1. Chapter 9, 10, 11, 17 Aggregate Demand and Aggregate Supply

2. Chap 9,10,11 Vocabulary Investment demand curve Investment demand curve MPC MPC MPS MPS Multiplier Multiplier Recessionary gap Recessionary gap Inflationary gap Inflationary gap Aggregate demand Aggregate demand Aggregate supply Aggregate supply Determinants of AD Determinants of AD Determinants of AS Determinants of AS Productivity Productivity Equilibrium price level Equilibrium price level Real-balances effect Real-balances effect Interest rate effect Interest rate effect Foreign purchases effect Foreign purchases effect

3. Aggregate Expenditures (or Aggregate Demand) Ch 9 Pg 160-165) The Aggregate Expenditures (AE) approach was developed by John Maynard Keynes. Aggregate demand is directly related to AE. The AE approach looks at total spending in the economy: C= Personal consumption (70%) I = Investment Spending (15%) G = Government Spending (15%) X n = Exports less Imports (?)

4. Keynes and the Long Run Keynes and the Long Run The British economist Sir John Maynard Keynes (1883–1946), probably more than any other single economist, created the modern field of macroeconomics. The British economist Sir John Maynard Keynes (1883–1946), probably more than any other single economist, created the modern field of macroeconomics. Published: The General Theory of Employment, Interest and Money Published: The General Theory of Employment, Interest and Money In it he decried the tendency of many of his colleagues to focus on how things work out in the long run: In it he decried the tendency of many of his colleagues to focus on how things work out in the long run: “This long run (a Classical Economic concept) is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the sea is flat again.”

5. Personal Consumption Personal Consumption is the largest component of the AE (or AD) approach Consumption is most dependent upon the level of Disposable (spendable) Income (DI) According to Keynes, we either spend or consume our incomes.

6. Autonomous Spending Average Propensity to Consume (APC) Average Propensity to Consume (APC) Spending that occurs at a specific level of income (and in a specific country). Based upon historical patterns, the APC can be anticipated for income levels.Spending that occurs at a specific level of income (and in a specific country). Based upon historical patterns, the APC can be anticipated for income levels. In determining the APC/APC, economists assume that we either Spend or Save our incomes, what is not spent is saved.In determining the APC/APC, economists assume that we either Spend or Save our incomes, what is not spent is saved. And a very important concept is that “consumption is dependant upon disposable income”!!!!And a very important concept is that “consumption is dependant upon disposable income”!!!!

7. $50,000 $100,000 $150,000 Current disposable income $100,000 80,000 60,000 40,000 20,000 0 Consumer spending 2006 Disposable Income and Consumer Spending Disposable income was $43,799 and Spending (APC) was $43,131.

8. APC/APS Continued The formula for the APC is: APC = consumption/income The formula for the APS is: APS = savings/income Since we either save or spend our income, the APC + the APS = 1 A very important concept is that savings is related to investment spending. Remember in the circular flow model, savings is a leakage, and investment is an injection. Savings creates investment spending. We will not need to know these formulas, but we do need to understand the concept of “autonomous” spending.

9. Marginal Propensity to Consume/Save (MPC and MPS) The Marginal Propensity to Consume is the fraction of any change in disposable income that is consumed. The Marginal Propensity to Consume is the fraction of any change in disposable income that is consumed. MPC= Change in Consumption MPC= Change in Consumption Change in Disposable Income Change in Disposable Income The Marginal Propensity to Save is the fraction of any change in disposable income that is saved. The Marginal Propensity to Save is the fraction of any change in disposable income that is saved. MPS= Change in Savings MPS= Change in Savings Change in Disposable Income Change in Disposable Income

10. Marginal Propensities MPC + MPS = 1 MPC + MPS = 1 MPC = 1 – MPS MPC = 1 – MPS MPS = 1 – MPC MPS = 1 – MPC Remember, people do two things with their disposable income (or a change to that income), consume it or save it! So MPC + MPS must equal 1. Remember, people do two things with their disposable income (or a change to that income), consume it or save it! So MPC + MPS must equal 1. “Autonomous spending” is that spending that occurs independent of the change in income. The MPC and MPS only examines how the “change” in income is consumed or saved. “Autonomous spending” is that spending that occurs independent of the change in income. The MPC and MPS only examines how the “change” in income is consumed or saved.

