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Unit III National Income and Price Determination.

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1 Unit III National Income and Price Determination

2 AD/AS model AD/AS curves look and operate much like S and D curves in micro Depict different concepts Change for different reasons Used to illustrate changes in real output and price levels of an economy

3 Aggregate Demand AD represents the sum of consumption, C Investment, I Government Expenditures, G And net exports, Xn The quantity of real GDP demanded is the total of all final goods and services that households, businesses, governments, and foreigners plan to buy

4 AD Be sure to always label correctly. – Price level – RGDP – The relationship is negative – As P L rises, the level of output demanded decreases. PLPL RGDP AD Visual 3.1

5 AD How is this similar to a Market Demand curve? Why does a Market Demand curve have a negative slope? The AD curves slopes downward for different reasons.

6 AD The downward slope of the AD curve is explained by 3 macroeconomic effects: 1.Interest rate effect 2.The wealth effect 3.Net export effect

7 The Interest Rate effect Interest rate is the price of borrowing to purchase capital or durable goods ( houses, cars) As the price level (including interest rates) increases, businesses buy less capital, consumers buy fewer durable goods As PL (interest rates) decreases, purchases of capital and durable goods increase-----giving AD negative slope What is an example of interest sensitive spending?

8 The Wealth Effect Also called: the real balance effect As PL increases, it takes more dollars to purchase goods: increase in PL decreases purchasing power of cash balances. Faced with decreasing purchasing power (real wealth) people decrease consumption. Decrease in PL causes an increase in purchasing power so people increase consumption giving the AD curve neg. slope.

9 Net Export Effect As domestic price level increases ( relative to foreign price level), domestic products are more expensive for foreign buyers Foreign goods are less expensive for domestic consumers to buy Increase in price level decreases exports and increases imports which decreases net exports (X-M) Decrease in price level will increase X (domestic goods become relatively less expensive) and decrease M (as foreign goods become relatively more expensive) so that Xn increases-giving AD neg. slope.

10 Shifts in AD Shifts to the right : increases in real GDP Shifts to the left: decreases in real GDP AD=C + I + G + Xn What sort of things will affect the AD curve? Visual 3.2

11 Shifts in AD Determinants of AD, “shifters” – Consumer spending – Investment spending – Government spending – Net export spending – Money supply

12 How will each of the following affect the AD curve? – Changes in government spending – Changes in income taxes – Changes in consumer expectations of future income – Changes in foreign income – Changes in business’ expectations of future sales Which of the 4 sectors of AD will be affected by each change?

13 Importance of Investment in determining AD Investment: spending on things that are used to produce other things (plant, equipment, machinery, buildings) that a firm uses to produce output. Investment is not the purchase of stocks and bonds or any other financial instrument

14 Determinants of Investment Output Interest rate – Demand for a business’ products determines investment; real GDP is a measure of the level of demand in the economy

15 Determinants of Investment The benefit of investing depends on the demand for the business’ product The cost of investing depends on the interest rate. – The firm needs to either borrow money to invest (and pay the interest rate on the loan) – OR it can invest its own money in which case the interest rate is the opportunity cost of the investment because the business has forgone earning interest.

16 “To Invest, or not to invest?” That is the question! To decide whether to invest: businesses compare the interest rate to the expected profit rate of investment. If expected profit is > interest rate, firms will invest As interest rate decreases, there are more investment opportunities for which expected profit is > interest rate, firms will invest more.

17 Challenge Draw an investment demand curve showing investment as an inverse function of the interest rate. Put Interest rate on the y axis and investment on the x axis. Visual 3-3

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