1Time

As incomes rise,

consumption increase.

04/19/23 © 2004 Claudia Garcia - Szekely

2

Chapter 8

Aggregate Demand

The Components of Aggregate Demand

4. Net Exports4. Net Exports

2. Investment2. Investment

3. Government Spending3. Government Spending

1. Consumption1. Consumption

4

Expenditures in consumer goods are 70% of GDP

GDP=Y

6Disposable Income

Con

sum

pti

on

What determines the level of Consumption?

Disposable Income Yd WealthPricesExpectations

C=bYd

Add these two components C = a + bYd

As income increases,

consumption increases

All other factors which

affect Consumption

C=aAutonomous from Yd

Induced by changes in

Yd

Slope:b

Consumption has two components

C = a + bYd

Real Disposable Income Billions

Con

sum

ptio

n B

illio

ns

300 500 700 900

425

575

875

1175

725

1025

1100 1300

C=bYdC=bYd

Induced by changes in Disposable

Income

Increase in Disposable

income

Yd

Increase in Consumption

C

C = a + (C/Yd)Yd

Slope

C/

Yd

MPCC/Yd

Slope

Consumption has two components

Real Disposable Income Billions

Con

sum

ptio

n

300 500 700 900

425

575

875

1175

725

1025

1100 1300

a: Intercept

a: Intercept

C = a + (C/Yd)Yd

C = a Autonomous Consumption (Independent from Disposable Income) responds to

changes in wealth, prices and expectations

C = a Autonomous Consumption (Independent from Disposable Income) responds to

changes in wealth, prices and expectations

C = a + MPCYdC = a + (C/Yd)Yd

MPC

C = a + bYd

Real Disposable Income Billions

Con

sum

ptio

n B

illio

ns

300 500 700 900

425

575

875

1175

725

1025

1100 1300

C = a + 0.75Yd

Choose any two points

Yd=400

Yd=400

C=300 bC=300 b

MPC=C/YdMPC=C/Yd

Calculating the slope

MPC=300/400MPC=300/400

Real Disposable Income Billions

Con

sum

ptio

n B

illio

ns

300 500 700 900

425

575

875

1175

725

1025

1100 1300

a: Intercept

a: Intercept

C = a + 0.75 Yd

725 = a + 0.75(700)

Value of Consumption when Disposable Income = 0

725 = a + 525

Choose any point

725-525= a

200= a200

C =725

Y= 700

C = 200 + 0.75Yd

13

S

S = Yd – CS = 0 - a

S = - a

C= a

C = a+ MPC*Yd

When Disposable Income is zero:

Income not consumed is

saved

When Disposable Income is zero:

C = a+ M

PC*Yd

S = -a+ MPS*Yd

MPC for the US is 90%

14

MPC=0.9

Real Disposable Income Billions

300 700

400

400+360=760

760+360=1120

1100 1500

C = a + 0.9Yd

Yd=400

Yd=400

C=0.9*400C=0.9*400

Yd=400

Yd=400

C=0.9*400C=0.9*400

Yd=400

Yd=400

MPC=0.9

C=0.9*400C=0.9*400

MPC=0.9

?

MPS=0.1

300 700

-a=-200

-200+30=-170

-170+40=-130

1100 1500

yd=400 yd=400

S=0.1*300S=0.1*300

Yd=400

Yd=400

S=0.1*400S=0.1*400

Yd=400

Yd=400

MPS=0.1

S=0.1*400S=0.1*400

MPS=0.1

-130+40=-90

-90+40=-50

yd=300

yd=300

2000

Real Disposable Income Billions

Con

sum

ptio

n B

illio

ns

2000 2500 3000 3500

2300

2750

3650

3200

4100

4000

Same Intercept “a” different slope “MPC”

18

Y0 Y1

C0

C1

C0

C1

1500 3000

1400

2750

1100

2150

aSmaller MPC=0.7

a

Larger MPC=0.9

Larger Increase in consumption

Smaller Increase in consumption

1,350

1,050

1,500

Different intercept “a” same slope “MPC”

19

Y0 Y1

C0

C1

C0

C1

1500 3000

2250

3300

1100

2150

a Same MPC

a*

Same MPCsame Increase in consumption

Same Increase in consumption

1,050

1,050

20

The Consumption Function

C = a + MPC* Yd

Consumption responds to changes in wealth, prices and expectations

Consumption responds to changes in wealth, prices and expectations

Yd = GDP - Taxes + Transfers

Consumption responds to

changes in after tax income

Consumption responds to

changes in after tax incomeChanges in

income: Movement Along

the C line.