11. The Multiplier (pg 182-186) MPC/MPS (pg 163-164) The Multiplier assumes that an initial change in spending causes a larger change in the GDP as the initial spending creates a chain of spending as it works through the economy. The Multiplier assumes that an initial change in spending causes a larger change in the GDP as the initial spending creates a chain of spending as it works through the economy. The Multiplier is based upon the Marginal Propensity to Consume (MPC). The MPC assumes that if a change in income occurs, we will consume (MPC) a portion of the change, and we will save (MPS) part of the change. MPC and MPS are inversely related. The Multiplier is based upon the Marginal Propensity to Consume (MPC). The MPC assumes that if a change in income occurs, we will consume (MPC) a portion of the change, and we will save (MPS) part of the change. MPC and MPS are inversely related.

12. The Multiplier Round 1 A change in income of $1,000 creates ………. Income + $1,000 Consumption $500 Savings $500 Round 2 $500 $250 Round 3 $250 $125

13. Change in GDP = Multiplier x initial change in spending THE MULTIPLIER EFFECT For example, the tax rebate of 2008 totaled $80 billion and the MPC was.2 (Multiplier = 1/1-.2 or 1.25), multiplier was 1.25. So we consumed $16 billion (20%). $16 billion X 1.25 equals a $20 billion increase in the GDP. Originally, the government projected an MPC of.5 which would have resulted in $80 Billion increase in the GDP Multiplier = 1/MPS (or 1/ 1-MPC) We use the following formula to find the multiplier

14. The Current Economy The Marginal Propensities help explain the political argument over tax cuts versus increased government spending. During a recession (when tax cuts seem like a good idea) people tend to spend less and save more. Consequently tax cuts may have less effect on the GDP. We will continue looking at this topic in chapter 12. The Marginal Propensities help explain the political argument over tax cuts versus increased government spending. During a recession (when tax cuts seem like a good idea) people tend to spend less and save more. Consequently tax cuts may have less effect on the GDP. We will continue looking at this topic in chapter 12.

15. THE MULTIPLIER EFFECT.9.8.75.67.5 10 5 4 3 2 MPCMultiplier MPC and the Multiplier

16. Chapter 11 Understanding Aggregate Demand Aggregate demand is the total demand for goods and services in an entire economy. Aggregate demand is the total demand for goods and services in an entire economy. The aggregate demand curve plots the total demand for GDP as a function of the price level. The aggregate demand curve plots the total demand for GDP as a function of the price level. The aggregate demand curve slopes downward. The aggregate demand curve slopes downward.

17. Why the Aggregate Demand Curve Slopes Downward The increase in spending that occurs because the real value of money increases when the price level falls is called the Real Balances. The increase in spending that occurs because the real value of money increases when the price level falls is called the Real Balances. The interest rate effect: With a given money supply in the economy, a lower price level will lead to lower interest rates and higher consumption and investment spending. The interest rate effect: With a given money supply in the economy, a lower price level will lead to lower interest rates and higher consumption and investment spending. The impact of foreign trade: A lower price level makes domestic goods cheaper relative to foreign goods. The impact of foreign trade: A lower price level makes domestic goods cheaper relative to foreign goods.

