Aggregate Demand Model AP Macroeconomics Aggregate Demand Model

Aggregate Supply & Demand Simple model of the complex economy Provides insights on inflation, unemployment, and economic growth

Aggregate Demand The sum total of all goods and services demanded in the economy (all final markets) Related to the overall average price level Formula: AD = C+I+G+(X-M)

Aggregate Demand Curve (and axes) Average Price Level AD Real GDP

Downward-Sloping AD Curve Different than micro demand curve Substitutes and Income Three reasons why the curve is downward sloping: Real-balance effect (a.k.a. Real Wealth Effect) Interest-Rate effect Foreign Purchases Effect

Shifts in the Aggregate Demand Curve Average Price Level AD2 AD Real GDP

Consumption Expenditure (C)

Consumption Expenditure (C) Tax rates Expectations: incomes, inflation rate Wage increases Household indebtedness Interest rates Wealth (property, shares, savings, bonds) Consumption Expenditure (C)

Investment Expenditure (I) Expected rates of return Interest rates Expectations of future sales Expectations of future inflation rates Confidence Investment Expenditure (I)

Government Spending

National (foreign) income changes Exchange rates Net Exports (Xn)

AD shifts arising from changes in C People decide to save more C falls, AD shifts left Stock market crash Tax cut C rises, AD shifts right

AD shifts arising from changes in I Firms decide to upgrade their computers I rises, AD shifts right Firms become pessimistic about future demand I falls, AD shifts left Central bank uses monetary policy to reduce interest rates Investment tax credit or other tax incentive

AD shifts arising from changes in G Congress increases spending on homeland security G rises, AD shifts right State governments cut spending on road construction G falls, AD shifts left

AD shifts arising from changes in NX A boom overseas increases foreign demand for our exports NX rises, AD shifts right International speculators cause exchange rate to appreciate NX falls, AD shifts left

White board practice A ten-year-old investment tax credit expires. A ten-year-old investment tax credit expires. The U.S. exchange rate falls. A fall in prices increases the real value of consumers’ wealth. The government decreases veterans’ benefits. A rising price level decreases the value of money held for purchases. Consumers expect the job market to be stronger in the next few months. The stock of physical capital has been falling for nearly a year. You might encourage your students to draw a separate diagram of the AD curve for each scenario, and show on the diagram what happens to the curve.

Investment Demand r r’ I I’ A decrease in the real interest rate will result in more gross private investment r When a firm considers investment spending, they are really doing a little benefit-cost analysis on the dollars they are about to spend.   Example: A firm is considering building a new factory. This will increase sales, but it will also require borrowing to fund the investment. Expected return on the investment = expected economic profit from the factory = (total revenue minus total cost)/investment cost. The market interest rate is the cost of investment. 1. Interest rate is cost of borrowed funds. 2. Interest rate is also cost of investing your own funds (no borrowing), since it is income forgone. The factory will only go ahead if the firm expects a rate of return higher than the cost of the funds they would have to borrow to finance that project. If the interest rate rises, fewer projects will pass that test, and as a result investment spending will be lower. Thus there is a negative relationship between the interest rate and dollars of investment spending. r’ I I’

Expected Future Real GDP, Production Capacity, and Investment Spending An increase in either expected future real GDP or production capacity will result in more investment at the same interest rate r There are some factors that would increase investment spending at any interest rate.   Expected Future Real GDP Suppose a firm believed that the economy was really going to take off next year. This firm might increase investment spending in anticipation of increased sales. After all, you can’t build a factory overnight; the firm must begin the factory now to take advantage of more customers in the coming year. Production Capacity Suppose a firm can produce 100,000 units if the factory is producing 24/7. The firm’s full capacity is 100,000 units. Right now, the firm has enough customers to produce only 50%, or 50,000 units, of full capacity. A firm in this situation would not likely be looking to increase investment. After all, if orders from customers were to increase, it would be easy to satisfy those orders without increasing the size of the factory. The best conditions for new investment spending consists of firms that are near production capacity with expectations of strong real GDP in the future. I I’

Average propensity to consume (APC) Consumption is largest part of rGDP. It depe3nds largely (and positively) on income…. Disposable income. If I give you a $10 at the end of class, what will you do? (Make sure SAVINGS comes up as an option.) C/DI Average propensity to consume (APC)

Average propensity to consume (APC) APC + APS = 1 C + S = DI S/DI Average propensity to save (APS) Remember: businesses invest. Consumers don’t. Households buying stocks is a way of SAVING. C/DI Average propensity to consume (APC)

Marginal Propensity to Consume MPS = S/ DI MPC = C/ DI Because DI = S + C, MPC + MPS = 1. What we care about is MARGINAL, not TOTAL! If you spend half of the $10, MPC is 0.5 The additional spending that results when a consumer receives additional disposable income. Marginal Propensity to Consume

$10-$25 billion

$10 billion Assume MPC is 0.8 $8 billion $2 billion $10 + $8 = $18 total spending $6.4 billion $1.6 billion $18 + $6.4 = $24.4 total spending $5.1 billion $1.3 billion $24.4 + $5.1 = $29.5 total spending $4.1 billion $1 billion $29.5 + $4.1 = $33.6 total spending Assume MPC is 0.8

M = 1/(1-MPC) Spending multiplier

1/(1-.80) M = 1/(1-MPC) Spending multiplier

1/.2 = 5 1/(1-.80) M = 1/(1-MPC) Spending multiplier

Spending multiplier 1/.2 = 5 Remember: MPC + MPS = 1 1/(1-.80) Therefore, M = 1/MPS M = 1/(1-MPC) Spending multiplier

$10 billion Assume MPC is 0.8 Multiplier = 5 $8 billion $2 billion $10 + $8 = $18 total spending $6.4 billion $1.6 billion $18 + $6.4 = $24.4 total spending $5.1 billion $1.3 billion $24.4 + $5.1 = $29.5 total spending $4.1 billion $1 billion $29.5 + $4.1 = $33.6 total spending Assume MPC is 0.8 Multiplier = 5 5 x $10 billion = $50 billion = total effect on the economy’s GDP

How is the tax multiplier different than a spending multiplier?

Tax multiplier -MPC/(1-MPC) = -MPC/MPS How is the tax multiplier different than a spending multiplier? Tax multiplier