1. Aggregate Demand Model
AP Macroeconomics
Aggregate Demand Model

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

3. 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)

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

5. 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

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

7. Consumption Expenditure (C)

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

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

10. Government Spending

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

12. 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

13. 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

14. 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

15. 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

16. 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.

17. 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’

18. 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’

19. 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)

20. 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)

23. 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

28. $10-$25 billion

29. $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
$ $5.1 = $29.5 total spending
$4.1 billion $1 billion
$ $4.1 = $33.6 total spending
Assume MPC is 0.8

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

32. 1/(1-.80)
M = 1/(1-MPC)
Spending multiplier

33. 1/.2 = 5
1/(1-.80)
M = 1/(1-MPC)
Spending multiplier

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

36. $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
$ $5.1 = $29.5 total spending
$4.1 billion $1 billion
$ $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

37. How is the tax multiplier different than a spending multiplier?

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