18. Why the Aggregate Demand Curve is Downward-Sloping?

21. Factors That Change Aggregate Demand

22. Factors That Change Aggregate Demand (Continued) and indebtedness 4. Degree of excess capacity 5. Technology

23. The Components of Aggregate Demand Aggregate Demand (also referred to as “Mainstream Economics”) is Keynesian Economic Theory. In our study of GDP accounting, we divided GDP into four components: Consumption spending (C), investment spending (I g ), government purchases (G), and net exports (X n ). These four components (using I n, net These four components (using I n, net investment) instead of I g because Gross investment) instead of I g because Gross Investment includes depreciation and inventory ) are Investment includes depreciation and inventory ) are also four parts of aggregate demand because also four parts of aggregate demand because the aggregate demand curve really just represents the aggregate demand curve really just represents total spending.

24. What is Investment Spending ? Money spent or expenditures on: Money spent or expenditures on: New plants (factories)New plants (factories) Capital equipment (machinery)Capital equipment (machinery) Technology (hardware & software)Technology (hardware & software) New Homes (40+% of the total investment spending) (an explanation of why the current financial crisis is being compounded by Housing)New Homes (40+% of the total investment spending) (an explanation of why the current financial crisis is being compounded by Housing)

25. Expected Rates of Return How does business make investment decisions? How does business make investment decisions? Cost / Benefit AnalysisCost / Benefit Analysis How does business determine the benefits? How does business determine the benefits? Expected rate of return (Marginal Benefit > Marginal Cost)Expected rate of return (Marginal Benefit > Marginal Cost) How does business count the cost? How does business count the cost? Interest costsInterest costs How does business determine the amount of investment they undertake? How does business determine the amount of investment they undertake? Compare expected rate of return to interest costCompare expected rate of return to interest cost If expected return > interest cost, then invest If expected return > interest cost, then invest If expected return < interest cost, then do not invest If expected return < interest cost, then do not invest

26. Real v. Nominal Interest Rate What’s the difference? What’s the difference? Nominal is the observable rate of interest. Real subtracts out the rate of inflation and is only known after the fact. Businesses and banks attempt to anticipate upcoming inflation rates. Remember if inflation is 5% per year and the bank makes no allowance for the 5%, they are being paid back with dollars that are worth 5% less. How do you compute the real interest rate? Nominal Interest Rate minus Rate of Inflation = Real Interest Rate What then, determines the cost of an investment decision? The Real Interest Rate

27. The Investment Demand Curve INTERESTRATEINTERESTRATE IGIG ID Changes in rate cause changes in I n. Factors other than interest rates may shift the entire ID curve 5% 3% $2 trillion $3 trillion  

28. Shifts in Investment Demand r% IGIG ID 4% $2.5 trillion $3.25 trillion ID 1  When investment demand shifts, different levels of gross private investment occur even while interest rate remains constant INTERESTRATEINTERESTRATE QUANTITY OF $ INVESTED

29. What Causes Shifts in Investment Demand Interest RatesInterest Rates Expected Rate of ReturnExpected Rate of Return Cost of Production Cost of Production Business Taxes Business Taxes Technological Change Technological Change Stock of Capital Stock of Capital Expectations Expectations Degree of Excess Capacity. Degree of Excess Capacity.

30. Understanding Aggregate Supply The aggregate supply curve depicts the relationship between the level of prices and the total quantity of final goods and services that firms are willing and able to supply. The aggregate supply curve depicts the relationship between the level of prices and the total quantity of final goods and services that firms are willing and able to supply. To determine both the price level and real GDP, we need to combine both aggregate demand and aggregate supply.

31. CHANGES IN SHORT RUN AGGREGATE SUPPLY (SRAS) Price level Real domestic output, GDP Q P SRAS 3 SRAS 1 SRAS 2 Increase In Aggregate Supply Decrease In Aggregate Supply

32. DETERMINANTS OF AGGREGATE SUPPLY (What shifts AS) 1. Change in Input Prices Domestic Resource Availability Land Labor Capital Entrepreneurial Ability Per unit production costs increase Per unit cost = total input cost total output Prices of Imported Goods, for example Negative supply shocks (like oil price increases in the 70s)