Changes in income:

Movement Along the C line.

Changes in wealth, prices and

expectations: Shift C line

Changes in wealth, prices and

expectations: Shift C line

Yd = NI- Taxes + Transfers

22

C = 200+0.75Y

5,000 10,000 19,000 25,000

C=3,950

C=7,700

C=14,450

C=18,950

Given the Consumption function,Find the value of consumption for each of these values of Y:

Y

C = 200+0.75*25,000

C = 200+0.75*19,000

C = 200+0.75*10,000

C = 200+0.75*5,000

Movement along the Consumption Function

Changes in Disposable

Income ONLY!

5,000 10,000 19,000 25,000

3,950

7,700

14,450

18,950

Yd

C

24

C0

S0

1200

1200

1300

1300

2080

-880

2170

-870

Move UP Along C

Move UP Along S

Consumption Increase

Savings Increase

Movement along

C=MPC*YdC=MPC*Yd

S=MPS*YdS=MPS*Yd

25

Smaller intercept

Higher intercept

C1

C0

S1

S0

a = 300

-a = -300

a = 200

-a = -200

Shifts in Consumption

Shifts in the consumption function

1. Changes in wealth: stocks, bonds, consumer durables, homes.

When stock prices go down, consumer wealth drops.

Consumers feel poorer (even though incomes may be the same!) decrease purchases.

A downward shift in the Consumption Line: a smaller intercept.An upward shift in the Savings Line: a larger intercept.

Shifts in the consumption function

2. Changes in consumer expectations:Pessimistic expectations about future:

employment, incomes, wealth.Consumers slow down purchases (even

though incomes are the same!)A downward shift in the Consumption Line: a smaller intercept.An upward shift in the Savings Line: a larger intercept.

Shifts in Consumption3. Overall Prices of goods and services

When prices rise (an increase in the CPI) consumers lose buying power.

This drop in the purchasing power of saved dollars make consumers feel poorer: slow down purchases.

Real Wealth Decrease

A downward shift in the Consumption Line: a smaller intercept.An upward shift in the Savings Line: a larger intercept.

Factors that shift the consumption function

Changes in wealth value of stocks, bonds, consumer

durables, homes.

Changes in consumer expectations

Pessimistic expectations decrease autonomous consumption.

Changes in Prices Affect the purchasing power of assets.

Shift Consumption

line

Interest Rates are NOT in the

list!

Statistical studies: interest rates have no effect on Consumption

Interest rates do not

shift C

Interest rates affect INVESTMENT: New

home purchases

30

Smaller intercept

Higher intercept

C1

C0

S1

S0

WealthExpectationsPrices

a = 300

-a = -300

a = 200

-a = -200

31

Larger intercept

Lower intercept

C1

C0

S1

S0

WealthExpectationsPrices

32

Write the equation for this consumption function

600 800 1000 1200 1400 1600

600

700

800

900

1000

1200

1100

700

1000

900

1300

300

200MPC

=200/300 = 2/3

To get the equation, we choose any two points:

C = 33.33 + 2/3 Y

We know that C = 700 when Y =1,000. 700 = a + 2/3 (1,000) solve for a = 700 – 2,000/3 = 700 – 666.67 = 33.33

To calculate the intercept (a), use the MPC and the consumption function: C = a + 2/3 Yd

33

Y=S= 0

C= Y

C = 33.34 + 2/3 * Y Set C =Y:33.34 + 2/3*Y = YSolve for Y = 100

Set S =0:-33.34 + 1/3*Y = 0Solve for Y = 100

S = -33.34 + 1/3*Y

-33.34

Y= 100

Y= 100

C

33.34

SY

Y

Disposable income Consumption Saving

0    

1000 1,400  

2000 2,200  

3000  

4000 3,800  

5000 4,600  

6000 5,400  

1. Calculate the MPC2. Calculate the Intercept3. Write down the formula for the Consumption function.4. Fill in the missing Consumption Values5. What is the value of Consumption when Income is 10,0006. Fill in the value of Savings in the table7. At what value of Y is Consumption equal to Income? 8. Write down the formula for the Savings function

