the
risks involved
– Demanders – see investment opportunities and
want to borrow financial capital, Q$ , if the
interest rate they will pay is less than the
perceived rate of return on the investment
Investment (I)
LTCM Demand
6
5
4
3
2
1
0
The vertical axis is rates
The height of each bar
represents
perceived rate
of return for that
investment
How many of these opportunities would
opportunity
be worth pursuing if the interest rate
investors have to pay is
4.5%
3.5%
2.5%
1.5%
Investment (I)
• Clearly, Demanders see more investment
opportunities worth pursuing as the interest
rate they pay goes down …
– As interest rate, r, goes down … the quantity of
financial capital demanded for investment Q$D
goes up and vice versa
Investment (I)
• When Demanders become more optimistic about the
future they see more investment opportunities worth
pursuing as every possible interest rate
r
Shift right due to
increased
optimism
DI
D’I
Q$
Investment (I)
And pessimism has the opposite effect …
r
Shift left due to
increased
pessimism
D’I
DI
Q$
Investment (I)
• We can see how pessimism contributed to the
Great Depression (GD)…
– With “Depression” the future looks bleak … so DI
falls
Given S, the fall r
in DI gives a new
equilibrium at a
much lower I
A collapse in I
was a major factor
in the GD’s falling AD
falling Y, and rising UNEMP
S
D1 I
I1
I0
D0 I
Q$
Investment (I)
• What determines Supply
– It slopes up because the more financial capital
individuals lend the greater the opportunity cost
of what they are giving up, so … the more they
have to be compensated
– On the Supply side as r goes up, Q$S goes up and
vice versa
Investment (I)
• Several different factors
shift Supply
– One is entry and exit
– Entry shifts supply to the
right…at any given interest
rate there is more financial
capital available
r
S0
S1
One source of Entry could be capital flowing into a country’s
capital market from other countries. Why might this happen?
Q$
Investment (I)
• Capital may flow into a
nation’s capital market due to,
ceteris paribus … a relatively r
better risk adjusted rate of
return
• Instability or other reasons
that capital holders get
nervous about keeping
financial capital in that other
country.
S0
S1
Q$
Investment (I)
• Ceteris paribus, by making financial capital
cheaper entry encourages more Investment (I)
– increasing AD … increasing Y … and reducing UMEMP
r
S0
r0
r1
S1
DI
I0
I1
Q$
Investment (I)
• Exit shifts supply to the left
…at any given interest rate
there is less financial capital
available
• One source of Exit could be
capital flowing out of a
country’s capital market to
other countries.
• Another source of Exit
could be capital
• “disappearing” as banks in
an economy collapse due to
fraud or irresponsible
behavior
r
S1
S0
Q$
Investment (I)
• Ceteris paribus, exit makes financial capital
more expensive, discouraging investment
r
S1
S0
r1
r0
DI
I1
I0
Q$
Investment (I)
• Another factor that shifts Supply is its underlying
structure: Three factors determine the level of
interest required by suppliers in Long Term
Capital Market (LTCM)
– Short run supply – this is an option for one’s capital
that requires less waiting.
– A “waiting premium” since the long term lenders have
to wait much longer for their payment
– An “inflationary expectation premium” – the longer
you wait to be paid, the more vulnerable to inflation
Investment (I)
• Graphically we can represent this structure as
follows …
which brings us up to
r
The long rate line
S
and an “inflationary
expectation” premium
To that “floor” we
add a “waiting premium”
s
This is the short rate line –
the “floor”
Q$
Investment (I)
• If the short rate line shifts up, and the premiums
remain constant, that will shift up the long rate line
…
r
S
s
Q$
Similarly if the short rate line shifts down, and the premiums remain
constant, that will shift down the long rate line …
Investment (I)
• The Fed’s standard policy tool is to manipulate short rates to influence
long rates and in turn the Macro economy. Since the Great Recession
began it’s lowered the short rate floor with the following intention …
increasing AD … increasing Y … and reducing UMEMP
S0
r
Ceteris paribus, a lower short
S1 rate line pulls down the long
rate line
•
r0
r1
Lowering
long
rates
DI
I0
I1
Q$
Stimulating Investment
Investment (I)
• If you see data that indicates that rates are rising
or falling, that alone is not an indication of how
the economy is doing
– They can be rising because, with optimism, demand
for financial capital is growing, or
– They can be rising because worried capital holders are
moving their capital out of the country, contracting
supply and making financial capital more expensive
– They could be falling because pessimism reduces
demand or because capital flows in based on
optimism
Investment (I)
• One thing is clear … for an economy to be
healthy and growing it needs healthy and
growing investments
• The long term capital market is instrumental
in making this possible because it brings
financial capital holders and potential
investors together.
Investment (I)
• For the economy to be healthy, the financial
market must be healthy…
– As the Great Depression and Great Recession
make clear, the power to manipulate this market
is dangerous for the Macro Economic well-being
of the nation
X-M
The Trade Balance
X-M: The Trade Balance
• What distinguishes trade between New York
and New Orleans from trade between New
York and Paris?
– …making the latter more complicated?
X-M: The Trade Balance
• People in New York and New Orleans
use the same currency: dollars
• People in New York and Paris use different
currencies so the NY to Paris trade requires
exchanging currency
Exchanging Currency
• In order to understand trade, we need to
understand the Foreign Exchange Market
– The market in which currencies are exchanged
• In the Foreign Exchange Market one currency
is the commodity … the item being bought …
priced in the other currency… the one with
which you are paying
Exchanging Currency
• Buying Euros with Dollars …
– the Euro is the commodity priced in dollars.