33. DETERMINANTS OF AGGREGATE SUPPLY (contd) 2. Change in Productivity Productivity = Real Output Input 3. Change in Legal-Institutional Environment Business Taxes and Subsidies Government Regulation

34. Negative Supply Shocks (decreases AS)

35. Original Keynesian AD/AS Model P1P1 Q1Q1 Price Level Real Domestic Output/GDP AS AD 1 AD 2 Q2Q2

36. (New)Keynesian (AS/AD) P1P1 Q Price Level Real Domestic Output/GDP AS AD LRAS/Full Employment The new Keynesian graph reflects an “intermediate” range to reflect increasing price levels while GDP increases.

37. Price Level Real Domestic Output, GDP Q P SRAS AD 1 Equilibrium in the Intermediate Range QeQe Q1Q1 EQUILIBRIUM: REAL OUTPUT AND THE PRICE LEVEL P1P1 PePe Economy tends to return to equilibrium (or Full Employment) as AD increases LRAS AD

38. How to Increase AD!

39. Price Level Real Domestic Output, GDP Q P SRAS AD Point P e, Q e, represents a fully employed economy; i.e. about a 5% rate of Unemployment; 3.5% Real GDP growth; and an Inflation rate of 2-3%. QeQe Where is the best place for the U.S. economy PePe LRAS

40. Growth Illustrated on PPC Also Increased LRAS on AD/AS Graph PPC Capital Goods Consumer Goods.. PPC 1 

41. Growth Illustrated on PPC Also Increased LRAS on AD/AS Graph PPC Capital Goods Consumer Goods.. PPC 1 

42. Classical Economic Theory We will review several economic theories in detail in Chapter 16. We will review several economic theories in detail in Chapter 16. The next few slides introduce the Classical approach to economics and the graphs that explain this theory. The next few slides introduce the Classical approach to economics and the graphs that explain this theory. One of the major tenets of this approach is that the government should NOT intervene in the economy. The economy is self regulating and will correct itself. One of the major tenets of this approach is that the government should NOT intervene in the economy. The economy is self regulating and will correct itself.

43. Full Employment THE LONG RUN AGGREGATE SUPPLY (LRAS) REPRESENTS FULL EMPLOYMENT. THE LONG RUN AGGREGATE SUPPLY (LRAS) REPRESENTS FULL EMPLOYMENT. GDP R PL AD SRASLRAS YFYF P THE MOST IMPORTANT GRAPH IN MACROECONOMICS (at least for the AP test.) Y F refers to Full Employment

44. Recessionary Gap A recessionary gap exists when equilibrium occurs below full employment output. A recessionary gap exists when equilibrium occurs below full employment output. GDP R PL AD SRAS LRAS YFYF P Y

45. Inflationary Gap An inflationary gap exists when equilibrium occurs at a point above full employment. An inflationary gap exists when equilibrium occurs at a point above full employment. GDP R PL AD SRASLRAS YFYF P Y

46. Increase in AD Price level increases, GDP increases and unemployment decreases GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1   

47. Decrease in AD GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1    The decrease in AD causes the price level to decrease, The GDP to decrease and unemployment to increase.

48. Increase in SRAS Price level decreases, GDP increases and unemployment decreases GDP R PL AD SRAS LRAS YFYF P Y SRAS 1 P1P1   

49. Decrease in SRAS Increase in input costs causes SRAS to decrease. GDP decreases, unemployment increases and Price increases GDP R PL AD SRAS LRAS YFYF P Y1Y1 SRAS 1 P1P1   

50. ECONOMIC GROWTH GDP R PL AD SRAS LRAS YFYF P Y SRAS 1    AD 1 LRAS 1 Economic growth occurs as an economy is able to produce more goods and increase the Real GDP. In the graph above, growth occurs as both AD and SRAS increase simultaneously and this enables price level to remain stable.

51. Growth Illustrated on PPC Also Increased LRAS on AD/AS Graph PPC Capital Goods Consumer Goods.. PPC 1 