Unit III: Aggregate DemandAggregate Demand The Consumer Confidence IndexThe Consumer Confidence...
-
Upload
mollie-dobbe -
Category
Documents
-
view
214 -
download
1
Transcript of Unit III: Aggregate DemandAggregate Demand The Consumer Confidence IndexThe Consumer Confidence...
Unit III:Unit III:•Aggregate DemandAggregate Demand•The Consumer Confidence IndexThe Consumer Confidence Index•MultiplierMultiplier•Crowding Out EffectCrowding Out Effect
ECONOMICSECONOMICSWhat does it mean to me?
READ
Mankiw, Chapter 33, 34
Krugman 27, 28, 29
Morton Unit 3
GROSS DOMESTIC PRODUCT---GDP
The value of the TOTAL of final goods and services
produced within the boundaries of the US whether by Americans or foreigners.
What is AGGREGATE DEMANDAGGREGATE DEMAND?
…a schedule or curve showing the sum of the demand for all goods and services in the economy……
It can also be seen as the quantity of real GDP demanded at different price levels.
It reflects the summation of desired expenditures by domestic
consumers, businesses, government, and foreign buyers
on newly produced goods and services.
The Aggregate Aggregate Demand CurveDemand Curve is
downsloping, which indicates an inverse
relationship between the price
level and the amount of real
domestic output purchased.
AD0
Real Gross Domestic Product
PRICE
LEVEL
The Aggregate Demand Curve
*Krugman
Shifts of the Aggregate Demand Curve
Changes in
Expectations
Wealth
Stock of physical capital
*Krugman
Shifts of the Aggregate Demand Curve
*Krugman
There are 3 reasons why the aggregate demand curve is negatively sloped:
1) Pigou’s REAL WEALTH EFFECT.
2) Keynes’s INTEREST RATE EFFECT.
3) Mundell-Fleming’s EXCHANGE-RATE EFFECT (also called the OPEN ECONOMY EFFECT or the FOREIGN PURCHASES EFFECT)
A higher price level reduces the real value or purchasing power of the total financial assets of the public.
When the purchasing power of your money is reduced, it is called the REAL REAL WEALTH EFFECTWEALTH EFFECT. It holds true for any asset of fixed dollar amount.
The wealth effect was emphasized by Arthur Pigou (1877-1959) and
is sometimes called the Pigou Effect.
Suppose that you were a retired person living on a pension (fixed-income) during a period of high
inflation. The costs you incur continue to rise in price but your income remains the same.
The reverse would be true if the price level were to fall. A decline in the price level will increase
the real value or purchasing power of a household’s wealth and increase consumption
spending.
In summary:
Price Level => Real Wealth => Purchasing Power => RGDP demanded
Price Level => Real Wealth => Purchasing Power => RGDP demanded
The INTEREST RATE EFFECTINTEREST RATE EFFECT also causes aggregate demand to have a negative slope.
This will increase demand for money.
Consumers will wish to hold more dollars in order to purchase those items they want to buy.
When interest rates increase, most goods and services will have a higher price tag.
As price level increases, so do interest rates.
To put it another way, the aggregate demand curve the aggregate demand curve assumes the money supply is fixed.assumes the money supply is fixed.
A higher interest rate will cause……..
The increase in demand drives up the price paid to use money (interest rate).
A higher price level increases the demand for money.
When the price level increases, people need more money for their purchases.
Other repercussions such as:Other repercussions such as:
Delayed expansion by businesses.
Delayed replacement of worn parts in businesses.
Delayed purchases of boats, cars, or homes by
consumers.
The Interest Rate Effect was emphasized by the only economist to have a branch of economics named after him: John Maynard Keynes (1883-1946). It is sometimes called the Keynes Effect.
If the demand for money increases and the
FEDERAL RESERVE SYSTEM does not alter the
money supply, then interest rates will rise.
At higher interest rates, the opportunity cost of borrowing
rises, and fewer interest-sensitive investments will be
profitable, reducing the quantity of investment goods
demanded.