Disposable income Consumption Saving

0 600  -600 

1000 1,400 -400 

2000 2,200 -200 

3000 3,000 0 

4000 3,800 200 

5000 4,600 400

6000 5,400  600

1. Calculate the MPC =800 /10002. Calculate the Intercept = 6003. Write down the formula for the Consumption function = 600 +0.8 Y5. What is the value of Consumption when Income is 10,000 = 600 + 0.8*10,0007. At what value of Y is Consumption equal to Income? At 3,0008. Write down the formula for the Savings function = -600 + 0.2Y

36

Using C function from previous slide, fill in the missing values/labels

Y=S= 0

C= Y

37

Event

Consumption Purchases Increase? Decrease?

Remain the Same?

Consumption line shifts

Movement Along the

Consumption Line Saving

Increase? Decrease? Remain the

Same?

Savings line shifts

Movement Along the

Savings Line

Up? Down? No shift?

Up? Down? No movement

along?

Up? Down? No shift?

Up? Down? No

movement along?

1A cut in taxes which increases Disposable Income.

2 Stock prices collapse 3 The CPI (overall prices) increase

4A decrease in transfer payments from the government to consumers which decreases Disposable Income

5 Home prices increase 6 Profits increase 7 Consumers decide to save more 8 Consumers become pessimistic 9 Decrease in interest rates

10Employer announces major layoffs of employees

11 Massive layoffs of employees.

Shift up

Shift down

Shift down

Shift down

Shift down

Down Along

Up along

Up along

Down Along

Shift down

No Change No Change

Down Along

Up along

Shift up

Shift up

Shift down

Up along

Shift up

Shift up

Shift up

Down Along

38

Investment Includes… Residential Construction

– Consumer purchases of new houses and condominiums.

Non-residential Construction– Factories, Office buildings.

Firms’ purchases of equipment– software, tools, etc.

Changes in Inventories: unsold goods are included as investment.

04/19/23 © 2004 Claudia Garcia - Szekely

39

Chapter 7

Investment“Growth Policy:

Encouraging Capital

Formation”

40

Po

Goods and Services Purchased

AD = C + I + G + NX

GDPo

Aggregate Demand

Price Level

Real GDP

P1

GDP1

Aggregate Demand Aggregate Expenditures

Goods and Services

Purchased at different Price

Levels

AD = C + I + G + NX

Price Level

AD=C + I + G + NX

Goods and Services

Purchased at different Income

Levels

AE = C + I + G + NX

C + I + G + NX

Income

Po

AD=C + I + G + NX

C + I + G + NX

Y0

S0

1200

1200

1300

1300

2080

-880

2170

-870

Move Up Along C

Move Up Along S

Disposable Income

Increase:

Disposable Income

Increase:

Savings Increase

Consumption Increase

Sav

ings

Con

sum

ptio

n

Downward shift in Consumption

Upward shift in Savings

44

1. Interest Rates: – Business borrow to

finance investment. – Consumers borrow to

purchase new homes. As interest rates drop,

more investment projects become profitable and investment increases.

2. Tax Incentives3. Technical Change

– Create incentive to invest as firms rush to adopt new technologies (Microchip, Internet, Faster Computers, bio - fuels)

– Open business opportunities to take advantage of these new technologies (Internet Cafes)

4. Expectations– High sustained level of sales and expectations

of growing economy boost investment

45

46

5. Political Stability and the rule of law– Business cannot be conducted without a

guarantee that property rights and contracts will be respected. (Danger of communist take over, public unrest, will negatively affect investment)

DictatorshipDemocracyMonarchyTheocracyKleptocracy

Political Stability can be achieved with

many types of Government

47

3. Government Spending3. Government Spending

Expenditures by federal, state and local governments.

– Include final, intermediate and capital goods purchased by the government.

– Exclude transfer payments (social security, unemployment benefits, etc)

Government expenditures are determined by the budget process: The president, Congress and the Senate.