• Graphically it looks like this:
Priced in
Dollars
S€
Supplying
and
$
D€
Demanding
Euros
Exchanging Currency
• A case of two currencies: Euros and dollars
– People supplying Euros to the foreign exchange
market must be doing it in order to demand
dollars
– So to S€ is at the same time to D$
• Similarly, people demanding Euros from the foreign
exchange market can only do so by supplying dollars
– So to D€ is at the same time to S$
Exchange Rates
• We can look at the euro/dollar transaction
from the opposite perspective
– Buying Dollars with Euros… the Dollar is the
commodity priced in euros.
€
Priced in
Euros
S$
Supplying
and
€
Demanding
Dollars
D$
$
Exchange Rates
These two red lines
represent the same
transaction:
Supplying Euros to
Demand Dollars
$
These two green lines
represent the same
transaction:
Supplying Dollars to
Demand Euros
€
S€
S$
D€
D$
€
$
Exchange Rates
• If these are two perspectives on the same
transaction, then $/€ and €/$ must be related
… what is the relationship between $0 and
€0?
$
€
S€
S$
$0
€0
D€
D$
€
$
Exchange Rates
• They are reciprocals:
if it takes $2 to buy1€
then ½ € buys $1
$/€
€/$
S€
S$
1/2€
$2/1
D€
D$
€
$
Exchange Rates
• Suppose the demand for dollars increased
That would raise the euro price of the dollar (e.g., to 1€/$)
Increased dollar demand implies increased euro supply …
Which would lower the dollar price of the euro to what?
If it now costs 1€/$, then it must be that it costs 1$/€
$
$2
€
S€
S€’
1€
.5€
$1 = $?
D€
S$
D$
€
D$’
$
Exchange Rates
• Now suppose you were in Paris six months
ago, before the currency shift shown below,
and you’d seen some shoes for 200€ how
much were they, in dollars, then? $400
How much are they, in dollars, now?
$
$2
$200
€
S€
S€’
1€
.5€
$1
D€
S$
D$
€
D$’
$
Exchange Rates
• What a deal! Same shoes … same price tag for
200€ but for you they’re on sale – ½ off
– The shift in the foreign exchange market has made
the dollar stronger – it buys more of anything
priced in the other currency because the other
currency itself is costs less dollars
Exchange Rates
• What about the euro in our story?
– If a sweater in the U.S.. would have cost a visitor
from Paris $100 six months ago – How much was
it then in euros?
– (Recall: it was .5€/$1 then) it was 50€ then
– How much is it for that visitor now?
– 100€
• It’s doubled in price because the euro has
gotten weaker
Currency Strength
• A currency gets stronger when it can buy more
of anything priced in the other currency
because the other currency itself costs less
• A currency gets weaker when it can’t buy as
much of anything priced in the other
currency because the other currency itself
costs more
Currency Strength
• What causes currencies to get stronger or
weaker?
– Shifts of Supply or Demand in the foreign
exchange market that, in turn, change exchange
rates
– What’s the most common cause of shifts in
foreign exchange market supply and demand?
International flows of financial capital
International Flow
• International financial capital is, as the term
“international” implies, not a “citizen" of any
nation … it salutes no flag
– It is liquid value that flows around the globe in
pursuit of the best risk adjusted rate of return
Capital Flow
• If the holders of financial capital get nervous
about the situation in a country, ceteris
paribus, capital will flow out to a more secure
“safe harbor” (nation)
– e.g., if capital holders get nervous about the
stability of the euro zone, ceteris paribus, capital
will flow from there to the U.S. or elsewhere
• Ceteris paribus, what would that do to the
dollar?, to the euro?
Capital Flow
• Ceteris paribus, nervousness about the
stability of the euro zone causes a capital flow
that weakens the euro and strengthens the dollar.
• Another example: ceteris paribus, interest rates
in Japan going up relative to those in the U.S.
causes a capital flow…
– Which way? … and what does it do to the yen and the
dollar?
• From the US to Japan, and it strengthens the yen
and weakens the dollar.
Trade Balance
• How’s all this relate to trade?
– A weakening euro/strengthening dollar would do what,
ceteris paribus, to the U.S. trade balance?
US exports US imports US trade balance more negative
– A strengthening yen/weakening dollar would do what,
ceteris paribus, to the U.S. trade balance?
US exports
US imports US trade balance more positive
Is one of these cases better?
The Trade Balance
• Absent any government intrusions, trade of any
particular item is determined by:
– The underlying market conditions in the producing country
• This determines the domestic price
– The exchange rate
• This determines the currency- adjusted price for the consumers in
other countries
– The demand conditions in those other countries.
• These conditions determine a nation’s trade balance
and the direction of trade’s affect on the nation’s
Aggregate Demand and the macroeconomy.
G-T: The Government’s Budget
Position
• Ceteris paribus …
• (G – T) = 0 , a Balanced Budget, is neutral. It
doesn’t shift AD
• (G – T) < 0 , a Budget Surplus, is
contractionary. It shifts AD left.
• (G – T) > 0 , a Budget Deficit, is stimulative. It
shifts AD right.
G-T: The Government’s Budget
Position
• In every country the budget determination is a
political decision
– In the U.S. each house of Congress (Senate &
House of Representatives) develops and passes a
budget resolution
– A Joint Committee (theoretically) resolves
differences and the common bill passes each.
– The President signs the bill … done
– The President vetoes the bill … override or back to
the drawing board