Price level Money demanded (money supply unchanged) Interest rate Investments RGDP demanded
Price level Money demanded (money supply unchanged) Interest rate Investments RGDP demanded
The net effect of the higher interest rate is fewer investment goods demanded and, as a result, a
lower RGDP demanded.
In summary:
and
The third reason for a negatively sloped aggregate demand curve is the OPEN ECONOMY EFFECTOPEN ECONOMY EFFECT, also called the FOREIGN PURCHASES EFFECTFOREIGN PURCHASES EFFECT
of changes in the price level.
A higher domestic price level causes the price of goods
and services to rise relative to the Global markets.
This lowers the real GDP demanded at the higher price level.
Consumers tend to buy fewer domestic goods and more foreign goods.
In summary:
Price level Demand for domestic goods RGDP demanded
Price level Demand for domestic goods RGDP demanded
and
Price level changes affects the level of aggregate spending, which, in
turn, affects the amount of real GDP demanded in the economy.
Real Domestic Output, GDP
Price
Level
AD2
AD1
AD3
Change in aggregate demandChange in aggregate demand, which is caused by changes in one or more of the determinants of aggregate demand (consumer spending, investment spending, government spending, net export spending).
AD0
Real Gross Domestic Product
PRICE
LEVEL
Change in the quantity of real Change in the quantity of real output demandedoutput demanded, caused by changes in the price level (real real wealth effect, interest rate effect, wealth effect, interest rate effect, foreign market effectforeign market effect).
To be more specific, an increase in the price
level, other things equal, will decrease the
quantity of real GDP demanded.
Real Domestic Output, GDP
Price
Level
By the same token, a decrease in the price level,
other things equal, will increase the quantity of real
GDP demanded.
1
2
3
GDP2 GDP1 GDP3
P1
P3
P2
AD
Real Domestic Output, GDP
Aggregate
GDP2 GDP1 GDP3
Expendi tures 450
2
1
3 (Ca + Ig + Xn + G)1 at P1
Additionally, aggregate expenditures schedule will rise when the price level declines and fall when the
price level increases.
(Ca + Ig + Xn + G)3 at P3
(Ca + Ig + Xn + G)2 at P2
Real Domestic Output, GDP
Price
Level
1
3
GDP2 GDP1 GDP3
P1
P3
P2
AD
Real Domestic Output, GDP
Aggregate
GDP2 GDP1 GDP3
Expendi tures 450
2
2
1
3
P2
P1
P3
Compare the GDP at each level.
With respect the U.S. exports, a $30 pair of U.S.-made blue jeans now
might be brought for 2880 yen compared to 3600 yen. In terms of
U.S. imports, a Japanese watch might now cost $225 rather than $180.
Under these circumstances, U.S. exports will rise and imports will fall. This increase in NET This increase in NET EXPORTS translates into a rightward shift in EXPORTS translates into a rightward shift in
U.S. aggregate demand.U.S. aggregate demand.
A
B
In other words, it indicates the quantities of real gross domestic product
demanded at different price levels.
The aggregate aggregate demand curvedemand curve
reflects the total amounts of goods and
services that all groups together
want to purchase in a given time
period.
AD
PL1
PL0
RGDP1 RGDP0
Real Gross Domestic Product
PRICE
LEVEL
A
B
In other words, when price level decreases ( ), the quantity of RGDP increases ( ); when price level
increases ( ), the quantity of RGDP decreases ( ).
The aggregate demand curve slopes
downward to reflect an inverse relationship
between overall PRICE LEVEL and
the quantity of REAL GROSS
DOMESTIC PRODUCT.
AD
PL1
PL0
RGDP1 RGDP0
Real Gross Domestic Product
PRICE
LEVEL
Notice that as we move from point A to point B, price level increases as RGDP decreases
But what are some of the factors that cause the curve to shift to the
right or left??
AD0
Real Gross Domestic Product
PRICE
LEVEL
AD2
AD1
Shifts of Aggregate Demand: Short-Run Effects
*Krugman
AD0
Real Gross Domestic Product
PRICE
LEVEL
AD1
An increase in any component of
GDP (C, I, G, X - M) can cause the
aggregate demand curve to shift to
the right.