1. U.S. GDP/National Income

2. GDP/Income in other countries

1. U.S Prices rise relative to prices abroad

49

U$1

1Euro 0.5 EuroU.S. Goods are

cheaper to GermansU.S. Exports increase

when the dollar becomes weaker.

Weaker dollar

One Dollar buys fewer

Euros

Germans now pay

50

1Euro

1U$ 2 U$

Foreign goods are more expensive to

AmericansU.S. Imports decrease when the dollar becomes weaker.

Weaker dollar

One Euro buys more Dollars

Americans now pay

Weaker dollar increase exports and decrease imports

51

Ag

gre

gate

Exp

en

dit

ure

s =

AE

I =

10

00

AE = C+I+G+NXAE

G =

5

00

NX =

30

0

Y = 5,000

C = 100 + 0.9Y

C =

9,1

00

I =

10

00

G =

5

00

NX =

30

0

Y = 10,000

C =

17

,20

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 19,000A

E =

10

,90

0

AE =

19

,00

0

C =

46

00

AE =

6,4

00

C =

22

,60

0I

= 1

00

0G

=

50

0

NX =

30

0

Y = 25,000

AE =

24

,40

0

AE = C + I + G + NX

Income (Y)

53

Identify the component of AE which is affected (C, I, G, X or M) explain how it is affected (increase, decrease).Determine the effect on Aggregate Expenditures (AE increase, decrease).a)Prices in the US decrease relative to prices

abroad.b)The U.S. dollar becomes strongerc) Home prices increased)Stock prices decreasee) Interest rates decreasef) A zero-emissions engine is developed.g)Government announces a decrease in the

number of troops deployed abroad.h)U.S GDP increase

Class Work

04/19/23 © 2004 Claudia Garcia - Szekely

54

The Effect of Changes in Exchange Rates

More on Strong Dollar

Which component of AE is affected?

a)Prices Increase b)Wealth Increasec) Interest rates Increase d)Technological Improvemente)Government spending Increase f) Taxes Increaseg)Transfers Increase

Review

 AE component

affected

Shift? Movement

Along?

AE Shift

sEquilibrium

Y AD

Prices Increase

Prices Decrease

NX Increase

NX DecreaseExports IncreaseExports DecreaseImports increaseImports DecreaseWealth IncreaseWealth Decrease

 AE component

affected

Shift? Movement

Along?

AE Shift

sEquilibrium

Y AD

Prices Increase

C drops due to wealth effect: consumers feel poor C shifts downdowndecreases

Movement up along

Prices Decrease

C increases due to wealth effect: consumers feel rich C shifts up up increases

Movement down along

NX Increase NX increase NX shifts up up increases shifts right

NX Decrease NX decreaseNX shifts down downdecreases shifts left

Exports Increase NX increase NX shifts up up increases

shifts right

Exports Decrease NX decrease

NX shifts down downdecreases shifts left

Imports increase NX decrease

NX shifts down downdecreases shifts left

Imports Decrease NX increase NX shifts up up increases

shifts right

Wealth Increase

C increases due to wealth effect C shifts up up increases

shifts right

Wealth Decrease

C drops due to wealth effect C shifts downdowndecreases shifts left

 AE component

affected

Shift? Movement

Along?

AE Shift

sEquilibriu

m Y AD

Interest rates increaseInterest rates DecreaseTechnological Improvement Government Spending IncreaseGovernment Spending DecreaseTaxes IncreaseTaxes DecreaseTransfers IncreaseTransfers Decrease

 AE component

affected

Shift? Movement

Along?

AE Shift

sEquilibriu

m Y AD

Interest rates increase Investment drops I shifts down

down decrease

shifts left

Interest rates Decrease

Investment Increases I shifts up up increase

shifts right

Technological Improvement

Investment increases I shifts up up increase

shifts right

Government Spending Increase G increases G shifts up up increase

shifts right

Government Spending Decrease G drops

G shifts down

down decrease

shifts left

Taxes Increase C drops

C shifts down

down decrease

shifts left

Taxes Decrease C increases C shifts up up increase

shifts right

Transfers Increase C increases C shifts up up increase

shifts right

Transfers Decrease C drops

C shifts down

down decrease

shifts left

60

AE component affectedShift? Movement

Along? AE Shifts

Relative US Prices Increase

Relative US Prices Decrease

Dollar weaker

Dollar Stronger