AD0
Real Gross Domestic Product
PRICE
LEVEL
AD2
Conversely, decreases in C, I, G, or (X - M) will
shift the aggregate demand curve to
the left.
Long-Run Macroeconomic Equilibrium
*Krugman
THE THE MULTIPLIER MULTIPLIER
EFFECTEFFECT
The Multiplier EffectThe Multiplier Effect
• Government purchases are said to have a multiplier effect on aggregate demand.– Each dollar spent by the government can
raise the aggregate demand for goods and services by more than a dollar.
The Multiplier EffectThe Multiplier Effect
• The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
Figure 4 The Multiplier Effect
Quantity ofOutput
PriceLevel
0
Aggregate demand, AD1
$20 billion
AD2
AD3
1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .
2. . . . but the multipliereffect can amplify theshift in aggregatedemand.
Copyright © 2004 South-Western*Mankiw
A Formula for the Spending A Formula for the Spending MultiplierMultiplier
• The formula for the multiplier is:
Multiplier = 1/(1 - MPC)
• An important number in this formula is the marginal propensity to consume (MPC).– It is the fraction of extra income that a
household consumes rather than saves.
A Formula for the Spending A Formula for the Spending MultiplierMultiplier
• If the MPC is 3/4, then the multiplier will be:
Multiplier = 1/(1 - 3/4) = 4
• In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.
The Multiplier
THE CROWDING THE CROWDING OUT EFFECTOUT EFFECT
The Crowding-Out EffectThe Crowding-Out Effect
• Fiscal policy may not affect the economy as strongly as predicted by the multiplier.
• An increase in government purchases causes the interest rate to rise.
• A higher interest rate reduces investment spending.
The Crowding-Out EffectThe Crowding-Out Effect
• This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.
• The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.
Figure 5 The Crowding-Out Effect
Quantityof Money
Quantity fixedby the Fed
0
InterestRate
r
Money demand, MD
Moneysupply
(a) The Money Market
3. . . . whichincreasestheequilibriuminterestrate . . .
2. . . . the increase inspending increasesmoney demand . . .
MD2
Quantityof Output
0
PriceLevel
Aggregate demand, AD1
(b) The Shift in Aggregate Demand
4. . . . which in turnpartly offsets theinitial increase inaggregate demand.
AD2
AD3
1. When an increase in government purchases increases aggregatedemand . . .
r2
$20 billion
Copyright © 2004 South-Western
*Mankiw
The Crowding-Out EffectThe Crowding-Out Effect
• When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.
Quantity of Output0 4 7
2….the increase in spending increases money demand….
1…When an increase in government purchases
increases aggregate demand…
Interest Rate
Sm
Quantity of money fixed by the Fed
MD1
MD2
r1
r2
AD1
AD2
3…which increases the equilibrium interest rate…. 4…which in turn partly offsets
the initial increase in demand.
AD3
The increase in the interest rate tends to reduce the quantity of goods and services demanded,
especially in the investment sector.
This CROWDING OUT of investment will offset the
expansion of Aggregate Demand and the AD curve will shift only to
AD3.
Macroeconomic PolicyFiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending. Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending.
*Krugman
Compiled by:Compiled by:Virginia H. Meachum, Economics TeacherVirginia H. Meachum, Economics Teacher
Coral Springs High SchoolCoral Springs High School
Sources:Sources:Principles, Problems, and PoliciesPrinciples, Problems, and Policies, by Campbell McConnell , by Campbell McConnell
& Stanley Brue& Stanley Brue
Economics,Economics, by Krugman, Wells by Krugman, Wells
Principles of EconomicsPrinciples of Economics, by N. Gregory Mankiw, by N. Gregory Mankiw
Notes by Florida Council on Economic Education and FAU Notes by Florida Council on Economic Education and FAU Center for Economic EducationCenter for Economic Education
Notes by Foundation for Teaching EconomicsNotes by Foundation for Teaching Economics